In this chapter we explore how newly created robo-advisors (artificial intelligence applied to financial services) increase access to financial products and financial advice while reducing costs. We will discuss the changing landscape of health care and retirement financing, including the differences that exist between countries. We will show how algorithms are rapidly replacing humans, but that new investment solutions and new services could provide a way to ease the tension between a human workforce and artificial intelligence. We also present a thorough and nuanced picture of fintech products being developed by entrepreneurs, venture investors, and traditional financial specialists.
Millennials, or Generation Y—people born between 1980 and 2000—are the first people to be considered “digital natives.” The internet and its applications have deeply influenced the way millennials think and behave. It has created informed citizens who expect instantaneous feedback. The Peter Pan syndrome, described by American sociologist Kathleen Shaputis, characterizes millennials as a generation unwilling to grow up, commit, or take on adult responsibilities. For millennials, owning homes and cars may not be a high priority. They are more likely to use Uber than to buy cars, and they prefer Airbnb over renting or buying a holiday home.1
Millennials are often characterized as having a different relationship to their jobs than their parents and grandparents had. They favor a flat corporate culture that emphasizes work–life balance and social consciousness. On average, they do not stay in a role more than three years. Online job comparisons and strong social networks offer them a more comprehensive view of the job market than was available for earlier generations. Generation X dreamed of a better work–life balance, but millennials demand it. Flexibility at work has become paramount. If a task can be completed from home or from the other side of the planet, why work in an office cubicle?
Millennials are entering the job market under difficult conditions, particularly in European countries. Jobs are migrating from company-based employment toward peer-to-peer employment via digital platforms (such as Uber). Jobs and work contracts for millennials are increasingly short-term. All of this results in unpredictable income and less ability to save for retirement. It also raises significant questions for health care and pensions.2
At present, employers are still usually responsible for contributing to workers’ retirement funds and health insurance plans (although this varies by country). In a world where independent contractors become the new normal and where gig employers do not provide health insurance coverage, pensions, or retirement plans, the future of pensions and health care looks bleak. How quickly and efficiently will governments resolve these issues, if at all?
The number of people struggling to pay for health insurance has steadily increased since 2015, according to the Kaiser Family Foundation. Today, 27 percent of the US population have delayed necessary medical care because it is too expensive. Another 23 percent have skipped a necessary medical test or treatment, and 21 percent have failed to fill a prescription.
As more people take part in the freelance economy through online companies, it would be sensible for governments to treat these freelance platforms like any other employer and with the same pension requirements. For example, Harris and Kruger (2015) proposed to structure benefits to make independent worker status neutral when compared with employee status.3 They also suggested that independent workers—regardless of whether they work through an online or offline intermediary—would qualify for many, although not all, of the benefits and protections that employees receive. These protections would include the freedom to organize and collectively bargain, civil rights protections, tax withholding, and employer contributions for payroll taxes.
For example, a US company like Uber could be required to offer workers a 401(k) or other retirement plan. This proposal could be unpopular, but it could also help freelancers better prepare for retirement and therefore be less likely to need government financial aid when they are older, an outcome that would be helpful for retirees and governments alike.
Interestingly, over the past few years several gig companies began partnering with online investment and wealth management companies as a way of resolving independent contractor complaints about retirement and other benefits. For example, in late 2015 Lyft formed a partnership with the investment firm Honest Dollar to give drivers an opportunity to sock away some of their earnings for retirement. The plan does not require Lyft to pay for its drivers’ retirement savings or divert drivers’ earnings into a separate retirement fund.4
In 2016 Uber followed suit by opening a company-wide retirement plan through Betterment, an online investment and wealth management company. This plan was first implemented in Seattle, Chicago, Boston, and New Jersey and then expanded nationally. According to their announcement about the plan, drivers could use their Uber app to “open a Betterment IRA (individual retirement account) or Roth IRA for free the first year. Uber drivers can get started without a minimum account balance.” This move was rather surprising because Uber claimed several times that its drivers were independent contractors—not company employees—who had to provide their own benefits.5
Millennials face increasing education costs with less certainty of a positive return on education investments. This is a major shift. Economists in the field of human capital have extensively studied the effects of education on income. Although researchers have recognized heterogeneity in the effects, few studies have looked at the effects of education on income inequality. As an exception, Harvard economists Claudia Goldin and Lawrence F. Katz have found evidence of a correlation between mass education, economic growth, and inequality. In The Race between Education and Technology (2010), they argued that mass education allowed the United States to build wealth and reduce income inequality for most of the twentieth century.6
The United States took an early lead in education. By the mid-1800s, the clear majority of (white) children in many states received a free grade-school education, while only 2 percent of British fourteen-year-olds were enrolled in school in 1870. By the 1930s most US households had a child attending high school, whereas only 9 percent of British seventeen-year-olds were enrolled in school in 1957. The United States was far ahead of the rest of the world. President Roosevelt pushed for mass college education, and by 1970 half of America’s students attended a university.7
Later in the 1970s the US education system began to stagnate, with high-school graduation rates of just 75 percent. This period was also associated with rising US income inequality. Around the same time, the rest of the developed world started investing massively in education. These nations caught up with, and in some cases surpassed, the United States.
As mentioned earlier, US postsecondary education fees since the 1980s have increased significantly. Average tuition and fees have risen 157 percent at private colleges, 194 percent for a public out-of-state education, and 237 percent for a public in-state education between 1987 and 2018.8
According to Mark Kantrowitz’s analysis of 2014 government data, the average US college graduate has accumulated $33,000 in school debt. After adjusting for inflation, this is more than double the debt of the 1994 class. The average cost of higher education could reach a record level when considering the cost of an MBA. Such a degree can lead students to incur a debt of $100,000 to $200,000 (including tuition, rent, books, overseas trips) over a two-year period.9
As previously mentioned, jobs are evolving at a fast pace. The market requires professionals to perpetually develop new, relevant skills. In this challenging context, more people will need to pursue additional education to remain competitive. But what might prevent people from earning a college degree or advanced degree later in their careers? Initial costs could be a deterrent, especially if the returns from education diminish. That outcome is more likely for those who pursue additional degrees later in life because the payoff phase is shortened.
Because they have inherited a dynamic economy with less job stability, millennials should be saving more. The concept of income smoothing implies that people should save money to cover the costs of job loss, health issues, down payments for a house, vacations, luxury items, a new car or car repairs, home improvements, education (including for children), and retirement income.
Savings is also important at a macroeconomic, or aggregate, level. Economies need to maintain a reasonable level of private saving because financial institutions match one person’s saving to another person’s investment. The latter is a key determinant of capital, productivity, technology, and eventually long-term economic growth.10
Different saving behaviors are influenced by the institutional, demographic, economic, and social characteristics of each country. Nevertheless, we can differentiate savers in two groups of high-income countries: (a) English-speaking nations, such as Australia, Ireland, the United Kingdom, and the United States; and (b) continental European nations, such as France, Germany, Luxembourg, Sweden, and Switzerland.11
First, the Anglo-Saxon countries tend, in general, to record a lower level of private saving. Anglo-Saxon countries are usually more indebted and less risk averse. A 2015 study of household debt in Europe and the United States shows that US households have access to large mortgage loans with a relatively low collateral value. Consequently, US households face significant debt-servicing costs.12
By contrast, countries in continental Europe generally have a higher level of private savings. According to a 2018 report by Bank of America, which surveyed 1,500 respondents, ages eighteen to seventy-one, millennials display distinct patterns of saving and spending.13
Millennials invest less of their money on goods with intrinsic value, such as cars or houses, and spend more on experiences and services. Moreover, millennials tend to prioritize personal interests over work (60 percent) and their salaries (24 percent). This relative disinterest in salary has led some to believe that millennials do not care as much about money or, more specifically, savings. Millennials are perceived, and see themselves, as a generation that does not save well: 75 percent of Americans millennials feel that their generation has overspent.
However, millennials are in fact a generation that has been keen to save money. Over the last two years, the portion of US millennials who have saved $15,000 or more has increased from 33 percent to 48 percent, which leads many to believe that the post-2008 financial crisis economic rebound enabled millennials to realize their saving aspirations.
A few theories may explain the rationale behind millennials’ savings: (a) It is a generation that experienced a financial crisis early in their careers; (b) millennials expect little from companies—more than one-fourth have already been laid off; (c) millennials realize that it will be more difficult in an unstable working environment to plan for retirement, leading them to save more than their parents have; and (d) home prices have increased significantly over the last decades, which makes home investment a less attainable objective.14
We have seen that many young people will spend years paying off educational debt. Technology, such as AI and robotics (among other changes), will make the job market more dynamic and less stable. And, as in any era, investment markets can crash and recessions can be severe. All of these factors—and more—will influence the ability of people to save and invest. Nevertheless, the fintech revolution will open new doors for wealth management strategies.
As the baby boomer generation moves into retirement, they will sell stocks and purchase bonds to stabilize returns and protect savings. And so, shifting demographics have encouraged millennials to look for alternative investment opportunities.
Unsurprisingly, many people lack basic financial literacy, which makes it difficult for them to manage investments and makes them more prone to make poor financial decisions. In that context, the safest bet is to let professional advisors manage the money.15
Millennials, however, embrace digital solutions, including new fintech advisory and investment options, such as exchange-traded funds (ETFs). These innovations are starting to make it simpler and cheaper for people to invest without hiring an asset manager.
What is an ETF? An exchange-traded fund is a security that tracks an index, a bond, a commodity, or a basket of assets. It automatically creates a basket of stocks or securities to match the underlying index or market performance. So, an ETF investor can invest in the average performance of the US stock market, or in small European companies, or in the technology sector. The first successful ETFs date back to 1993. In 2020, the assets managed by ETFs globally amounted to approximately $7.74 trillion USD.16
Active funds, in which asset managers select investments, are increasingly challenged by ETFs. In the 1960s, active fund managers mainly competed with amateur individual investors or conservative mutual funds holding blue-chip securities. As a result, active fund managers regularly beat the market by an average of 200 to 300 basis points each year between 1960 and 1980. Stock markets rose steadily between 1980 and 2000. Clients of active fund managers enjoyed large capital gains. Yet the performance of active fund managers was merely aligned with the index, after deducting fees and costs.
Between 2000 and 2010, active fund managers did not sufficiently outperform the index to finance operating costs and fees. Investors became increasingly interested in ETFs, although they remembered the good performance by active fund managers in earlier years.
From 2010 to the present, a large proportion of active managers have underperformed their benchmarks. According to a study conducted between 2012 and 2017, “84.23 percent of large-cap managers, 85.06 percent of mid-cap managers, and 91.17 percent of small-cap managers lagged behind their respective benchmarks.” This underperformance is regularly explained by higher competition, widely shared information, and the emergence of related technologies.17
According to Morningstar, the relative underperformance of active funds (considering related fees) has opened a new avenue for ETFs. As of this writing, ETFs have grown four times faster than active funds since 2007.
The next generation of ETFs will use artificial intelligence to analyze a wide range of information on stocks, to track an index, and to make active investment decisions. Information about stocks can include the stock’s related news, social media publications, as well as conventional financial information.
ETFs can, to some extent, replace an asset manager for a lower fee. They can also track specific indexes or follow defined investment strategies. However, several questions remain for the individual investor: What investment strategy would best fit my own needs and objectives? Where should I invest to preserve my capital or to make larger gains?
The 2001 Daft Punk song “Harder, Better, Faster, Stronger” is an apt description of robo-advisors, which offer many advantages. Robo-advisors are not actually robots; they are online services that use computer algorithms to provide financial advice and manage customers’ investment portfolios. In other complex domains of artificial intelligence, computer programs can beat chess masters. Can they now beat traders and asset managers?
The first robo-advisors, Wealthfront and Betterment, began providing financial advice to public investors in 2010. Wealthfront began as a mutual fund company called KaChing that originally used human advisors. Wealthfront’s founders, Andy Rachleff and Dan Carroll, wanted to expand on this model by providing financial advice to the tech community. They quickly shifted focus by identifying the potential for lower-cost investment advice, which made services accessible to a larger number of people.
Robo-advisors combine several innovations to provide comprehensive financial advice to clients over the internet without human contact. The clients typically fill out a questionnaire that asks about their attitude toward risk, their age and expected retirement date, and perhaps about their other investments. Robo-advisors use quantifiable factors, such as wealth, income, tax situation, investment goals, and risk tolerance to analyze a client’s financial status and to provide portfolio recommendations that are tailored to each client’s needs. Typically, these programs do not provide advice relating to decumulation, which is the withdrawal of money from the pension account during retirement.
Robo-advice comes in different forms. It may be part of a program that manages other financial market assets of the participant, or it may be focused solely on pension plan investments. It may be part of a program that considers other financial goals, such as savings for college, or it may be focused on assisting in making pension investments. It may be part of a program that addresses issues of financial wellness, including issues of debt and insurance, or it may be more narrowly focused. It may be a stand-alone program, or it may also involve the participation of an investment adviser. It may directly interact with the pension participant, or it may be used by a financial adviser to assist the advisor in providing advice to the client.18
Fintech clearly impacts the financial advice service sector. Robo-advisors allow savers to receive less costly and more professional advice related to the management of their savings. Prior to the introduction of robo-advisors, such advice was unaffordable for many individuals. Thomas Philippon argued that robo-advising will likely democratize access to financial services and that Big Data is likely to reduce the impact of negative prejudice in the credit markets. According to Bartlett et al., algorithms improve financial inclusion because they are less discriminating than face-to-face lenders. Erel and Liebersohn found evidence that borrowers were more likely to get a fintech-enabled Paycheck Protection Program (PPP) loan if they were located in ZIP codes where local banks were unlikely to originate PPP loans. Carlin et al. showed that millennials incur lower financial costs when they use fintech to manage their finances.19
Robo-advice is generally cheaper and more accessible than human advice. This means it could be especially useful for defined contribution plans because members face numerous financial choices and relatively small accumulated savings. According to the UK’s government chief scientific adviser, fintech companies can increase the availability of financial advice to previously underserved populations, thanks to “lower cost structures, greater customer reach, or superior ability to monitor or score risk.” Robo-advisors were estimated to be managing $440 billion in assets as of June 30, 2019.20
A robo-advisor that has received little attention to date uses online advice programs provided to pension participants through their 401(k) plans. According to TIAA Institute research, in 2012 and 2013, 6.5 percent of TIAA participants in the sample sought asset allocation advice using an online tool made available to them. The demand for advice increased fourfold with the introduction of online advice tools.21
As an added benefit, the advice provided by robo-advisors is more transparent than that of human financial advisors. It is nearly impossible to monitor private conversations between human advisors and clients, but it is possible to evaluate the advice provided by computer models. Greater transparency may lead robo-advisors to adhere more closely to regulatory requirements than human advisors.22
Finally, robo-advisors are convenient. They are always available from any location. For some customers, accessing information from a website platform is more convenient than filling out paper documents or meeting with a human advisor. These robo-advisor features may be particularly appealing to young generations because they are so comfortable with technology and prefer handling their affairs at a convenient time and location.
The assets managed by robo-advisors have grown exponentially. At the end of 2014, Corporate Insight reported $19 billion in US robo-advisor managed assets. By 2016 that number had grown to $126 billion. The amount should grow even more because young people are more likely than older people to use robo-advisors. A survey of people with non-pension-plan investments found that 38 percent of individuals age eighteen to thirty-four have used a robo-advisor, compared to 4 percent of individuals age fifty-five and older.
Another advantage of robo-advisors is that they are more accessible to less wealthy people. Human advisors typically have a minimum asset requirement of $500,000, which makes them inaccessible to low- and middle-income customers. By contrast, robo-advisors offer far lower minimum account balance requirements. Wealthfront, for example, requires a minimum balance of only $500, and Betterment does not require any minimum balance. These lower minimums make robo-advisors well suited for young people who are just starting to save. As a result, the current user-base of fintech products is skewed toward the younger population (age twenty-five to thirty-four), who are technologically literate and in need of financial services.23
Historically, human financial advisors have charged fees ranging from 1 to 2 percent of assets under management. They have tended to charge lower fees for larger portfolios. In the United States, robo-advisors have typically charged fees that are substantially lower, ranging from no fees to fifty basis points (Table 3.1).24
Computer technology and algorithms, which are less expensive than humans, make these lower fees possible. Robo-advisors also have the advantage of economies of scale, meaning that one computer algorithm can advise numerous clients. These already low fees are expected to fall even further as robo-advisors acquire more clients and their clients accumulate more assets.
In addition to advisory fees, clients must pay expense-ratio fees for underlying investments. Most robo-advisors allocate their portfolios among passive index fund strategies, whereas traditional financial advisors are incentivized (and therefore more likely) to recommend active asset management options with higher fees. Thus, robo-advisors offer less expensive advisory fees and mutual fund fees. They also cost less to trade. For example, Betterment’s fees on investment options range from nine to twelve basis points.25
So, robo-advisors are more accessible and less expensive. But do they perform just as well? The first criterion for successful wealth management is the advisor’s choice of asset allocation. Historically, equity investments have generally outperformed fixed income. This has been particularly true over the past five to ten years, when interest rates have been extremely low. An advisor’s performance is therefore heavily influenced by the degree to which that advisor’s recommended portfolio is concentrated in equities. For example, Cerulli compared the advice of seven robo-advisors for a hypothetical person age twenty-seven. Cerulli found that portfolio allocation of equities varied from 90 percent to 51 percent.
Market competition may lead robo-advisors to overconcentrate in equities in order to generate higher returns, a strategy that may operate to the customers’ detriment in a market downturn. However, in 2019 the rates of return earned by the robo-advisors for Personal Capital (19.68 percent) and Betterment (18.97 percent) outperformed a weighted average return of a benchmark made of 60 percent equity and 40 percent fixed income (Figure 3.1).26
What about risk management? Kitces (2017) has criticized certain robo-advisor approaches, particularly those attempting to match people to portfolios using questionnaires. He notes that an individual with a high net worth and a high capacity to bear risk, but with a low tolerance for risk, could be placed in a moderately risky portfolio because of his or her wealth. The underlying reason is that the robo-advisor might set risk-bearing capacity and risk-tolerance scores to an overly conservative, or incorrect, risk / reward default. For example, an individual with high capacity to bear risk but low tolerance for risk should be put in a low-risk portfolio.27
Data source: Jill Fisch, Marion Laboure, and John Turner, “The Emergence of the Robo-Advisor,” in The Disruptive Impact of Fintech on Retirement Systems, ed. Julie Agnew and Olivia S. Mitchell (Oxford: Oxford University Press, 2019), 13–37.
Note: Benchmark is calculated based on a 60 percent fixed income index (US ten-year bond yield) and 40 percent equity (S&P 500) weighted average return.
FIGURE 3.1 Returns of selected robo-advisors vs. benchmark
In comparison to target-date funds, in which a person’s pension fund portfolio is based solely on the year in which he or she plans to retire, robo-advisors provide more personalized advice concerning portfolios. In theory, the more relevant information a robo-advisor can gather about the client, the more it can provide personalized guidance. So, many robo-advisors are attempting to do a better job in determining the risk tolerances of clients. Robo-advisors already have an advantage over target-date funds because the former can help clients pick investments appropriate for their risk tolerances, not just their ages. Breen (2019) speculates that eventually robo-advisors could largely replace target-date funds.28 However, these funds are often the default for people automatically enrolled in a 401(k) plan, whereas advisor-managed funds are not the default fund.
A future development may be that funds managed by robo-advisors will be offered to pension participants as default funds. Although target-date funds usually have fees of around fifty basis points, one financial service provider has started offering funds managed by robo-advisors that are designed for 401(k) plans with fees of twenty basis points.
Robo-advisors began relatively recently in the United States, and the concept has spread rapidly to other countries. The number of robo-advisors in Europe has increased significantly since 2014, and the amount of money they manage has also grown rapidly. Robo-advisors now operate worldwide. Nevertheless, most robo-advisors are based in the United States.
Although it is difficult to generalize the European market, European robo-advisors (e.g., Nutmeg, Quirion, Marie Quantier) tend to charge higher fees than US robo-advisors—from forty to one hundred basis points more. The higher fees may be due, in part, to the fact that robo-advisors are a relatively new phenomenon in Europe and do not yet have the scale found in the United States. In addition, European financial and banking legislation is national and therefore differs across countries. This means that there are many national markets for robo-advisors rather than a centralized European market. Also, Europeans are usually more risk-averse than Americans, resulting in more saving and safer investments. These factors may have led European robo-advisors to grow slowly, thereby reducing their ability to benefit from economies of scale.
Artificial intelligence and advances in computer science have recently generated humanized algorithms with a capacity to sympathize with people. Robo-advisors do not just use algorithms; they create algorithms that can adapt to and comprehend different environments. This is called “machine learning.” The algorithms of robo-advisors can learn from a vast amount of data, just as human beings can learn from innumerable perceptions and experiences.
Researchers are already working to give the algorithms the ability to recognize human emotions based on voice intonations, thereby capturing not only the note, but the “color,” tempo, and speed of enunciation. To accomplish this, up to 2,500 features must be individually programmed.
Innovative studies of neural networks have dramatically accelerated “deep learning,” which enables robots to mimic the human brain’s functions. This eliminates the step-by-step nature of robots. With auditory intelligence and facial recognition, robots can already recognize micro-expressions.
So, the future of robo-advisors is bright. They offer increasingly relevant and human services to clients. However, little is known about the wider socioeconomic implications of digital wealth management solutions. Can robo-advisors democratize finance and decrease wealth inequality?
Over the course of the twentieth century, finance has become a leading driver of inequality. Atkinson et al. (2011) showed that very wealthy individuals have access to investment products with significantly higher financial returns than the mainstream products accessible to most. In his book, Capital in the Twenty-First Century, Piketty outlined the evolution of wealth inequality over the last three centuries. He found that the rate of return on capital has been significantly greater than the economic growth rate and, as such, has been greater than income from labor activity.29
According to the IMF, the per capita real income of the top 1 percent of advanced economies grew by 282 percent between 1980 and 2012, whereas per capita real income of the remaining 99 percent grew by only 144 percent during the same period. When annualized, the difference per year appears less pronounced, but it is still significant. The income of the wealthiest has grown by 3.3 percent per year on average, compared to 1.1 percent for the rest of the population. This represents the difference between investments in low-yield, fixed-income assets and high-yield equity.30
Wealthy individuals have access to a wide range of investment opportunities, including investments in alternative asset management plans (such as hedge funds), whereas small investors typically hold “vanilla” investments (such as bank deposits and government bonds).
Figure 3.2 shows the annual rate of stock returns, Treasury bills (short-term bonds) and ten-year Treasury bonds (long-term bonds) from 1928 to 2020. This chart shows an investment of $100 in 1927.
On average, stocks have outperformed short- and long-term bonds during most periods over the last century. Clearly, long-term dormant savings can add up to a lot of money. We also see that small differences in investment returns make a big difference over the long term (compounding effect). And regular savings, even in moderate amounts, can accumulate significant wealth. These facts apply to pension planning and complementary retirement investments. Even small differences in investment fees can make a big difference over time.
With the rise of the gig economy, many workers won’t have access to steady employment with good retirement pensions, employer savings plans, or other benefits. This means that they need to do more on their own to prepare for the future.
Data source: The raw data for Treasury bond and bill returns was obtained from the Federal Reserve database in St. Louis.
Note: The return on stocks includes both price appreciation and dividends. The Treasury bill rate is a three-month rate and the Treasury bond is the constant maturity ten-year bond, but the treasury bond return includes coupon and price appreciation. The graph is based on a compounded value of $100.
FIGURE 3.2 Annual rate of returns on stocks, T-bonds, and T-bills from 1928 to 2020
Older workers also have had to adapt in recent years. With the growth of 401(k) plans and Individual Retirement Accounts (IRAs), employees increasingly have had to take responsibility for investment decisions about pension accounts. While only 13.8 percent of US households directly held stocks in 2013, 49.2 percent of households held retirement accounts, primarily IRAs and 401(k) plans.31
Not everyone, however, is well positioned to take advantage of their own retirement investments. Choi, Laibson, and Madrian (2010) found that lack of knowledge about index funds led some people to experiment with high-fee index funds because those funds also had relatively high rates of return, due to the timing of the funds’ inception. Similarly, Hastings, Mitchell, and Chyn (2011) showed that people who had greater financial knowledge paid lower fees for mutual funds.32
It is well established that people suffer from exponential growth bias, underestimating the effect of compounding over time: however, that bias affects both interest compounding and the effect of fees.33
Investors with smaller asset amounts usually pay higher investment advisor fees, as a percentage of assets. For example, most investment advisors have asset-based fees and a minimum fee. Therefore, the minimum fees paid by investors with low levels of assets are a higher percentage of assets than the percentage paid by wealthier investors.
Kitces (2018) reported that advisory fees have come down because financial advisors have been using robo-advisor assistance. This has allowed advisors to manage more clients and lower fees without reducing their income. Lower financial advisor fees may reduce the inequality of fees charged.34
A study by Munnell, Aubrey, and Crawford (2015) found that IRAs tend to receive net rates of return that are about 1 percentage point less than the rates of return for employer-provided contribution plans, such as 401(k) plans.35 This was largely due to a difference in fees, but it was also due to differences in asset allocation. Based on this research, a higher percentage of assets in IRAs is often invested in money market funds, which would seem to be a poor investment choice for retirement savings.
An example from the US Department of Labor (2016) revealed the importance of fees on investment outcomes. “Assume that you are an employee with thirty-five years until retirement and a current 401(k) account balance of $25,000. If returns on investments in your account over the next thirty-five years average 7 percent, and if fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, however, your account balance will grow to only $163,000. The 1 percent difference in fees and expenses would reduce your account balance at retirement by 28 percent.” If fintech innovations can reduce or remove these fees, the benefits for investors will be significant.36
Younger generations are open to new fintech solutions, so we should expect to see rapid changes in digital wealth management. Due to increased use of robo-advisors and improved financial education, we could see a democratization of finance and decreased wealth inequality for low- and middle-income persons.37
As we previously saw, inequality is often exacerbated when the rate of return on capital surpasses economic growth and income from labor activity. Many people lack access to wealth management and therefore earn lower returns. This has fed growing inequality over the last decade. The recent emergence of robo-advisors could dramatically change the rules of the game, making wealth management accessible to most.
Digital wealth management solutions democratize finance by making investments accessible to millennials and the middle class. They provide tailored investment solutions and access to highly sophisticated asset classes. They virtually facilitate access to wealth management. It is very easy to set up automatic monthly savings directed to a robo-advisor that automatically invests it and reinvests the dividends and realized capital gains. Robo-advisors charge low fees and have no (or low) minimum asset requirements. As a result, many more people could see investments produce rates of return like those received by wealthy individuals.38
Financial literacy is an essential key for helping people think about investing and long-term financial planning (retirement, children’s education, and so on). More people need to become acquainted with finance and investment, including its risks and benefits. The solution will probably come from the private sector (by simplifying the process, reducing fees, and lowering the initial capital required) and from governments (by educating people about financial principles).
As of 2017, US robo-advisors managed a combined total of less than $100 billion in assets. Since 2019, robo-advisors have risen 30 percent to reach $460 billion assets under management in 2020. Experts expect the robo-advisor industry’s growth to be substantial, reaching $1.2 trillion by 2024.39
Of course, many economic variables (such as interest rates and debt levels) can negatively or positively impact the returns on savings rates and wealth accumulation. For the purposes of this discussion, we cannot address every variable. However, digital wealth management could become up to eighty times larger in the next three or four years. Retirement planning and pension management could be a promising catalyst for robo-advisors, especially in countries that lack universal access to retirement plans, such as the United States. Educated millennials could also be a promising customer segment for digital wealth management solutions because they are financially literate and comfortable with technology.
This level of growth could lead larger players to scale up their advertising and education efforts, possibly leading to a virtuous cycle that fulfills disruption promises. Thus, greater access to financial investments could become a critical tool in bridging the wealth inequality gap by providing low-cost financial services to relatively low-income people.