Tim discusses Dave Ramsey's controversial recommendation that retirees invest 100% in equities and withdraw 8% annually. He challenges this retirement strategy due to sequence of return risk, unrealistic stock return assumptions, lack of diversification, and differences between arithmetic and geometric returns.
Recently radio talk show host Dave Ramsey sparked a good deal of controversy because he recommended retirees invest 100% of their assets in equities and withdraw 8% per year, with no guardrails. I don’t think so Dave.
He also called his own teammate, George, a moron, and in the process called everyone recommending a less than an 8% withdrawal rate “stupid” and a “goober” and “it pisses him off.”
And of course, many financial advisors, myself included, obviously challenge his advice for the reasons that I’ll go into in a bit.
But first, I do want to say that Dave has a huge platform, and, in the aggregate, he has done a great job advising people how to get going in the right financial direction - certainly, his advice to pay down debt and specifically, credit card debt.
Dave Ramsey is Not a Licensed Advisor
But you must realize he is not a licensed advisor and has no clients of his own. So, he is not bound by any regulations or held to a higher standard as he would be if he were a part of FINRA, the SEC, or if he held a CERTIFIED FINANCIAL PLANNER™ designation.
His financial interest is to get viewers. He’s selling his show! He also seems to not understand that most people don’t have a nationwide television show, and don’t have a net worth over $100 million like he is estimated to have.
So, sometimes his advice, specifically as it relates to retirement, is a bit exaggerated or reckless. I would say that maybe 80% of what he recommends is great solid advice, but you certainly need to do your own due diligence when it comes to his retirement advice, and here are four reasons why, as it pertains to his relatively high, recommended 8% withdrawal rate.
4 Reasons Why I Don't Recommend an 8% Withdrawal Rate
- Dave’s simplistic approach does not consider the effects of market volatility and sequence-of-return risk.
- The false assumption that stocks will consistently deliver double-digit returns.
- His advice lacks consideration for the importance of diversification, particularly the role of bonds or other fixed-income investments in mitigating risk.
- Dave overlooks the difference between geometric and arithmetic returns. Market returns are very lumpy. As I’m sure you’ve witnessed if you’ve been invested for any amount of time.
Now, for a bit more color:
1. Sequence-of-return Risk
Sequence-of-return risk is the risk that poor investment performance early in retirement, when investors start withdrawing funds from their portfolio, can have a lasting negative impact.
This is because withdrawals during a market downturn can deplete the portfolio more quickly, leaving less capital to benefit from potential market recoveries in later years.
Also, positive returns in the early years can provide a buffer against later market downturns.
Managing sequence-of-return risk is crucial, especially for retirees who are relying on their investment portfolios to fund their living expenses. This is why we use strategies that may include having a more conservative asset allocation than what Dave recommends. So, we have funds to draw from during market downturns, we call this the war chest at my firm.
The key factor influencing portfolio success is market performance in the initial years, because bad returns early on in retirement, can lead to a higher risk of failure.
2. Market Volatility
If we look at historical scenarios, specifically during times of large negative returns, this will show us why funding 8% inflation-adjusted withdrawals, with a 100% equity portfolio can cause you to run out of money too soon. The data shows us, retirees adopting this strategy faced significant declines, especially during economic downturns like the Great Depression, during 1973 and 1974 and during more recent market collapses like2008 and 2009.
Since 1900, there have been a few 15+ year periods of time where the stock market has provided no returns. And there is one example that shows how following Dave's advice in the 2000s, could have led to running out of money in as little as 13 years. And about 40% of the time, you would run out of money in under 30 years.
3. Diversifying with Bonds
Now, obviously, Dave’s advice may sound great, but it does carry more risks. Most times, it would not be prudent for retirees to rely solely on stocks for their savings. Bonds, treasuries, and other fixed income sources are gonna play a crucial role in mitigating downturns and contributing to a safer withdrawal rate by minimizing sequence-of-return risk.
4. Geometric vs. Arithmetic Returns
What in the world does that mean? Well, a 12% average return does not translate to a consistent 12% annual growth for a retiree's portfolio. As I mentioned, returns are lumpy, right.
Now I’m going to throw some numbers at you in this example: if $1 million invested in stocks experiences a 20% decline, the portfolio value decreases to $800,000. If the stocks increase 25% the following year, the value rebounds to $1 million.
The average annual return, calculated by combining the -20% and positive 25%, is 2.5%. However, despite this average, the final portfolio value remains at a million dollars. In essence, the actual return in this scenario is zero.
This discrepancy between arithmetic returns (2.5%) and geometric returns (0%) is very critical. Because investors cannot spend arithmetic returns; we are subject to the lower, geometric returns.
And the greater the volatility in the investment, the more pronounced the difference between these two will be. And this scenario didn’t even account for withdrawing $80,000 or 8% which would obviously make the geometric returns negative. His strategy also says nothing of the tax liability of the account. If this is a pre-tax IRA, the odds of running out of money too soon are even higher.
Now, to be fair, there are situations where Dave’s 8% withdrawal strategy may succeed. If you have a short time horizon, like a decade or so, this can make more aggressive withdrawal feasible.
Dave's strategy may be suitable for those with shorter time horizons or health issues, but not for those with longer life expectancies.
We like to use a dynamic guardrail withdrawal strategy which means, we advise clients to withdraw more than the traditional 4% rate, but not as high as the 8% rate. It’s usually somewhere between 5-6%, and you have to be willing to follow a few rules in order for it to work properly.
But if you are willing to follow those rules, which pertain to investments and increases and/or decreases in withdrawal amounts, in response to market fluctuations, it's obviously going to pay higher than the traditional 4% rate and helps mitigate sequence-of-return risk if you bump through a guardrail. This will put the odds ever in your favor.
There is no question that Dave has made an important contribution to promoting financial responsibility. However, his stance on retirement spending is a bit narrow and short sighted in my opinion and I would highly recommend investing according to experts, who have extensively studied safe withdrawal rates over time. Yes, the same experts he rails against in his rant on his show.
Ultimately, the debate underscores the diversity of opinions within the financial planning community and the importance of tailor-made approaches for individual clients. Please reach out if you’d like to have a discussion of a safe withdrawal strategy.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.