Robo-advisers are all the rage.
A robo-adviser is software – usually a website or an app on a mobile device – that provides financial advice or performs portfolio management online with minimal human intervention.
I'm not a big fan of robos because I have a finance background and I know how difficult retirement planning can be, but also because I'm a computer scientist and I know how difficult writing the algorithms can be. To develop a truly effective robo-adviser would require a great deal of financial knowledge effectively translated to a really good software developer. I don't think that happens often, at least not yet.
I'm also not a fan because my recent experience with robo-advisers has not been encouraging. Most are little more than simplistic games. The good ones, in my opinion, are better than a poor retirement planner and certainly better than not planning, at all.
The good robo-advisers are nowhere near as effective as a good, human CFP given the current state of the technology and none compares with a top financial planner. This is merely my opinion, but as I said, I have a lot of training in retirement finance, and I was once a damned good software developer if I do say so myself. (I have considered writing a robo-adviser program for a long time. I haven't because I fully understand how difficult it would be to do it right.)
Several clients and readers have been stressed out by the chore of picking the “optimal” asset allocation for their retirement portfolio. I decided to try several free robo-advisers by creating a retirement planning scenario to run through each and then comparing the recommendations. I also asked retirement planner Mike Lonier to provide his recommendation representing the human race.
The scenario is the following. A husband age 66 and wife age 64 just retired and have saved $3.75M for retirement as shown in the table below. The husband will receive about $3,250 per month in Social Security benefits at age 70 and the wife about $2,000 per month at age 66. They have a small pension that will pay $1,000 per month beginning at the husband's age 66, and the wife will be entitled to a 50% survivors benefit. They believe they need to spend at least $180,000 a year and at most $220,000. The question I asked Lonier and the Robos (sounds like a 50s rock-and-roll band, doesn't it?) is how these funds should currently be allocated.
|Desired annual spending||Per Year|
|"Wins the game"||$220,000|
|Husband at 70||$39,268|
|Wife at 66||$24,703|
|Pension at husband's age 66||$11,000|
The following table summarizes the results of the planners.
|Planner/Robo-Planner|| Recommended Annual |
|Annuity Allocation||Stock Allocation||Bond Allocation||Cash Allocation|
|AACalc with Annuity||$260k||59%||41%||N/A||N/A|
|AACalc No Annuity||$220k||0%||34%||66%||N/A|
|Mike Lonier (1)||$220k||8.0%||0%||86.2%||5.8%|
|Mike Lonier (2)||$180k||8.0%||10.4%||77.4%||4.2%|
|Fidelity Planning & Guidance||N/A||N/A||50%||40%||10%|
|Vanguard Planning & Guidance||N/A||N/A||30%||70%||N/A|
|Elevator Ride with Annuities||$150k ||N/A||30%||70%||N/A|
|Elevator Ride No Annuities||$150k to $195k ||N/A||40% - 60%||60% - 40%||N/A|
Let me explain each of the approaches.
AACalc.com, developed by Gordon Irlam is, again in my opinion, the most thorough asset allocation software available. AACalc asks several detailed, specific financial questions and explains its calculations well. (As you will see, some calculators ask generic – and frankly, sometimes plain weird – questions to generate a recommended asset allocation.)
The first two rows of the table suggest that a key differentiator among robo-planners is whether or not the client/user is willing to purchase fixed income annuities. (All of the annuities discussed in this post are simple fixed annuities without indexing. ) Row one shows AACalc results when fixed annuities are acceptable and row two shows recommendations when fixed annuities are not acceptable. Mosts robos don't even ask this question.
AACalc recommends in row one that a client willing to purchase annuities can generate $40,000 more lifetime income than one who won't buy them (row two). It recommends that the client invest 59% of assets in annuities and 41% in stocks. With income guaranteed by a secure floor of annuity and Social Security income, the client can be very aggressive with the remainder of the portfolio. Annuities replace bonds. This is the floor-and-upside strategy recommended by most economists.
For clients unwilling to purchase annuities, AACalc recommends a 34% stock allocation and 66% bond allocation.
Betterment.com is perhaps the best-known robo-investment adviser. The website asked me just three questions, my age, my annual income and whether I was already retired, before advising me that I should invest 56% of my portfolio in stocks and 44% in bonds. It calculated this without knowing the size of my portfolio, whether I was married, or even how much I needed to spend annually from the portfolio. I clicked on "Details" to find a very precise breakdown of twelve sub-asset classes I should invest in – 4.8% in emerging markets, for example. Who knew retirement planning was so easy?
It isn't. And any planner, living or robo, who doesn't ask the right questions is subject to one of the oldest truisms of computers: garbage in, garbage out.
Mike Lonier also advocates the floor-and-upside strategy, unsurprisingly since he is associated with the Retirement Income Industry Association (RIIA). Lonier provided two recommendations, the first based on $220,000 annual spending and the second on $180,000 spending. For planned spending of $220,000 per year, he recommends an 8% annuity allocation (specifically, to a type of annuities called QLACs that are held in retirement accounts – see note in References below) with the remainder of the portfolio invested in bonds. He also notes a reasonably high concern that this level of spending may not be attainable.
For $180,000 annual spending, a level at which Lonier is more comfortable, he still recommends an allocation of 8% of assets to QLACs, but a 10.4% stock allocation with the remainder in bonds and cash.
Lonier elaborates on his approach:
"I don’t usually recommend “bonds” meaning bond funds. I recommend a lifestyle (floor) allocation built as a liability matched risk-free or guaranteed ladder of CDs, individual Treasury bonds held to maturity, and/or single premium income annuities (SPIAs) and deferred income annuities (DIAs). The SPIA/DIAs would be as floor ladder components, in addition to any DIAs that are part of longevity.
With very-well funded clients, some percentage of the Lifestyle (floor) portfolio might be exposed to credit and interest rate risk in a partial allocation to bond funds, meaning that the very well-funded might follow, to some degree, an investment-based (MPT) portfolio rather than a strict goals-based approach, especially with funds above those needed to fund expenses in the ladder.
My own algorithm, which analyzes the present value of assets and liabilities (current and future) on the balance sheet, indicates 0% and 10.4% for the Growth and Legacy (Upside) allocation for the two spending scenarios. My “human” adjustment changes that based on the balance sheet math but increased by the planner to 20% for the $220k scenario and 30% for the $180k scenario. The rationale is that there are sizable assets, so the concerning risk is spending risk, not necessarily asset loss (sequence of return risk), so the plan would manage spending risk while providing modest exposure to growth."
I should note that all of the robo's services I studied are free, though Mr. Lonier's services are not. Still, I believe he provides much better value. The above quote shows the additional value you get from human tweaking.
Next, I looked at Bankrate.com. Bankrate requests more relevant input than most robo-advisers but less than asked by Mr. Lonier or AACalc. In this scenario, Bankrate recommended 45% stocks, 31% bonds, and 24% cash. Still, if someone ran this scenario by me in an elevator, I would probably suggest a 40% to 50% equity allocation and be in the ballpark most of the time.
ESPlannerBASIC doesn't offer a recommended asset allocation that I could find, but it did suggest annual spending of $191,000 that I found useful.
Finding the calculator isn't always easy. After I had given up on Fidelity Investments offering an asset allocation calculator, I discovered the link that would provide one. Go to GUIDANCE & PLANNING > RETIREMENT PLANNING > PLANNING & GUIDANCE CENTER . . . You know what? Can you just trust me that there is an asset allocator in there somewhere if you look long enough?
Along the way, Fidelity posts a warning that its “advice” is for educational purposes only and shouldn't be used for actual planning. I feel like that warning belongs on all robo-advisers. In the end, Fidelity recommends 50% stocks, 40% bonds, and 10% cash.
My favorite robo-adviser so far is NewRetirement.com. I've been working with founder Stephen Chen on this website, and I find it closer to a real adviser than any of the alternatives. Unfortunately, the site doesn't provide asset allocation recommendations, at least not yet, but it did recommend annual spending of $192,000. I recommend you try out this website. It gets better all the time and I think it's already as good as the typical human planner.
Vanguard's Advice & Guidance tool recommended 30% stocks/70% bonds based on generic input. Still not much different than my elevator advice.
Lastly, Yahoo! Finance offered the most detailed asset allocation but again based on a few generic questions. With so little input data, these calculators are giving the same advice to a huge range of clients. Yahoo! recommended 10% US large cap growth stocks, 15% US large cap value stocks, 10% US small/mid-cap stocks, 15% international equities, 45% bonds and 5% cash.
How do we compare such a wide range of recommendations? First, let's separate recommendations with annuity allocations from those without because these represent two very different strategies. The former is floor-and-upside while the latter is essentially a sustainable withdrawal rate (probabilistic) strategy. The two strategies provided by Lonier have low stock allocations because the required spending is high (4.8%) and because his strategy is to guarantee one's standard of living first and invest anything left over aggressively. (That's my approach, as well.) Also, note that the highest annual spending comes from these strategies and not from large stock market bets.
AACalc's no-annuity recommendation proposes a similar strategy to Lonier's, but invests in a bond ladder instead of annuities – secure the floor, then invest aggressively. Bottom line, these are quite similar strategies when annuities are allowed.
Looking at the remaining strategies, recommended annual spending ranges from $191,000 to $213,000. That's only an 11.5% difference.
The strategies without annuities recommend stock allocations between 30% and 50%. Personally, I would recommend more weight be given to calculators that require a lot of financial input instead of generic lifestyle questions. Those were AACalc and Fidelity with recommendations of 35% and 50% equities, respectively.
The goal of my readers and clients is presumably to narrow down an “optimal” asset allocation. But as I explained in The Whoosh! of Exponential Retirement, Irlam showed that the 95th percentile optimal asset allocation could range from 10% to 82% equities. The problem is that we simply can't predict future stock returns accurately enough to determine the optimal allocation so any of these allocations is mathematically defensible. The best strategy is to determine not the optimal asset allocation, but one that works well across a broad range of potential future outcomes.
My own approach is quite different and doesn't require a computer. It is based on the advice of William Bernstein and the idea that an asset allocation has two main purposes: to manage short-term volatility (my risk tolerance ) and to optimize long-term risk-adjusted return within my risk capacity.
Managing short-term volatility means implementing a stock allocation that won't lose so much money in a severe bear market that you might be tempted to bail out of equities. I believe I can personally tolerate about a 15% short-term loss of my investments (though my risk capacity  is greater than that) and that has historically meant choosing about a 40% equity allocation. Bernstein suggests we begin there.
| I can tolerate a |
short term loss of
For investors who can ignore bear market losses, including the more than 50% loss during the Great Recession, an equity allocation can be much higher. Floor-and-upside strategies can recommend up to 100% equity positions because, with a floor, you're not betting your standard of living.
I personally find that my short-term volatility limit of a 15% loss is lower than any long-term asset allocation I calculate, so the latter becomes irrelevant for me. My advice is that investors who can't stomach large losses in a bear market go with the Bernstein max-loss allocation. For many, that will mean somewhere between 40% to 60% equities.
For those retirees who can tolerate short-term losses well, use AACalc to determine an allocation, remembering that its developer notes that an optimal asset allocation is probably unknowable. (In other words, don't sweat a 5% change in your allocation.)
Lastly, retirees with a secure floor can be as aggressive with equities as they like because even in the extremely unlikely event that they lose their entire portfolio, they won't lose their standard of living.
I'm a computer geek and have been since the early seventies. I'm also a statistics and modeling geek. I have found, though, that with many retirement planning calculations using extensive computer models don't give us dramatically new usable information. As you can see in the last two lines of the table, the recommendations I would give you for an asset allocation during a two-minute elevator ride don't vary dramatically from what robos recommend and I would be providing this advice with precious little information about your financial situation, as do most of the robos.
Importantly, the optimal asset allocation is unknowable so there's no sense laboring over a precise allocation, tweaking yours 5% one way or the other, or rebalancing frequently.
Worse, the computer calculations to four decimal places leave people who don't understand computers and models overconfident in their predictions.
If you use an asset allocation calculator, use a good one like AACalc that asks all the important financial questions instead of a pretty app with a lot of marketing pizazz and "ease-of-use" that doesn't. At this point, however, as a planner and a programmer, I prefer skilled humans.
 SWR spending rates and annuity payouts were taken from the Dashboard at Wade Pfau's Retirement Researcher blog.
 Risk tolerance describes an investor's emotional ability to deal with market volatility.
 Risk capacity describes a retiree's ability to risk investment losses and still achieve important financial goals.
 Fixed annuity, variable annuity and indexed annuity, defined at Investopedia.
The Intelligent Asset Allocator, William J. Bernstein, Table 8-1, page 144.
Betterment.com, robo-investment adviser.
Mike Lonier, Retirement Planner, email firstname.lastname@example.org.
AACalc, asset allocation calculator by Gordon Irlam.
RIIA, Retirement Income Industry Association.
QLAC, qualified longevity annuity contract.
Bankrate.com, asset allocation calculator.
ESPlannerBasic, retirement planning website.
Fidelity Investments retirement planner.
Vanguard Investments retirement planner.