Look what they've done to my super funds, Ma!

On the brink of the worst super returns in years, investors should ignore the urge to purge.

Brace yourself. Some time in the coming months you'll be hearing from the trustees of your superannuation fund about how it performed over the past financial year. It's likely to be ugly. How you respond to the numbers you see when you open the envelope or the email will determine whether things get uglier still in years to come.

An ill-advised switch to another fund or a poor decision to change investment options, just because of poor performance over the past 12 months, could set you up for much bigger financial problems later.

The superannuation ratings firm SuperRatings estimates the average so-called "balanced" fund (a fund that has its money spread among a range of different asset classes) will post a loss of about 6.4 per cent for the financial year. That's painful enough, but there will be worse news for investors in funds that have a more concentrated focus. SuperRatings estimates "growth" funds will post losses in the order of 9.7 per cent and "high-growth" funds 11.8 per cent.

[These funds' names refer to the proportion of "growth" assets - such as shares and property - that they hold. The higher the growth objective, the higher the proportion of growth assets, and as some members are about to find out, the higher the volatility and the greater the probability of short-term losses.]

But even investors in growth and high-growth funds will be looking at the returns from Australian and international share funds and breathing a sigh of relief: SuperRatings estimates that Australian share funds' losses will be in the order of 12.2 per cent for the year and international share funds' losses in the order of 17.3 per cent.

So-called "capital stable" fund options have done exactly what it says on the tin: the average return for the year should be about 0.6 per cent, according to SuperRatings.

Meanwhile, cash funds have increased in value by about 5.4 per cent over the year. And while that might seem like a clear indicator cash is the best place to invest your retirement savings, it has been discussed on these pages recently why investing in cash can look smart in the short term but in the long term leave you looking foolish.

So, faced with bad news from your fund, you have decisions to make: do you accept the returns your fund has produced and stick with it, or do you seek out a better alternative? Do you stay where you are but switch to a different option within your existing fund?

Switching investment options is simple. So is seeking out an alternative fund - certainly it's far simpler than it was the last time super funds produced such poor results, now that choice of fund is available to the vast majority of members. For precisely the same reason, it's also easier to make a dud choice.

Before switching, you need to take into account several factors, not least of which is whether you're 100 per cent sure the fund you plan to switch to is a better prospect than the fund you intend leaving.

John Paul, chief executive of industry super fund Asset Super, says switching from one investment strategy to another, or from one fund to another, could force you to crystallise losses that have already happened.

He says there are also insurance issues to consider if you decide to switch funds - the arrangements of the fund you're moving to may not be as generous as those of your existing fund, or there may be some other reason why you cannot get the same cover.

A decision to switch should not be a knee-jerk reaction, Paul says.

"People forget very quickly that the sharemarket has given more than 20 per cent [returns] now for three years in a row," he says. "That's 60 per cent growth in a three-year period, but this year it's gone backwards and they [members] are upset."

Paul also advises members to make sure any comparisons they make between funds are true like-for-like comparisons. For example, the returns of each fund need to be calculated and quoted on the same basis - it could be disastrous to make a decision to switch if you compare the gross return of one fund with the net return of another.

"But it's not just gross versus net returns - you've got to compare the mix of assets," he says. One "balanced" fund might have a 60/40 split of growth and defensive assets; another "balanced" fund might have a 70/30 split. This difference can have a big bearing on performance, and the funds' returns can't be directly compared.

Andrew Boal, managing director of the consultancy firm Watson Wyatt Australia, says chasing past performance has its dangers. It's very difficult to pick in advance which fund is going to perform best, he says, and picking a fund on the basis of past performance is almost guaranteed to cost you a lot of money.

Boal says a good illustration is someone who switched regularly between two different types of super fund - a growth fund and a conservative fund - over the past 20 years. Boal assumed the person started out the period in the growth fund.

In the first year - 1988 - the growth option returned 9.2 per cent and the conservative option returned 14.5 per cent. So the investor switched to the conservative option for the next year. But in 1989 the growth fund returned 19.6 per cent and the conservative fund 14.8 - so they switched back for the third year. Then, in 2000, the growth fund returned just 1.4 per cent and the conservative option returned 13.1 per cent - so they switched funds again. And so on.

In total, over the 20 years, there were 10 switches (only 10, because in some years the fund they were in was the best-performing fund so they stayed put). At the end of the period, Boal compared the return earned by the investor with what they'd have earned if they'd stayed put for the whole 20-year period. He found the strategy was successful at one thing in particular - destroying value. In fact, it wiped an average of 0.7 per cent a year off the return the member would have received if they had sat tight and accepted that poor years every now and then are part and parcel of investing in growth assets.

It might seem like 0.7 per cent a year isn't a big deal - no great damage done. But the effect of a poor switching strategy can be significant. Consider two fund members, both earning $58,000. Each has contributed the maximum 9 per cent superannuation guarantee contributions over their working lives. One sits tight and the other switches, as described by Boal. The member who sits tight and earns 8.5 per cent a year on his savings would reach retirement at age 65 with about $400,000 accumulated. The "switcher" who earned 7.8 per cent a year (that is, 0.7 per cent a year less) would reach retirement with $340,000 - a difference of 15 per cent.

The poor switching strategy puts the switcher behind the eight-ball from the moment he retires. Pursuing the same strategy in retirement can cause you to fall further behind during the decumulation phase, too.

Imagine you've reached retirement, that you're single and that you earn about $58,000 a year and plan to retire on an income of about $38,000 a year (that is, about two-thirds of your pre-retirement income). Boal says that if your retirement savings earn about 8.5 per cent a year, your retirement savings will last from age 65 to age 79.

But if your retirement savings earn 0.7 per cent a year less (that is, 7.8 per cent a year), your money will run out three years earlier. Boal says that when you factor in the age pension entitlement, the investor who sat tight would have savings that last 20 years (almost until age 86), while the switcher would run out of money 4.5 years sooner, at 81.

Depending on your perspective (or who you listen to), 2007-08 has been the worst year for superannuation fund members since 2001, since 1994, in the past 20 years, or ever. But that's partly the point - if you only vaguely recall the events of 2001, 1994 or 20 years ago then you can take some comfort from the idea that the events of the past financial year will also eventually be just a vague memory.

Despite the turmoil in financial markets, there is nothing that professional investors can point to to suggest that the way we go about investing should change. So, as long as you're in the right fund now, there's not necessarily a need to radically change where you're investing your retirement savings.

Brian Parker, investment strategist for MLC, says if your aim is long-term wealth creation - and for most superannuation fund members that is the case, whether they're in the accumulation or the decumulation phase - then a healthy exposure to shares is still critical. But so is a properly diversified portfolio, and Parker questions whether a typical "balanced" portfolio, which may have performed well in the 20 years to date, is sufficiently well diversified to perform as well over the next 20 years.

"In virtually all of the asset allocation work that's done, one fundamental premise that it's based on is that, over time, higher risk tends to be associated with higher reward, and higher return comes from taking 'business' risk," Parker says.

"We're living in a free-market economy, and wealth in a free-market economy is built by businesses. So, if I want to build wealth for my retirement I need to have exposure to business.

"Will it still pay to have a fairly substantial chunk of equities as part of an investment strategy? The answer is a resounding 'Yes'.

"But another part of it is how people arrive at their asset allocation. If you decide your asset allocation in a relatively naive way - if you just say that over the past 20 years shares have returned this, bonds have returned that, cash this and property this, and I am going to determine my asset allocation based on what has happened in the past 20 years, and 20 years is a long time and that's as good a guide as any to what is going to happen in the future . . . it would be easy to come to the conclusion that a typical diversified fund is set for a re-run of the past 20 years.

"If the next 20 years looks like the past 20 years, then that type of diversification is home and hosed. And there's every chance that that could work out quite beautifully - but I am just wondering if the typical diversified fund out there is diversified enough.

"Does an over-reliance on Australian shares still make sense?

"To the extent that people have been a bit unconventional [with asset allocation] in the past few years … I think that you can make a case to say that some of the 'alternative' strategies that have been incorporated into some funds - in some cases the emperor has no clothes. People have taken risk that they do not know about, or they have been prepared to give up too much liquidity for not enough return.

"You could also make the case that some people think they are putting their money into strategies that were meant to generate good returns when things got tough, but what they have ended up with is really just a leveraged exposure to high-risk markets or high-risk assets."

Parker says asset allocations that are rigorously "stress-tested" - those that are designed to stand up well under a wide range of positive and negative investment scenarios - will fare best in coming years. And that means super funds, and fund managers, have to find assets that provide genuine diversification, not just take on more risk in the hope of higher returns, or take geared exposure to the same asset classes they already hold.

"[You have to] really stress-test your asset allocation, and I don't think there has been enough stress-testing done," Parker says.

"We need to do our homework a lot more and really stress-test … a wider range of scenarios than just looking at the last 20 years and hoping that the next 20 years is exactly the same."