There is a popular car insurance commercial featuring someone who “just saved a ton of money by switching to GEICO.” How much is a ton of money? $400? Well, by that measure we just saved more than “100 tons of money” or a whole century worth of car insurance savings. And we didn’t do so by switching, but by not switching our brokerage account. Ka-Ching, how easy was that?
We decided to keep one of our (taxable) accounts at Fidelity instead of switching to the highly acclaimed and heavily endorsed Robo-adviser called Betterment. Betterment and its lesser known rival Wealthfront seem to be en vogue in the Financial Independence (FI) community. A lot of bloggers wrote rave reviews about Betterment. Some of the bloggers even met the Betterment founder, toured the Betterment office in NYC, and got a free T-shirt, too. But the rewards for the blogging community go beyond free T-shirts. Betterment also has an affiliate program and offers referral bonuses if new customers sign up. Hmmm, if we were malicious we’d suspect that the enthusiasm might have something to do with the referral fees because we found very little criticism of Robo-advisers in the blogosphere. We have written about the weaknesses of the Robo-advisers and in today’s post, we’d like to pile on to our Robo-adviser criticism some more by pointing out another flaw that – to our knowledge, at least – hasn’t been pointed out anywhere else. And it’s a major flaw, potentially worth many thousands, even tens of thousands of dollars.
Hardly anybody who considers investing a meaningful amount of money with Betterment has that kind of fresh cash just sitting around in a checking account. Personally, we are very financially savvy with a net worth qualifying as FI (financial independence) but even we have very little loose change to deploy right now because it’s all invested. Our little green soldiers are all working hard in equity funds and real estate to earn their upkeep. Thus, our commitment to Betterment would have to come from existing investments. So, here’s one taxable account with Fidelity worth about $270,000 right now. We hold Fidelity equity index mutual funds (one U.S. large cap index fund and one broad market index fund) in that account. How about we shift that account to Betterment?
The big problem with that move is that Betterment doesn’t accept incoming transfers of mutual fund shares. Why? We don’t know. There is nothing that prevents them from doing so. Most Mutual fund shares, including the run-of-the-mill equity index funds we hold at Fidelity, can be transferred through the so-called Automated Customer Account Transfer Service (ACATS).
The fact that Betterment doesn’t want to do it is more than an “inconvenience” to us: it’s worth almost $42,000. Here’s why: in order to transfer the money we’d have to first sell our Fidelity funds. We have about $145,600 in long-term capital gains, which we’d have to tax at our current marginal rate for long-term gains of almost 29% (15% federal, 3.8% ACA, roughly 10% state/local). Our tax bill: $41,932.80. Ouch! If we were to keep the money with Fidelity and wait until 2019, the first year after retirement, we could realize those gains tax-free because we intend to stay in the first two federal tax brackets in retirement and also move to a state with zero income tax. (This assumes we liquidate those capital gains not all at once in 2019 but over many years to avoid bumping into the higher tax brackets.) Wealthfront apparently does accept incoming mutual fund shares. But Wealthfront will still liquidate your funds with the same disastrous tax consequences because their systems are geared towards ETF trading.
But shouldn’t we be “rolling in dough” to compensate for the minor inconvenience of a nasty tax bill because of all that fancy “Robo tax loss harvesting” they do at Betterment? Hardly! We would have a maximum of three tax years (2016, 17, 18) with high marginal taxes on ordinary income (45%). Even if we generate the maximum $3,000 a year that we can write off on the tax return, we’d recover a paltry $1,350 per year (=$3,000 * 0.45), and even that only in the years 2017 and 2018. Any short-term loss we generate in the tax year 2016 would first be netted against the long-term gains realized in 2016. So that tax write-off is worth only $3,000 * 0.288=$864. Once in retirement in 2019, tax losses, even the carry-over tax losses from 2016-18, are no longer of any use because they would be used to first offset our long-term capital gains during retirement. But those gains are already taxed at 0%. Total maximum gain from Betterment tax loss harvesting: $3,564. This maximum possible tax loss harvesting benefit from Betterment would not be sufficient to make up for even one-tenth of the upfront cost of $42,000. And we haven’t even included the fees (0.25% p.a.) and some of the other inefficiencies in the Robo-adviser process, see our post here.
OK, OK, we can already hear people shouting at their screen:
“Objection, objection, ERN: that’s your own fault that you invested in your boring mutual funds and not in those hip and fun ETFs, the ones they would have accepted as transfer assets at Betterment.”
Partially true but mostly irrelevant. Had we invested in ETFs, the transfer to Betterment would still be a major headache:
- Betterment does accept incoming ETFs, but unless they are part of the “approved” ETF universe of 24 funds, your ETF will be liquidated and capital gains will be realized. If you got the iShares ITOT in your portfolio, tough luck. It might be highly correlated with the VTI (both are proxies for the U.S. Total stock market index), but Betterment will sell your ITOT and reinvest into the VTI, tax consequences be damned. It’s not even 100% clear they will delay liquidation until the transferred tax lots with gains become long-term gains, though it wouldn’t matter for us personally since all gains in the Fidelity account are indeed long-term already. Wealthfront does point out that for each tax lot they will delay the forced liquidation until the gain becomes a long-term gain to prevent an even worse tax impact. They sanctimoniously announce that the forced liquidation will be done in the most tax efficient way, avoiding short-term gains (see link) but it’s still inefficient! They basically tell you, “sure, we slap your face, but consider yourself lucky that we didn’t punch in the face!”
- Even in the best possible case, i.e., had we held our Fidelity equity index portfolio in VTI, Betterment liquidates 83.8% of it to buy other ETFs that fit their target portfolio. That’s because in the Betterment target portfolio VTI has a share of only 16.2%. The rest is made up of other domestic equity ETFs, international equity ETFs and, inexplicably, bond funds. Even taxable bond funds! How dumb is that? They liquidate 80+% of our cherished long-term capital gains at a tax of 28.8% (instead of 0% in 2019) and then – adding insult to injury – use the proceeds to buy tax-inefficient bonds in a taxable portfolio. That is the epitome of tax-inefficiency. Robo-advisers call themselves a great innovation in personal finance. Some of what they are doing seems more like financial malpractice.
There’s another objection coming:
“Objection, objection, ERN: Your situation is special because you are so close to retirement. If someone has a longer investment horizon they can use tax loss harvesting longer and make up for the tax bill!”
The exact opposite is the case. The longer the horizon, the more the Betterment account will fall behind. Here’s why: If we assume that the Fidelity account starts out at $270,000, the Betterment account at $228,000. Both accounts grow at a (conservative!) rate of return of, say, 5% and Betterment receives an additional $1,350 from Tax Loss Harvesting per year (making the most optimistic assumption that Betterment garners enough tax losses to max out the $3,000 every year) you’d get the following:
Year 1:
- Fidelity: $270,000*1.05=$283,500
- Betterment: $228,000*1.05+$1,350=$240,750, or $42,750 behind the Fidelity account
Year 2:
- Fidelity: $283,500*1,05=$297,675
- Betterment: $240,750*1.05+$1,350=$254,147.50, or $43,537.50 behind Fidelity
We get the picture: not only will we never recover the $42,000, but the foregone capital income from the missing $42k is more than you can ever recover from the maximum tax loss harvesting every year. You’re in a $42,000 hole already; digging a few more years won’t help! A longer horizon makes the problem only worse.
Then why do the Robo-advisers encourage account transfers?
“Not only is [a transfer] possible – we encourage it. […] For taxable accounts, we will do [the transfer] in a tax-minimized way. In particular, we will […] [s]ell assets with long-term capital gains.” (our emphasis)
Two explanations:
- A principal-agent problem: Robo-advisers are not in this for charity. They’d rather see assets invested with them than elsewhere even if it’s costing you more in taxes. It’s already difficult enough to gather assets. If you attract new savings from your clients at the pace of a few hundred dollars a month (or a few thousands a month from your rich clients in NYC and Silicon Valley) it’s still only a slow trickle. The real money motherlode is the trillions of dollars of existing investments. But that money is somewhat sticky. Why make it harder to access that money by telling your clients about unpleasant tax implications?
- Applying Hanlon’s Razor (“don’t suspect malice in what can be explained by stupidity”) there could be a certain degree of ineptitude. My impression from the occasional interaction with folks working for the Robo-advisers is that they are very smart, tech-savvy and expert programmers. But with all due respect, finance and economics seem foreign to them. Talking to some even very senior folks, I had the impression they don’t even fully understand the one concept they claim they do really well: Tax Loss Harvesting. They seem to think that TLH is mostly about the arbitrage between ordinary income taxes and long-term capital gains. Hence their nonchalance about realizing long-term capital gains prematurely. Betterment might think it’s irrelevant when you pay taxes for your LT gains; today or in three years or twenty years down the road, it doesn’t matter, right? Well, it does matter, and it matters a lot! In our own research (see our previous post) we found that the “time value of money effect” and the “lower future tax bracket effect” are equally or even more important than the arbitrage between ordinary income tax rates and long-term capital gains tax rates. But the Robo-advisers may simply be oblivious to those.
Whether it’s malice or incompetence, it doesn’t really matter. In the world of finance, both are deal-breakers and we are not shifting any money to a Robo-adviser anytime soon.
Conclusions:
Robo-advisers are not for us. We are DIY asset allocators and like to keep it that way. Some of the inefficiencies in the Robo-adviser technology are merely quirks, destroying a few basis points of annualized returns here and there. The fees are also too high for us, even at 0.25% (Betterment and Wealthfront). Destroying 15% (again, not 0.15% but 15%, the equivalent of 100 years worth of Betterment management fees!!!) of the portfolio value for no good reason right upon transferring assets doesn’t help either.
Robo-advisers can be a good alternative for folks who don’t want to deal with their personal finances: Folks who don’t want to implement the TLH themselves. Still, they should invest only new savings or transfer existing investments that have zero (or close to zero) capital gains or even capital losses. Never, ever transfer existing taxable accounts with sizable capital gains! The tax implications could be so disastrous, you will never recover the initial loss, even under the most optimistic tax loss harvesting assumption.
Does anybody have experience with the Robo-advisers, especially for account transfers? We’d like to hear your opinion!
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