Superannuation Guarantee contributions and age cohorts estimating the risk in retirement benefits for Australia employees

Transcription

1 Page 1 of 18 ANZAM 2011 Superannuation Guarantee contributions and age cohorts estimating the risk in retirement benefits for Australia employees Michael B Cohen Deakin Graduate School of Business, Deakin University Michael.Cohen@deakin.edu.au

2 ANZAM 2011 Page 2 of 18 Superannuation Guarantee contributions and age cohorts estimating the risk in retirement benefits for Australia employees * ABSTRACT This paper investigates the risk inherent in the Superannuation Guarantee system that arises because of the effect of the economic cycle on the growth of the investments over time. This aspect of risk has been largely neglected in the literature and proves to be of substantial magnitude. The phase of the economic cycle affects the return on assets already in the portfolio as well as the probability of periods of unemployment during a working career. A Monte Carlo approach is used to synthesise the variance of returns that can be expected under historic stock market returns for the Australian economy. The results indicate that there is an important role for Human Resource Management to provide financial advice to employees well before retirement age is reached. Keywords: retirement, remuneration systems, risk, forecasting Adequate provision for the years of retirement has both private and social benefits. In some countries the task of funding retirement is undertaken via a centralised funding scheme whereby individuals contribute towards a fund that then pays out a pension based on a set of rules. The funds are comingled (or pooled), and the ability of the scheme to meet the commitments to pensioners is the responsibility of the State. In Australia retirement funding is managed via a scheme of individual accounts, whereby the retirement funds of each individual are maintained in a separate account. There is no comingling of funds, and individuals have considerable choice in how their retirement assets are deployed. Each individual is thus considered to be responsible for providing adequate funds for their own retirement. The State encourages such savings with an array of tax relief and other measures to encourage retirement savings. There is also a safety net in the form of the State Pension for those individuals who have been unable to accumulate sufficient funds during their working years. * The author wishes to acknowledge the helpful the comments provided by an anonymous referee. All errors and shortcomings remain the responsibility of the author.

3 Page 3 of 18 ANZAM 2011 In a system were the amount of retirement income is based on the accumulated balance in that individuals retirement account there is significant scope for financial planning. The ability to predict the final balance in the superannuation account well before the date of retirement can therefore be of great importance, both to the individual as well as the employer. The accumulated balance is affected by both the amount that is contributed to the fund as well as on the rate of return earned by the assets in the fund. It is common practice to use the average rate of return over a period of time to forecast the expected balance in the fund at the date of retirement; however, as this study suggests, this might be a less than optimal approach. While risk is always an economic bad (i.e. the opposite of an economic good in that it decreases economic welfare) it cannot always be eliminated. While there will always be a component of risk in any investment activity, the risk needs to be managed in such a way as to ensure that the maximum reward is obtained for the risk that is inherent in the pool of assets. The objective is thus not to remove all risk from the superannuation assets, but to ensure that the risk matches the expected investment returns. The paper proceeds as follows; firstly the literature of the business cycle and the effect of the business cycle on the return on assets is discussed. In the following section uses a Monte Carlo simulation is used to estimate the expected variance of the accumulated balance at the end of a typical working career. Substantial risks are found in the final retirement balances of the hypothetical employee. The paper concludes with an appeal for the early monitoring of superannuation balances to help mitigate these risks. THE BUSINESS CYCLE AND ITS EFFECT ON ASSET RETURNS; A REVIEW OF THE LITERATURE The period of macro-economic stability that has become to be known as The Great Moderation (Stock & Watson 1999; The Federal Reserve Board 2004) has resulted in a dearth of research into this once

4 ANZAM 2011 Page 4 of 18 popular field. Prior to the mid-1980 s there was heated debate about the causes of changes in economic output. Members of the Classical School generally ascribed such changes to shocks to an existing equilibrium (for example, war) and subsequent adjustments to a new equilibrium. A theory of alternating cycles of economic activity was developed by Charles Dunoyer in 1845 (Benkemoune 2009) and by the 1940 s there were many schools of thought contending for the best explanation of the business cycle. The Socialists derived their theory of cycles from Marx s prediction of periodic crises in capitalist economies, while the Austrians argued that excessive credit creation under a fractional reserve banking system was the primary cause (Von Mises 1953, 1978). The Neo-Keynesian s argued that shocks to aggregate demand may result in a business cycle, but that this result was by no means certain (Samuelson 1939). Current research is largely empirical and agnostic to theory. It includes the NBER's Business Cycle Dating Committee ( The NBER s Business Cycle Dating Committee 2010) ( The NBER s Business Cycle Dating Committee, 2010)which maintains a chronology of the U.S. Business cycle, and the Center for Economic Policy Research (CEPR) Business Cycle Research unit which has various research activities related to measuring and understanding business cycles in the Euro area. In the world of investment management the work of the Economic Cycle Research Institute (ECRI) in predicting business cycles in the major economies of the world has gained some acceptance in predicting turning points in economic growth, inflation and employment. The return on any financial asset is simply the future expected cash flows discounted by a rate which is based on the current risk-free interest rate and the inherent non-diversifiable risk the asset (Lintner 1965, Sharpe 1964). The business cycle may impact on both the level and variance of returns, and is thus usually considered to be a factor in the return of most financial assets. The effect of an upturn in the business cycle may n be to enhance returns (pro-cyclical assets) or the reduce them (counter-cyclical

5 Page 5 of 18 ANZAM 2011 assets). In addition, the relationship between the business cycle and the return on assets is complicated by the fact that at least some of the participants in the financial markets will have divergent expectations of future events. Thus even if the business cycle itself were to follow a (vaguely) predicable cyclical pattern, the relationship to the return on financial assets would be expected to be less well defined. George Soros (1987, 2008) was amongst the first to attribute this to a phenomenon that has been termed reflexivity. Empirical tests of the relationship between the business cycle and the return on financial assets is somewhat dated, which is not surprising given the arguments above. Campbell (1999) examines the evidence from the US and other economies, and derives the general features that must be incorporated into any model that attempts to explain asset prices; the market price of risk is high, time-varying, and correlated with the state of the economy (Campbell 1999, p. 1232). Rouwenhorst (1995) supports this conclusion. Hamilton (1996) contends that economic recessions are the primary factor that drive fluctuations in the volatility of stock returns (emphasis added), which leaves the question of the level of returns open. Indeed Chauvet (2001)( 2001) turns the problem of forecasting the return of assets based on the business cycle on its head by investigating if it is possible to forecast turning points in the business cycle with reference to changes in asset returns. While it may be difficult for non-professional assets managers to decouple the link between the economic cycle and the returns on a portfolio of assets, professional asset managers have many tools to help them in this endeavour. Diversification between assets classes, geographic diversification, and the use of derivative instruments are all tools that can be used to achieve these objectives. The empirical results have at times been disappointing; (Ibbotson & Kaplan, 2000) examined portfolios of US (balanced) mutual funds over a 10 year period and found that the actual returns failed to beat index returns and that the linear correlation between monthly index return series and the actual monthly actual return series was

6 ANZAM 2011 Page 6 of 18 measured 90.2%, thus displaying little effect of a reduction the link between the economy in general and the managed portfolios. Similar results for mutual funds were found by Statman (2000). In theory the use of derivative products allows portfolio managers to shape their portfolio so that any desired reaction to changes in the economy may be achieved; however this needs to be tempered with the knowledge that such strategies can be expensive (both in transaction costs and increases in over-all risk) as well as limited in scope in the mandates of most funds that are used for the investment of superannuation savings. Given the current state of knowledge of the relationships between the business cycle and the expected rate of return on financial assets, as well as the restrictions on the ability of mutual funds to use derivative instruments, it seems prudent to proceed on the basis of empirical evidence of the relationship between overall economic activity and the return on investments. ESTIMNATING SUPERANNUATION RETIREMENT BALANCES In order to examine the likely effect of the variations in asset returns over time, this section of the paper uses actual data for the Australian economy. In addition, one particular sector of the workforce has been chosen for analysis, however the method that is used is easily extended to any number of other groups. The objective is to derive a distribution of the retirement balance that an individual could reasonably expect at retirement. The group chosen for analysis is that of academics working in higher education. This group is expected to have some resonance with the audience of the paper, however the results are generally applicable to many mid-level occupations. Specifically, this paper will examine a cohort of identical individuals who enter the pool of labour in higher education as academics at the age of 25 and retire at the age of 65. As all

7 Page 7 of 18 ANZAM 2011 individuals are identical they progress in their careers at the same rate. Using the salary scale of an actual university, a realistic career-earning path is shown in Figure 1. This earnings profile is used throughout this section, and each individual in the cohort is assumed to earn the same salary for the same number of years of work experience, except for periods of unemployment, which are determined stochastically. The effect of the economic cycle on lifetime earnings is becoming more recognised in the economic literature. The work by Modigliani and others (Ando & Modigliani, 1963) on the life-cycle hypothesis had suggested that individuals consume a constant percentage of the present value of their life income, and thus the effect of the economic cycle on life-cycle earnings was expected to be minimal. Empirical results have however suggested otherwise; Haider & Solon (2006) survey the literature and state that: the relationship between current and lifetime earnings departs substantially from the textbook model in ways that vary systematically over the life cycle. Our results can enable more appropriate analysis of and correction for errors-in-variables bias in a wide range of research that uses current earnings to proxy for lifetime earnings. The findings in this study extend the analysis from life-cycle earnings to life-cycle savings. In order to determine the distribution of possible outcomes that result from differences in the economic cycle, in this simulation it is assumed that 500 individuals enter employment at the beginning of each year. Despite the fact that all individuals are identical, they will accumulate different balances in their superannuation funds because of the differences in the economic environment that each individual finds him/herself in during their career. The extent to which these differences will affect the accumulated balance in their individual superannuation fund are discussed in the sections below.

8 ANZAM 2011 Page 8 of 18 The effect of using the average return over the business cycle to predict retirement balances As discussed in the first section of the paper, there is little agreement as to the causes of the business cycle, or the effect of the business cycle on the expected returns on the equity market. Never-the-less, fluctuations in the return on assets is beyond dispute. Figure 2 illustrates the actual daily returns on the Australian All Ordinaries (AORDs) over the past 25 years. The annual returns over this period can be calculated and are used as a proxy for the return on the investment in the superannuation fund. The returns need to be adjusted for the rate of inflation in each period, and the real return on assets over the period is shown in Figure 3. In order to remain as agnostic as possible to different economic theories, and without loss of generality, the actual returns over the period are used in the simulation as an indication of the returns that are possible over the working life of participants in each cohort. This implies that each individual will experience, on average, 1.6 cycles during their working life. It is usual to assume that the effect of the starting date in not important and to use the average expected return over the cycle as an estimate of the growth in the assets in the superannuation fund. In the case in hand the geometric mean over the 25 years is 3.841% p.a. Using the mean return and following the earnings profile given in Figure 1, the expected final balance in the Superannuation account at the age of 65 years is $ 1,048,292 and the interim amounts are shown in Figure 4. Since all observations follow the same path there is no variance in these amounts. Figure 4 represent the usual manner in which the growth of superannuation balances is portrayed to the general public. As the analysis below will illustrate, this portrayal can be grossly misleading.

9 Page 9 of 18 ANZAM 2011 Incorporating the effect of the date of entry into the labour force into the retirement balances in superannuation accounts In order to examine the effect of entry into the labour force at different periods in the business cycle, a simple Monte Carlo simulation is performed. Five hundred individuals each enter the labour market at random start dates. The contribution to the growth of the superannuation fund for each year depends only on the date of entry and the growth of assets already in the portfolio, which in turn depends on the prevailing rate of return. Under these conditions the expected final balance in the Superannuation account is a stochastic variable which is distributed as shown in Figure 5. Note how very few of the balances equal or exceed the mean previously calculated. This is because once a loss in the portfolio is incurred the effect of future positive returns is severely compromised. Allowing for the additional effect of periodic unemployment Finally, the effect of periodic unemployment is considered. The random starting date is retained as in the previous analysis, but it is further assumed that each person is subject to a 5% probability of unemployment in any year in which there is a negative return in the stock market index (as measured by the All Ordinaries Index). Unemployment last for the full year and no contributions are made in that year. However it is assumed that the career path of the individual is not affected, and they resume employment in the subsequent period, at the same salary. Individuals can become unemployed on more than one occasion as the cause of unemployment is purely stochastic and depends only on the state of the business cycle. The resulting distribution of outcomes in the retirement balances in superannuation accounts for

10 ANZAM 2011 Page 10 of 18 individuals under these conditions is illustrated in Figure 6. CONCLUSION AND IMPLICATIONS The date at which employment begins is a factor largely beyond the control of most individuals, yet it can have a large effect on the final value of a retirement investment if a constant rate of savings (in this case a constant ratio of savings to income) is followed. In addition, towards the end of the earnings lifespan it is often too late to effect any meaningful change to retirement savings. These findings argue for an increased and early monitoring of the balances in retirement savings accounts and for timely intervention if the accumulated amount is too far off the desired path. Both of these factors are important considerations for the continued productivity of employees. HR departments can play an important role in increasing the financial literacy of employees in these matters. Since the employee cannot teleport to another time zone, the following considerations become part of a wider debate ; (a) is removing cyclical volatility effects from superannuation earnings a desirable objective? (b) if so, can firms/society 'do something' when such effects are detected? I am grateful to an anonymous referee for point these questions out to me.

11 Page 11 of 18 ANZAM 2011 References Ando, A., & Modigliani, F. (1963). The Life Cycle Hypothesis of Saving: Aggregate Implications and Tests. The American Economic Review, 53(1), Benkemoune, R. (2009). Charles Dunoyer and the Emergence of the Idea of an Economic Cycle. History of Political Economy, 41(2), doi: / Campbell, J. Y. (1999). Chapter 19 Asset prices, consumption, and the business cycle (Vol. Volume 1, Part 3, pp ). Elsevier. Retrieved from b382c1885d Chauvet, M. (2001). Stock Market Fluctuations And The Business Cycle. Retrieved from Haider, S., & Solon, G. (2006). Life-Cycle Variation in the Association between Current and Lifetime Earnings. National Bureau of Economic Research Working Paper Series, No Retrieved from Hamilton, J. D., & Lin, G. (1996). Stock market volatility and the business cycle. Journal of Applied Econometrics, 11(5), doi: /(sici) (199609)11:5<573::aid-jae413>3.0.co;2-t Ibbotson, R. G., & Kaplan, P. D. (2000). Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? Financial Analysts Journal, 56(1), 26. doi:article Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics & Statistics, 47(1), Rouwenhorst, K. G. (1995). Asset Pricing Implications of Equilibrium Business Cycle Models. Frontiers of business cycle research. Princeton University Press.

12 ANZAM 2011 Page 12 of 18 Samuelson, P. A. (1939). Interactions between the Multiplier Analysis and the Principle of Acceleration. The Review of Economics and Statistics, 21(2), doi: / Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), Soros, G. (1987). The alchemy of finance : reading the mind of the market. New York: Simon and Schuster. Soros, G. (2008). The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means (illustrated edition.). PublicAffairs. Statman, M. (2000). The 93.6% Question of Financial Advisors. The Journal of Investing, 9(1), Stock, J. H., & Watson, M. W. (1999). Chapter 1 Business cycle fluctuations in us macroeconomic time series (Vol. Volume 1, Part 1, pp. 3-64). Elsevier. Retrieved from e The Federal Reserve Board. (2004). Remarks by Governor Ben S. Bernanke. Retrieved January 17, 2011, from The NBER s Business Cycle Dating Committee. (2010). Retrieved January 17, 2011, from Von Mises, L. (1953). The theory of money and credit. New Haven: Yale University Press. Von Mises, L. (1978). The Austrian theory of the trade cycle and other essays. New York: Center for libertarian studies.

13 Page 13 of 18 ANZAM 2011 Figure 1: Earnings by individuals in the cohort, by years of in the workforce.

14 ANZAM 2011 Page 14 of 18 Figure 2: Daily returns on the Australian All Ordinaries Index (AORD) over the past 25 years

15 Page 15 of 18 ANZAM 2011 Figure 3: The real rate of return in the Australian stock market over the period 1986 to 2010

16 ANZAM 2011 Page 16 of 18 Figure 4: Expected growth and the final balance in the superannuation fund, without consideration of the starting date of entry into the workforce

17 Page 17 of 18 ANZAM 2011 Figure 5: Distribution of final balances in superannuation accounts, allowing for the differences in entry dates into the workforce

18 ANZAM 2011 Page 18 of 18 Figure 6: Distribution of outcomes in the retirement balances in superannuation accounts allowing for the effects of both the economic cycle and unemployment