You probably shouldn't be using Wealthfront or Betterment 💰
You probably shouldn’t be using Wealthfront or Betterment, but not for the reasons you might think.
In fact, arguments against robo-advisors rooted in the hidden costs of compounding management fees or in examining the true value of tax-loss harvesting are clouding the bigger trap that many Millennials fall into.
What’s the trap?
Well-intentioned Millennials are investing meaningful amounts of their income into robo-advised taxable accounts before maxing out the annual limit of their primary tax-advantaged accounts (IRA’s and 401(k)’s) — and the robo-advisors have no incentive to steer them in the right direction.
Note: In no way does the below argument attempt to assert that the use of Wealthfront or Betterment is an exceptionally bad choice for the management of tax-advantaged retirement accounts like IRA’s or rolled-over 401(k) funds.
It’s true that retirement investing via robo-advisors is objectively more expensive when compared to directly funding the underlying Vanguard mutual funds, but only by a margin of .25% for investment portfolios of over $10,000.
The primary objective of this essay is to surface how the slick on-boarding interfaces and customer acquisition strategies of Robo-advisors are seducing Millennials into sub-optimal investing strategies and to examine why it’s not in the best interest of Wealthfront and Betterment to advise their customers to take the most optimal investing approach.
I’ll first lay out how the word of mouth acquisition strategies and overly-simplified on-boarding interfaces of robo-advisors are clouding millennials’ ability to make optimal personal finance decisions.
In closing, I’ll lay out the (significant) benefits of maxing out tax-advantaged accounts before investing a dime into a taxable brokerage account or individual stocks.
A breakdown of how robo-advisor services lead to sub-optimal investment activities by Millennials
1. Customer acquisition via word of mouth & referral programs:
To illustrate the path that leads Millennials to sub-optimal investment decisions facilitated by leading robo-advisors, it’s important to first lay out the primary customer acquisition strategies in use by Wealthfront and Betterment.
Common Millennial investment monologues:
“I know I should be investing, but it’s too complicated.”
“Everyone else must have a ton invested with Wealthfront and Betterment since they’re constantly talking about it. They wouldn’t be investing if they weren’t making money, right?.”
“Jim was just talking talking about how he’s shorting Salesforce before their big conference and Mary said she’s going to buy into the Square IPO so that she doesn’t miss the first-day “pop.”
For those without a Wall Street background (or a healthy amount of skepticism towards statements made by their peers), it might seem like the emulation of flashy activities like stock picking and market timing is the correct (or only) way to invest.
And this is precisely why word of mouth and incentivized referral programs are working so well for robo-advisors — when faced with the complexity of opening up a traditional brokerage account to make trades of individual equities, the robo-advisors win out and add a new Millennial investor to their growth charts.
Let’s be clear: the removal of barriers to entry of investing that the robo-advisors have provided is great! In the long-term, some investing (via low-cost index funds) is almost always better than no investing.
So why is there an issue with Millennials using these services? The next action - the account funding and initial investment selection are where sub-optimal decisions are made.
2. Fund selection and onboarding flows:
After collecting some basic information on the new investor, the robo-advisor’s fund selection and initial deposit screens take over. This is where the sub-optimal decisions are made, and there’s absolutely no indication that a less-than-ideal choice is being made.
To provide examples of these screens, I first provided the below assumptions to both robo-advisors. If you’d like to re-create these flows for yourself, you can do so on Wealthfront.com and Betterment.com.
Investor age: 25
Annual income: $135,000
Risk tolerance: high
New to investing
Default recommendation: “Taxable Mix”
Location of the selector to choose a tax-advantaged account:
Default recommendation: “Regular (Taxable)”
Location of the selector to choose a tax-advantaged account:
Even though the selectors to toggle between account types is front-and-center in both flows, it’s easy to imagine how a new investor without knowledge of the benefits of tax-advantaged accounts might get confused and go with the default (and robo-advisor recommended) option:
Oh, I’m not ready to plan for retirement just yet. I’ve heard there are penalties if I withdraw that money early. I’ll pick the ‘Taxable’ account so that I can withdraw the money if I need it for a house or something.”
“What are these funky acronyms? SEP? IRA? Roth? I’ll just go with ‘Regular.’”
It’s not totally clear whether these flows are intentionally designed to encourage Millennials to make what end up being sub-optimal choices, but it’s easy to put together a list of reasons why Wealthfront and Betterment might see greater lifetime customer value from individuals who choose to initially open taxable investment accounts v.s. tax-advantaged retirement accounts on their platform:
The robo-advisor’s most buzzed about feature, Automatic Tax-Loss Harvesting, does not apply to the retirement account types offered (Roth and Traditional IRAs).
- Based on homepage and sales page prominence, Tax-Loss Harvesting is far and away the most flaunted feature of leading robo-advisors. Because this benefit does not apply to Roth and Traditional IRA investment accounts, discerning customers may become increasingly unable to justify the .25% management fee solely for the benefit of a slick interface to view the performance and value of their retirement accounts.
Annual maximum contribution limits of $5,500 (in 2015-2016) for IRAs put a cap on the total potential investment amount per customer.
- Those who open taxable accounts are far more likely to make both greater initial deposits and continued ongoing deposits in larger amounts than those using the service solely for the management of their retirement accounts.
As Millennials grow older and hit life milestones (wedding, home purchases, first child, etc.), their propensity to evaluate the fees associated with their investment accounts increases and could lead to the rollover of invested assets to lower-cost funds (e.g. Investing directly in Vanguard funds).
The many benefits of maxing out your tax-advantaged retirement accounts before taxable investing
Why is it so important that Millennial investors max out their tax-advantaged accounts before investing in taxable accounts each year?
Let’s look at one realistic and relatable example:
If you invest the maximum allowable amount to your tax-advantaged retirement accounts each year (both IRAs and 401(k)’s’), the value of your investments (assuming a constant 5% rate of return) will be over $550,000 after just 20 years without doing any taxable investing at all.
These accounts are offered through your employer and not Wealthfront or Betterment though they provide significant advantages and should be maxed out before making investments in taxable robo-advisor accounts.
Contributions to your (Traditional) 401(k) are pre-tax, meaning that you can invest the annual limit of $18,000 for the low, low price of between $10,692 and $15,300 post-tax dollars (depending on your tax bracket).
Because your income will likely be lower at the time of retirement, you’ll likely be able to withdraw from your 401(k) and be taxed at a lower rate than you would have if you invested in a taxable account during your working years.
You can significantly lower your tax liability. If you contribute the 2015/2016 max to your Traditional 401(k), you’ll lower your taxable income by $18,000!
Your investments in tax-advantaged accounts are exempt from capital gains tax. At the time of withdrawal, you’ll pay only income tax on the capital gain.
Over many years of working and investing, the choice to max out contributions to tax-advantaged accounts before contributing a dime to taxable accounts via a robo-advisor like Wealthfront or Betterment can mean hundreds of thousands of dollars in tax savings and additional cash at retirement.