I just returned from the RIIA (Retirement Income Industry Association) Fall Conference in Charlotte where I gave a presentation on emerging robo-advisors and financial planning.

For most of you, sitting through a conference listening to talks about retirement income probably ranks somewhere between enduring a visit to the dentist and enduring a visit from a basement waterproofing salesman.

So I’ll spare you and summarize. Wealthfront, Betterment, FutureAdvisor, SigFig, etc. all do pretty much what your local neighborhood investment advisor does—ask a few questions, invest your money in a model portfolio, and show you the probabilities that you can draw +/-4% at retirement. It’s neat, clean, automated, and low cost. That’s the good news.

The bad news is that it is pretty much the same thing your old-school investment advisor does. Is that really all there is to it? Is it the right thing for you?

The Shortcomings of a Short Questionnaire
In this investment-based orthodoxy, whether robo or old-school, financial planning equals a short questionnaire about how you feel about risk and losing money. Your answers drive how much of your savings is exposed to market risk, that is, how much your balance might drop in a downturn. Unfortunately your feelings can change arbitrarily based on news events, how you feel about your job today, or even a discussion or argument you’ve had with someone recently.

Similarly, formulas based on your age, which are used by target date funds, are also arbitrary. In both cases, the allocation formula may not fit you well, putting far more (or less) of your savings at risk than your balance sheet shows aligns with your goals. The allocation of your savings to stock market risk should be based on the risk capacity or surplus above the liabilities (all expected future expenses) on your balance sheet, not on arbitrary formulas.

At the other end of the robo or old-school plan, retirement income planning equals a probability calculation that a market crash won’t happen just as you start drawing income, causing you to run out of money before your plan ends. 90% probability is fine as long as you don’t end up on the wrong side of 10%, but who can say with certainty that you won’t? You wouldn’t fly in a plane with a 10% chance of crashing. With a deeper understanding of your goals and household balance sheet, there are safer ways to protect your lifestyle with far less risk than hoping the stock market doesn’t hurt you at the wrong time.

Once you login into a web-based advisor, it’s almost too easy to move a big chunk of money—maybe your whole life savings—into their custody and get it all set up. There is clearly appeal in this almost frictionless way to set up and automate a “personalized” investment process.

As Wealthfront stated today, announcing another round of $64 million in financing, in “the next 5-10 years…we now believe almost every investor will be using some form of automated investment service.” Schwab, always the pioneer, announced yesterday it is launching a new automated investment service with an unbeatable low-cost fee—free. Their pre-launch website says “Relax. The algorithm does it all for you. Investing.” How can you resist that?

The problem, of course, is that it’s not totally intelligent nor is it really personalized. The allocation formula and income probability are arbitrary—they are not informed by your goals and the assets and liabilities on your household balance sheet.

So does this approach—the questionnaire, the model portfolio, and the withdrawal rate—really work? Is it right for you?

What’s Missing From Your Robo-Plan
There are any number of considerations that are more important to your quality of life and reaching your goals than how to invest in the stock market. The stock market has surprisingly little to do with important things like:

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  • What skills should you acquire and what relationships should you build that will help you succeed and earn a higher income?
  • How much should you be saving for the future?
  • How much should you contribute to your children’s education?
  • How do you want to live in the future, and what changes should you make now to get there?
  • What steps will help you achieve financial independence?
  • How will you know when you can afford to quit working?
  • How will you spend your time when you are no longer working?
  • How will you pay for your retirement lifestyle?
  • How long might you and your spouse live, and how can you ensure you won’t run out of money?
  • How should you plan for possible long-term care and unexpected healthcare expenses?
  • How will you handle the inevitable life-shocks that will come along as you get older?
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I could go on, but you get the idea.

These considerations lead right to your most private concerns and to your only source of financial strength—your household balance sheet. The healthier your balance sheet, the more options and flexibility you have. If your options do not align well with your goals and aspirations, then you should be focusing on improving your balance sheet. There’s much more to improving your balance sheet than investing in the stock market, starting with spending less and saving more.

Managing All the Risks That Threaten Your Goals and Lifestyle: Upside, Floor, Longevity, and Reserves
Your balance sheet provides the Floor, which is the first and most important allocation of your savings. The Floor is the amount you need to cover all of your expected future expenses net of earnings, Social Security, pension, and income other and from invested securities. The Floor is the amount of savings you need to cover your expenses and protect your lifestyle.

Since the Floor supports your goals and lifestyle, it and not the stock market is central to your plan. Knowing your Floor amount, you can set achievable goals and protect the amount needed to achieve them by managing your Floor allocation to minimize risk. Options depend on your specific household risk exposures but include cash, CDs, bond funds, and “risk-free” Treasury bond ladders.

The second allocation is Longevity, which provides lifetime income you will not outlive. This might be as simple as working longer and/or delaying claiming Social Security benefits and covering the gap after the last paycheck until you start collecting from savings. Others who are not as well funded might need to add a simple income annuity to provide additional guaranteed income.

The third allocation is Reserves, which provides a reservoir to cover the cost of life-shocks such as un-insured healthcare costs, long-term care, and the other nasty things that can drop into our lives unexpectedly. Reserves are usually equal to 1-2 years of expenses, vary based on household circumstances, and are held in cash, CDs, or risk-free Treasury bonds. Think of it as the grown-up version of the emergency or rainy-day fund.

Once you have determined your Floor and covered the other two allocations, Longevity and Reserves, what’s left over—your cushion or surplus—becomes your Upside allocation. Upside is what you can afford to invest for growth in the stock market after covering your floor. It represents your risk capacity. If capital invested in Upside declines, it will not affect you expenses or lifestyle because those costs are covered by the Floor, which is invested in risk-free holdings.

Note these allocations are all derived from your household balance sheet, which brings together the value of all of your assets such as earnings, Social Security, and financial capital (savings) and all of your current and future liabilities (debt service and expenses). You don’t need to guess your risk tolerance or wonder if the formula in a target date fund is right for you. Your balance sheet provides the math, not arbitrary formulas.

Web-based automated investing is really slick. It’s as easy and alluring as ordering a big flat screen from Amazon. But unfortunately, it’s not completely smart about what’s best for you. Without reference to your balance sheet, the robo or old-school advisor has only a fraction of the information needed to created a truly personalized plan for managing your household growth (Upside), lifestyle (Floor), lifetime income (Longevity), and life shocks (Reserves).

The downside of robo or old-school investing, is that it’s just Upside.

Until the robots get a heck of a lot smarter, talk to someone who can find the Floor, Longevity, and Reserves on your balance sheet, before you give up your Upside to a clever but incomplete automation.

–Michael Lonier, RMA℠