Active and Passive Strategies Within a Retirement Portfolio

Emma Wall: Hello, and welcome to Morningstar series, "Ask the Expert." I'm Emma Wall, and I'm joined today by Morningstar's Daniel Needham.

Daniel Needham: Hi, Emma.

Wall: So we’ve reached the final day of our Active and Passive Investing Week and today we're focusing on retirement and pensions. So, we want to talk about how you can blend active and passive strategies within a retirement portfolio. But before we do that, let's go right back to the beginning and talk about what should be your considerations when building a retirement portfolio?

Needham: Sure. I think the most important thing is the savings and spending patterns knowing how much you think you're going to need to retire and making sure that you save that amount of money. I think saving is the most important element of any retirement strategy.

Once you get to retirement obviously you need to have a spending pattern, so making sure that you don't spend too much. That's the most important thing. Once you worked out what your savings and spending goals are, then you determine what the investment strategy should be.

Wall: And there are two distinct types of retirement portfolio, we sort of group them together, but they have very different requirements, going into that saving and spending. First is the accumulation stage and we know the majority of people using Morningstar.co.uk are saving for retirement. What asset allocation should they be considering in that saving for retirement process and how does active and passive tie into that?

Needham: I think those people have a pretty long investment horizon, normally more than multi-year – multi-decade. So they can tend to have fairly aggressive investment strategies. I think somebody with that kind of savings pattern, that type of investment horizon, can afford to ride out the big fluctuations in markets. Over the long term inflation erodes the value of many assets so equities and property and assets like that are quite important. Now those markets tend to be inefficient, certain markets are inefficient, and so therefore having some active management there can make sense.

Wall: And you mentioned the things that can affect returns, of course, price is one of those, and although you have a long-time horizon when you are in an accumulation stage and market fluctuations can be made up with drip feeding, prices still be a consideration, shouldn't it?

Needham: Absolutely. I mean you should only spend money on active funds if you think they can outperform their fees and the index that they are measured against. I think that effectively markets appear to be inefficient from time to time, but on average, many active fund managers can't beat it after fees. So people shouldn't forget that statistic.

So, I would say a healthy level of scepticism is required before appointing any active fund manager, and you should have a high degree of confidence that that manager can do better than fees, otherwise you better off paying the lower fees that are associated with passive investments, and then just taking a very long-term view.

Wall: And, of course, our Morningstar fund analysts here can help you with that selection of active funds, with the Gold, Silver and Bronze rating.

What then about the stage where you've got to retirement, it's time to collect your pension pot. But of course, retirement is no longer 10 years long like it used to be. You can be retired for as long as you are saving. So, there are slightly different requirements of an investment portfolio in retirement. How does asset allocation and active, passive play into that?

Needham: I think, you tend to have more of a bias towards lower risk assets and income generating assets, although that doesn't mean that you don't own equities. As you quite rightly pointed out, somebody at 65 has a reasonably long period that they'll be retired, assuming that they stop working at 65. So that means you need to have a diversified portfolio that can help effectively fund retirement through your life expectancy.

So, within there I would say that active/passive is still a decision that has to be made. Within certain asset classes, I think active management makes more sense. So, for example, where it's clearly inefficient, so that might be smaller cap equities, for example, or very specialist areas within capital markets.

Also, there are certain areas where the index is actually quite a poor portfolio. So, for example, high-yield bonds. Effectively, the index weights to determine by whoever has issued the most debt. That's not a very sensible portfolio. So, having active management within places like high-yield or bank loans actually makes a lot of sense.

But ultimately it should be driven by whether or not you think the manager can beat the index, and if they can't then it's better for you to have that money in your pocket than to be in the pocket of the fund manager.

Wall: We should just end on the point that there some one-stop solutions for people in retirement, that promise a “guaranteed income”. Now these are active strategies that fall underneath the active management umbrella, although they can have passive instruments in them. These are things like with profits funds, like structured products, and they are not for everybody, are they?

Needham: No. I think one of the key pieces of advice is that, if you're investing on your own, you should really understand what you're buying. If a product is too complex for you to understand it and is offering reasonably high returns and what potentially seems to be low-risk with high fees. I think a healthy level of scepticism is warranted because the only thing that's certain is that you'll pay the high fees. Whether you get the high income or whether you don't experience risk is uncertain.

So that would be my first I guess point on that one. I think there are some pretty easy to understand products like lifetime annuities. Maybe the rates aren't very attractive, but you should be able to understand the product, but once you start to get into complex products that have maybe option structures within them and are somewhat illiquid and rely on guarantees from investment banks. I think it requires a really healthy level of scepticism.

Wall: Daniel, thank you very much.

Needham: Thanks, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.