Don't Bet Your Retirement On Robo-Planning

by: Michael Lonier


After all the additional income and expense options are netted out, the PersonalCapital retirement calculator offers an opinion on the chances of your portfolio providing the balance needed each year.

The only risk this kind of calculator addresses is sequence of returns risk - the risk that early poor returns will deplete your portfolio so much that you run out of money.

It’s not enough to only address sequence of returns risk - for many, sequence is neither the most likely nor the most calamitous risk that they face in the years ahead.

Robo-advisers are websites that provide automated low-cost investment in balanced portfolios. Typically, the portfolio balance is based on risk tolerance quizzes and/or client-supplied time horizons, two common but limited methods for establishing how much market risk to allocate to the portfolio. As we discussed previously, simple quizzes and assumptions about time in the market may not be a sufficient basis for a recommendation that meets the new DOL ERISA fiduciary rules that go into effect next year for retirement money.

Nevertheless, robo-advisors are beginning to build out their platforms beyond mere portfolio allocation. One such area, not surprisingly, is retirement planning. Retirement calculators are not new - there are dozens out there. Generally, these calculators are simple web gadgets designed to drive a client into a discussion with an advisor from the sponsoring firm, though some are fairly complex and meant to provide the basis of a serious plan.

If you try them out, you'll likely find each one gives you a different "answer" as recent testing has shown. This is not surprising since they are usually black boxes that give little indication of how they actually calculate results beyond some basic assumptions.

Robo-advisor has added a retirement calculator to its site that uses the portfolio allocation it detects from the accounts being tracked on the site and/or the accounts you transfer to PersonalCapital to estimate returns, which is the only robo function it provides. You can turn this off and the gadget will use whatever portfolio amount you enter and a "moderate" portfolio default to estimate returns (the disclaimer indicates this is an 8.4% average annual return with an 11.4% standard deviation). With the exception of the connection to the portfolio already linked or held on the site, the calculator is similar to many available on other sites.

Essentially, it does a Monte Carlo analysis of the portfolio drawdown based on start date (age) and an annual retirement spending amount. You are 66 and retiring, have this much ($1,000,000), want to spend this much of it each year ($30,000), and so you are in "good shape" with a "90% chance" of funding your spending goal, or will "require flexibility" (36% chance) or will need to "make adjustments" (for an even lower %).

You can add the amount and timing for various types of income (annuity, pension, inheritance, employment, etc.) and spending goals (education, healthcare, vacation, renovations, vehicles, weddings, etc.), but in some ways, this just complicates what is essentially a simple calculator.

When all the additional income and expenses are added in and subtracted, the calculator is still just offering an opinion on the chances of your portfolio providing the balance needed each year to cover your spending. The singular risk this kind of calculator addresses is sequence of returns risk - the risk that poor returns early in retirement will deplete your portfolio so much that you will run out of money if you don't cut spending significantly. Calculators like this do a poor job of illustrating and managing even just that risk, let alone the other major risks retirees face. They rarely expose the depth of the risk that average retirees are taking by using an investment-based method to fund retirement.

Here's an example from the PersonalCapital calculator to underline this. For a 66-year-old facing a 29-year retirement ending at age 95, with $1,000,000 as the portfolio, using the default "moderate" returns, and a $30,000 retirement spending goal from the portfolio, the result is a 90% chance of success - defined as the percentage of 5,000 random simulations that end with more than $0 in the portfolio. Or, a one in ten chance of running out of money towards the end. You may or may not agree that means you are in "good shape." (The 3% withdrawal rate this implies is not the focus of this example).

The annual cash flow shows that the portfolio in an "average market" ends at 95 with $627,000 and with $69,000 in a "poor market." The average market presumably represents the median of the 5,000 Monte Carlo runs, while the "poor market" scenario is not defined.

So we defined our own "poor" scenario and reran the results. Four years after retirement, when the 66-year-old is 70 and the $1,000,000 has been spent down to $968,977 (from the base result cash flow) in an average market, we posit that the market collapses, and stocks lose 40% of their value. The now 70-year-old's portfolio, a moderate 60/40 stocks and bonds, is now worth $620,145 after the drop. The calculator only allows portfolio adjustments in 50k chunks, so we enter age 70, $650,000 savings, and $30,000 in retirement expenses.

The chance of meeting that $30,000 goal now drops to 36% and the portfolio runs out of money at age 93 - even without any further shocks over the next 25 years. To get back on track to a more robust 90% chance, the retiree has to change the annual retirement spending goal from $30,000 to $21,500, almost a 30% cut, for the rest of the plan, which then ends with a median result of $337,000. No one would probably make that drastic of an adjustment, but then what's the point of a Monte Carlo analysis in the first place?

It's a cool, simple calculator, and it's fun to play with. But I wouldn't bet my retirement on it. Among other things, you'd have to have significant knowledge of sequence of returns risk, its impact on portfolios, and insight into how this calculator works to uncover this once-a-decade or so outcome.

Even more importantly, it's not enough to only address sequence of returns risk in retirement planning. There are many other risks that we need to manage by allocating resources to different kinds of strategies - insurance, hedges, avoidance, diversification, and so on.

It turns out that for many, sequence of returns risk is neither the most likely nor the most calamitous risk that they face. That's one reason why the new DOL fiduciary rules require that retirement advice take a much broader view of the client's situation than just their investment account and its market exposure.

Add a new risk to the list retirees must learn to manage: The risk of being lured in by shiny web gadgets. Retirement is not Pokemon Go. When it's well planned, it's much more fun than that.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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