What extent do historical returns act as a predictor?

The Productivity Commission’s (PC’s) issue paper for the enquiry into the competitiveness and efficacy of superannuation has not addressed what extent the industry’s historical returns acts as a predictor of whether the sector is efficient today or will be in the future, according to Rice Warner.

Rice Warner said while the paper addressed several technical questions related to the measurement and benchmarking of historical returns this issue of higher order had been left unaddressed.

In an analysis, the research house said they believed a forward-looking approach was sensible as part of the PC’s assessment process.

Rice Warner said the strong arguments for this approach were:

• Many investment experts have been forecasting lower expected future returns because of the current era of low interest rates and the likelihood that these returns will continue for some time;
• The introduction of MySuper saw the creation of many new investment options and strategies, particularly lifecycle options. For these, benchmarking on previous performance is inappropriate in this context; and
• The population is ageing and as demographics shift we are likely to see changes in asset allocations and investment strategies.

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“Thus, it is important to ensure that Trustees have set their investment strategies in a way to continue to earn real returns above inflation into the future,” Rice Warner said.

“Past performance does provide us with useful information.  Those funds which have performed relatively badly will have failed in some areas, whether asset allocation, governance or high costs.  The first step in any analysis is to test whether the reasons for failure have been overcome.”

The research house said it used a stochastic investment model to project asset returns into the future, based on the medium-to-long-term expectations from their annual investment survey of asset consultants and other investment professionals in Australia.

“This forward-looking process measures the expected balance at retirement, longevity of retirement income and expected volatility of outcomes based on a given asset allocation,” it said

“The model is not perfect.  Unless we put in value for ‘alpha’, it will always show passive investments as equal to active ones for the same asset allocation.  However, it is a good tool for assessing the likelihood of achieving fund targets over the next decade or so.  Most funds will use similar tools from their asset consultants.”

The analysis said it hoped their expected outcomes gave a probability of at least 67 per cent of achieving investment targets.

“Any less than this and members would consider the risk of under-achieving the target is too high,” it said.