When it comes to investing, the experience matters just as much as the returns earned. That’s why the idea of smoothing investment returns continues to resonate, especially in today’s climate of elevated uncertainty and market volatility. While smoothing may sound like a technical concept, at its heart it’s about helping investors stay the course by making the experience less turbulent.
This article explores the thinking behind smoothing and cross-subsidy, and why these ideas, though not new, remain relevant and even evolutionary in the current investment landscape.
Why smoothing matters today
Markets are unpredictable. From the Asian crisis in 1997 to the global financial meltdown in 2008 and the Covid-19 shock in 2020, investors have repeatedly experienced volatility. But for retirement fund members, especially those nearing retirement, volatility isn’t just uncomfortable, it can be destabilising.
Smoothing offers a way to manage this experience while delivering inflation-beating returns. Instead of exposing members to the full ups and downs of the market, smoothing distributes returns more evenly over time. This doesn’t eliminate risk, but it reshapes how risk is felt. In a world where member behaviour is increasingly influenced by short term performance, smoothing helps people stay invested for the long haul.
The theory behind the practice
At its core, smoothing is about helping investors get a better balance between risk and return. Instead of exposing them to the full ups and downs of the market, smoothing spreads out returns over time using a structured method called a bonus framework. This can reduce the bumps along the way without giving up the potential for long term growth – at least in theory.
The idea is based on a principle known as the efficient frontier, which simply means aiming for the best possible return for the level of risk you’re willing to take. Smoothing shifts that balance by offering the same expected return with less volatility. That’s especially useful in retirement investing, where both growth and stability are important.
But smoothing isn’t just about theory and maths. It’s also about trust. These products are complex, and their success depends on how well they’re managed. Investors need to feel confident that the provider is focused on delivering fair outcomes for them and not making decisions to protect its financial position.
The cross-subsidy question
One of the trickier parts of smoothing is how returns are shared across investors. Because returns are pooled and then distributed, there’s a chance that some investors might end up getting more than their fair share, or less. Managing this balance is key to keeping things fair.
Several factors influence how well this works. These include how bonuses are calculated, whether guarantees are offered (and what they cost) and how solid the underlying growth portfolio is. If the solution is credible and performs strongly, smoothing can add real value. But if, for example, the cost of guarantees is too high or if the same company manages both the insurance and the investments, there’s a risk that value may be eroded.
That’s why transparency and good governance matter. Investors should be able to understand how bonuses are set, what guarantees cost and how their returns compare to the actual market value of the underlying investments.
Evolution, not reinvention
Smoothing products have evolved over time. Bonus declarations are more frequent, guarantees are lower (and cheaper), and transparency has improved. Some newer models even allow for negative bonuses, reflecting a more realistic approach to market cycles.
What hasn’t changed is the need for stability. In today’s environment, the thinking behind smoothing remains as relevant as ever. It’s not about selling a product; it’s about solving a problem.
A trust-based solution for a volatile world
Smoothing is not a silver bullet. It’s a tool. One that requires careful management, clear communication, and a strong foundation of trust. But when done right, it offers a compelling way to help retirement fund members navigate uncertainty without losing sight of their long term goals.
In that sense, smoothing is more than a technical strategy. It’s an evolutionary idea that continues to shape how we think about retirement investing in a market that rarely moves in a straight line.
