Senior Quantitative Investing Researcher
Nearly a decade of historically low interest rates has forced investors to take extraordinary measures to reach their investing goals. Meanwhile, one of the longest stock market rallies in history has left other investors fearing that we’re near a market top and too nervous to invest at all.
To better help the growing number of Betterment customers who are seeking a low-risk investment strategy that seeks to minimize stock market losses, we are proud to announce our new income portfolio strategy, sourced from BlackRock.
The income portfolio strategy is a diversified 100% bond basket that seeks to provide a steady stream of cash income while minimizing potential loss of capital or stock market volatility. Customers can choose from four levels of risk, each with different targeted levels of income yield. The tradeoff for higher expected income is greater risk.
In addition to our other portfolio strategies, you can now choose a different investment strategy for each of your goals. This will help you create a truly personalized investment plan that matches your specific financial goals, values, and preferences.
Keep reading to learn which situations may be best suited for the income portfolio strategy, and for a look under the hood of how the strategy was constructed.
Why the Income Portfolio Might be a Good Fit For You
An income portfolio strategy, like ours, is designed to provide a steady stream of income, while minimizing the risk of losing principal. Of course, this means taking on less risk and generally achieving lower returns than you’d expect in a stock portfolio.
We’ll highlight two situations that are typically well-suited for an income portfolio, and we’ll compare the income portfolio to Betterment’s core strategy so you can make an informed decision to fit your personal preferences.
Generating Retirement Income
Often, retirees value stable income and principal preservation during the later stages of their lives. They also tend to hold most of their wealth in tax-advantaged accounts, such as IRAs and 401(k)s. The income portfolio strategy can help you preserve your nest egg after you retire.
You can invest the majority of your retirement savings into an income portfolio to help provide as much steady income as possible, or you can use a “bucket approach,” investing a portion of your retirement portfolio with an income strategy for short-term needs, while leaving the rest in stocks for long-term growth.
The chart below shows the expected income yields for each of the four risk levels in the income portfolio strategy and how those levels compare to the Betterment portfolio strategy with similar levels of risk.
Expected Income Yields
Betterment Portfolios vs. BlackRock Target Income Portfolios
Disclosure: This chart compares the four BlackRock income portfolios available to Betterment against four allocations of Betterment’s core portfolio strategy with similar relative risk levels. All four of the comparison allocations include both stocks and bonds, while BlackRock’s income portfolios are comprised completely of bonds. The Betterment Portfolio’s income yield is comprised of dividends from equities and coupon income from the underlying bonds in the fixed income ETF. The BlackRock Target Income Portfolios’ income yield is comprised solely of coupon income from the underlying bonds in the fixed income ETF.
The expected income yields are expressed in annual terms and are based on the historical dividend yields over the past 1-year period ending August 30, 2017 for the individual funds in each of the portfolios, as reported by Yahoo Finance. These expected yields correspond to the time period referenced above for the funds in the relevant portfolios and will change over time as economic and market conditions change. When an economy is expanding (contracting), for example, interest rates will tend to rise (fall) and credit markets will tend to strengthen (weaken) as companies become less (more) vulnerable to defaulting on their debt.
These figures do not include the Betterment fee or fund level expenses. The Betterment stock allocations shown here correspond to the Betterment portfolios that have expected volatilities that are closest to the expected volatilities of the four BlackRock income portfolios. The stock-to-bond allocations used for Betterment are: 9% stock to 91% bond, 22% stock to 78% bond, 37% stock to 63% bond and 40% stock to 60% bond. Expected volatilities are estimated based on the historical total returns data for the relevant funds over the past 10 years using the methods of Ledoit and Wolf (2003). This chart is hypothetical and used to illustrate the points discussed in this article. Past performance is not indicative of future results and does not guarantee that any particular result will be achieved.
As you can see in the chart above, BlackRock’s income portfolios have a higher expected income yield than allocations in Betterment’s core portfolio strategy with comparable risk levels.
For example, if you had a $1,000,000 retirement portfolio, you could invest it in the 40% stock Betterment portfolio, and the income portion of your return would be about $24,000 per year in gross investment income. (Note that the income portion composes only part of the total potential return generated by a Betterment portfolio allocation.) However, if you invested in the income portfolio strategy, with the same level of expected risk, you could potentially receive an expected $43,000 per year in investment income.
But remember, investments generate returns in two ways: income and principal growth. We refer to these two forms of growth as the total return of an investment. Bonds can provide steady income, but have historically provided lower principal growth than stocks. For this reason, putting some money in both the income strategy and the Betterment strategy may be a preferable alternative for some investors.
It’s also important to note that income-focused strategies will be inherently less tax-efficient than a strategy that balances income and growth. The lack of tax efficiency is due to the fact that, for most investors, bond interest is taxed at a higher rate than long-term capital gains. This is why we generally recommend the income portfolio strategy for tax-advantaged retirement accounts, like IRAs.
Retirees who are interested in the income portfolio strategy can pair it with Betterment’s automatic withdrawal feature to set their retirement income on autopilot.
Low-Risk Investment Alternative
If you are nervous about the stock market or are just looking for investments with a lower risk than stocks, investing in the income portfolio strategy can be a good approach. It’s one way of not letting your money sit idly in cash without taking on more risk than you’re comfortable with.
According to Gallup, 48% of Americans have no money invested in the stock market. And with the best savings accounts paying only slightly above 1% in interest, keeping too much money in cash means your money loses value to inflation every day. Choosing bonds over cash can be a nice middle ground that better balances risk and return.
Historically, bonds have been much less volatile than stocks. The chart below shows the risk (as measured by standard deviation) for various types of bonds over the past 15 years, compared to stocks in large U.S. companies.
The chart shows the risk (as measured by standard deviation) for various types of bonds over the past 15 years, compared to stocks in large U.S. companies. Click respective categories for data on short-term bonds, intermediate-term bonds, long-term bonds, high-yield bonds and large cap stocks.
Short-term bonds were almost six times less risky than U.S. large company stocks. Even high-yield bonds, the most risky type of bonds, were almost two times less risky than stocks.
As a Betterment customer, you now have two ways to help reduce the risk of your portfolios. In addition to reducing your stock allocation in Betterment’s core portfolio, you can now choose an income portfolio for some or all of your goals.
It’s worth noting that investing in bonds is generally more costly than investing in stocks, so you will pay a higher expense ratio on income portfolio funds compared to funds invested in the core Betterment portfolio. The Betterment portfolio strategy, which contains a mix of stocks and bonds, has annual ETF fees of only 0.07% – 0.16%, depending on the portfolio’s allocation. Our income portfolio strategy, while still far lower cost than the industry average, has slightly higher ETF fees of 0.21% to 0.38%, depending on the portfolio’s target income level.
Note: Expense ratios data are from Xignite as of August 30, 2017.
Different Income Targets to Meet Your Needs
The strength of Betterment’s approach is that all of our portfolio strategies can adjust to your risk tolerance. The income portfolio strategy is no different. We selected BlackRock’s iShares™ ETFs to invest in different types of U.S. and international bonds including U.S. Treasuries, mortgage-backed securities, corporate, high-yield, and emerging market bonds.
We had no incentive to partner with BlackRock other than the strength of their fixed income expertise and the robust construction of the iShares™ ETFs.
To align with your risk preferences, we offer four different risk levels to choose from, each targeting different levels of income. The income portfolio strategy is actively managed, so the exact allocations of the underlying bonds is subject to change approximately once per quarter (and up to six times per year depending on market volatility). With each rebalance, we allocate to the asset classes that are designed to help maximize your income return while limiting overall volatility.
Risk and return are connected, so lower-risk bonds pay less income than higher-risk bonds. The income portfolio increases projected income by taking on more risk in two main ways:
- Investing in longer-term bonds: Long-term bonds are more sensitive to changes in interest rates, and thus carry more risk. To compensate for this risk, long-term bonds pay more interest.
- Investing in lower-quality bonds: When you lend money from less-established companies, the chances of the company defaulting and not paying you back are higher. To compensate for this risk, low quality bonds pay more interest.
We are proud to offer an income portfolio strategy because, with more strategies like this one, you can personalize your investments to match your specific goals, risk tolerances, and viewpoints.
Whether you’re a retiree looking to preserve your principal and help generate income, or you’re uncomfortable with the risks of investing in stocks, the income portfolio strategy is an approach that may be right for you. Because Betterment lets you customize your accounts based on different real-life goals, you can choose to invest in an income portfolio with just part of your savings or your entire net worth.
To get started, open a new goal account and select the BlackRock income portfolio strategy.