We’re often our own worst enemies when it comes to investing, which is why taking away the human element and automating decisions such as timing of purchases and regularly rebalancing will likely lead to better outcomes for investors. That makes the robo-advisor argument so compelling because it reduces the need for human intervention and sticks to your investment plan, no matter what the markets happen to be doing today.
But even if you’ve been convinced that a low-cost, broadly diversified set of index funds or ETFs is an ideal way to build an investment portfolio over the long term, questions abound when it comes time to turn your nest egg into a retirement income stream.
Investors at this stage become fixated on generating income through dividends and monthly income funds, unsure of the best way to create their desired annual income in retirement and scared of outliving their money.
An automated solution for retirement withdrawals?
Is there a way to automate the process? Last year Dan Bortolotti wrote a great piece in MoneySense about generating retirement income through a total return approach: keeping a portion of your portfolio in cash, fixed income, and equities and then creating a cycle of selling off ETFs to replace the fixed income each year.
It’s one of the best examples I’ve seen on how to generate retirement income year-after-year, but I fear that in practice investors will be paralyzed by the process when it comes to their own portfolios.
Which got me thinking: can the robo-advisor industry respond to the needs of investors during their retirement withdrawal phase by automating a plan with a similar total-return approach? Perhaps they’re already doing this…?
ModernAdvisor founder and CEO Navid Boostani said an automated retirement withdrawal plan could be hard to grasp for most investors and the topic has come up several times with their clients.
“I think Dan’s right on the money with his idea of focusing on total returns as opposed to the income from the portfolio. But the implementation for most people gets tricky and cumbersome.”
He added that it could also get expensive if transactions costs are significant with respect to the size of their portfolio. His solution:
“Most robo-advisors (including us) elegantly solve this problem by automatically selling a portion of client’s holdings to raise enough cash to cover the outflows. This is done while still maintaining the client’s target asset allocation. Because transaction costs are included in our management fees, the additional trading activity doesn’t cost our clients anything.”
I’ve written before about how I’d like to see robo-advisors step in and offer an automated solution for RESPs – something along the lines of a target date fund that automatically rebalances and adjusts your portfolio allocation as your children get closer to college age.
Potential hurdles for robo-advisors to overcome
Could it be just as simple to set-up an automated solution for retirement withdrawals? Justin Bender, a portfolio manager at PWL Capital doesn’t think so. He finds it unlikely that robo-advisors will be able to effectively manage withdrawal portfolios “without being overwhelmed with additional administration and client correspondence.”
Bender says that potential issues may include:
1. RRIF minimum withdrawals – A financial planner would generally estimate how much tax will ultimately be owing, and withhold this amount as a percentage of the minimum. A robo-advisor will likely not do this, and then will be contacted by many of their RRIF holders in April of each year, when they require additional cash to pay their taxes.
If this continues, clients may have to contact the robo-advisor each quarter as their instalment payments become due (the robo-advisor may simply make a decision to withhold 30% from each payment, in order to minimize this potential issue).
2. Multiple account type holders – (i.e. personal taxable, RRIF, corporate taxable, TFSA). Robos may not be able to provide advice on which accounts to withdraw from in any given year (as most would have done zero retirement planning or projections.
3. Other account withdrawals – As RRIF minimums change each year, adjustments will have to be made to other account withdrawal amounts (i.e. if the RRIF minimum dollar amount drops due to poor investment returns, the client may need additional funds from their taxable account). This will require more client correspondence and more admin work to adjust the account withdrawal amounts each year.
4. Fixed income limitations – Robo-advisors do not typically use GICs, so Dan’s examples would not be possible – if they did start using GICs, this would add to the work they would need to do (i.e. it’s much easier to hold a short term bond ETF than to hold a ladder of 5 or more GICs that require manual ongoing attention).
5. Individual tax information – Robo-advisors do not have useful tax information about the client – this could be an issue for taxable investors, as the robo-advisor would be selling securities based on a set formula, possibly resulting in large taxable capital gains at inopportune times.
I have our clients sign a CRA T1013 form, which provides me with historical net capital gains, net capital losses carrying forward, past tax return information, RRSP/TFSA contribution room, etc.). I never rebalance a taxable portfolio without going through all of this information manually in order to make the most informed rebalancing decision (they would not have the time or data for this process). If a rebalancing decision is expected to realize a significant capital gain, we prefer to contact the client beforehand to discuss the proposed trades (even though we have trading discretion).
Bender brings up some good points about an automated withdrawal plan for individual investors being more complicated and time-consuming than the robo-advisors are letting on. The robo-industry in Canada is small and the last thing it needs is to add a bunch of human employees to take care of individual retirement plans behind the scenes.
But I’m still convinced that the FinTech industry can find a way – that automating withdrawals through a total-return approach is going to lead to better outcomes for investors, including peace of mind knowing that an automated system is set up to ensure their portfolios last a lifetime.
I looked to the U.S. for more examples and saw that Betterment, a robo-advisor founded in 2006 with over $4 billion in assets under management, had the most sophisticated automated retirement income solution. Here’s an example of Betterment’s dynamic approach to retirement income:
“Margaret is a 65-year-old college professor, and she is likely to live to 85 based on her family history and health. Using Betterment’s income service, her $500,000 Roth IRA is allocated for a 20-year time horizon at 56% stocks and her expected monthly withdrawal this year is $1,941—an annual rate of 4.65%. This is not her only income—she also has income from Social Security, a pension, and 401K.
If the markets go up: In the first year, her Betterment portfolio grows by 7% and her new balance is $510,000 even after a year of making withdrawals. She’s a year older, however, and now her new recommended allocation is slightly less risky. Margaret’s monthly withdrawal rate will now be about $2,062 (about 4.85% of the new portfolio balance, but about 4.95% of the original value).
If the markets go down: If instead the markets were down 7%, her new balance would be $443,338 after the withdrawals. The new withdrawal rate will be $1,791 per month, or $150 lower than the original starting withdrawal amount, and 4.30% of the original value.
Although the withdrawal amounts do change depending on Margaret’s portfolio performance, her average withdrawal over 20 years is expected to be around $2,503 assuming an average market return of 6%. It’s exactly this dynamic withdrawal strategy that virtually guarantees that her capital will last for the full 20 years. To be sure, every retiree can customize his or her time horizon.”
A question to our Boomer readers, those retired and soon-to-be: Would you sign-up for an automated retirement income solution that manages your portfolio withdrawals and asset allocation from year-to-year?