Slight departure from my usual postings; One of my good friends encouraged me to share this (*cough* James Corr *cough*).
I originally wrote this for my parents, who adore Dave Ramsey. As I make fairly clear in the opening paragraph, Dave Ramsey is the man when it comes to helping people with their debt situation. Just because someone is good at one thing, however, doesn't mean that person is also good at another, even when the two seem to go hand-in-hand: in this case, debt management and investments.
Below is a link to a famous Dave Ramsey video clip as well as my response:
Before I go into this, I'll be the first one to say that I think Dave is probably one of the best in the business at helping people become debt free. He's also amazing on the radio. That being said, here we go!
His hypothetical client's stats:
32 years old
4 year old child
2 year old child
20 year term insurance policy
--FAST FORWARD 20 YEARS--
52 years old
24 year old child
22 year old child
Term policy expired
Kids have zero reliance on parents
Home is completely paid for (15 year mortgage)
Completely debt free
15% income until debt free into 401k and then double up
$40,000 annual income = $700,000 in mutual funds
--HUSBAND DIES--
Mom has no liabilities + $700,000 to "struggle through" rest of life
$1,000,000 Term insurance cost for 20 year term @ age 32 (standard) is about $960/year or $80 per month (the reason it's $1,000,000 is time value of money: if he dies prematurely, the retirement plan is over and wife will need even more money than the $700,000 she will get when he dies after term expires @ age 52).
$40,000 per year income is roughly 25% tax bracket so $10,000 is gone off the top (yes, they will get some back through 401k deductions and mortgage interest, but when you figure in the other taxes they will pay such as property and such, call it 25% anyway).
15% saved of gross income ($40,000) deducted from pay check into the 401k is $6,000 per year or $500 per month. S&P 500's annualized returns since inception when adjusted to inflation equals 7.3% (dividends reinvested), so we can safely use that as an assumption for per annum yields.
15 year mortgage, $500 invested per month @ 7.3% per year return = $154,304
5 years of "doubling up" because mortgage is paid off: $1,000 per month @ 7.3% per year return (including the present value of the first 15 years of investing) = $288,893.
Problem #1: You don't get $700,000 at 7.3% return per year after 20 years with the numbers he gave in his hypothetical.
The % return they would have to make in order to obtain the $700,000 mark is actually over 10% and that's assuming they save $1,000 per month the entire 20 years. If you drop the savings rate to $500 per month, that raises the required rate of return to over 16%. Remember that is NET (after fees and expenses).
To quantify the risk one would have to undertake in order to reasonably expect 16% average annual returns is 26 (rounded down). This means 66% of the time, you can expect to make between 42% in one year and -10%. What about the 1/3? You must do the standard deviation again to cover 95% of cases. So 95% of the time, your returns you should expect will fall between -36% and 68%. Even then, there will still be outliers. Most people are not ok with losing 36% of their portfolio within one year. That, and the market rate of return is not as high as 16% annually. You hardly ever see anything above or below 40% (2008--the worst year in recent history--only saw about 40% loss from mutual fund portfolios).
Now, let's assume that they magically hit their $700,000 mark because they averaged 16% every single year in their 401k for 20 years.
At $50,000 draw down from her portfolio (remember she still must pay the 25% income tax because she is pulling the money from an IRA), the wife will run out of money (assume that inflation stays the same, and to conserve wealth, she keeps her eggs in super conservative investments that just keep pace with it) in 18 years at age 70. The average life expectancy for a woman in the United States is over 85. At that point, she will have social security and that's it.
Problem #2: Even with $700,000 maintaining current standard of living, wife will run out of money roughly halfway through expected retirement period
These are the two big issues with Dave's financial plan. Also, keep in mind that his assumptions are fairly unrealistic. Most children these days remain somewhat reliant on parents past ages 22/24. Not ideal, but also remember that parents chose retirement with their $40,000/yr salary over children's college.
Also, at age 32, most people still have a decent amount of college/grad school debt as well as other obligations which makes saving 15% highly unrealistic (most people I find are lucky if they save 10%).
Nevertheless, taking all of Dave's assumptions into account (and ignoring a lot of things like the 5-year rule in which the spouse is supposed to take out all the money from the decedent's retirement plan), the family just doesn't get there, and even if they did, the plan doesn't last through the survivor's life expectancy. Objection: "Well, the wife can just go work." After 20 years of not working? That's certainly possible, but then if that's the case, it defeats the entire purpose of saving and buying life insurance. The common assumption is always to enjoy an equal or, preferably, better standard of living in retirement than you had during your working years. With Dave's numbers, this is not possible--even with the ridiculously high annual yield they would have to earn in the 401k.
Hopefully, this shows the level of complexity involved in financial planning (not just to show that Dave's wrong). And it's not to sell permanent insurance. There's a lot of reasons to buy term over permanent (and vice versa), but that's an entirely different conversation.
Keep in mind I wrote this during my MBA program at Cal Lutheran many years ago; The analysis doesn't take the TCJA (Tax Cuts & Jobs Act) into account, including the new marginal tax brackets. It also doesn't account for numerous other variables such as a reverse mortgage option, a two-income household beginning at
marriage, remarrying, taking out life insurance on the children, employing the children and starting a family business, etc. I also realize that Dave was pulling figures out of thin air, but to be fair, he does spend a lot of time doing this and probably should have checked his numbers given his aggressive view towards permanent life insurance.
