I should start this post off by saying I really enjoy listening to Dave Ramsey. He's on the radio every weeknight for 3 hours so I often listen to him coming or going from a shift. He is far better than the other two “gurus” on local radio, one of which sells his advisory services and the other of which is selling permanent life insurance.
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I think he is a fantastic motivator at getting people out of debt and keeping them from screwing up the big things, like using credit cards for credit, spending more than you earn etc. You can do far worse than following his “baby steps” out of debt and toward financial independence.
I also like the advice he gives people about money and relationships. He does a great job advising those being hounded by creditors and facing possible bankruptcy. In fact, the worse the shape of your finances, the better Dave's advice is. His investing advice, however, leaves a lot to be desired.
4 Ways Dave Ramsey's Investing Advice May Be Leading You Astray
1) The Cost of Debt Aversion
Many people have a problem with Dave's absolutely rabid anti-debt stances. For Ramsey, there is basically no good debt. Dave's approach leans a little too far toward the behaviorally correct thing to do, and too far away from the mathematically correct thing to do.
For instance, it's nice to have no house payment and no risk of losing your house to the bank if you lose your job. So Dave recommends paying off your mortgage as soon as possible. Behaviorally, that might be the right answer. But mathematically, it often isn't.
Consider a 3% mortgage, 2% after the mortgage interest tax break. If inflation is 3%, the bank is basically paying you to borrow money after inflation. Even if you only expect 5% out of your investment portfolio, you're still far better off (mathematically) directing new money into the portfolio than toward paying down the mortgage early.
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There are still lots of benefits to paying down the mortgage (less risk of losing home, ability to cut back at work, the feeling of being debt-free, improved cash flow etc), but you should probably calculate how much those benefits are likely to cost you before making that decision.
Consider $100K in your pocket that you can either pay down your mortgage with or put in your investment portfolio. Say the mortgage is costing you 2% after tax, and the portfolio (while riskier) returns 8% after tax and expenses. Over the next 10 years, putting that $100K toward the mortgage will save you something in the neighborhood of $94,000. I might be able to live with a little debt for a decade for $94K. You might too.
2) His Endorsed Local Provider List
Dave continually pushes his “endorsed local providers” for investing (as well as insurance, real estate etc.) Most of these, unfortunately, are commissioned salesmen who sell you loaded mutual funds. My local ELP says he discloses his fees and commissions to clients, but he doesn't do so on his website. He does, at least, recommend against permanent life insurance as an investment product.
Dave's attitude toward loads is that they don't matter over the long run. I disagree. I don't see any reason to pay a commission when commission-free products are available. Even if you view that as a way to pay for “good advice“, you should realize you are introducing a serious conflict of interest for the adviser, and likely getting crappier investments, even ignoring the load.
3) Good Growth Stock Mutual Funds
Dave often recommends you go out and get yourself some “good growth stock mutual funds” that will return you 12% a year. No mention of bond funds or any other type of diversification. Apparently, 3 or 4 growth stock funds will do you. Never mind that is exactly the type of portfolio you are most likely to bail out of in the event of a market downturn. For someone who is so concerned about the behavioral aspects of debt, he seems to ignore them in investing.
12% is an extremely optimistic long-term expected return, especially after paying the high ERs and loads you're likely to get from Dave's ELPs. The long-term return of the S&P 500 (good growth stocks) is on the order of 9-10%, and the return for the ultra-low-cost Vanguard Growth Index Fund is only 8% over the last 20 years. How likely do you think 12% is going forward?
4) The 8% Safe Withdrawal Rate
Dave often mentions that you should be able to spend 8% of your portfolio a year in retirement. Never mind that all the best minds in academia recommend a safe withdrawal rate between 3 and 5%.
In fact, the updated Trinity Study suggests that a withdrawal rate of 8% on a 50/50 portfolio has less than a 50% chance of lasting 20 years. Even if you stick with Dave's recommended asset allocation of 100% stocks throughout your retirement, you still have a 1 in 4 chance of running out of money in 15 years. That's hardly a safe withdrawal rate.
The Real Danger of Following Dave's Investing Advice
The problem with throwing these numbers out — “12% returns” and “8% a year withdrawals” is that if you really run the numbers, you'll arrive at the wrong amount to save.
Consider someone who wants to live on $100K a year in retirement in today's dollars. If you assume a relatively standard 4% withdrawal rate, and a portfolio that returns 5% real a year (some people would argue even these numbers are optimistic), you need a portfolio worth $2.5 Million at retirement. Assuming you acquired that over 30 years, you would need to save about $36,000 per year.
If you followed Dave's advice, and assumed a return of 9% real (let's make a big leap and assume Dave's listeners can adjust for inflation) and an 8% withdrawal rate, you'd need to save $1.25 Million in today's dollars at retirement, and somehow magically do that by only putting away $8500 a year. There's an awfully big difference between $8500 and $36,000 a year.
So, while I like how Dave recommends eating “Rice and Beans, Beans and Rice” until you're out of debt (similar to my recommendation to live like a resident for a few years after graduating), I'd be very cautious taking investing advice from him or his endorsed local providers.
In what ways has Dave Ramsey's advice helped you be a better investor? Do you agree with me that some of his investing advice is off base and detrimental to his followers? Comment below!
I have plenty of respect for the CFA, CFP, and ChFC. I think they’re all top level designations in the field. I’d like to see a higher one, but will take what I can get.
[Rude comments deleted]
Here’s some feedback from an advisor with the CFP and ChFC.
Me: “How would you compare the CFP and the ChFC in terms of difficulty and the breadth of the material? I was having a discussion with someone recently and want to be sure I’m being fair in how I describe the two.”
CFP, ChFC: “The biggest differences are that the CFP has a final exam and the public is less familiar with the ChFC, which makes the ChFC designation less valuable. I got the ChFC because I used the courses to fulfill my continuing education – I figured I might as well get something out of the CE. I would recommend the CFP hands down and believe it will do more to prepare you and reinforce financial planning skills.”
Very good article… especially the mention of the 12% idea. When you study the history of the market never has a “good growth stock mutual fund” returned 12% over a consistent period of time. In fact, the only time we’ve ever seen that time of growth in the market was from 1980-1999; the reason was two-fold – getting off of the gold standard in 1971 (this allowed us to begin printing money like it was going out of style) and the introduction of the 401(k) in 1980. The implementation of the 401(k) introduced most working Americans to the stock market which began to artificially inflate the value of stocks. (Think of basic supply and demand.)
“In 1950 less than 2% of Americans owned a common stock.” – John Bogle
What percentage of Americans own stock today?
Also, these posts are very entertaining! The ChFC is 9 fairly difficult exams. After one has passed all 9 he or she can sit for the CFP.
http://www.theamericancollege.edu/financial-planning/chfc-advanced-financial-planning
Many people can pass a test(s). It about continually learning after you’ve taken the test. I’ve found that many MD’s, DDS’s, ChFC’s, CFA’s, CPA’s, CFP’s, and so on pass the test (or series of boards in the case of physicians) and think they’ve made it when, in fact, the most successful professionals are continually learning. They never stop.
AuthorofTheWealthyPhysician –
You’re right…those posts were extremely entertaining. Still can’t believe I was censored but there’s a first for everything.
I disagree with the 2 reasons you offered being the primary causes of the bull market we experienced in the 80’s and 90’s. If you have some research to back it up, I’d be interested in taking a look. I’d argue that beginning at single digit PE’s in the early 80’s and topping out at PE’s north of 40 (based on Shiller’s CAPE – http://www.econ.yale.edu/~shiller/data.htm) explained the vast majority of the robust returns we saw during the period. And stocks have been about flat over the past decade despite contributions to 401k plans likely being some multiple higher than where they were back in the 80’s and 90’s.
And, yes, many people can pass tests. But, it’s been my experience that those of us who demonstrated the commitment to passing those tests also seem to be more likely to continually educate ourselves. My doctor, dentist and Ph.D. clients appreciate that I have obtained the most respected credentials in the field – though admittedly, not as rigorous as theirs. The conversation begins from a place of mutual respect.
I enjoy Ramsey on the radio.
He talks as if he knows everything though, which is annoying. He has made many statements about mortgages and origination that are absolutely inconsistent with the truth.
His committment to us all being able to snatch up the 12% mutual funds is hollow. I have listened for him to name one of his good funds that do this every single time the subject comes up…. I’m still waiting. I’d bet the farm that people have called in asking, and they certainly were given a dial tone.
You got some really good points, but I still choose to follow Dave’s advice.
Dave calls his product line “Financial Peace University” and the word “Peace” plays such an important part in his teaching. The fact that we have all read this article above menas we are all money-minded people and we can all do the math, but math isn’t always the solution. If math were the solution, nobody would ever carry a balance on a credit card or take out a car loan (and how many americans actually have both?). The debt-free lifestyle brings you so much peace and that’s not what your math can bring. The fact that the house is paid off means way more than the possibility of being able to make a better return with this money; it anchors you and that’s simply priceless.
I’m debt-free as of now and my house will be paid off as well in 3-4 months. You know what? That means I have choices now. Maybe I can choose not to work? If you have payments, you always will be stressed one way or another. If you have payments, you always, like it or not, have to hang on to your job.
Financial peace; financial peace. Can’t put a return rate on peace! Dave Ramsey rocks!!
Kool-aid anyone? 🙂
Nothing wrong with living debt-free, just realize some people choose not to do so and still feel “at peace” with their decision.
Would you rather have a paid off $300K home or a $300K home on which you owe $200K and $400K in the bank? That’s the question those who invest instead of paying off low interest debt ask themselves. Even Dave Ramsey is quick to point out you should invest prior to paying off a mortgage. Don’t believe me? Which Baby Step is paying off the mortgage? Step 6. Which is investing 15% of your income toward retirement? Step 4. There you go. Perhaps Dave isn’t quite as rabidly anti-debt as he at first appears.
On his show for February 7/2013, a caller tells that years ago a payroll deduction was set for her to buy EE bonds. Now she got more interested in investments, but says she does not know anything about EE bonds, and asks Dave Ramsey what should she do with those EE bonds. Dave Ramsey says that EE bonds are cute, like a CD, paying only 2 or 3%, but she should cash them in to “invest in good mutual funds”.
Good grief. EE bonds are a super-safe investment that will pay 3.5% — if you keep them 20 years. Where else can one get that very safe return? If the person wants to invest in something more risky, fine, don’t buy any more EE bonds, but keep them, because if she cashes them now she’s getting no return whatsoever.
Dave Ramsey defends himself against critics about his investing recommendations:
http://a1611.g.akamai.net/f/1611/23422/9h/dramsey.download.akamai.com/23572/audio/mp3/itunes/03112013_the_dave_ramsey_show_itunes.mp3
The Bogleheads respond:
http://www.bogleheads.org/forum/viewtopic.php?f=10&t=112770&newpost=1640155
I agree too with others who say this review is fair – but I would not call it un-biased, as you base many of your assumptions about what may happen in a particular investors lifetime. Let me explain.
First, I just retired last year, and I have always done my own investing, and never even heard of the name Dave Ramsey before 2010, but despite all that I have done quite well, mostly by unknowingly following a few of Dave’s principals, like staying out of debt, and investing 10-15% of my salary every year – at least from age 30. Before that — well not so much.
I survived the late 1990’s when everybody was shooting for 20% gains, and the drop that followed. I survived 2008, at least to realize, that yes I can still retire at 60 as I had planned. All with no bonds whatsoever, mostly by learning to not always believe what someone says right out of the box, but test and verify and if it can’t be verified – like future projections, then the truth of that item is yet to be determined. Much like whether an investor is apt to earn 12% or not over their lifetime, which generally I agree the odds are against them, HOWEVER, anyone who reads Malkiel, or even Bogle, knows there are at least a few 25 year periods in history where the returns of the market have been north of 15% (Malkiel puts the top of that bar chart at just above 17%.)
Now, I certainly would not tell an investor that they can expect to earn 12% on their investments over time, as I try to deal more closely in what I perceive are the facts, depending on the type of asset allocation the investor has and the fact that we can’t predict the future anyway.
However, if an investor starts at a young age putting 15% or more of their salary into retirement funds, do you really think they are going to be hurt thinking that they could earn 12% on their money and will quit working at age 50 just because they saved their first $500k and only need a $40k income. Day after day on the DR forum I read posts by individuals that are excited about the day they are going to, or have started, investing. IF you know anything about the statistics of the US investor you will understand that just getting started is 80% of the battle. If it takes some radio talk show host yelling “SHOW ME THE MONEY” to do so, how can we be to critical.
In the two years that I have been following DR and trying to push my version of the “facts,” he has come, at least in my opinion, to parse what he says a little carefully. During 2010 & 2011 and even early 2012 he learned that a couple of his darling American Funds could no longer be quoted as specifically earning greater than 12% over their lifetime, so it was more of an “about 12%” quote. Unfortunately 2013 is not really helping the “under 12%” fund enthusiast, as they are all over my Morningstar portfolios that I track in the 10 year and 15 year columns. One of the reasons I am hoping for a big market meltdown soon. 🙂
Not really@!
fd
Are you suggesting that 12% is reasonably accurate? We’re now at the head of a 4 year bull market. Vanguard’s mutual fund screener shows 3823 stock funds, 868 of which have a 10 year return over 10%, and only 92 with a 10 year return over 15%. Of those 92, there are only 2 funds with a 20 year return greater than 12% a year. T Rowe Price Media and Telecommunications Fund and Fidelity Selected Chemicals Portfolio. That’s after a 4 year bull market which as you know biases everything upward, and doesn’t account for all the funds that have disappeared from the market in the last 20 years. The denominator is probably closer to 6000+ funds we’re talking about. 2 funds out of 6000! That seems like an easy chore to you?
Sure, if your idea of a diversified buy and hold stock portfolio 20 years ago was 1/2 Telecommunications companies and 1/2 chemical companies, I suppose 12% is a reasonable number. Otherwise, better lower your sights a bit.
These numbers, of course, are arithmetic returns, not geometric returns (the only kind that count) which are a little lower.
They also don’t account for inflation. Real returns, again the only ones that count, are even lower.
I’d love for future returns to be 12%. It would be very helpful to my retirement plans. But I think it is grossly optimistic and I think Dave does a disservice to his listeners when he uses that number. I don’t even think I’d criticize 10%, although I think that’s probably too high even for a 100% stock portfolio going forward, but 12% from a “good growth stock mutual fund”? The screener shows 5 total funds with a 12%+ return since inception, none of which have a 12% return in the last 10 years. It shows 8 with 12% returns in the last 10 years, none of which have a 12% return since inception. The data seems pretty darn clear to me.
Not sure where you got that idea – here is what I said about 12%:
“Now, I certainly would not tell an investor that they can expect to earn 12% on their investments over time, as I try to deal more closely in what I perceive are the facts, depending on the type of asset allocation the investor has and the fact that we can’t predict the future anyway.”
Let’s not get off on a tangent of “real adjusted returns” because that is not what we are talking about here. While I agree they matter over time, but only to the effect that MY OWN income or expenses is affected by inflation — which of course you have no earthly idea. I buy items with the money in my account and my bank doesn’t seem to care what the “inflation adjusted” value of it is. In fact there are a number of ways to “buy items for less” especially when you are retired like I am.
As far as funds with returns larger than 12%, I suggest you check on AGTHX, which has a return from inception (1973) of 13.3%. Maybe just take a quick look at the list of 31+ American Funds, as there are other examples – though I am sure you will argue these numbers are on a non-load adjusted basis, but we know that DR does not pay a load, and there are certainly ways for anyone to cut down the load fees, especially if they are investing in a 401k, which normally waives the fees, or at least reduces them.
FYI, I am not recommending Load Funds either – just using them as an example, as they are SOME of what DR invests in.
fd
Morningstar says the returns for AGTHX the last 10 years are just 9.54% and for the last 15 years are just 7.81%, and that isn’t counting the loads.
http://performance.morningstar.com/fund/performance-return.action?t=AGTHX®ion=USA&culture=en-us
Just another example of not being able to buy past returns.
I agree. In the last couple of years, I think I and others have given him much grief about quoting statistics that are not true. So now what he says it that you can find good funds that have a return of 12% or better from their inception. Specifically, in the podcast he did recently, he was quoting his 12% funds over 50, 70, or 20 years.
What I DO NOT agree with in the podcast is that the scope of his funds have done 12% over the time he has owned them.
As you might know, whether any investor pays a load or not is dependent on both how much money they already have in the funds and whether the load fee is waived – such as in a 401k.
fd
did @Independent Advisor, CFA, CFP, MBA ever submit a guest post?
Hi Dr. L,
Here’s a link to the post – https://www.whitecoatinvestor.com/the-importance-of-credentials-for-financial-advisors-guest-post/.
Enjoy!
KLB
Ah youth! Old school medicine says we respect the opinions of other Doctors – we do not openly disrespect them. Caution to all who read any investing advice on White Coat: Get a second opinion, Doctor.
Never hurts to get a second opinion.
WCI doesn’t get everything right, Dave Ramsey doesn’t get everything right, Bogleheads don’t get every thing right. The discussion in this thread is excellent, though. Lots of people coming at the various topics from their own unique angle.
This is helpful.
(I’ve read most of D. Ramsey’s books, and just re-read “the Millionaire next door”, which I highly recommend)
Concerning the authors first point…it is a valid point. However, re-phrased, I wonder if the author would advise me to go out and borrow a couple of hundred thousand just to invest? That is what you are doing by diverting money away from paying off your mortgage and investing it. Looking at it from the re-phrased point of view, the risk becomes more apparent.
Sure, but a non-callable margin loan at 1.8% is a deal I just might take. If my investments can’t do better than that, I have no business investing anyway.
White Coat,
Good point. I am happy not to pay extra on my mortgage as my investing account does 20%. I am also happy to know if the landscape changes I can pay off the mortgage I have left at any time.
Though investing is never a given, there is nothing in history at least to this point, that suggests real estate is a better investment – unless you use the leverage of a mortgage!
By the way, seems to me like just investing in your own personal REIT.
fd
Lets not forget that Dave is making a living from selling his advice!
I have been looking into debt consolidation/management companies. Our debt is pretty simple, I feel – two credit cards with upwards of 7k (combined) debt with very high interest rates – 20%. We do not qualify for any lower interest rate, and need these simply paid down. I just want to cancel the cards, lower the interest rate and the monthly payment – and pay them off sooner. I did receive a quote from one debt management company that can do this, but they want $40/month for the service. I’m not sure if this is high compared to other companies or not, and every company has to do a complete work-up of your finances – if I can help it, I do not want to spend several hours and several credit checks getting a quote from every company. Can somebody out there tell me if this is high or not? I have already done the appropriate research on how this will effect my credit, etc. – I do not need advice in that direction. I just simply need to know if this is a high monthly recurring charge, or if there are other companies out there that can do the same for less. Does anybody out there know? Thank you.
I find it interesting that “you have been looking into debt consolidation/management companies” yet your email address and website are for a debt management company. That’s some of the best written Spam I’ve seen in a while, so I’ll leave it up.
11/23/2013
Hey everyone, sorry I am a bit late to the party. I am no expert, no insurance person, and certainly no adviser but I have done my research on this particular subject for a long, long time.
First off, full disclosure here, I am a huge fan of Dave Ramsey. I think he is correct on most all of what he says. He has a great ministry, great business, and has really good advice for most average people. Does he go too far sometimes? Yes. Why? I think human behavior, he knows if he tells you to save $1,000; you’ll get to $950 and think, ah that’s good enough. So he knows if he tells you that some debt is ok, it will come back to haunt him and you. After all, he is selling his advise and books.
I think he is absolutely right on paying off ALL your debt. Mortgage, student loans, all of it. No debt. Aside from the great security it gives you, why would you willingly give away your money to a bank? The average person in 2005 paid $13,500 in mortgage interest (US Dept of Comm). $13,500!! And the average total US consumer interest (mtg, cars, credit cards) was $16,900.00, that is 36.7% of the average US salary that year ($46,000). That said, what investment do you KNOW that will make you $16,900 year, guaranteed? Nothing. Instead of throwing away $16,900 a year, you keep it! You just had a 100% return because you now don’t have a 100% loss on that money.
Keep in mind that your mortgage, if paid in full, at 4.5% is a -100% return, yes negative. At 6.5% it is a -200% return. And please don’t spout the non-sense about a tax write off—you’re paying a bank $13,500 a year to reduce your taxes by $2,025? That is a terrible trade! Keep your money. Instead of being out $13,500 in interest paid from cash you would have $11,475 in cash. I like that trade better. Moving on…
I said all that to say this: I think that Dave is wrong about investments for the average, retail person. NOTHING FITS EVERYBODY. But the buy term and invest the difference (BTID)? I have no idea where his average 12% mutual fund return number comes from. There is no magic fund. No magic market. A 100 year average is just that, a 100 year average. If you haven’t been in the market for 100 years, you won’t get that. In fact, I just read a Dalbar study that said the average 20 year return on a mutual fund is only 3.8%. 3.8%??!! All that risk for that tiny return. And that doesn’t even account for taxes and inflation over time you have to pay. The markets have returned about 9.6% since 1928 BEFORE inflation, after, its only about 6.2% (USA Today).
I also found where an average joe stock trader only gets, on average, about 2% back in the equities when losses are accounted for (can’t remember where I saw this right off). Remember that is average, half of yall did better, but half are thinking, I wish I had that return! What causes the 2%? My guess, again, human behavior. If the average guy has control, he is influenced by news and friends. Selling low and buying high.
I simply don’t think the average normal guy can really beat the markets nor match them. The information he is supposedly legally entitled to, that the pros get, he gets late or never at all, the big wig fat cats that control the markets have already tanked the stock and your money is gone. I have tried the markets and most of my good gains eventually get (at least partially) wiped by losses. Do you realize a 15% gain one year is totally erased PLUS some of your principal with a 14% loss the next year? Do you realize a fund can have a positive return average and you can make $0 or even loose money?!?
Now, I don’t know a lot about insurance and stocks but I know this: There are two things sure in life, death and taxes (Ben Franklin, 1817). I have knowledge of a tool that I can cash in on death and avoid taxes. That is whole life, when used correctly. Everyone who has ever lived has died. So why would you NOT want to buy a policy that is SURE to PAYOUT? Yes it costs money but so do all investments. Lastly, there are few things in this life that carry guaranteed returns or guaranteed anything for that matter. Whole life is guaranteed; if you pay the premium. I know no other investment that carries a guarantee. On top of that, if you have paid off all your debt, my attitude is that you don’t need the risk of the markets. Take the guarantee and keep what you’ve got. Build guaranteed value slowly. There is no way to get rich quick. Take it for what its worth, I have nothing to gain or loose in this.
That guaranteed value, guaranteed return, and the ability of being able to know I will leave a legacy to my children is worth something, at least to me anyway. What’s it worth? That is up to you.
It is actually surprisingly easy to match the market’s return. Yes, I realize a fund can make money and you can lose money due to the timing of your inflows and outflows. Yes, I realize losses count more than gains, both mathematically and behaviorally. I do not, however, find either of those as a reason to invest in whole life insurance. A vague reference to death and taxes in no way justifies choosing such a poor investment. If your ability to invest in stocks is such that whole life will provide you superior returns, then I agree that is perhaps the best way for you to invest, but I think most people will get more bang for their buck by fixing the way they invest in stocks.
You also seem to misunderstand the mathematical advantage of borrowing at a low rate and then investing at a high rate. There is a real arbitrage opportunity there, especially when both the borrowing and the investing are tax-advantaged. The difficult thing is playing that out against the behavioral aspects of carrying debt. But saying the math is wrong is just being ignorant, because it isn’t. “Giving all your money to the bank” isn’t very accurate. It should be described as paying the bank a fair fee to use the bank’s money. What you do with that money and how much you pay for it is what determines your eventual financial outcome.
Don’t get me wrong. I like Dave. I dislike debt far more than the average American, physician or even investor. But math is math, and it’s not up for debate.
With all due respect, I have run the numbers (many times) and they work. Again, I have nothing to gain but I hope people understand what this method really is. If you were like me, you are tired of the market risk and want something safe but that grows and protects your money. There is so much dis-information and just bad info out there. I’m sorry, I do not find paying a bank 4.5% interest on what I borrow from them and them paying me 0.1% on what they borrow from me “fair” I believe you put it. Especially considering risk. I can have 1 payment left on my mortgage and the bank can take it if I don’t pay. Again, I believe it benefits you to not pay any interest at all. Pay off all your debt, then invest. Why not pay a bank 0% interest and the bank PAY YOU 0% interest? I guess, invest in yourself, pay your stuff off, then gamble in the market casinos or take the safe whole life path. Remember, risk nothing you can’t afford to loose. Also remember that you carry all the risk in a 401k until you retire and almost no risk in a whole life policy. No risk of loss with guaranteed returns. Also, as your investments grow with mutual funds in a 401k or SEP, your loads and taxes get higher—not so with whole life.
In fairness, a bit of clarification is probably warranted here, when I refer to “Whole Life” (WL) I am speaking of a good, solid, 100+ year WL policy company with someone like Northwestern Mutual, Mass Mutual, etc that pays dividends, not a public stock traded company. Not state farm or nationwide, etc. Not that they are bad. And you NEED help. Get lots of opinions, meet with lots of advisors.
I am speaking here NOT about your average whole life policy, I agree that 95% of those policies are terrible and won’t work with this model and that probably 97% of those policies sold were not needed. That said, good mutual companies build cash slowly. You won’t get rich overnight but you will save your money and earn steady, good interest. Think of this as a high powered savings account with a death benefit. Remember too, insurance companies ARE banks.
And what I mean about this a 30 or 40 year plan is this (very crudely) —how it works: lets go with a WL policy from Northwestern Mutual that carries a $12,000 yearly premium for a $1,000,000 benefit (which is a real premium for a 33yo nonsmoking female, just checked for my wife). In year one (1) I pay my premium PLUS another $36,000. That $36,000 goes straight to cash. I can borrower from that immediately and it starts earning interest at 5.75% immediately. The next year, I do the same, and repeat. My yearly payment next year (year 2) of $48,000, almost all of that, about 90% goes to cash. (and you can change these numbers, I just used them because I had them) Year 3 ALL of my payment goes to cash and so on. (you do have to be careful you don’t MEC the policy) So, by year 3, I already have saved up about $127,000 of MY money that is earning interest AND dividends with NO RISK of loss. I can also take all that $127k back out immediately or borrow portions and keep the policy in place.
Now also keep in mind that I don’t ‘need’ a term policy in this 30 year period, that would have total a cost of about $13,500 in today’s dollars. You do need insurance, I think—but I never buy as much as I am told I “need” by salesmen.
Believe me, I understand borrowing low and then earning higher interest, I do also known as “lost opportunity cost”. I get it. (you actually do this in the policy later in life which is why you don’t pay back the loans you take for income).
While I have considered the “potential” lost opportunity cost, if any, of no debt and have looked at it too, there is also a lot of risk—as shown in 2000, 2008 and 2009—, I am simply (and totally for the sake of being able to post this) speaking in averages that we can look at. That said, and with all due respect, I see little lost opportunity for the “average” investor in the last, say, 10 years (because I can’t see 10 years into the future) in borrowing, for example, $250,000 against their house to invest in the markets as opposed to keeping the mortgage paid off and investing the surplus cash earned later.
For example, say a person inherits (gets a bonus, earns…whatever) the amount of $250,000.00. And say they can either pay off their mortgage on their home/condo or keep their mortgage and invest the $250,000 in equities.
Keep in mind average and that we don’t know the future so I’ll base this on a 2003 thru 2013 look-back/back test. Now, full disclosure, I know people who make a lot of money in real estate, of course, I know people who have lost a lot also. Again, nothing fits everybody and no investment is guaranteed (except the whole life argument I made). Remember, if you would have invested a lump sum in the markets in December of 1999 you would still be waiting to get your money back! (a -1.7% loss after inflation and BEFORE TAXES-S&P500)
If we look at the S&P 500 returns and invested on December 1, 2003 (10 years ago), our average annualized return is about 5.38% through today (12/16/13). Now remember that we must base the interest rate on the 2003 rates (not today’s 3.5%) which were about 6%. We have to account for taxes and inflation too. Basic math tells us that if you had invested that $250,000 in the markets and gotten the average return of 5.38%, you would have LOST money.
The interest you would have paid would be $102,229 on that money for the last 10 years with an adjusted net rate of 4.5% (6.0% mtg rate minus 1.5% tax deduction for mortgage interest yearly, makes the effective net mortgage rate 4.5% for this example). The 10 year gain at 5.38% downwardly adjusted for inflation of 3.5% makes our real rate of return only 1.88%. So, our net adjusted gain would have only been $49,841. Income taxes would take another $13,955 of our inflation adjusted gains (at 28% for that $125,000 tax bracket, more if you hit the 45% bracket) and we actually loose -$66,343. Again, all that risk and you still LOOSE money!
Now could this be different? Of course! Some investors could have done MUCH better but some did a lot worse too. Remember average is just that, 50% did WORSE and 50% did BETTER. When you consider inflation, risk, and taxes, I (personally) can’t see any lost opportunity.
But! Even if we hypothesize in the future with what you said, our equation still isn’t that great when we consider the risk. Remember cash into a good mutual company’s whole life with dividends carries a guaranteed, no loss return…if we pay the premiums, which we have to assume we do, since we assume we paid all $250,000 into the market.
For our future equation, again based on what you said, assuming 4.5% interest over 30 years. Assuming the average market return (after inflation adjust) since 1928 of 6.2% minus our mortgage interest 4.5% = 1.7%, now add back in the mortgage interest tax write off of 1.5% = 3.2% average net rate of return but remember we now have to back out our taxes of 28%, makes our real rate of return 2.3%. BUT this hypothesizes things in a straight line with no deviations. Life and real investments don’t run in a straight line and are never perfect. You could do a lot worse—or better. There are no guarantees with this method. If you do loose more money, you now owe for the mortgage and the losses in the investment. Even the averaged 2.3% doesn’t beat the whole life method making say 4% or 5% because taxes, interest costs, and term insurance costs eat all your gains. Maybe some people are smarter than me and can consistently get higher returns, I don’t know any of them.
Again, I agree a person has to commit and stick with it, whichever method you choose. I invest over 30 years, not 30 days. That said, I still like a good whole life dividend mutual return with guarantees instead of the risk. Might I sacrifice some opportunity in exchange for the guarantee? Maybe yes, maybe no. If yes, that is the cost of something guaranteed, if no, it is the more sound method. Again, it is a gamble that you will make more money in the market. There are only 4 outcomes: 1. Life Ins. with guaranteed amount. 2. Market returns same amount as Life Ins. 3. Market returns less. 4. Market returns more.
If I go with the market, 2 of the 3 possible market outcomes don’t beat the guaranteed Life Ins. method, that is a 66% failure rate and only a 33% chance of success in the market method but that 3% return is still less than the whole life average return NOT including our risk and the lack of insurance factors. 3 of 4 (75%) of my choices return the same or less. That is a 25% chance of success. That is why I like my returns and dividends on the whole life.
Remember too, that using the mortgage method, you still have to buy term life insurance to get the equations closer in death risk which raises the mortgage method losses because you must expend capital on the insurance needed and, if you really want to get it seriously complicated, look at the tax advantages of the money building inside the policy compared to the taxes owed on the investments. The money you first pull out of your policy is not taxed because you paid it in and unless you cancel the policy you withdraw the rest through loans TAX FREE that are practically 0% or 0.5% net interest.
Absolutely no offense meant but I prefer the no debt method because I can also draw back if I loose my income and have no risk of loosing my house to a debt taken on for risk (if I have a disability rider, which I do, I can even get disabled with the whole life method and come out better because I keep my income and the insurance company keeps paying into the policy so my investment still grows AND my house is paid for).
Here’s a scenario to also consider, what about the opposite?: in both options, after 10 years, what if you loose your job AND the markets decline? If you took the mortgage method, you loose your house and your your investment looses money. If you paid off your house, you keep your house and the worst is the policy might not make as much if it has to self fund for a year or two.
Also, what about this: the money inside your whole life policy is protected from creditors and asset disclosures in most states. What if you get sued for malpractice and the hospital hangs you out to dry and the patient comes after you personally and wants to take your 401k? What if you E&O carrier tries to burn you and doesn’t cover you? They can’t get to your WL cash value because you don’t own it, the insurance company does. Creditors can’t get it.
And if there is anything I can tell you, if there is anything I have learned in this life, it is that you had better plan for things to go wrong in life. If you’re a doctor, you see everyday. Always plan for the worst. If you do that, you will be fine. If you don’t plan for the worst, life will punch you in the face, take your lunch money, and laugh at you. Cancer happens. People die. Kids get sick. Houses burn. Car accidents will change your life. You can’t control it all. You’d better be prepared. It is a lot easier to loose money than to make it. Something guaranteed? For me, it’s a no brainer.
(from above) Sorry meant the Bank Pay you 5%
That’s quite a comment.
First, let’s establish for readers whether or not you have anything to gain. You don’t mention what you do for a living, but like most people who post lengthy comments about whole life, I suspect you sell it for a living. If so, then you do have something to gain.
Second, proponents of whole life like to discuss how whole life avoids market risk. While this isn’t entirely true (since the insurance company must also invest in the market), it also isn’t the most important risk that investors face. That risk is the risk of not meeting their goals due to their money growing too slowly. This is the main risk of investing in whole life insurance. It is discussed, along with many of the other tired arguments you bring up, in a recent series I did on whole life insurance starting here:
https://www.whitecoatinvestor.com/debunking-the-myths-of-whole-life-insurance/
Third, I agree that the vast majority of whole life policies sold are terrible policies AND are sold inappropriately.
Fourth, I’ve written about the pluses and minuses of the Bank on Yourself/Infinite Banking theory here:
https://www.whitecoatinvestor.com/a-twist-on-whole-life-insurance/
I’m not going to repeat the arguments again. If you wish to live your life this way, there are far worse things you can do financially, so feel free to do so. But don’t pretend it’s some magical fountain of money.
Fifth, there is plenty of lost opportunity cost in the last ten years. The average ten year returns for several Vanguard funds I’ve been investing in for the last decade range from 7.5-12% per year. The lost decade argument wasn’t particularly good 3 years ago, and it’s terrible now. You use a figure of 5.38% for the S&P 500 for the last 10 years. I see over 7.5%. Perhaps that’s the effect of changing the period by just 11 months. Perhaps you didn’t include dividends. I don’t know. Either way, I find your figure misleading. Your example about money invested in the market in 1999 still not being back to normal (after inflation) is so incredibly cherry picked that it is nonsensical. Why not use a 3 year period starting in October 1929 instead? How about money invested in late 2002 or March 2009? Or perhaps use small value stocks or some other asset class besides large cap US stocks? Oh, that wouldn’t make your point, would it.
Sixth, whole life dividends are only guaranteed at the guaranteed scale, which is generally less than the rate of inflation. Even that guarantee is only as good as the company backing it (plus some possible assistance for a low amount of cash value from the state guaranty association.)
Seventh, if you’re investing in an S&P 500 index fund you’re not paying taxes at short term capital gains rates. If you’re going to use examples to make your argument, at least try to be reasonably accurate about tax cost.
Eighth, if you don’t think you can choose investments that will average better than 4-5% per year, after tax and expenses, over 50 years, then I agree you’d be better off investing in whole life insurance. Personally, I have found that to be relatively trivial. In fact, just buying all the stocks in the world without regard to to which ones are good and which are bad, using low cost index funds in a retirement account, has bested that figure by 4-7% historically. The difference in compounding your money at 4% (1% real) and 10% (7% real) is astounding. I agree there are only four outcomes, however they are not all equally likely over a long period of time. If you really think the returns of aggressive, long-term investments like stocks and real estate are going to do worse than 4-5% per year over the next 50 years, then it is unlikely that an insurance company will provide anything more than their guaranteed scale, if they can even do that.
Ninth, one problem with buying whole life insurance is that you don’t need life insurance your whole life, so you are paying for something you don’t need.
Tenth, I’m not sure you understand how malpractice insurance nor asset protection works. I addressed the issue of whole life as an asset protection scheme here:
https://www.whitecoatinvestor.com/debunking-the-myths-of-whole-life-insurance-part-2/
If you would like to talk more about this subject, let’s do it in the comments section of that post.
Finally, guarantees aren’t free. They have real costs, and when the costs outweigh the benefits they should be passed on. This is generally the case with using whole life insurance as an investing strategy.
@ jim levenstein- I actually think anyone can match “the market” (minus a tiny fraction of a percent), using low-cost index funds. Few people are able to beat the market, and very few do so consistently. Whole life doesn’t get you around investing in the market. the insurance companies invest their assets in the market and can not pay returns that are any greater than market returns (usually returns of intermediate-term, high quality bonds), and in fact must be much less than market returns for the insurance company to make a profit. the fees associated with whole life are also horrific when compared with even the most expensive mutual funds.
@ jim levenstein
I am also a little unsure how the WL death guarantee is going to help you in retirement, unless you are somehow going to cash out the cash value for less than the guarantee, thus invalidating the guarantee entirely.
Again, I am telling you only what I have learned, so I don’t know it all.
Essentially, you build your cash value inside the policy, it grows tax free to some amount, then, when you retire, you take out what you need, if needed but also, a mutual company pays you dividends each year, mine will be around $50,000 (minimum) yearly by year 25 and my policy will only be $21,000 yearly, not including the interest gained each year.
I simply take the growth out each year if I needed or take policy “loan” for anything above what I paid in. Since a loan is not taxable, no income taxes.
When I die, say I had $2,000,000 total cash value, I took out $500,000 in retirement to live, I still have $1,500,000 cash value inside the policy PLUS whatever the death benefit is (say another $1,500,000) that all goes to the kids and/or wife (total to heirs $3,000,000). In retirement, if needed, I could cash out the policy (unlikely) or simply take its growth from interest and dividends to live off of and maintain the principal amount.
There is no risk of loss, unless the earth burns up. My money I have earned never looses value.
So, say I have gotten the cash value to the $2,000,000 mark. The dividend paid to me by the Ins. Co. is $50,000 and my yearly interest is $100,000 yearly (5% interest for example). The policy costs me $21,000 yearly to keep in place. So, I can take my $150,000 in growth, pay my $21,000 premium and keep $129,000 each year to live on. Cash value doesn’t change. If I die, family gets the cash value and the death benefit insurance amount, $3,000,000.
Remember, very important here, you want a policy where the death benefits GOES UP every year and with every overpayment of your premium. In other words, a $1,000,000 policy today, after 30 years, may have a death benefit of $4,200,000. I think that is missed a lot. The death benefit goes up every year.
The death benefit isn’t guaranteed to go up at all, much less every year. Will it probably go up? Yes, probably. But if we’re going to talk about what’s probably going to happen, you’re probably going to be better off investing in something besides whole life insurance.
Loans may be tax-free, but they are not interest free.
Again, as mentioned earlier, you don’t get the cash value AND the death benefit. That is simply false. You get one or the other.
There is risk of loss without the earth burning up, especially for a policy the size of yours (premiums of $21K per year.) Have you looked into how much cash value your state guaranty association actually insures? Have you looked into the asset protection benefits for cash value life insurance in YOUR state? They might not be as high as you think.
@Jim,
Surely, you should not be posting about how WL insurance policies work if you don’t even know the most basic facts, such as you will not get both the cash value and the death benefit, you will only get the death benefit.
Furthermore,
Taking out money from the cash value will affect how much the death benefit can increase each year — so it is not a win-win, in that you can’t take money out and still see the same increases.
Dave recommends paying off the smallest amount as opposed to the highest interest rate debt. There is sound reasoning. Most everything that most humans do is behavior related and not brain related as far as finances. If you pay off the smallest amount, your number of debts goes down by one and you feel a sense of accomplishment. On the other hand if you start with a high interest debt and start paying extra on that you may not get much leverage because of all the interest, After a few months, the debt is still close to the original amount and the person feels like “why bother” and quits. Now the same person who was doing the smallest amount may have already knocked out debt number two and feels like there is hope. Based on your total amount of debt and the amount that you will pay in the long run, the difference in the total won’t be much whether you start with the lowest amount or the highest interest rate. Dave has explained this on more than one occasion on his show. The only people that would benefit from starting with the high interest debts would be those already motivated and with some sort of math understanding.
You mean like doctors? 🙂
I agree that difference may not be very big for most and that for most people behavior trumps math on this issue, especially when the debt is consumer loans, but even when it is student loans. But consider a physician couple who emailed me today.
$800K in loans. Let’s say $500K at 8.5% and 300K at 6.8%. First, Dave wouldn’t recommend refinancing, he would instead recommend “Gazelle intensity.” “You don’t get out of debt with debt”, he would say. In this case, I disagree. These debts should be refinanced whenever possible, not to lower payments, but to lower the total amount of interest paid and shorten the term of the loan. DRB’s variable rate loan is currently at 2.76%. Prior to refinance, those loans generate up to 8.5%*500K + 6.8%*300K = $62,900 in interest per year. If you refinance at that lower rate, the interest due each year would be up to $22,080. (Not 100% accurate as I’m ignoring amortization). So you’re looking at an extra $40K per year you can put toward the principal by refinancing. You don’t think you can get out of debt faster with an extra $40K a year to throw at it? Now that’s Gazelle Intensity.
Second, assuming no refinancing, Dave would recommend against paying off the larger loan first. But in this case, the difference is thousands of dollars over a 5-10 year period.
If you just pay both loans off over 10 years with the minimum payments, then you’d pay $244K in interest on the 8.5%/$500K one and $114K in interest on the 6.8%/$300K loan. Total interest paid is $358K.
Let’s say you want to get out of debt sooner, so you put an extra $2000 into each monthly payment. How much interest do you save and how much sooner do you get out of debt if you pay off the smaller, lower interest rate loan first?
You pay off the first loan in 67 months, paying a total of $61K interest. The $2K plus the payment for the first loan then goes toward the second loan. You end up being out of debt in 90 total months, having paid a total of $61K+$211K in interest, for a total of $271K, a savings of $87K in interest.
Now what happens if you put that $2K toward the larger, higher interest loan?
You pay off the larger loan in 81 months, having paid a total of $157K in interest. The $2K plus the payment for the larger loan now go toward the smaller, lower interest rate loan. You get out of debt in 88 total months and pay a total of $260K in interest.
Dave might not think $11K is much money, but it’s better than a kick in the teeth. It pays for a couple of nice trips to Europe.
How much faster do you get out of debt if you refinance AND put an extra $2K toward the loan each month? You get out of debt in 75 months and end up paying only $72K in interest.
The moral of the story is you can take Dave’s approach, get out of debt in 89 months and “feel good” about it, or you can do a couple of math problems, maintain a little discipline (far less than it takes to get into, much less through medical school) and get out of debt over a year sooner paying $200K less in essentially non-deductible interest. I don’t know about you, but I can think of a lot of things to do with $200K.
@ Diane-
This makes no sense at all. I have never heard Dave Ramsey speak, but I’m not sure I want to, if this is his approach. To use a medical analogy, this is like advising an emergency physician to completely address the runny nose first in a patient who is having both a runny nose and a heart attack.
I disagree with the author; I think Dave Ramsey is right on. He motivates his listeners to annihilate all debt. I got charged up after listening to his show and became determined to “kill off” those med school loans, once and for all. About 14 months later I did that – and my student loans are now GONE and I feel FREE.
I never have to worry about taking a bad job that features student loan payoff. I made that mistake when I started off. I was accepted into the NIH Loan Repayment Program in fellowship. I genuinely wanted to go into medical research at the time. I took my first job at the University with 32k a year in loan pay off, but I my salary was half of what it would be in private practice. My academic career floundered and I was miserable; however, there was no way out of the NIH LRP. When the NIH LRP ended for me, I resigned from the university several months later. I started working as an independent contractor, worked extra shifts, and paid off those loans! There is no reason to keep those loans around for 25 years. Pay off your high interest debt first then pay off your student loans. Move on with your life !!
I can’t figure out from your comment which part of what the author wrote you disagree with.
Congratulations on becoming free of your student loans. The author has been free of his student loans for years and agrees it really opens up a lot of options personally and financially.
I don’t agree with “For Ramsey, there is basically no good debt. Dave’s approach leans a little too far toward the behaviorally correct thing to do, and too far away from the mathematically correct thing to do.” I don’t think that people should hang on to this debt for 20 years. We should be focused on being successful and happy, rather than being tempted to sign up a bad loan forgiveness deal. As long as one hangs on to student debt, they could be tempted to sign up for a bad loan forgiveness deal. Work extra shifts, pay the stupid things off, and move with your life.