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Over the past few weeks, we’ve examined Robo-Advisors, what they are, how they work, and we even took one out for a test drive to see what the user experience was like.
So today, as we wrap up our Robo-Advisor investigation, let’s try to answer the question: Are Robo-Advisors compatible with FIRE? Does it help people hit Financial Independence faster, or does it make their path to early retirement more difficult?
For the most part, it would seem that the underlying fundamental building blocks of Robo-Advisors are pretty compatible with FIRE. FIRE generally advocates using low-cost index ETFs to build your portfolio, and regularly putting money into it as you work and save. Robo-Advisors like WealthSimple do as well.
However, where FIRE and Robo-Advisors diverge is in the fact that FIRE advocates for lowering your investment (and living) costs as much as possible. And while WealthSimple would argue that a 0.5% MER is better than a traditional full-service investment advisor, it’s still an extra cost that DIY investors wouldn’t have to pay.
So the real question is, is this fee worth it, and how much does it actually impact your FIRE journey?
Impact on Time To Retirement
In order to quantify the actual impact of using a Robo-Advisor, let’s turn to the metric that everyone understands: Time. Specifically, how long does it take to retire, and how much longer would using a Robo-Advisor force you to work?
In our book Quit Like a Millionaire, we showed that it’s possible to express your time-to-retirement as a function of your Savings Rate (as a percentage of your income) and your portfolio rate of return, and if you graph it out it looks like this.
See Appendix A in our book if you’re curious about the actual math.
So how does using a Robo-Advisor change the math here? Well, it affects it in two ways. First, it adds a 0.5% drag onto our portfolio returns, so our rate or return goes down. Secondly, it increases the amount we need to save, since your 4% withdrawal needs to cover both your living expenses AND the 0.5% management fee going forward.
To better understand what this means, let’s focus on a single line in the above chart: The 6% return line.
6% is our typical conservative estimated return for a 60/40 portfolio anyway, so this makes things nice and consistent. When we account for these two effects of using a Robo-Advisor, this is what happens.
Or, if we subtract one line from the other to see the additional years you’d have to work if you use a Robo-Advisor, we get this.
Now, people on the FIRE path usually have a savings rate north of 50%, so that means that by using a Robo-Advisor versus DIY, our “typical” early retiree (if there is such a thing) savings 50% of their income would have to work an extra 2 years if they used a Robo-Advisor.
Impact on Investor Behaviour
However, it would be unfair if we only looked at the cost without looking at the benefit, which in this case, is convenience.
Convenience is kind of difficult to quantify, and if it was just used as an excuse to be lazy, I’d argue that a Robo-Advisor wouldn’t be worth it. However, there are certain situations where this would have value, and that’s if this lack of convenience was keeping someone from getting their money invested at all.
I know, that sounds like kind of a cop-out answer, and for many people it is, but there are some people for whom this is a legitimate problem. Certain professions, like doctors, lawyers, or commissioned salespeople often have their work hours bleed all over their free time. An E.R. doctor, for example, who’s constantly on call legitimately doesn’t have a lot of time to read over investing books (or blogs) and learn how to manage their own portfolio.
These types of people are, unfortunately, often preyed upon by unscrupulous finance types, precisely because they know they’re so busy with their careers that they often neglect the financial side of their life. These people would definitely benefit from a Robo-Advisor, because in just a few minutes of setting up their account, they really can set-it-and-forget-it and be on their way on their FIRE journey without a lot of ongoing effort going forward.
It may take a bit longer than DIY, but as they say, “better late than never.”
The Best of Both Worlds
There is one way to get most of the benefits of a Robo-Advisor without taking the full 2-year hit to your retirement journey. And that is: Use a Robo-Advisor while you’re working, then switch to DIY in retirement.
The majority of that 2-year penalty comes not from the reduced compounding, but the fact that you have to save more to account for the ongoing fee in retirement.
There are also other reasons to switch back to DIY in retirement. First of all, the convenience argument kind of disappears after you retire. You may not have had time to manage your portfolio while you’re working, but after you leave your stressful job time is something you have tons of.
The second is that while a Robo-Advisor will do mostly the right thing when you’re working and putting money into the portfolio by automating your deposits and doing your rebalancing for you, in retirement I’ve found that I need to have far more precise control over my portfolio in order to manage my withdrawals. I use a strategy that combines my Yield Shield and my Three-Bucket system in order to manage my cash flow post-retirement, and a Robo-Advisor just doesn’t give me the flexibility to do that.
And finally, in Canada the Robo-Advisor fee is tax-deductible, which has the most impact when you’re working because your marginal rate is quite high. After you retire, your earned income drops to zero so the fee being tax-deductible no longer helps.
Let’s see how using this strategy affects our time-to-retirement. Because we’re still using our Robo-Advisor during our accumulation years, our portfolio return still takes a 0.5% hit every year. But because we aren’t going to need to keep paying that fee in retirement, the target portfolio no longer needs to be adjusted higher. So here’s what that looks like in our TTR chart.
Or, if we express these lines as the difference between them and the DIY option…
We can see that by using Robo-Advisors during our working years and switching to DIY in retirement, the additional time we have to work drops dramatically. It’s still higher, but for our early retiree hopeful saving 50% of their income, it only increases their time-to-retirement by 6 months rather than 2 years. And if their savings rate is even higher than 50%, then their time-to-retirement penalty drops to the point where it becomes negligible.
So, that’s Robo-Advisors. If fear (or lack of time) is keeping you from getting your money invested and performing in the stock markets, a Robo-Advisor can really help you get moving towards your FIRE goal. But as you approach retirement, you may want to sit down and consider whether it makes sense to stick with them or switch to a DIY approach once you pull the FIRE trigger.
What do you think? Would you consider using a Robo-Advisor, or would you just stick to DIY the entire way through? Let’s hear it in the comments below!
On an unrelated note, we just did an online pandemic-themed escape room, and you should too! It was well designed, a ton of fun, and all proceeds go to the Food Bank of Canada! Check it out here!
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.