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VP of Behavioral Finance & Investing, Betterment
Dan Egan is the VP of Behavioral Finance & Investing at Betterment. He has spent his career using behavioral finance to help people make better financial and investment decisions. Dan is a published author of multiple publications related to behavioral economics. He lectures at New York University, London Business School, and the London School of Economics on the topic.
Articles by Dan Egan
Betterment’s 401(k) Investment Approach
Helping employees make better decisions and providing choice to those who want it.Betterment’s 401(k) Investment Approach Helping employees make better decisions and providing choice to those who want it. Dan Egan, Betterment’s VP of Behavioral Finance and Investing, explains why Betterment’s investment approach is effective for all 401(k) participants Investment Approach Q&A Betterment’s 401(k) investment approach differs from that of traditional providers, but can you give us a little history about the 401(k) environment pre-Betterment? If I go back to the first job where I had a 401k, probably about 20 years ago, there was a lineup of funds, and it was up to me as a 401(k) participant to figure out which funds to pick and in what ratios, how much to save and so on. The research coming from that period showed that people often ended up in an analysis paralysis state, where there was so much choice and so many things to consider. It was very difficult for people to know whether they were investing at the appropriate risk level, how much they were paying and so on. Many people were so overloaded that they decided to forego saving for retirement than risk making a “bad” decision. But as the industry matured, and everyone realized that more choice does not necessarily lead to better decision-making, the Pension Protection Act (PPA) was passed in 2006. The idea here was not to eliminate choice, but to encourage good defaults that would encourage 401k plan participation. How exactly did the PPA encourage more 401(k) participation? Well for one thing, it allowed for safe harbor investments in the form of QDIAs, or qualified default investment alternatives. The most popular QDIAs were target date funds, which are linked to an individual’s age so if you're 40, it’s assumed that you will be investing for the next 25 years and retiring at 65. Target dates have a glidepath so that the stock allocation becomes more conservative over time, so the employee doesn't have to do anything like managing a portfolio or rebalancing. After the PPA, it became much more common for employees to be auto-enrolled using a target date fund or something like it, and all of sudden, they no longer had to make choices. People were no longer worried about picking and choosing from a whole bunch of individual funds or even individual stocks. And the plan designs promoted by the PPA really worked: plan participation rates that had been languishing saw rates increase to 80 or 90% after implementing auto-enrollment. By the time Betterment started its 401(k) platform, the changes brought about by the PPA were already well established. So talk a little bit now about how Betterment's 401k investment approach differs from that of traditional 401(k) providers. Betterment takes and builds upon a lot of the ideas in a target date fund and goes further. Number one, we are not a fund manufacturer. We are independent from fund companies. So part of our job is to be a real investment advisor and financial advisor, and do the due diligence on all of the funds that are available out there. If you're picking from amongst eight large-cap US stock funds, there's not a lot of variation in what their returns are going to look like and you can generally predict performance versus a benchmark knowing the fund costs. So part of our job is to actually do the work on the behalf of participants, to narrow down the field of funds towards just the ones that stand out within a given asset class and that are cost-effective. We then ask more specific questions including not just how old someone is, but also more personalized questions like when someone plans on retiring. Some people want to retire as early as possible. That might be 55, 57, 62, which is when you can start taking social security. Other people want to keep working as late as possible, which is 70 or 72. Those are extremely different retirement plans that should have different portfolios based upon those hugely different time horizons. So unlike a target date fund, which says, this is your age and you're done, Betterment is going to ask about your age, but also things like, when do you want to retire? Putting together a holistic retirement plan, it might involve your spouse or significant others, retirement assets, and even doing tax optimization across the account types that you have available to you. And how does that help the employee? A lot of it is about making it easy for consumers to make better decisions, not imposing a bunch of choices on them. You have to remember, the vast majority of people are not commonly and frequently thinking about stocks and investing. They don't want to have to look up prospectuses and put together a risk managed portfolio. So Betterment does the work for them to make it very easy for them to understand how to get to where they want to be. I want to be clear that that's not necessarily about removing choice, it's about making it easy to get to a solution quickly. It’s also about minimizing the number of unnecessary choices for most people while maintaining choice for people who want it. At Betterment, 401(k) investors can still modify your risk level. You can say, "Yeah, maybe it makes sense for me to be at 90% stocks, but I'm not comfortable with it. I want to be at 30% stocks." Or they can modify their allocations using our flexible portfolio strategy, so that they can come in and say, "Actually I don't like international as much." So it's not about removing choice. And we let them see the consequences of that in terms of risk and return. So employees in Betterment 401(k)s have choice, but how do you respond to people who might already have a 401k or are already invested in funds outside of their 401k, and have a favorite fund that they feel is an absolute must have? I’m not necessarily against people who have put time and effort into researching something and wanting to invest in it. But I think it is focusing on the wrong thing. When you look at long-run research statistics on funds, the predictability of fund success within a category is very low. A fund that outperformed last quarter is very unlikely to continue to outperform this quarter. So I would say that the fund is very rarely the most important aspect of the 401(k) plan or decision. And I’d guess most participants don't have a favorite fund. Again, going back to research we've looked at across a wide array of companies, most people are looking to minimize how much burden is imposed upon them in making decisions about what they should do for their retirement. There is generally a very small minority who have very strong views about what the right investments are. And that trade-off shows up in that we will generally look at low-cost funds, well-diversified funds. We do offer a range of choice in terms of portfolio strategy: do you want a factor-tilted portfolio or a socially-responsible portfolio or an income portfolio? Without necessarily saying that you're responsible for doing the fund due diligence yourself. It is true that we offer a trade-off: we're not the wild west where you can go out and get anything you want. And that is because that level of discretion is just very, very rarely used by plan participants. There's a lot of potential to do the wrong thing when somebody has a completely open access plan. Not to mention, all plan fiduciaries have an obligation to act in the best interests of their plan participants as a whole. So they have to evaluate what makes the most sense for the majority of plan participants, not a small, vocal minority. Somewhat related, what is your response to people who argue that Betterment’s all-ETF fund line-up is too limited? A 401(k) plan made up exclusively of ETFs is no less limiting than a 401(k) plan made up exclusively of mutual funds. Because mutual funds have been around much longer, it’s true that their universe is larger, but I think anyone would be hard pressed to argue that 8,000+ ETFs is not enough to choose from. ETFs represent an advancement over mutual funds because they are cost-effective, highly flexible, and technologically sophisticated. They are critical to Betterment’s investment approach and a better alternative for 401(k) plans, in large part because mutual funds have complex fee structures and are typically more expensive than ETFs which have transparent and low costs. So why do so many plans still use mutual funds? We believe it’s not despite these issues but because of them, since fees embedded in mutual fund expense ratios are often used to offset the costs of 401(k) vendors servicing the plan. In addition, many legacy recordkeeping systems do not have the technology to handle ETF intraday trading and must restrict their clients to using funds that are only valued at the end of the day. Betterment’s 401(k) plan comes with a 0.25% investment advisory fee. What do employers and employees get for that? I think there's actually two levels to this. The first is “does this actually cost me more?” It’s definitely more transparent in its cost, but most 401k plans charge more via higher fund fees. The fund fees may even include embedded fees that go to pay for other plan services. In these more traditional models, the fees are hidden from you, the consumer. But trust me: everybody is getting paid. It's just a matter of whether or not you're aware how much and who you're paying. That also sets up the very important second aspect which is: what is this investment manager responsible for and what are they incentivized to do well? What does Betterment do for 25 basis points? Well, number one, that's how we make sure that we're independent from the fund companies; we don’t get paid by them. Every quarter, we go out and we look at all of the funds that are available in the market. We sort through them, independent of who provides them, looking at cost, liquidity, tax burdens etc. And if we find a better fund, because we take no money from fund companies, we're going to move to that better fund. So one thing that you're paying for is, in effect, not only ongoing due diligence and checking, but you're paying for independence, which means that you get the best raw materials inside of your portfolio. The other thing you get is that we want to earn that 25 basis points by serving clients better. So we want to invest in things like personalized retirement portfolios (available to every 401(k) participant) where we are actually able to give better retirement advice that takes into account you, your partner, all the various kinds of retirement accounts you have: Roth, IRA, taxable, trust, maybe even pensions or other income sources. Or asset location, for example, which works across tax-advantaged retirement accounts so that employees can keep more of their money and enjoy higher levels of spending in retirement. So what you get from paying somebody to do a good job, is you get them really incentivized to take care of their customers. Betterment takes care of its customers. We are motivated to do a good job and to retain all of our customers.
How Betterment’s investment approach helps 401(k) investors
Dan Egan, Betterment’s VP of Behavioral Finance and Investing, answers the most common ...How Betterment’s investment approach helps 401(k) investors Dan Egan, Betterment’s VP of Behavioral Finance and Investing, answers the most common investment questions asked from 401(k) plan sponsors. Questions and answers with Dan How should plan sponsors think about the investment funds within a 401(k)? People may be surprised to hear this, but aside from avoiding high-cost funds, the specific funds in a 401(k) are probably the least important part of a 401(k) plan. If you’re not saving, using the right account types, or looking at things holistically (for instance how you’re going to claim social security), then the returns won’t be very powerful. The savings base those returns are built on needs to be adequately established. So how do you respond when someone asks “how do your funds compare to the market?” Betterment tries to match, not under- or out-perform the market. Generally, when we’re talking about the market for a given asset class we’re talking about an index, which is not something you can invest in directly. So we invest in funds that seek to track the market index, and we do it for as little cost as possible. Betterment likely won't be the worst or best performer because we don’t make concentrated gambles. We don’t take bets on specific companies, sectors or strategies. However, we do know that how much you pay for a fund - its expense ratio - is the best predictor of its future success. The less you pay, the better your outcome compared to peers. People may be surprised to hear that Betterment isn’t trying to beat the market. Can you explain why that is? First, the most important job of a financial advisor is helping people make the most of their money, especially in crafting a successful retirement plan. For 401(k) plans, it’s all about helping individuals achieve their retirement saving goals. Are they saving the right amount? Are they using the right accounts? Do they have a plan that aligns with how they’re actually going to spend money in retirement? We guide investors toward those levers over which they have control and that have a high degree of certainty. Second, the odds of anyone consistently beating the market is quite low. When you try to pick funds to beat the market, in any given period your fund may be very much above or below the market. Consider that even Warren Buffet has underperformed the market by up to 67% over a two-year period. There’s very little predictability about which fund is going to be above market in the future. On the other hand, there’s actually very good predictability about who’s going to be below average—because of costs. Costs are just a deadweight headwind that you pay for no matter how well or poorly the fund does. So given the low expected benefit of trying to pick winning funds, and the higher downside of high-cost funds, Betterment focuses on keeping costs low. How does this “independence” manifest itself? We’re different from many advisors in that we don’t run our own funds, we don’t take a cut of anything, and we don’t take kick-backs. So we make decisions that are based purely on doing what’s best for our clients. There’s no undue influence on what is a very rigorous, systematic process. Every quarter we consider new funds that might be a better fit. There might be changes to the existing fund line-up, or we might switch funds between primary and secondary positions based on forward-looking fund performance. The fact that we don’t have our own funds means we are free to pick whichever ones are right for clients, regardless of who manages them. Our sole mission is to deliver the best performance in a highly predictable way. And we do that by focusing on low costs, high liquidity and tax efficiency. How does your approach protect investors in down markets? We diversify portfolios across stocks and bonds, both domestically and internationally, which offers some amount of downside protection. But there’s no short-term reallocation involved that would cause us, for example, to move to 0% cash one month and 100% stocks the next month. Our approach is to reduce risk through diversification. So when the global markets go down, our portfolios will go down with them. No one has a crystal ball to know what the markets are going to do (and if we did have one, we would keep it to ourselves!). What we do instead is help clients align their level of risk in their portfolio to their goals and time horizon. That’s where the idea of a glidepath comes in. If someone is getting close to retirement, they don’t have a lot of time to recoup losses from a market downturn, so they should be taking less risk (ie., have a lower percentage of stocks to bonds). On the other hand, someone who is 20 or 30 years from retirement should tolerate being in a portfolio with a high percentage of stocks because even when there’s a market downturn, they’ll probably still be ok at the end of their investment horizon. Can you tell us more about the advice and guidance Betterment provides? We provide advice and guidance within the application to every individual, encouraging them to use the right account type, aggregate external accounts, and have a holistic plan that considers other assets. We also give access to investors to techniques like tax coordination that high net worth advisors have been using for years. By using knowledge and information about the tax code and tax rates, we can help investors keep more of their after-tax spending money in retirement. Taking advantage of that strategy also means participants may not have to save as much (or alternatively can have a higher target retirement spending amount). What are some other tools that Betterment 401(k) participants have access to? Most people stick with the default portfolios. But our Flexible Portfolio Strategy was built primarily for 401(k) participants who wanted to have more control over how their portfolio was allocated. What’s interesting is that even when people change the weights of individual funds within a portfolio, we provide guardrails of sorts that tell them when they’ve become too concentrated or taken on a risk level that is quite different than what we would recommend. And we see that people who use these tools really pay attention to those guardrails. They have the comfort of having some control but also respect the guidance that we provide them. We know that the Betterment platform allows 401(k) to save for other goals besides retirement. How does that work? Our platform allows for multiple goals so that investors can think about different pots of money differently. If there’s only one pool of money, then the investor has to figure out a way to quantify the average risk or asset mix that would be appropriate across all goals. By allowing people to assign different pools of money to individual goals, all with different time horizons, investors actually behave better because they have a purpose in mind. For instance, having a safety net that is fully funded allows people to “check the box” on the conservative side of things, making them more comfortable to take more risk with their retirement savings. Why doesn’t Betterment use the risk tolerance questionnaires to determine how to allocate someone’s investments? Rather than classifying people into categories, we want to interact with them and engage them in a conversation. When setting an allocation, for instance, we display the expected returns over both the long-term and the short-term. Sure, the 500% cumulative return over 30 years looks great, but are you comfortable knowing that you might lose 30% in any given year? If not, you may need to dial back your risk level. We want to have clients wrestle with that a bit, take it in and make a better decision off the bat. We think it’s better to have an ongoing conversation so that investors are thinking ahead about, for instance, the impact of a market downturn. So when the inevitable happens, people realize it’s a normal part of the process and don’t get so rattled. That ongoing conversation is important, too, because people’s attitudes toward risk often change over time. What about plan sponsors who are putting off starting a plan or moving to Betterment because they are nervous about the market volatility? If they’re waiting for the market to stabilize, well, that’s just market timing of a different sort. Sure, in a perfect world it would be great never to have to be out of a market (as with conversion plans) but over a short period of time, the market can do any crazy thing. So I worry about people putting off a good long-term decision for something that is outside of their control and only relevant in the short-run. There’s very low predictability about what’s going to happen in the market, but there’s a high predictability that moving to Betterment would give your employees access to advice and tools that could help them have more money in retirement. I would caution plan sponsors to avoid putting off a good decision waiting for something that they can’t plan for and encourage them to make decisions for things they can control.