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.