Retirement Planning: The Dangers of False Optimism

Three weeks ago, I wrote an article about investment assumptions that financial guru Dave Ramsey encourages his readers to make. Specifically, I took issue with the fact that Mr. Ramsey was telling followers to assume they could earn consistent 12% returns over a 40-year time frame; I called it "dangerous" to preach such a message.

One day later, I ended up appearing on Mr. Ramsey's radio show. That visit, combined with time digging into Mr. Ramsey's assumptions, has led me to write this follow up.

Below, I want to provide you with information that I think is crucial to understanding what history has taught us. My goal is to allow you readers to carefully weigh the facts, and make decisions that are in your own best interest.

Mr. Ramsey's 12% number doesn't stand up
The crux of my earlier article was that Mr. Ramsey's promise of 12% returns -- based on historical market averages -- was misleading. It's true that the average annual return of the S&P 500 since 1926 is about 12%, as Mr. Ramsey claims.

But several sources have repeatedly demonstrated that average annual returns are worthless when trying to figure out an investment's historical rate of return. Instead, the compound annual growth rate (aka CAGR or annualized return) is the only reliable number to use. The CAGR of the S&P 500 since 1926 is actually 9.87%.

This is why I refer to Mr. Ramsey's projections as "false optimism:" He is taking a number (average annual return), and plugging it into a calculation (projected returns over a 40-year timeline) that it was never meant to be used in.

Mr. Ramsey admitted that the criticism of CAGR vs. average annual returns was "fair," and also stated that his 12% number was used for "educational" and "illustrative" purposes. But when asked why he didn't simply use the more accurate 9.87% number, he said, "Because it's my show!" In the end, he said I was "splitting hairs," and simply trying to smear his name.

Numbers don't lie -- this advice could leave you retired and broke
To illustrate why this advice is so dangerous, let's take a look at Mr. Ramsey's advice when it comes to retirement. In his Total Money Makeover (starting on page 159), Mr. Ramsey suggests that people can withdraw 8% of their nest egg in the first year, and increase that withdrawal each year to match inflation.

That 8% figure is twice as high as the industry standard of 4% withdrawals. Where does the 8% figure come from? Mr. Ramsey says: "If you make 12 percent and only pull out 8 percent, you grow your nest egg by 4 percent per year. That 4 percent keeps your nest egg, and therefore your income, ahead of inflation 'til death do you part."

In other words, the withdrawals Mr. Ramsey suggests are based squarely on this 12% assumption of returns, and having 100% of your nest egg in stocks while you are retired.

In the real world, these are incredibly risky assumptions. Want proof?

If you retired in 2000, using Mr. Ramsey's withdrawal recommendations, you would have been broke by 2009!

Full stop. Read that again to digest it.

Although the example below uses a $375,000 nest egg and a $30,000 initial withdrawal (because that's the example Mr. Ramsey uses on page 160 of his book), you could plug in any number for the nest egg and, as long as the initial withdrawal is at 8%, you'd still be broke in nine years.

Sources: S&P 500 returns include dividends reinvested, via Moneychimp.com. Average inflation rates per decade from inflationdata.com.

A quick look at the data will show you that if you had, instead, taken a much more prudent 4% return, you would still have over 43% of your nest egg intact, despite pretty awful market conditions. And remember, I'm not saying $15,000 per year is enough to live on --no matter what your starting nest egg was, you'd have about 43% of it left following the 4% withdrawal plan.

Sources: S&P 500 returns include dividends reinvested, via Moneychimp.com. Average inflation rates per decade from inflationdata.com.

Of course, it would be easy to retort that we are just cherry-picking the data to make Mr. Ramsey's plan look bad.

However, the truth of the matter is that this would have occurred with alarming frequency. If you wanted to retire at 65 and have your money last until you were 90 -- and your returns matched the S&P 500's -- you would have run out of money early if you retired in 1926, 1927, 1928, 1929, 1930, 1931, 1936, 1937, 1938, 1939, 1940, 1956, 1957, 1958, 1959, 1960, 1961, 1962, 1963, 1964, 1965, 1966, 1967, 1968, 1969, 1970, 1971, 1972, 1973, 1974, and 1977.

And, even though you wouldn't be 90 years old yet, you would have also run out of money if you retired in 1998, 1999, 2000, and 2001. And you'd be dangerously close to running out of money if you retired in 1997 or 2002.

All in all, you would have run out of money early in 34 out of 84 of these years. If you only include the situations where retirees have lived to be 90 years old (for instance, we wouldn't include 2012, because we have no idea what the next 39 years hold), then the failure rate for Mr. Ramsey's plan is about 50%!

Think about it: Following this advice gives you a 50/50 chance of being broke before age 90.

And what if you had opted for the traditional 4% withdrawal rule? You would have run out of money if -- and only if -- you retired between 1928 and 1930, just at the start of the Great Depression. If you'd like to look at all of the numbers yourself, they are available here, on two different tabs (one for Mr. Ramsey's plan, one for the standard 4% plan).

Remember, the exact years aren't all that important. What's important is that we have a whole body of history that shows what kind of returns have led us to what we have today. We can't predict the future with any degree of certainty, so the best we can do is use the past as a proxy -- in much the same way Mr. Ramsey gets his erroneous 12% figure.

What this means for you
I'm glad that Mr. Ramsey encourages his followers to get second opinions. Based on the information above, that's extremely important advice. I have no qualms with Mr. Ramsey's advice for getting out of debt, or for saving; you're in good hands if you follow it. In fact, over the course of his career, it's possible that no one has helped as many people right their financial ship as Dave Ramsey has.

But when it comes to investing, saving for college, and retirement planning, I suggest educating yourself, or finding a fee-only advisor to help you with the process.

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