“I’m going to have over ten million dollars by the time I retire!” I heard one of my colleagues proclaiming this to a few others sitting around the lunch table. Myself being the resident money nerd had to walk over to listen. I mean I want ten million dollars too. We work for the same company so whatever he is doing I should be able to copy? He was really excited talking about setting up contributions to a Roth IRA in addition to his 401k and how easy it was all going to be. I listened for awhile without asking any questions but then I simply had to.
Me: Brian (not real name), what kind of rate of return are expecting?
Brian: I am being conservative (literally said this) and using 12% rate of return.
Where Does 12% Rate of Return Come From
When I heard Brian say this I knew exactly what flavor of kool-aid he had been drinking. Dave Ramsey is the only person in the financial world that I have ever heard of using this 12% number. He preaches it like it is an absolute certainty. Dave also has one of the largest followings of all the financial gurus so lots of people are hearing this.
Dave comes up with 12% based on the S&P 500 had a market average return of 12% since 1926. He also argues that if you pick good mutual funds you can easily outperform that 12% number. He has been challenged on this by many people and has always doubled down on this claim. He says to pick mutual funds with a 10-year history of returns over 12% and recommends working with a financial advisor.
The Problem With 12% Rate of Return
This 12% number is an average rate of return and not the compounded annual growth rate (CAGR). The CAGR is the number you want because that is real money in your pocket. The simple example is if I invest $1,000 and the market drops -50% the first year I have $500. If it then goes up 100% the next I am back at $1,000 with an average rate of return of 50% but not having made any money. In the same example, your CAGR would correctly be 0%. The CAGR of the S&P 500 is 10% since 1926. 200 base points lower.
His 12% Rate of Return does not include any fees. Fees can absolutely crush your returns. Index funds will have fees of around 0.1% but Dave recommends loaded mutual funds and working with a financial advisor. You would be on the extreme low end if you were only paying 1.2% in fees per year in that scenario. Using Dave’s 12% return the difference from fees is millions at retirement.
The Dangers of 12% Rate of Return
Dave would argue that I am just being a nerd and that I need to put the calculator away and start making some money. He has said that even if he is half wrong you are still a millionaire. Unfortunately with how compounding interest works that if you are half wrong it could mean the difference between well off and poverty.
Let us take my friend Brian from early with some hypothetical numbers. He is 40 years old and is planning to work till 66. He doesn’t have much saved now but is starting to save 15% of his $60,000 per year salary like Dave recommends. A 12% rate of return leaves him with $1.7 million at age 66. Far cry from his 10 million but still a nice nest egg to live off. However, at 6% he only has $600,000. That is almost a third of what he thought he would have. A 4% withdrawal rate gives you $24,000 per year for expenses. Adjust for inflation at age 66 and you can see hard times ahead for my friend.
Dave is extremely conservative in everything he teaches about when comes to emergency funds, debt, credit cards, paying cash and mortgages. However, his investment advice is as risky and reckless as anyone I have ever heard of. Assume 12% rate of return, plan for an 8% withdrawal rate in retirement and keep your investments 100% in stocks.
If you take Dave’s advice when you are young you will probably be fine by age 65. Even if you don’t have 10 million dollars. If you assume a 12% rate of return when you are starting at age 40 and older it could mean having to work well beyond age 65.
What Rate of Return To Use
If 12% is no good what rate of return should we be using? To be honest I don’t recommend using a fixed number. Depending on what I’m looking at I like to use Personal Capital‘s retirement guide, FireCalc.com or CFireSim.com. With these calculators, you are looking at thousands of different scenarios over different time periods in history. This will give you a realistic range of what to expect.
If I do need to assume a percentage I will typically use 7.5%. This is not a magic number but what I would call a realistic but slightly conservative figure. Over most 30 year periods, you would have ended up doing better than 7.5%. Again you should not be looking for a perfect number as nothing can predict future returns.
Assuming a 12% Rate of Return on your investments is dangerous and nothing in history says you can expect that over the long term. Use a more conservative value or better yet use the calculators I mentioned to plan your nest egg. If you end up getting 12% or better returns then you can just stop working earlier. Much nicer feeling than getting to 55 and realizing you are 20 plus years away.
The final nail in the 12% Rate of Return coffin is Dave will never name a fund. He claims there are hundreds that perform better than 12% but has never named one. Instead, he recommends you contact one of his certified financial advisors who will attempt to take your returns down to about 2%.
This article kind of turned into me attacking Dave but he is the only person I know who uses that figure. I think Dave gives some really sound advice for your average person covered in debt. His investment advice is dangerous on many levels though.
So what rate of return do you use? Am I being too hard on Dave?