Tuesday, March 07, 2006

A Critique of Dave Ramsey 
I wrote at length the other night about how much I owe to Dave Ramsey, and what a blessing I think his ministry - and I do think it's the best ministry in the country - has been for working Americans. He's a tremendous motivator, and does more than anyone else to help people harness emotional energy in pursuit of financial stability. And as any successful salesman will tell you, it is EMOTIONAL energy that closes the sale.

But as the saying goes, if two people agree all the time, only one of them is doing any thinking. And so here is where I would part company with Mr. Ramsey:

Ramsey's the best motivator in the business, but to be honest, it seems like he stopped learning new things somewhere around 1999. He does not seem to have kept up with any of the academic investment literature, for instance. If he had, he would have seen people like Vanguard Group founder John C. Bogle pointing out that for most of the period in which stocks had generated those 11-12 percent returns, they were issuing dividends at the rate of 4-6 percent, which is several TIMES what those dividends are today. Economic growth is strong...but it's not strong enough to make up for that, and because of the additional leverage implicit in the no-or-low dividend model, you have to expect volatility to increase - which is, over the last decade or so, exactly what we find.

Ramsey's insistent projection of 12% returns from equity mutual funds is, quite frankly, nuts. Ramsey is projecting the long term returns of an unmanaged index through a period of price-earnings multiple expansion on mutual funds which themselves experience cash drag, trading costs, and sap investors with tax inefficiency, loads, expenses, and 12-b-1 fees.

What concerns me is whether the endorsed local providers are using Dave's unrealistic assumptions when conducting financial planning, because if you're projecting 12% return on anything over more than a few years, you are going to undersave by as much as half, or even more.

Furthermore, if you really DID expect a 12% return on equities, you would have to be nuts to pay off a 6% mortgage with tax-deductible interest. You'd have to be bonkers, because mortgages come in 30 year chunks, and - I'm drawing on some research by Wharton's Jeremy Siegel here - there has never in market history been a 30-year period in which the S&P 500 has not outperformed the U.S. Bond market.

Now, if you're like me, and you're really looking for a 6-8% return on equities, then paying down a home mortgage makes a lot more sense. You can always borrow it back, tax deductible, up to 100,000 dollars, if you REALLY needed to (But Dave is right about being loathe to put your home at risk.)

Third, I think Dave Ramsey's missing an opportunity here, because he ought to be an index fund zealot. Index funds - particularly lifestyle funds that adjust asset allocation as an investor cohort nears retirement - are ideally suited for his usual audience, who have limited financial educations and, to be honest, have no business trying to select active fund managers. David could get his listeners an extra 70-100 basis points per year simply by pounding the table for them to use Index funds. He's got a lot of military listeners, too, and he should be pounding the table for the TSP program as well. He does not - at least, not in anything that I've heard. But expense ratios in the TSP program are as low as you'll find anywhere. Their large cap US fund charges just six basis points!

Fourth, Dave's hip-pocket approach to asset allocation is suboptimal. By advising listeners to divide up their money between "four types of mutual funds, growth, growth & income, fixed income, and international," he may get a rough value vs. growth split - but many investors will find themselves with no exposure to small caps or micro caps, and Dave ignores the diversification benefit of REITs and emerging markets altogether. Furthermore, by dividing contributions up four ways, well, 25% in international funds might be a bit much.

Lastly, Dave pays little attention to tax efficiency when discussing mutual funds. But the inherent low turnover in index funds makes a big difference in any money held outside of tax-advantaged accounts.

I would replace Dave's quick-and-dirty asset allocation advice with the following:

1.) Use index funds. 80 percent of money managers underperform indexes anyway by the amount of their costs. There is no reliable way to tell, IN ADVANCE, who the outperformers are going to be. Plus, research from Ibbotson shows that 90 percent of investment returns are attributable to asset allocation decisions, and NOT to individual security or fund selection. Costs will kill you.

2.) Put 40-50 percent of your money in a Large Cap index, like an S&P 500 fund. Don't pay more than .18 percent in expenses, and don't bother paying a load. That much you can do on line. That's going to get you growth, it will get you value stocks, it will get you dividend-paying stocks, and will get you all US industries in one shot.

2.) Put another 20-40 percent in bonds. Use an index that tracks the Lehman U.S. Aggregate market, which represents all investment-grade bonds traded in the United States.

3.)Divide the rest up between an international fund (not a global fund, which will duplicate your US exposure), a small-cap fund, and a REIT fund.

4.) Limit gold and precious metals to 2-5% of your portfolio.

5.) Alternatively seek out a cohort, or lifestyle fund, that does all the above FOR you in one account, but tailors your asset allocation to reflect your time horizon. For example, American Century's Target 2030 fund does that for a cohort of investors who are retiring in or close to 2030. You can choose a different fund to fund known time horizons, as well, such as a Target 2025 fund to save for college costs for children born today.

Notice that the INTENT is the same - diversification among different asset classes but I'm being a little more specific than Dave is. And trying to ensure that as much after-tax growth remains in the hands of the INVESTOR as possible.

When it comes to lump-sum planning, Dave's so far off base he's not even in the stadium. Here's why:

Here's Dave Ramsey on his page for Endorsed Local Providers:

"Q: My factory just closed. I am being asked to choose between a lump sum settlement and a lifetime pension. Help!

A. The short answer is that the lump sum usually makes more sense. The more thorough answer is that the stream of pension payments must be weighed against the value of the lump sum invested in good mutual funds over time. Typically, the stream of pension payments equates to somewhere around a 7 percent annual return. If you take the lump sum, it can be invested into good mutual funds that have a history of earning closer to 12 percent annually."

Frankly, Dave is wrong as a football bat. Mutual Funds don't have a history of earning 12 percent. The INDEX does! Mutual Funds have a history of failing, of lagging returns by fees, costs, and taxes. Watson Wyatt Worldwide notes that the average individual investor trails the average pension fund by 2 percent per year. That's huge! Barclays notes that defined contribution plans like 401(k)s, in which investors choose their own asset allocations, drag traditional pension plans by .56 percent annually.

There is simply no evidence that Dave's readers will, in practice, be able to net better returns - especially adjusting for risk - than the professional pension fund managers.

And DALBAR's annual quantitative investor behavior study finds that investors get, on average, only 25% of market returns, when cash flows are taken into account: Meaning that investors buy and sell at the wrong times.

Dave's information is flatly and dangerously wrong.

And if a fiduciary professional such as a CFP gave that advice, and took a commission or asset-based fee from any moneys resultant from the lump sum, it would be a lawsuit waiting to happen.

On the insurance side, Dave gives short shrift to whole life and other permanent forms of life insurance. Yes, they generate higher commissions than an equivalent amount of term insurance. But Dave has no problem with commissions to good advisors in other financial fields like mutual funds and real estate. Dave also understates the estate tax planning benefits of permanent life insurance plans, and the biggest drawback to term insurance - the possibility that the insured will become uninsurable during his or her term - is generally ignored. Yes, if we all got 12% in our mutual funds every year, we could all eventually self-insure. But we'd also all be subject to estate taxes, too. I think a permanent life insurance policy sufficient to cover any estate settlement costs, probate, and estate taxes for high net worth individuals just makes good sense.

A universal policy also might make sense for someone with a highly irregular income, like a yacht salesman or seasonal business owner or farmer, because it allows him or her to choose when and how often to pay premiums. And no, I'm not an insurance salesman. I have no vested interest in permanent product commissions whatsoever, and nobody advertises on the blog. Term insurance is great - for temporary needs, like funding college or paying off a home mortgage. But for most successful people, I think the solution will involve a combination of term and permanent insurance policies taylored to match temporary and permanent insurance coverage needs.

Them's my thoughts. Take them for what they're worth. Dave understands families and consumer psychology much better than I do - he's got a family himself, including a couple of consumer daughters. Now THAT'S got to be a lesson in and of itself! And I cannot compare with his knowledge of real estate and bankruptcy-related topics, because he's been there and done that himself. But I think I've got a better handle on a few things than he does now, and I think there are a lot of people who are ready to take the Baby Steps to the next level, and really refine their asset allocations, and match their means to their goals more precisely.

But you know, if it wasn't for Ramsey, hundreds of thousands, if not millions of listeners would never have gotten to the point where that was possible. So I can't overstate how much many in the heartland owe to him.

Well, unless they cashed out their pensions thinking they could do better with Dave's advice.

Splash, out



In the Lump Sum vs. Pension question, I think that a lot depends on if the pension is funded or not. The wisdom of planning on the security of an unfunded pension in today's rapidly changing market is extremely questionable. How much do you trust an unfunded GM pension right now?

Said the man who is betting on military retirement to deal with medical expenses after age 65...
Regardless of funding issues, GM's pensions are covered by the Pension Benefit Guaranty Corporation, a quasi-federal agency which guarantees normal pension benefits for retirement up to $3,971.59 per month ($3,574.43 per month for a joint and 50% survivor annuity) PBGC does not guarantee health benefits, though.

At any rate, remember - if the pension were fully funded, they'd have a hard time giving up the lump sum in the first place.

For more info, see here:http://www.pbgc.gov/workers-retirees/benefits-information/content/page13181.html
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