Dave Ramsey is a household name when it comes to teaching finance. He gives a lot of advice on various financial topics, but should we take what he says to the bank?
In full disclosure, I was formerly a part of Dave Ramsey’s SmartVestor Pro program for the past year. All that really means is that my business was analyzed by Dave’s people, and I pay them a fee to be listed as a financial advisor on his website. However, that doesn’t mean that I agree with everything Dave says -- and here’s why you shouldn’t either.
When it comes to debt and debt reduction, I think Dave does an outstanding job. I may not agree with every little detail of his program, but if you stick with his program it will work. Where I don’t agree with him is in retirement planning.
Dave makes two big assumptions that I believe can be devastating to an individual’s retirement:
- Plan on making a 12% return on your investments
- Plan on taking a distribution from your investments of 8% per year
If you read no further in this article know this – you SHOULD NOT count on each of the two criteria above in your retirement planning.
Why shouldn’t I count on those great returns?
Simply put – because they aren’t realistic. According to Dimensional Fund Advisors Matrix book, large cap stocks have averaged a 9.9% return dating back to 1928. . During the same time small caps have averaged 12.2% (Dimensional Fund Advisors). I suppose it is possible to invest all of your money in small cap stocks -- as Dave’s 12% figure would imply-- but that isn’t a very responsible way to invest because it lacks diversification. Small cap stocks have been more volatile than large cap stocks in the past, therefore you are taking on more risk to invest in them.
What percentage distribution should you take in retirement?
That is a great question, but the answer probably isn’t 8% as Ramsey suggests. Dave’s theory is that your investments will make 12%, you will take an 8% distribution, and your account balance will continue climbing by 4% a year.
That sounds great in theory, but the real world doesn’t work that way.
I can’t say that I have ever seen a business or retirement plan succeed based on a unicorn scenario. Most financial experts would tell you to plan on taking a 4% distribution from your assets in retirement. However, there have been many studies that show that a 5% or 6% distribution can work.
Let me explain what I mean by study. There are two common elements of most retirement studies: a time period of anywhere between 20 and 40 years, and a Monte Carlo analysis. The time period is important since most retirees want their assets to last throughout retirement. For some people a 20-year time period may be sufficient while other may need their assets to last for 40 years or more.
A Monte Carlo analysis is a tool that generates many random returns (usually 1,000 different trials). The reason that the random variables are needed is that returns on an investment don’t happen in a straight line. If you have a mutual fund that has averaged 12% a year, that doesn’t mean that it makes 12% every year, but is simply the average. It could be up 10% one year and down 30% the next year.
A Monte Carlo analysis does a good job of accounting for sequence of return risk. For example, if you retired at the end of 2007, you would have seen close to a 40% drop in your stock investments in 2008 (based on the returns of domestic and international indexes). Even a moderate exposure to stocks in 2008 could have been destructive to retirement plans, and especially one that is based on a 12% annual return and 8% withdrawals. On the opposite end, if you retired in 2009 you would have started retirement with a 9-year bull market which is an outstanding start to retirement.
There are a multitude of factors that need to be considered when determining your withdrawal rate. One thing I would not recommend for most people is counting on a 12% return and taking an 8% distribution. If you don’t believe me, try doing a Monte Carlo analysis to see what your results will be.
Will you take a steady withdrawal in retirement?
Studies on retirement withdrawals are interesting and provide a lot of good data, but in reality, many people don’t take a consistent withdrawal in retirement. For example, what if a couple retires at the age of 60 and doesn’t plan to take Social Security until age 67 or even 70? They will likely need to take a much larger withdrawal from their investments until they start collecting Social Security.
What about the couple that wants to travel the world in their first five to ten years of retirement? They will likely need to take a larger withdrawal for their early retirement years.
Please do not base a retirement plan on an expected 12% return and an 8% withdrawal. Do your own due diligence or work with an advisor to come up with an appropriate investment allocation and continue to monitor it. Withdrawal rates and Monte Carlo analysis are two elements that we analyze in our retirement plans. If you would like to schedule a call to discuss you can do so here.
Dimensional Fund Advisors (DFA) Matrix Book 2018. Large cap returns are from the S & P 500 Index and small cap returns are from the Dimensional U.S. Small Cap Index.
Brad Bobb, CFP® is the owner of Bobb Financial Inc, and an expert in retirement planning for federal employees.