Betterment’s Model for Financial Advice: An Overview
Saving enough, choosing the right accounts, deciding when you can buy a house or when to retire—all of these are essential decisions before you build an optimal portfolio.
TABLE OF CONTENTS
- How Betterment Helps You Plan
- We Plan Despite the Future’s Uncertainty
- How We Estimate Market Performance
- How We Estimate Future Tax Rates
- How We Estimate Inflation
- Our Commitment to You: Constant Improvement
- Model Release Notes and Assumption Updates
When it comes to investing, it’s easy to get lost in a myriad of decisions about strategies, diversification, investment costs, or funds to buy, to name a few. These decisions are important, but their apparent complexity can obscure an even more important question: What are you trying to accomplish with your portfolio?
At Betterment, we deliver easy-to-use financial planning tools that help you design a plan to achieve your financial goals. And to that end, we continually update the tools we provide—factoring in new possible scenarios and redeveloping our assumptions as we learn about the future. In this article, we’ll outline how our model works and provide a list of updates we’ve made.
Planning for your future with financial goals
Establishing financial goals, and a plan to achieve them, is critical. This is why Betterment has been a goal-based investing service since the beginning. Goals help root your thinking about the future, and they have well-documented behavioral benefits. Your situation can change, as can your goals, so it’s essential to have flexibility in your plan, and the ability to answer key “what-if” questions. Goals help enable a financial advisor—automated or human—to give you quality advice, which can add significant value beyond the simple returns of a portfolio.
How Betterment helps you plan
Betterment’s online financial planning tools are designed to make it easy to set up a personalized, flexible, easy-to-track plan. Starting in our signup process, you establish your first goal, and can add other goals at any time once signed up. A goal is a future spending need, and will fall into one of four categories, each with different attributes and investing advice. These categories are:
- Safety Net
- Major Purchase
- General Investing
Once you choose a category, you provide details about the goal so that we can recommend a portfolio, a level of risk, and how to save (or withdraw, if in retirement) to help achieve the goal. Then you can use our tools to see how a one-time deposit, recurring deposits, and the time horizon change how you can achieve your goal. For more complex goals like retirement, our built-in retirement planning advice factors in other variables, such as the impact of Social Security, other income streams like rental real estate, as well as future spending, tax rates, and inflation.
Here are some examples of questions you can start to answer with Betterment’s financial planning tools:
- How much do I need to save to put a downpayment on a house in five years?
- When can I retire? Can I retire early?
- How much should I save to retire at age X? What if I save more or less than that?
- How can a poor market affect my savings plan or retirement?
- What if Social Security isn’t around? How much do I have to save then?
- Should I use my 401(k) or an IRA?
- Should I use a Roth IRA / 401(k)?
- How much should I save in my Safety Net?
- If I save X per month, what can it be worth in 10 years?
Our tools help provide guidance on all of these questions and more. And we think they are better than most financial planning tools for two key reasons:
- We keep your balance up-to-date at a high frequency, so you know where you stand and what to do next.
- Changes are simple to make and applied in real time, so you can update your goals and form a better game plan.
We plan despite the future’s uncertainty
The key challenge in planning for the future is that nobody can truly forecast the future. You can’t be sure how or when your situation will change, and we can never predict how external factors like shifting markets, inflation, or tax rates will change. However, as the statistician George Box once said, “All models are wrong, but some are useful.”
As investors, our lack of ability to know the future should not mean we give up and stop planning. Instead, we should aim to identify the “useful” models Box was referring to—tools that factor in potential variability and allow you to envision how various changes are likely to affect your plan. Tools like these help you understand the range of potential outcomes, which will better inform the decisions you make today.
For example, if financial markets (and thus your portfolio) perform worse than the average we expect (a “poor market” scenario), your savings may be wholly inadequate to meet your spending needs in retirement. To help avoid this result, you could save more today to increase your projected future income, even if a poor market occurs. If you didn’t know this information in advance, it would be too late to adjust if a poor market scenario did occur.
How we estimate market performance
One of the key estimates about the future we make is how your portfolio will perform in the future. As you can see from the blue shading on our Advice tab in Figure 1, there is a wide range of potential portfolio growth results, depending on if the market performs poorly, or well over the time horizon of the goal.
Figure 1: Setting a major purchase goal to buy a Tesla Model S using Betterment
There are many ways to estimate future returns of a portfolio. The simplest way, used by many financial calculators, is to assume a constant average return which is typically based on historical returns of a typical benchmark, like the S&P 500 index. A common estimate is 7% for U.S. stocks. While there may be benefits to simple assumptions, this one has several problems:
- You are not usually invested exactly like that benchmark. For example, you might hold both stocks and bonds. Different mixes of these assets in your portfolio will have different ranges of outcomes.
- You probably have multiple financial goals, with different time horizons. For example, your retirement account should not be invested the same was as an education fund for your kids, because one is based on spending in (say) 30 years, the other in 15 years. Thus you may hold different risk portfolios for each goal which should not have the same returns assumption.
- Using a historical estimate is very sensitive to the time horizon used to calculate it.
Betterment makes several improvements on this method to help make our estimates more accurate:
- We use a return estimate for the specific portfolio you select, for each goal. For example, our estimate for a 90% stock portfolio is different than that of a 85% stock portfolio. This estimate is based on the specific asset classes that you actually hold.
- We consider volatility in our returns estimates. This allows us to produce the range of returns you see on the Advice tab, and also allows configuring the chance of success of our models. For example, our savings estimates assume a somewhat conservative 40th percentile outcome (60% chance of success) rather than the simple average (a 50% chance of success).
- The return we assume is based on risk-free rate and an asset premium. The “risk free rate” (which is the return a risk-free asset such as a U.S. Treasury bill will return), and an equity (or bond) “risk premium” or excess return, which is how much we expect risky assets like stocks and bonds to return in addition to this risk-free rate.
- We assume risk-free returns vary over time. You probably know that interest rates (set by the Fed via it’s U.S. Treasury buying and selling program) are low right now, and most economists expect them to rise. The returns of each stock or bond fund in your portfolio are expected to be in addition to the safe or “risk-free” Treasury rates. So when rates rise, so should our expectations of your returns. Our projections assume these will increase from their low now to more normal rates in the future. (Learn more about this) Also, we make the typical assumption that longer term treasuries have higher returns than short term, due to the added interest rate risk they contain.
How we estimate future tax rates
Just like how no one can predict the outcome of a presidential election, we can’t predict what tax rates in the future will be. However, we are pretty sure that certain incomes and account types will be subject to some tax, so good planning tools like Betterment’s factor in some adjustment for taxes. This is most relevant in retirement planning, where taxes affect the account types you might use (e.g., IRA or Roth IRA) and your current and future income.
How we incorporate tax rate estimates to our retirement planning advice:
- We use the latest federal tax data available. For federal taxes, these are known in advance and updated every Jan. 1. For state tax rates, this data is harder to come by, and we update them as soon as reasonably possible. Historically that is six to 12 months into the year. For example, given it’s early in 2018, we are still using 2017 state tax rates.
- Tax bracket ranges are typically adjusted for inflation, so we assume that inflation by itself will not cause major changes to tax rate assumptions.
- Your income will be different in the future, which affects your tax rate. We account for income increases due to inflation and typical salary growth (see our full retirement planning methodology for more information). We use these factors to estimate what your future tax rate might be.
- We allow tax deduction and dependent overrides, which can affect your personal rate.
How we estimate inflation
Like tax rates, we cannot know how inflation will change through time. There are certain known historical ranges and understood targets set by fiscal policy. The most important thing is to factor in some inflation, especially for long-term goals like retirement, because we know it won’t be zero. Good tools will always do this, even if assumptions vary from tool to tool. At Betterment, by default we currently assume a 2% inflation rate in our retirement planning advice and in our safe withdrawal advice, which is what the Fed currently targets. You can override this value in Edit Assumptions if you have a different view. Read more about our assumption on inflation.
Inflation: 12-Month Average Consumer Price Index Growth
Figure 2: Inflation through time, as shown by the Consumer Price Index for all consumers and all items. Seasonally adjusted. Data Source: Federal Reserve Economic Data
Our commitment to you: constant improvement
Just as you should review your goals and their status periodically, our commitment to you is to keep our tools updated and as forward-thinking as possible. Our Investment Committee and team of analysts periodically review our economic, tax, and returns assumptions, as well as make improvements to the capabilities of our tools. For example, we make regular updates to our risk-free rates, especially now that rates have started to move upward.
An example of how we invest in our tools is the release of RetireGuide in 2015, which was the first time we factored Social Security, inflation, and taxes into our retirement calculations. These ongoing improvements, as well as actual performance of your account, can cause our recommendations to vary, so we recommend reviewing your goals and status at least once per year.
In order to be transparent about the changes we make, we keep a log of all historical changes to our models. You can also review our Projections Methodology and methodology for more model details and limitations.
Updates to Betterment’s Financial Advice Model
|May 2010||Portfolio Strategy Betterment launches service with a portfolio strategy composed of U.S. stocks and treasury bonds.|
|Financial Planning Goal projections are introduced with expected returns based on historical returns.|
|Sept. 2011||Portfolio Strategy International stocks are added to the Betterment Portfolio Strategy as a new asset class.• Expected returns estimates are updated to include this asset class.|
|Nov. 2011||Financial Planning Betterment launches the option of having multiple sub-accounts within a Betterment account for goal-based advice.|
|Dec. 2012||Financial Planning Goal tracking advice launches, which tells customers if an account is on track or off-track.New savings advice is introduced, based on a more conservative 40th percentile.|
|Sept. 2013||Portfolio Strategy Betterment updates the Betterment Portfolio Strategy with new expected returns, utilizing a risk-free curve.|
|Apr. 2014||Financial Planning Betterment launches safe withdrawal advice for retirement income, using conservative market outcome projections (1st percentile returns).|
|June 2014||Assumptions Update Betterment updates the risk-free rate.|
|Oct. 2014||Assumptions Update Betterment updates the risk-free rate.|
|June 2014||Portfolio Strategy Municipal bonds added to the taxable portfolio, updated taxable expected returns and risk-free rates|
|Tax Optimization Betterment introduces automated tax loss harvesting for taxable accounts.|
|Jan. 2015||Assumptions Update Betterment updates the risk-free rate.|
|Apr. 2015||Financial Planning Betterment introduces RetireGuide as a separate tool to enable retirement planning based on a customer’s Betterment accounts and non-Betterment accounts.|
|Assumptions Update Betterment updates the risk-free rate.|
|June 2015||Assumptions Update Betterment updates the risk-free rate.|
|Jan. 2016||Tax Rates Betterment updates IRS tax rates, limits and phaseouts for 2016.|
|Assumptions Update Betterment updates the risk-free rate.|
|Apr. 2016||Assumptions Update Betterment updates the risk-free rate.|
|Oct. 2016||Assumptions Update Betterment updates the risk-free rate.|
|Dec. 2016||Tax Rates States tax rates are updated for 2016.|
|Jan. 2017||Tax Rates Betterment updates IRS tax rates, limits, and phaseouts for 2017|
|Mar. 2017||Assumptions Update Betterment updates the risk-free rate.|
|May 2017||Assumptions Update Betterment updates its capital markets assumptions for projections of all portfolios. Generally, our updated expected return assumptions are lower (more conservative) than our previous assumptions. Along with this update, we re-calibrate our retirement income advice to use 4th percentile returns. Betterment updates default economic assumption for inflation from 3% to 2%, equal to the long-term Fed inflation target.|
|Assumptions Update Betterment updates the risk-free rate.|
|July 2017||Portfolio Strategy Betterment introduces a second portfolio strategy designed for socially responsible investing, the Betterment SRI portfolio strategy. The portfolio strategy represents a 42% improvement in US Large Cap ESG ratings compared to the Betterment Portfolio Strategy. Optional for customers looking for an SRI approach.|
|Sept. 2017||Portfolio Strategy Betterment introduces two additional portfolio strategies as alternative strategies that customers can utilize as options: The Goldman Sachs Smart Beta portfolio strategy and the BlackRock Target Income portfolio strategy.|
|Nov. 2017||Portfolio Strategy Updated portfolio optimization methodology triggers changes to the Betterment Portfolio Strategy for tax-advantaged accounts.|
|Tax Optimization Betterment introduces service for donating appreciated shares to charitable organizations to help customers save capital gains taxes, with the ability to deduct the gift on their taxes.|
|Dec. 2017||Allocation Guidance Betterment enhances its allocation advice to provide a recommended allocation every month (rather than on an annual basis). Betterment also updated its Major Purchase and in-retirement allocation advice.|
|Allocation Guidance Customer allocations in goals for retirement, major purchases, and building wealth become eligible to be adjusted automatically, in line with Betterment’s allocation advice. Exceptions include goals using the BlackRock Target Income portfolio strategy and goals that are classified as Safety Net goals.|
|Feb. 2018||Portfolio Strategy Introducing the option to modify the asset class weights of the Betterment Portfolio Strategy for a degree of self-direction in an account.|
|April 2018||Financial Planning Integrating retirement planning advice into goal-based investing interface, to help customers put retirement planning advice into action.|
|Allocation Guidance Enable syncing of external accounts to specific goals, helping customers assess their overall allocation for a specific goal.|
|July 2018||Portfolio Strategy Updated the Betterment Portfolio Strategy’s portfolio optimization methodology triggers changes to the Betterment Portfolio Strategy for taxable accounts. The Betterment SRI portfolio strategy replaced the market-capitalization weighted emerging markets fund with a socially responsible emerging markets fund.|
|Aug. 2018||Money Management Betterment provides cash management solution called Smart Saver, designed to hold extra cash to earn a high yield compared to a low-interest savings account by investing in a high-quality, short-term bond portfolio.|
|Portfolio Strategy Added Short-term, Investment-grade bonds to portfolios with 42% stock allocation and below in the Betterment Core portfolio to further help optimize lower-risk Betterment portfolios.|
|July 2019||Money Management Betterment replaces Smart Saver with Cash Reserve.|
|Sept. 2019||Allocation Guidance Betterment’s recommended portfolio allocation for Safety Net goals changes from 40% stocks with a 30% buffer, to 15% stocks with a 15% buffer.|
|March 2020||Portfolio Strategy In the Betterment SRI portfolio, the primary, secondary, and tertiary ETFs for U.S. Large Cap stock representation are now all SRI-based. An SRI-based Developed Market stock ETF is also introduced.|
|January 2020||Money Management Betterment Cash Reserve expands to offer joint accounts, so that two users can save together.|
|June 2020||Portfolio Strategy Betterment now projects and incorporates volatility of the risk-free rate in our projections, leading to slightly more uncertainty in the projection outcomes.|