Innovation key to constructing comprehensive retirement income products, shows latest Parametric research


If current superannuation themes were arranged, like pop songs, into a Top 40 chart, the concept of a ‘Comprehensive Income Product for Retirement’ (or CIPR as it is commonly known), for superannuation members would be ‘number one with a bullet’, says Raewyn Williams, Director, Research and After-Tax Solutions, Parametric.

“This is the industry’s opportunity to position superannuation as a genuine whole-of-life financial solution and not just a pre-retirement savings vehicle, and most super funds should be grabbing this opportunity with both hands.
“Nowhere in the superannuation industry is innovation more needed, and more important, than in the area of CIPR design. And the clock is ticking: the Government intends, ‘MySuper style’, to legislate by the end of 2016 to compel super funds to introduce a default CIPR solution.

“As funds tackle the challenge of balancing the ‘attack’ and ‘defence’ elements in a true CIPR solution, we believe it will be useful to cast a wide net for potential solutions and compare these solutions against the ‘triangle of needs’ for high income, risk management and flexibility presented in the Financial Systems Inquiry report.

“Solutions which more naturally deliver a balance of all three outcomes are, surely, worthy of further consideration.
Yet, designing a CIPR with the right balance of features is no easy task, added Ms Williams.

“Adding ‘defence’ – risk management – to a CIPR solution is particularly challenging because of its potential to unduly compromise the other objectives of high income (and growth) and flexibility.

For example, ‘simple defence’ through de-risking – shifting from growth (equities) to defensive asset classes – could give up too much of the ‘equity risk premium’ needed to meet income objectives.

“Hence, super funds are considering ‘complex defence’ which allows them to maintain equities exposure by buying protection through derivatives which carve out downside risks or hedge against volatility.

“These can be effective risk management strategies, but still present problems to super funds trying to balance the CIPR ‘triangle of needs’ because the usually high cost of buying the protection erodes income and sometimes reduces flexibility due to liquidity challenges and limited transparency.

“Our latest research suggests a better way of adding defence to a CIPR solution which avoids the cost of buying equity market protection in a crowded and expensive market.

The Parametric approach uses liquid markets, is transparent and does not involve leverage.

“From a CIPR design perspective, this ‘Defensive Equity’ approach is attractive because it reduces the retiree’s exposure to equity market volatility and downside risk but, instead of introducing a cost to this, finds a healthy replacement source of income for the retiree to the ‘equity risk premium’ the retiree has given up.

“This approach combines partial de-risking with an overlay strategy which positions funds on the sell-side of the equity protection other funds are buying. Not only does this avoid the cost (income drag) and flexibility issues with buying CIPR protection, it generates option writing (premium) income and allows the fund to harvest a consistently observed ‘volatility risk premium’ in the market.

“Both simulated and actual results of this ‘Defensive Equity’ approach, which we manage over both MSCI ACWI and S&P 500 equity portfolios, are available to super funds on request.

“Parametric has also published extensively on the nature and persistence of the ‘volatility risk premium’ in option markets and how the pricing of this risk, through time, has favoured sellers rather than buyers of equity risk protection,” she added.

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