Future Focus: How to pick a super investment option
How do you pick an investment option to achieve your retirement goals?
Asset allocation is the key driver of investment returns. The investment option that you pick in your superannuation is going to be one of the largest determinants of how comfortable your retirement is.
It is also one of the smallest lifts.
Investors have several levers to improve their investing outcomes. You can contribute more – but you have a finite amount of funds, and there are contribution limits. You can reduce costs to maximise returns. There’s a limit to how much you can minimise costs. You can extend your working years and delay retirement. This can be a painful decision to make, and sometimes not feasible. Changing and monitoring your asset allocation requires a small time commitment. It can have a large impact over time to your outcomes with no pain.
This piece will run through a framework to choose an investment option in your superfund, connected to your retirement goals.
Common methods and why they’re not fit for purpose
First, it’s worth exploring the common methods for how superannuation investment options are usually chosen as the ‘alternatives’.
Staying in the default fund
Disengaged Aussies tend to keep their superannuation in the ‘default’ fund. Usually, this is the equivalent of a Balanced fund – it could have between 50-80% allocated to aggressive assets depending on the superfund. This fund has been chosen with no context of your age, yearly contributions, aspirations for retirement or personal circumstances. The fund will still grow over your working life, but may not be optimised to what you want to achieve.
AustralianSuper is Australia’s largest superfund. 90% of their members are in their default option – Balanced. This could be a 20-year-old that’s 40 years away from retirement, or a 50-year-old that’s 10 years away from retirement.
Choosing based on name
Pre-mixed investment options through superfunds
Available through industry and retail superfunds, this is the basic option that offers a pre-mixed asset allocation. Think your ‘Balanced’, ‘Aggressive’, or ‘Conservative’ type funds. MySuper options are also pre-mixed asset allocations. These funds are classified as ‘multi-asset funds’, and will typically contain asset classes such as Australian and International Equities, Fixed Income, Listed and Unlisted Property, Alternatives and Cash.
You may identify as a ‘Balanced’ or ‘Aggressive’ investor, but it is important to look under the hood.
Each fund will have a mandated range dictating how much of your portfolio will be allocated to each asset class. For example, AustralianSuper’s Balanced option can hold a range of Aussie shares between 10 and 45% - it currently holds 24.8%. A balanced fund with Rest Super can hold between 11-21% Australian shares – it targets 16%. Then – you look at QSuper’s Balanced option – they’ve got 25.5% in Aussie equities.
Professional investors will manage the allocation decisions and the underlying investments in each asset class.
The choice of pre-mixed option is based on the return that you’re looking to achieve for your retirement and the level of diversification that’s appropriate for your circumstances. As you can see, the mix in the portfolios can vary greatly between superannuation funds so it is important to pay attention to the specifics of each fund.
Choosing based on risk tolerance
A risk tolerance questionnaire is common practice in financial advice firms, in robo-advice and even self-help tools for new investors. These risk tolerance questionnaires do what they say on the box. It is a short questionnaire – usually between 8-10 questions, that measure how much risk you can tolerate, or the degree of volatility you can withstand when it comes to investing.
Based on your answers, you’ll be assigned an asset allocation. Risk tolerance is only one part of the picture. It does not take into account what you actually need to acheive your goals, and only considers your potential reaction if markets fall, and surface level circumstances. Ultimately, if you are only taking risk tolerance into account, whether you reach your goals or not is entirely left up to chance.
You can read more about the difference between risk tolerance and risk capacity here.
What we’re omitting in this process that should be considered
There are many external factors involved inthe decision of picking an investment option. This includes the superfund that you are choosing, the fees that you are being charged and your family/relationship circumstances. Your asset allocation may change based on your retirement plans with your spouse, and when you are accessing the funds.
How to work out what return you need
Your asset allocation decision should be based on the required rate of return you need to achieve your retirement goals. Naturally, the first step is understanding what your retirement goal.
ASFA believes that a comfortable retirement can be achieved with $630,000 for a single person that owns a home. A common rule of thumb is having a lump sum that offers you 70% of your pre-retirement income a year. Although there’s industry guidance on what you need for a comfortable retirement, this number will be individual to you.
You can find a detailed framework to find your retirement number here.
I am 33 years old and currently have $200,000 in my superannuation. Assume I contribute $25,000 a year (post-tax) over my working life, have a 2.8% inflation rate and retire at 65. I want $80,000 annually (in today’s dollars) in retirement.
To achieve this, I need a 7.5% p.a return over the next 32 years. This is the return I need to bridge the capital I have contributed, to my portfolio goal amount of $5,000,000 ($2,092,000 in today’s dollars).
To work out your required rate of return, you can use a financial calculator. The process is outlined in this guide.
How to get from required rate of return to investment option
To get from a required rate of return to formulating the asset allocation you need, means understanding the returns that each asset class is likely to give. The future is unpredictable, so we need to lean on historical and projected returns to make an informed decision.
Historical returns have happened – they are what asset classes have offered in the past. Projected returns take into consideration the current market and economic conditions to forecast likely future outcomes. Projected returns are sometimes also called capital market assumptions, and are offered from large fund managers such as BlackRock, Vanguard and Morningstar (below).
Source: Morningstar Investment Management, projected return by asset class.
Theoretically, I could put all my funds in Australian shares and call it a day. However, I want to make sure that I diversify between asset classes, providing me with exposure not just to additional asset classes, but potentially to regions, sectors and economic drivers.
There is a balance, however. Diversification has generally been portrayed as a pie chart of assets. Adding additional asset classes is supposed to provide diversification. It’s worth taking a step back and looking at what drives the performance of these assets. Two assets can belong to different categories but respond to the same market forces.
The pre-mixed options already have a diversified range of assets. You want to match the asset proportions to the projected returns that the asset class has.
I know that a large proportion of my fund will have to be in aggressive assets, such as Australian and international shares. If I had a lower required rate of return, I could consider an Aggressive asset mix to comfortably service my requirements.
An example is AustralianSuper’s High Growth. With around 6% of the fund in assets projected to offer me less than projected inflation, I need to look elsewhere. I am able to take on this level of volatility and risk because of my long time horizon before retirement. This must be a key consideration when balancing your asset allocation in your superfund.
Many industry superfunds don’t offer me a pre-mix that has the exposure I am looking for. I have over 30 years until retirement – I do not need an allocation to cash which is included in all the pre-mixed options from my superfund. What options do I have if the pre-mixed options don’t work?
Asset class level options through industry and retail superfunds
Also available through industry and retail superfunds, these options allow you to choose your exposure to certain asset classes. The fees tend to be lower than the pre-mixed options, and you’re able to make your asset allocation more aggressive – or more conservative – than the pre-mixed options.
This option allows you to invest 100% in Australian equities if you choose. You could put 50% in international equities and 50% in cash. It provides the flexibility to choose your exact allocation to each asset class you want exposure to in your portfolio.
Direct Investment options through industry and retail superfunds
This option is for investors that do not want the complexity of SMSF administration, and are happy with a limited number of direct securities that they can invest in. Most industry and retail funds that offer this option allow investors to choose between ASX 300 shares, ETFs and LICs. For example, instead of choosing a 40% allocation to Australian equities, I can choose a 3% allocation to CBA, a 4% allocation to BHP, a 30% allocation to the NASDAQ 100 ETF NDQ, and so on.
Self-Managed Superfunds (SMSFs)
SMSFs allow complete control and transparency for investors, but come with regulatory and compliance burdens. Given their flat service and administration fees a SMSF only suits balances of a certain size.
More Self-Managed Super Funds are opening, as investors look to access the benefits and flexibility of the vehicle. It offers unique options for investors – examples include the ability to invest in direct property or the ability to have multiple members in the Fund (particularly appealing to reduce the flat service fee cost across multiple individuals).
Final thoughts
Going through this exercise will undoubtedly align your super closer to your retirement goals. Any adjustments made will ensure that you are taking the right amount of risk – be it a higher or lower amount.
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