TABLE OF CONTENTS
Betterment provides financial advice in our digital service and through our advisors who customers can contact over the phone (using the Betterment premium plan). In both cases, we have a standard methodology that incorporates recent research and economic circumstances. A major focus of our financial advice is to help investors save intelligently for retirement and successfully live off their savings during retirement.
Here, we provide a complete overview of our financial planning methodology for retirement goals. Whether you’re using Betterment’s digital plan or if you’re getting help from our financial professionals, you’ll find we rely on the same fundamental assumptions and approach to helping customers achieve their retirement goals.
What Are the Tools of Retirement for Americans Today?
Betterment strives to help investors utilize all of the options and capabilities available to them to successfully retire. These include various federal tax benefits, account types, portfolio construction decisions, asset management strategies, economic forecasting, and insights from behavioral economics. Over time, insights on effective retirement planning tactics will inevitably improve and regulations will change; our methodology for retirement planning will evolve as well.
We aim to help you set a clear, realistic retirement goal and stay on track to achieve that goal. In this way, it is an elaboration on the fundamentals of our goal-based approach to financial planning. We aim to include the following components of retirement planning:
- Projecting an estimate of your desired spending in retirement
- Determining the total pre-tax savings amount you’ll likely need to achieve that spending level with high confidence
- Calculating how much you should save during each period prior to retirement
- Prioritizing which retirement savings vehicles are likely to be most efficient
1. Estimating Retirement Spending
How much you would like to spend during your retirement is the most important driver of your retirement plan, but it is often the hardest part to predict. We choose to focus on how much you’ll need to spend (or consume), rather than your pre-tax income, because pre-tax income that is subsequently taxed does not help you maintain your lifestyle.
We use several factors to help you estimate your spending when you retire, including how your earned income will grow over time, what the local cost of living will be like, and what your spending habits look like before retirement. In this section, we’ll describe our methodology for anticipating each of these factors when making customer recommendations
A. Growth of Real Earned Income
How much you spend is strongly related to how much you earn, but your income could change during your life for multiple reasons, including raises and inflation. We model real growth of your annual pre-tax income as the first step to estimating consumption at retirement. A young worker with 40 years ahead of them should plan on earning more just before they retire.
We use the current pretax income provided by you, and then, by default, we estimate that the growth of your annual income will outpace inflation by 1% per year. You can modify this assumption if you’d like.
B. Cost of Living for Where You Retire
While it’s common to retire where you lived during your working years, some people plan to retire somewhere else. By default, we assume you’ll continue to live where you do now (using the ZIP code you specified when opening your account), but if you’re expecting to move somewhere less or more expensive, you can specify a ZIP code to help you estimate that new cost of living.1 It can be enlightening to learn how much less you need to save if you move somewhere less expensive in retirement. We assume that the cost of living in that ZIP code will be the same at the time you retire as it is now, adjusted for inflation.
C. Spending Prior to Retirement
It can be difficult to predict exact expenses in retirement. We assume that, during retirement, you’ll want to maintain the standard of living you had just before you retired, which means consuming the same amount (adjusted for your new zip code). Although you may no longer have a mortgage or be supporting children, those expenses are typically replaced by new activities or hobbies, as well as travel and medical expenses. While you are saving, your finances can be described simplistically as:
Net Income = (Gross Income - Pre-tax savings) * (1 - Average Tax Rate)
Spending = Net Income - Post-tax Savings
However, we need a way to estimate how much of your income you save. It’s a general rule (both empirical and theoretical2) that at low income levels you choose to consume a higher proportion (all) of your income, but that as net income rises that proportion falls. Estimates of the wealthy find that they often consume less than half of their net income. That relationship is modeled by our Average Propensity to Consume (APC).
Consumption Ratio = APC * (Net Income)
Spending = Net Income * Consumption Ratio
Our goal is to deliver the same amount of spending in retirement as just before retirement. Critically, once you're retired, you're no longer saving, so you don't need as much income to support the same level of consumption. Your APC goes to 100%.
Net Income = (Gross Income) * (1 - Average Retirement Tax Rate)
Consumption = Net Income * 1
As a result, you enter a positive cycle — you need less gross income for the same amount of consumption because:
- You aren't saving before tax.
- As you take less gross income, your average tax rate falls, as well.
Net Income = (Gross Income) * (1 - Average Retirement Tax Rate)
This model allows us to model how much gross income (pretax) you need in retirement to actually experience the same living standards as you had preretirement.
Of course, if you’d prefer to specify your spending needs based on your own estimates, you can override our estimation.
D. No Specific Assumptions on Required Minimum Distributions
Aside from planning that distributions will be taxed appropriately, we do not specifically calculate or handle Required Minimum Distributions (RMDs) in this retirement planning advice. We assume that your spending needs will meet or surpass your RMD requirements, if you have traditional IRAs.
We do calculate your RMDs for your Betterment Traditional IRA or SEP IRA on an annual basis and provide this to you in your tax forms if the account was held here on Dec. 31st of the prior year.
II. Determining Total Savings Needed
Once we’ve collected information and estimated how much you’ll spend in retirement, we can figure out the total amount you’ll need to have saved by the time of your desired retirement date to have a 96% chance of success you will not run out of money during retirement.
A. How long will your retirement be (the time until end of life)?
The length of your retirement dramatically affects how much you’ll spend in total once you stop saving and, therefore, the total amount of savings you need. We ask for your desired retirement age, and we default your life expectancy to 90 years old (a fairly conservative assumption), which determines how many years you’ll be spending for. You can adjust both your retirement age and your life expectancy if you’d like.
B. Accounting for all sources of retirement income
Income in retirement can come from multiple sources. We need to understand all sources before we can figure out how large your nest egg needs to be. The main sources for most people are Social Security and investment income or withdrawals from retirement accounts. However, some people may have additional sources such as rental property or a pension.
Social Security Based on Retirement Age
Social Security is the most common source of income in retirement for Americans. The extent of this government benefit varies by both your level of lifetime earnings and when you decide to start claiming Social Security income.
We estimate Social Security income according to the U.S. Social Security Administration’s benefit rules. Inputs for their rules include current income (for you and your spouse separately) assumptions for growth rate of your earned income, assumptions for inflation, and the age you (and your spouse, if applicable) choose to retire. Generally, we assume you start benefits in the year you retire.
Additionally, we apply the following assumptions to the SSA’s guidance:
- Because you can’t take Social Security before age 62, if you choose a retirement date before this, we will assume you take withdrawals from your portfolio or other sources to meet your income needs until Social Security income can be taken at age 62.
- If you retire in between ages 62 and 70, we assume you start Social Security benefits at the retirement age you choose, unless you specify a different age. In general, each year you delay claiming Social Security benefits after age 62 but before age 70 increases your benefits.
- There are no benefits to delaying claiming Social Security after age 70. However, if you input a retirement age greater than 70, we assume any SS benefits you receive before you actually retire are spent instead of saved.
- If you specify a retirement age for your spouse that is earlier than your retirement age, we assume you will simply spend their Social Security benefits rather than investing them, so that they don’t affect your plan or portfolio growth.
Social Security benefits are subject to an annual cost of living adjustment (COLA) that varies year to year. We assume COLAs are constant in retirement at the assumed level of inflation, but you can override this setting when editing assumptions within your Betterment account.
Finally, given the projected deficits in the Social Security trust funds, some customers prefer to plan for retirement assuming partial or zero income from Social Security. According to the Social Security Administration, zero benefits are not likely, but the SSA does currently predict that younger workers may only receive three-fourths of benefits because of the deficit. As a result, we default to three-fourths of calculated benefits, unless you adjust your retirement planning assumptions.
There are several other important assumptions that are used in our Social Security calculations:
- We use full retirement age as defined by the SSA rules and your date of birth.
- Salary growth is assumed as you specify, with a default of 1%. Note that the SSA.gov benefits calculator does not assume any income growth. Earnings history is also estimated using this growth rate in the opposite direction (i.e. you earned less when you were younger).
- COLAs are assumed to be equal to our assumed rate of inflation (2% by default).
- You can override the start age and benefit amount in “Edit Assumptions > About your income” for you and your spouse.
- Social Security continues until life expectancy for each person. No survivor or disability benefits are assumed.
Other Income Sources
Often, retirees also have income from other investment sources, such as rental properties, pensions, or annuities. You can add these to your plan by selecting “Edit Assumptions” and/or adding them as manual synced accounts. For any of these other income sources, we assume they begin at your retirement age, are adjusted for inflation, and will end upon your specified date of death (or your spouse’s, whichever is later). If you add other income sources to the assumptions, we interpret the value to be in today’s dollars, and will adjust it for inflation through accumulation and retirement. Manually synced accounts are assumed to have no fund fees.
If Social Security and other sources of income are not enough to meet your spending needs, the resulting gap needs to be filled by your savings and investments. We assume you will need to make withdrawals from your portfolio each year to make up this gap, making adjustments for taxes and planning for the variability of markets.
C. Ensuring You’ll Be Okay in the Worst-Case Scenario
Not having enough savings in retirement is a dire situation, and securities markets are unpredictable. Betterment employs a conservative market performance expectation in retirement (lowest 4% of expected returns, or a 96% chance of success) to estimate how much you’ll need to have saved when you retire.
D. Accounting for Taxes on Withdrawals in Retirement
Accounting for future taxes is complex—impossible to do precisely —because we cannot predict with 100% certainty the outcome of your retirement investments, your future personal situation, or what tax rates will be during your retirement years. Yet, ignoring taxes completely would not be accurate either, so in Betterment’s retirement planning practice, we attempt to adjust for your tax liability as best we can.
We estimate your future tax rate based on your specified spending (income) in retirement (see Section I.), your state of residence, and standard deductions for your marital status. Your withdrawals will come from growth on the holdings you have when you start a retirement goal as well as future deposits into your investment accounts working toward retirement. In both cases, your retirement accounts likely may include accounts invested with Betterment and those held at an external firm. We handle each part of your savings differently based on what we know, so here we’ll provide an overview of our method.
Projecting Current Retirement Balances
Because we know your current retirement account balances and types, we use these balances to make projections and adjust for taxes using your current tax rates and what we assume tax rates might be like during your retirement.
- For existing traditional IRAs and employer plans, we assume you’ll pay no taxes while saving, and, during retirement, you will pay your average rate on the full amount of each withdrawal. Notably, this means we assume all traditional retirement accounts have zero cost basis. If you have made after-tax contributions to your traditional retirement accounts, this assumption will cause us to overstate the taxes you will owe.
- For existing taxable accounts, taxes are paid in two ways:
- As you save, you will need to pay taxes on dividends and capital gains realized from rebalancing, so we reduce your projected returns by 7/100ths to account for that payment. For example, if you have a gross return of 7%, your after-tax return will be 6.44%. Learn more about after-tax returns.
- For when you withdraw, we assume you will pay tax at the long-term capital gains rate that is associated with your future taxable income on the whole balance.
- For existing Roth retirement accounts, we assume no taxes are paid while saving or withdrawing, because you have already paid the taxes before contributing.
Projecting Future Retirement Contributions
Because we aren’t sure in which accounts you will use to save going forward, we conservatively assume all withdrawals from those savings are taxed at your average tax rate6 during retirement. This assumption is likely to overstate your tax rate6 (make your tax higher than it is) in certain situations, such as the case of all savings being in a Roth IRA (which is not taxed on withdrawal). But given the choice, we have decided to be conservative in this projection.
Using this tax rate, we estimate the total tax you will pay on your withdrawals of these balances, and we add that to the amount you need to have saved when you retire. This is to make sure you have enough saved for all your taxes in retirement, too. We accomplish this with a simple formula:
After-Tax Balanced Needed / (1 - Average Tax Rate) = Pre-Tax Balance Needed
For example, if we calculate you need $1,000,000 of after-tax money to live off of, and your average tax rate of your withdrawals will be 25%, you actually need $1,333,333.
$1,000,000 / (1 - 0.25) = $1,333,333
III. Calculating Required Savings
The great thing about compound interest and investing is that there is a difference between how much you plan on spending and how much you need to save in order to spend that much. Once we know your target balance, our advice decides how much you should save to reach that total balance, and we break that down by month or year. The savings amount required depends on how much time you have until your retirement age, the level of risk you’re willing to bear in order to pursue higher returns, and how much certainty you feel you need to hit that balance.
We give you advice about an appropriate risk level, which is based on your time until retirement, but you can tailor your allocation as you see fit. If you follow the recommended allocation of stocks and bonds in your Betterment accounts for your retirement goal, we offer to automatically adjust your risk level over time as you near retirement.
Our default savings advice gives you a 60% probability of hitting your goal. That level of certainty is more conservative than most basic retirement calculators, which often assume an expected average return (or, effectively, a 50% chance).
Shorter time horizons, less risk, and greater certainty will all lead Betterment to recommend higher savings amounts.
IV. Prioritizing Retirement Account Savings
Saving intelligently for retirement can be boiled down to maximizing expected spending in retirement per dollar saved today. Prioritizing which accounts you save into depends on your specific tax situation and access to retirement accounts. We provide you with recommendations in our advice labeled “See How to Save,” when reviewing your retirement goal. Betterment is not a tax advisor and does not cover all potential accounts, nor do we have your tax return and all details about your situation. So, Betterment’s recommendation for retirement goals only incorporates the external accounts that you have synced and any Betterment accounts within your Retirement goal. The recommendation is guidance only, and it should not be considered personal tax advice. Contact a qualified tax advisor to understand your personal situation.
A. Identifying Employer-Sponsored Retirement Savings
Our “See How To Save” retirement account suggestions are based on your eligibility to take advantage of different retirement account types according to IRS rules, based on your income, your marital status, and your eligibility for employer plans—depending on if you have synced your employer plan (electronically or manually) as an external account. If you do not add existing plans, we assume you do not have them available.
B. Accurately Assessing Modified Adjusted Gross Income (MAGI)
By default, we assume that your MAGI for IRA limit calculations is equal to the pretax income you provide us with when setting up your retirement goal. You can adjust your Adjusted Gross Income (AGI) and add “above-the-line” deductions you take on page one of Form 1040, such as IRA deductions, student loan interest, HSA contributions, and others. See IRS Pub 590a for details on what makes up MAGI for IRA qualification limits. You can enter these values under “Edit Assumptions > About your taxes” when reviewing your retirement goal on the Plan tab in your Betterment account. You should keep these values up to date each year to get the most accurate advice from Betterment. If these values change during the year but you do not update them, the advice may not be applicable to your changed circumstances. Contact a qualified tax advisor if you have questions.
C. Account Types Included in Prioritization Recommendations
Betterment’s retirement account advice is limited to eleven account types that are typically available to most people: traditional IRA (deductible and non-deductible contributions), Roth IRA, a spouse’s traditional IRA, a spouse’s Roth IRA, employer-sponsored retirement plans (401(k), 403(b) etc.), Health Savings Account (HSA), a spouse’s HSA and taxable investment accounts. We do not consider the possibility of after-tax contributions to employer plans, since relatively few plans offer them.
If you are a self-employed individual, you should know that we do not include SEP IRAs in Betterment’s retirement advice, though you can open a SEP IRA at Betterment. If you’d like to use a SEP IRA, this account cannot yet be put toward a retirement goal in Betterment’s advice. We look forward to a time when SEP IRAs are a part of our retirement advice.
As a self-employed individual, you have access to various other types of retirement accounts. These include SIMPLE IRAs, SIMPLE 401(k)s, Individual 401(k)s, Defined Benefit Plans, and more. Betterment does not support these types of accounts, and thus they are not included in our prioritization of which accounts to save into.
HSAs are only available to IRS eligible individuals with qualifying high-deductible health insurance plans. HSAs allow for pre-tax contributions and tax-deferred growth. Additionally, if withdrawals from the account are used for qualified healthcare expenses, the withdrawal is also income tax-free. If you include your HSA in your retirement goal8, Betterment makes the assumption that you will be using the account as a vehicle for long-term healthcare savings, and that any withdrawals from the HSA will be for qualified medical expenses.
D. Prioritization Based on Matching Contributions and Tax-Advantaged Accounts
As mentioned above, our guidance seeks to maximize your expected spending in retirement per dollar saved today.
We account for the potential positive impact of an employer match.
As long as you sync your external employer-sponsored retirement plan as an external account or if you’re enrolled in a Betterment for Business 401(k) plan, Betterment will use the information we have on your employer match percentage and maximum contribution percentage. For Betterment for Business 401(k) plan participants, we prompt you to tell us your match information. If your 401k has a fixed match, we use a weighted average of your plan’s matching tiers. If you indicate you have a match but do not provide those details, we assume your employer matches 50% of your contributions up to 6% of your compensation, since this is the most common matching scheme.4
If you specify that you have a “discretionary match,” meaning your employer may match, we also prioritize recommending that you contribute to the employer plan up to the amount needed to maximize the potential match, since there is some chance of match. Again we default to the most common matching scheme above (50% of 6% of compensation), unless otherwise specified by you.
We prioritize the account type with the better projected outcome after taxes and fees.
We recommend either the employer-sponsored plan or another retirement account that you qualify for, depending on the cost and which of the account types has the best projected after-tax outcome.
To project the better after-tax outcome of the account type possibilities, we factor in how much time you have between your current age and your retirement age. We assume the same average expected returns for all accounts (based on the Betterment Portfolio Strategy allocated to your current target allocation), with the following adjustments:
- The projection working in the background adjusts for Betterment’s management fees7 and the employer plan fees you provided when syncing the employer plan as an external account. By default, we assume that external employer-sponsored plans have a 0.6% fee and also a fund expense of 0.17%. If you have a Thrift Savings Plan account synced without information on fees, we assume that there are no management fees and a fund expense of 0.03%. If you have an HSA, we assume that the account has a fee of 0.62%. These fee assumptions can be overridden by the customer. Generally, lower fee accounts are more favorable.
- For taxable accounts, the projection assumes a 1% lower return than for a tax-advantaged account, which is meant to reflect the effect of paying taxes on dividends and realized gains in the account throughout the savings period.5
We only prioritize account types we expect you to be eligible for.
We use the following assumptions to determine which account types you’re actually eligible to contribute to.
- We utilize IRS guidelines for the most current tax year for contribution limits and income phaseouts. We do not consider contributions made in the calendar year following the current tax year.
- We estimate your marginal federal income tax rate6 based on your gross income, marital status, standard deduction, age, and age of spouse. If you itemize deductions or have dependents, you can provide these values to make the estimate more accurate by selecting “Edit Assumptions.” We include state income tax for the state on your account profile, but we do not include local tax. We assume you are not blind, which means we assume you are not eligible for the increased standard deduction associated with being legally blind. You can also override this estimation entirely by adjusting the “Federal Tax Bracket” selection in Settings under “Financial Information.”
- We estimate your tax rate6 during retirement from the desired income you specify, leaving out wage deductions for Social Security and Medicare. This conservatively assumes you will be paying full taxes on all income sources, but may not be true if your Social Security is not taxable, or if your income needs are met from tax-free sources like Roth IRA withdrawals.
E. Advantages of Employer Plans that Are Not Considered in Betterment’s Advice
While not an input into our advice for any individual, there are other potential features of employer-sponsored plans, 401(k) accounts in particular, that are not incorporated into Betterment’s recommendations. Here’s a brief list that may be worth considering depending on individual circumstances:
- 401(k) accounts may offer greater protection from creditors in the case of bankruptcy.
- You may have the ability to take penalty-free distributions at an earlier age or to defer minimum required distributions.
- Some 401(k) accounts may also allow for loans or distributions in a broader set of circumstances.
- Some 401(k) plans may also offer specific educational and advisory services to participants. The desirability of contributing to a 401(k) may also depend on the range of investment options offered within the 401(k).
To learn more about these various benefits, you should contact your plan administrator about whether such features are relevant to your personal situation. In our retirement advice, we incorporate information about 401(k) fees you provide (or those of Betterment for Business 401(k) plans), but not the actual fees on investment options available in externally synced employer-sponsored plans.
F. Where to Manage Your Retirement Accounts Based on Fees
Betterment’s advice on how to save will suggest that you fund accounts in a prioritized order based on the advantages of funding specific types of accounts (with matches, taxes, and fees as considerations). These recommendations stand regardless of whether you utilize Betterment accounts to fund your goal if recommended to do so. The projections that help inform our prioritized recommendations are based on Betterment’s management fee (of 0.25%), and our recommendations for retirement savings assume fees of 0.37% (a sum of the management fee with an estimate of the typical underlying fund costs – 0.12%). Because our projections assume Betterment’s fees, we do not take into consideration higher or lower fees for the same account types at other institutions. Our recommendations could be different if the assumed fees in our projections were different. Actual client experience may vary.
V. Interpreting Your Retirement Projection Chart
When viewing your retirement goal and our advice on retirement saving and spending, you should note several assumptions and aspects of our visualization.
- The retirement goal projection graph shows after-tax investment growth, in real dollars (adjusted by the recommended rate of inflation of 2%, or the rate you specify).
- We assume a management fee of 0.25% annually if you have the Betterment Digital plan. Premium plan customers have an assumed management fee of 0.40%, and for customers of an advisor using Betterment for Advisors, we assume their specific advisory fee.
- All current investments and recommended additions to your accounts from present day forward assume the expected returns of the Betterment Portfolio Strategy, according to your current target allocation. This includes synced external accounts, regardless of whether they have the same allocation as your current target allocation. In the case that you have opted in to having Betterment automatically adjust your allocation, our projections will include adjustment over time.
- The contributions line on the graph (shown in black on the Advice tab in your account), is not inflation-adjusted.
- Projected withdrawals during retirement assume that you would follow Betterment’s safe withdrawal advice and assume a cost of living adjustment (COLA) in line with inflation.
|1||Cost of living sourced from U.S. Census data
ZIP code data under license from UnitedStatesZipCodes.org. All U.S. ZIP codes were mapped to the closest ZIP code with data available.
|2||Johnson DS, Parker JA, Souleles NS. 2006. Household expenditure and the income tax rebates of 2001. Am. Econ. Rev. 96:1589–610|
|3||Tax deferred retirement accounts include traditional IRA and 401(k)s, SEP and SIMPLE IRAs, 403(b) and Thrift Savings Plans.|
|4||"Annual Defined Contribution Benchmarking Survey." Exhibit 4.7, Page 25.|
|5||See backtest reported in this article on performance in an IRA vs. a taxable investment account|
We generally assume that tax rates as of the current calendar year are the same as they will be in the future. Since the income tax brackets are indexed with inflation, we believe this is generally a good assumption. However, it does not account for potential legal changes in the tax code that more significantly affect how tax is assessed. If tax law changes do occur, we will update our methodology in a reasonable timeframe.
Our tax rate calculations do not currently support Alternative Minimum Tax (AMT) or “PEP and Pease” phaseouts which may affect high income taxpayers.
|7||This includes an annual fee of 0.50% of your HSA balance that Betterment manages, which includes fees for Betterment and Optum Bank, as well as an average fund expense of 0.12%.|
|8||Optum Bank, Inc. is the custodian and administrator of the Optum Bank HSA. Investment features offered by Betterment are managed by Betterment.|