Ramsey’s Step 4: Invest 15% for Retirement

Just to recap, in this (more occasional than I intended) series I am discussing Dave Ramsey’s Seven Baby Steps.  I’m skipping steps 1, 3, and 5 because there’s not much to say about them.  (They are, in order, $1,000 to start an Emergency Fund, 3 to 6 months of expenses in savings, and College funding B&O_stock for children.) I’m sure that if I looked carefully into these three I could find something to disagree with, but with so many other things to get myself upset about, I just don’t have the time.

I already did step 2.  The official title of Step 4 is “Invest 15% of household income into Roth IRAs and pre-tax retirement.”  Plenty there to get my dander up. Why 15%? Why Roth?  And then there’s how Ramsey wants you to invest the money.  Oh my.  This may be a long post.

There’s nothing scientific about 15%.  As far as I can tell, it’s just a number Ramsey thinks sounds about right.  Ramsey does concede that a few percent higher or lower probably won’t kill you, but, at least in The Total Money Makeover, he doesn’t explain why 15% and not 10% or 20%.  (Total Money Makeover has a chapter on each step and so is, along with his website, my primary source for his advice for this series.)

I  am not going to suggest a different percentage.  I am going to suggest that a single fixed percentage for all people at all income levels, wealth levels, and stages of life is beyond absurd.  A young person just starting out might rationally save nothing, if they expected income to grow significantly in the future, and a 50 year old who has not saved much so far should probably save a lot more than 15% if they want to retire in comfort.  I write a lot about how one-size-fits-all advice is the Achilles’ heel of mass market gurus, but this is possibly the most extreme example.

I have also previously discussed why a Roth IRA is not for everybody.  Reading Ramsey’s book and searching his website, I haven’t found any concession to the idea that there are any circumstances that would make a traditional IRA a better idea. 

One of the problems with discussing advice intended as “baby steps” is that it is impossible to distinguish between inaccuracies due to simplification for a simple audience and inaccuracies due to the speaker not knowing what he is talking about.  I assume that Ramsey would prefer his conflicts with reality to be considered well-meaning conscious deceptions on his part, rather than evidence that he has a weak command of his material. 

Unfortunately, on several topics, IRAs included, I’m leaning heavily towards ignorance as an explanation.  The following is from a radio show Q&A on his website, discussing a Roth IRA vs. a traditional 401k, italics his:

Let’s say you’re 30 years old bringing home $40,000 a year.  If you put 15% of that into retirement, that’s $6,000 a year – $500 a month.  If you put $500 a month into good growth stock mutual funds that average 12% from 30-70 years old, then you would have almost $6 million.  Over 40 years, you’ve put in $240,000 and your return is $6 million.

If you do that in a 401K, that money is taxable.  The money went in before taxes, but the money is taxable as it comes out.  Your $240,000 that went in pre-tax is almost irrelevant in light of the $6 million that is going to be taxed.

But if you put money in a Roth IRA, it grows tax-free.  That means if you put the same amount into the Roth, you’ve got $6 million, none of which goes to Uncle Sam.  The Roth IRA is always superior to the 401K because of this.

That last italicized bit is just flat-out unequivocally wrong.  The tax savings you get from the up-front deductibility of traditional IRA (or 401k) contributions is exactly the same as the tax savings you get from the distributions of Roths not being taxed, assuming tax rates are constant.  If the tax rate is higher now than in retirement, a traditional will save more money.

Ramsey passes along information that is false to millions of listeners.  That’s bad enough, but what is worse is that I am just about convinced he doesn’t know it is false.

Further evidence that Ramsey just doesn’t know any better can be found in his advice about how to invest the money inside your Roth.  Not only does he advocate putting it all into stock mutual funds, which is foolish enough, he wants you to put it all into growth stock mutual funds.

The stocks in the stock market, and the mutual funds that invest in them, can be divided into two broad categories, growth and value.  A person who knew no better might guess that growth was a better long-term investment, because, well, growing is a good thing, isn’t it? As a matter of fact, as broad asset classes, growth and value perform roughly the same over long periods, although over short periods one can do a lot better than the other.  (Since 1994, when the indexes started, the Russell 1000 Value has slightly outperformed the Russell 1000 Growth, 6.49% vs. 4.79% annualized.  See Russell.com for more.)

What you get if you invest in only growth funds is not more growth in the size of your investments, but more volatility.  A balanced mix of growth and value makes more sense, as does, for the same reason, investing less than 100% of your money in stocks.

Ramsey further convinces me that his understanding of this material is paper-thin when he gets specific as to what types of growth funds to invest in.  He recommends 25% in “growth & income” funds.  A civilian could be excused for thinking that a fund called “growth & income” is a growth fund, but Ramsey ought to know that those are generally value funds. (I know it doesn’t make sense, but it’s true.  Go to a site where you can search funds by name, e.g. to Fidelity, search on Growth & Income, and look at the Morningstar categories if you don’t believe me.  Most are value funds, some are blend, and only one or two is classified as growth.)

And then there is Ramsey’s aversion to ETFs. “ETFs are baskets of single stocks that intend to operate like mutual funds; but they are not mutual funds.” I’m not a huge fan of ETFs either, but they are, in fact, mutual funds, and do a pretty decent job of acting like the open-end index type.

Of course, all this misinformation can be excused a little bit by the fact that Ramsey wants you to work with a stock broker, who presumably will know what he is doing.  (That’s actually quite a presumption, but for now let’s ignore it.)  Ramsey may be the last person left who explicitly recommends that you buy old-style class A load funds, which can carry a commission of as much as 5%.  That’s very nice for the broker, but not so much for you.

In fact, it’s so nice for the broker, and Ramsey is so sure that you should use one rather than do it yourself without fees, that a cynic (e.g. me) might begin to wonder what Ramsey’s relationship with the full-service brokerage community is.  That turns out to be a very interesting subject, but one that will have to wait for another post.  This one is long enough already.

[Read the other posts in this series: Step 6, and Step 7.]

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