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.

Year

S&P 500 return

Inflation Rate (Decade Average)

Withdrawal

Amount Left After Withdrawal

Investment Return

Year-End Balance

2000

-9.11%

2.56%

 $30,000

 $345,000

 $(31,430)

 $313,571

2001

-11.98%

2.56%

 $30,768

 $282,803

 $(33,880)

 $248,923

2002

-22.27%

2.56%

 $31,556

 $217,367

 $(48,408)

 $168,959

2003

28.72%

2.56%

 $32,363

 $136,596

 $39,230

 $175,826

2004

10.82%

2.56%

 $33,192

 $142,634

 $15,433

 $158,067

2005

4.79%

2.56%

 $34,042

 $124,026

 $5,941

 $129,966

2006

15.74%

2.56%

 $34,913

 $95,053

 $14,961

 $110,015

2007

5.46%

2.56%

 $35,807

 $74,208

 $4,052

 $78,259

2008

-37.22%

2.56%

 $36,724

 $41,536

 $(15,460)

 $26,076

2009

27.11%

2.56%

 $37,664

 $(11,588)

 $0

 $0

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.

Year

S&P 500 return

Inflation Rate (Decade Average)

Withdrawal

Amount Left After Withdrawal

Investment Return

Year-End Balance

2000

-9.11%

2.56%

 $15,000

 $360,000

 $(32,796)

 $327,204

2001

-11.98%

2.56%

 $15,384

 $311,820

 $(37,356)

 $274,464

2002

-22.27%

2.56%

 $15,778

 $258,686

 $(57,609)

 $201,077

2003

28.72%

2.56%

 $16,182

 $184,895

 $53,102

 $237,997

2004

10.82%

2.56%

 $16,596

 $221,401

 $23,956

 $245,356

2005

4.79%

2.56%

 $17,021

 $228,336

 $10,937

 $239,273

2006

15.74%

2.56%

 $17,457

 $221,816

 $34,914

 $256,730

2007

5.46%

2.56%

 $17,903

 $238,827

 $13,040

 $251,867

2008

-37.22%

2.56%

 $18,362

 $233,505

 $(86,910)

 $146,594

2009

27.11%

2.56%

 $18,832

 $127,762

 $34,636

 $162,399

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.

Social Security plays a key role in your financial security, and with millions of Americans relying primarily on the government program for their retirement income, it's more important than ever for you to make the most of the Social Security benefits you have coming to you. In our brand-new free report, "Make Social Security Work Harder For You," our retirement experts give their insight on making the key decisions that will help you boost your monthly benefits, and ensure a more comfortable retirement for you and your family. The report is absolutely free, so click here to get your copy today.


Read/Post Comments (20) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 29, 2013, at 2:38 PM, valari25 wrote:

    Great article.

  • Report this Comment On June 29, 2013, at 3:15 PM, TMFCheesehead wrote:

    @valari25-

    Many thanks,

    Brian Stoffel

  • Report this Comment On June 30, 2013, at 2:09 PM, cgervasi wrote:

    I agree with everything in this article, except I didn't think he was saying 8% of the investment balance at retirement but rather 8% of that year's balance. That way you never run out of money, although the inflation-adjusted withdrawal amounts will likely decrease.

  • Report this Comment On June 30, 2013, at 3:34 PM, TMFCheesehead wrote:

    @cgervasi-

    Exactly, in reality, there's no way that could be what was meant. If that were the case, you'd have to live off of an extremely low income compared to what you started with.

    Brian Stoffel

  • Report this Comment On July 01, 2013, at 8:59 AM, TMFCheesehead wrote:

    To anyone who checks the Excel sheet, 1952 under the "Dave" plan was erroneously marked as a year where money would have run out. This was due to an error in equations.

    This error was not, however, included in the article analysis or in the success rate percentage for either plan.

    Brian Stoffel

  • Report this Comment On July 02, 2013, at 10:08 AM, marketmommy wrote:

    Wow, Brian. Fantastic article and analysis!

    Well done, and thank you!

  • Report this Comment On July 02, 2013, at 10:54 AM, rhutmacher wrote:

    Fantastic article!

  • Report this Comment On July 02, 2013, at 2:12 PM, damilkman wrote:

    I think the better point is that 350K is just not enough. For a unit looking to retire with about 50K to play with you would need to double to 700K assuming your getting 20K from social security. I personally always shot for 5%. But that was presuming not having everything in stocks but having contributions from bonds. Hopefully the bonds will be a meaningful method of income in fugure when I am ready to retire.

  • Report this Comment On July 02, 2013, at 2:28 PM, HectorLemans wrote:

    For some reason I always assumed he was talking about CAGR when he said average annual return. I'm surprised he doesn't make that distinction. He should know better. I understand he might not want to make it too complicated for everyone to understand but if that's the case he should be using a much lower average annual return.

  • Report this Comment On July 02, 2013, at 2:50 PM, TMFCheesehead wrote:

    @damilkman-

    Agreed on both front. First, that diversity out of stocks is a wise decision, and second that a bigger nest egg will be needed.

    @HectorLemans-

    I'm baffled by why he uses the number and refuses to change it, but am hopeful that if enough people ask him why, he might consider it (not holding my breath though).

    Brian Stoffel

  • Report this Comment On July 02, 2013, at 2:54 PM, johaba wrote:

    I think Dave Ramsey is a hack. He is more concerned with generating book sales than giving good advice for investing. I used to listen to his radio show sometimes and his advice on getting out of debt was always very simplistic and obvious, no need to buy a book!

  • Report this Comment On July 02, 2013, at 3:16 PM, TMFCheesehead wrote:

    @johaba-

    Whether its simplistic or not, he's found a way of reaching millions and changing their behavior for the better. For that, he should be applauded.

    However, it's that same magnetism that makes his retirement advice so dangerous. Many could follow it without ever second guessing.

    Brian Stoffel

  • Report this Comment On July 02, 2013, at 4:53 PM, stockdissector wrote:

    I think a number of people gets annualized and average annual returns confused.

  • Report this Comment On July 02, 2013, at 4:59 PM, JeffGodofBiskits wrote:

    I'm so glad this follow up article was written.

    I led a 'stewardship' small group recently using the DR Financial Peace University. While the content and presentation was largely excellent, I too laid on the 'sanity check' comments pretty thick when it came to the Retirement Planning section. The folks in our group received that all in the right spirit (and laregly agreed with my concerns).

    While I believe it is good practise (and indeed possible) to simplify the whole 'get out of debt' approach, retirment planning is a completely different animal that should not be so quickly simplified for presentation.

  • Report this Comment On July 02, 2013, at 9:01 PM, TMFCheesehead wrote:

    @Jeff-

    Very glad to hear that that message is getting across.

    Brian Stoffel

  • Report this Comment On July 02, 2013, at 11:18 PM, lngtrmcptlgns wrote:

    Great article.

    I have stopped being surprised at the number of unbelievably dumb things I hear so-called financial experts say.

    I heard Ramsey say (years ago) that he could "make 12% a year off of a good growth mutual fund like falling off of a log!" and lost all respect for his advice at that time.

    One of you smart motley fool writers should compile a list of the top dumb things the so-called experts have said. Seriously. That would be great fun and educational.

    Another that comes to mind is the lady (who is a top executive at one of the big financial firms) on the recent Frontline special on retirement who claimed to have never heard of the studies showing that cheap passive index funds have consistently outperformed actively managed funds.

    I would also love to see you write an article about how few people have a clue what their portfolio CAGR is.

    For all of the talk the MF engages in about helping people do the best they can with their investing, nobody is showing people how to even measure (accurately) their portfolio CAGR!

    If you don't know your CAGR, how can you make wise adjustments, if necessary?

    How do you even know if you are "beating the market" (ie a simple S&P 500 index fund)?

    I would wager that less than 1% of retail investors have a clue what their own portfolio CAGR is (and fewer still know if it is beating the market), and the MF could easily educate in this area!

  • Report this Comment On July 03, 2013, at 4:28 PM, lintsniffer wrote:

    While your point is factually correct and well-taken, the fact remains that Dave Ramsey is a personal finance rock-star. If the entire country would follow his advice about personal finance, there wouldn't be so many financial problems and the 2008 housing crisis would have never happened (because no one would have bought a house they couldn't afford, and there would have never been subprime mortgages to package into CDOs)

    I'm not so sure that fool.com or Brian Stoffel can make the same claims. I'm not sure people's financial futures are being changed by what is written on this webpage. Dave Ramsey has changed many people's financial futures.

    Furthermore, if you are stupid enough to just obey everything Dave Ramsey (or anyone else) says and never check it out to see if it's working the way he said it would, then you are destined to be broke anyway.

    So, in summary, your retort is pointless Brian, because those people who are not smart or savvy enough to figure this out on their own are never going to read it and those who are smart enough to figure this out already knew it.

    I suggest you develop thicker skin.

  • Report this Comment On July 03, 2013, at 4:55 PM, cgervasi wrote:

    If someone questions someone else's numbers or facts, what does that have to do with having a thick skin?

  • Report this Comment On July 03, 2013, at 5:20 PM, lintsniffer wrote:

    I say Brian needs thicker skin because it seems that he won't let it go. He already made the point in his first article. So to beat the drum again after being on Ramsey's show to me shows that he took the disagreement personally. How about filling this space with good investment advice instead of trying to point out bad investing advice?

    And for the record, I don't think Ramsey did any better from a "thick skin" perspective. He obviously took it personally that he was being called out for using an inaccurate number and his response was rather juvenile.

    Of course I could be totally wrong and both Brian and Dave are just doing this for ratings/page views. In which case, I've been had.

  • Report this Comment On July 03, 2013, at 6:25 PM, TMFTrog wrote:

    Great work, Brian. You did the Fool proud.

    Lint - welcome to the Fool community. I see these are your first ever posts. I hope you'll stick with us!

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