The real danger of offering choice in superannuation

Chasing returns from fund to fund can be a dangerous activity, says Vincent O'Brien*

A great deal has been written about the dangers associated with offering superannuation choice of fund. The main focus has been on the high profile allegations of swindles that occurred when choice was introduced in the UK in the early 90s and many life insurance agents twisted members out of corporate funds into high-cost personal plans. Salomon Smith Barney Asset Management's view is that this is unlikely to be a major issue in Australia, as we already have a stringent compliance regime that covers all such selling practices. However, we believe that investment choice in superannuation presents some real dangers. A major concern is that members will chase the highest returns each year and this has the potential to have a dramatic negative impact on their final account balance. Our view is based on an analysis of the investment performance of the past 16 years of the funds appearing in the Mercer pooled fund survey. The analysis was completed as at 30 June each year. The calculation assumed an initial investment of $100,000 at 30 June 1983 and then compared a number of alternate strategies.

The first strategy was to invest the $100,000 with the fund that had achieved the highest performance over the previous 12 months and keep switching it each year to the fund that had achieved the highest performance over the previous 12 months. The second strategy was to put the $100,000 with the fund that had achieved the lowest performance over the previous 12 months, and switch it each year to the fund that had achieved the lowest performance over the previous 12 months. The third strategy was to put the investment in the Salomon Smith Barney Balanced portfolio and just leave it there. The calculations assumed that there were no costs involved in switching the investment each year.

The result of these strategies as at 30 June 1999 was that the $100,000 had grown to:

Strategy 1: $584,437 (follow the highest performers)

Strategy 2: $636,653 (follow the lowest performers)

Strategy 3: $722,852 (buy and hold the Salomon Smith Barney Balanced Trust)

A number of lessons flow from this simple analysis:

1. Chasing returns can be a dangerous activity. Performance over one year is not considered to be a very useful tool for predicting performance for the next year.

2. If a member does want to chase returns, they may be better off investing in the previous years worst performer, however, this approach is unlikely to ever become popular because it is against our natural instincts.

3. By selecting a sound balanced portfolio and sticking with it, members may well be better off. The analysis understates the value of the approach, because it has ignored the impact that switching costs would have on strategies 1 and 2.

4. Members need to be appropriately educated in order to make informed decisions and take long term views of investment performance.

If members aren't given appropriate education and information regarding choice, they may just chase returns and, judging from the above analysis, they could suffer quite dramatically. In selecting a default superannuation fund for their employees, executives should ensure that their members will receive appropriate and timely investment education. The hard part about that is that while it is easy to compare fees and insurance premiums, it can be very difficult to compare the relative merits of different education services. We suggest that the best way to compare education services is to seek references and ask the employers to advise how valuable the education programs have been.

* Vincent O'Brien is director of Salomon Smith Barney's Corporate Superannuation Master Trust. For further details contact Vincent O'Brien on (03) 9623 8739, e-mail vincent.j.obrien@ssmb.com.au or John Farrington on (03) 9623 8478, email john.m.farrington@ssmb.com.au

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