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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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12 thoughts on “Investment Workshop 59: Are Robo-Advisors Compatible With FIRE?”
All of this math ignores the fact that not all robo-investors have that fee. For example, Wealthfront only charges 0.25%, and M1 charges no fee! If you use my referral link, we both get $10, but I would genuinely recommend M1 regardless: https://m1.finance/UpHCTZSmccKv
Ah yes, in the USA. Not in Canada, where I suspect the example was run using Wealthsimple.
Good point. I’m not very familiar with the Canadian robo-advisor market.
But how does M1 make money without a fee? Typically there is always a cost, even if it’s hidden.
I’d like to see an analysis taking into account any tax loss harvesting that a robo may offer.
I second this! But, I’d imagine that’s pretty hard to calculate. And, those of us in Canada can’t benefit nearly as much from tax loss harvesting as Americans do.
In my experience the tax loss harvesting benefit (at the stock level) more than offsets the fee. And it does so by significant multiples in a down market. And no matter how much time I have I couldn’t do that myself.
Mark – are you in the US, or Canada?
In the US tax loss harvesting opportunities are much more prevalent, since you sell individual stocks against their individual sell price. In Canada, you sell against the average price you’ve paid of all that stock, regardless of when you’ve bought it, and any gains/losses are calculated against that average paid price. Much easier for records keeping, but doesn’t present nearly as lucrative tax-loss harvesting opportunities. So if you’ve found if it more than offsets the fee even in Canada, I’d find that particularly interesting to hear about!
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“And finally, in Canada the Robo-Advisor fee is tax-deductible,”
Not sure that is the case. My understanding is that MER fees are not deductible.
Perhaps only on non registered accounts but not TFSA, RRSP, etc
Please clarify and provide a link if possible.
Enjoyed the Robo-Advisor series. Great place to start saving and investing.
Schwab’s Roboadvisor is also free* (above a certain asset level.) I am a CFP, former fee-only advisor, & could obviously do my own portfolio management. Did for a long time. Then I switched 1 account at a time to test my theory the Roboadvisor would do a better, more timely job than I would, especially with tax loss harvesting. Answer after a couple years through various market conditions: sure seems that way. Frankly, I’d rather be working or riding my bike while it keeps an eye on my $. When it comes to managing money, lazy isn’t always a bad thing. 😏
*free, as in no fees. My understanding is they make their money by keeping a certain amount in cash (some argue too much) instead of investing it & taking a % of what that earns. I’m OK with that. They deserve to be comp’d for this valuable service, never mind how cheap that is vs. virtually all other options.
@Sherrill – the cash portion is actually why i left Schwab. they were keeping 7-9% of the portfolio in cash, which they are not willing to change (spoke to the several times on it). If you look at the math and assume 7% returns and 7% in cash it roughly equals a 50bps fee. So it is effectively a 50bp “fee” on your money, even if its not a fee. As returns go up, the impact is higher, and vice versa for when returns go lower.
I switched to Betterment given the lower fee in the US (25bps) and full investment, which net net cost less.
@Firecracker – i think this is actually a really important article. The biggest hurdle my friends and family face when starting investing is that they are scared and just cant get to a mental place where they can pull the trigger on investing. I think these provide a really nice intermediate step, to test the waters per-say on investing. You can watch the markets, but the robo-investors can alleviate the anxiety that comes with actively managing your own portfolio, and helps to enforce the, index and wait model that FIRE relies on, providing time to educate and get involved while still being invested with a generally correct strategy.
I also think you are spot on for the timeline of use here. Tools like this are great as you are getting to FIRE, but afterwards it probably makes sense to manage it yourself. I think that is probably also the case for financial advisors: great to have a professional look over and help manage affairs pre-FIRE like setting up trusts, wills, insurance consultation etc… hopefully once you are ready to FIRE, you have been fully educated on the full spectrum of financial well being, and have all your ducks in a row, so you can set them aside and manage on your own. I believe from reading your blog, that this is essentially what you guys did as well, no?