Is Dave Ramsey's 12% Expected Return and 8% Withdrawal Rate Reasonable?

Over the years Dave Ramsey has become a household name by helping thousands and thousands of households get out of debt and achieve financial freedom. However, Ramsey has made waves recently with his bold statements that investors should be earning a 12% annual return, while withdrawing 8% annually from their investments. While I think Ramsey’s advice on achieving financial freedom is sound, these comments caught my attention and raised some eyebrows. So, I had to take a deeper look into his proclamations.  

By leveraging the award winning  wealth management software platform like Zephyr, which helps investment professionals Plan, Invest, Monitor, and Grow you can see how reasonable these proclamations are and if they are right for your clients.

Let’s start with Ramsey’s statement that investors should expect an annual return of 12% on their equity investments. This statement might not be as outlandish as you think after looking at the historical returns of the S&P 500 index. Since 1922, the S&P 500 index has produced roughly a 10.5% annual return. While it’s not 12% it’s still awfully good. Ramsey has mentioned that he has achieved a 12% annual return over the past decade, so I went back to 1922 and broke the returns into 10-year rolling periods to see how many 10-year periods since 1922 the S&P 500 index returned over 12%. Of the 1104 10-year periods between 1922 and October 2023, 458 periods had an annualized return of greater than 12%.

 Included in that 101-year stretch there were two periods of lost decades, the Great Depression and the Great Financial Crisis. During those two crises, a decade of returns was lost during each period. That 12% annual return was nothing but a pipe dream during those very difficult times. 

Now let’s look at the 1-year time periods between January 1979 and October 2023. Of the 527 1-year time periods, the S&P 500 index beat the 12% target 299 times. Not surprisingly it’s easier to beat the target return on a 1-year basis versus a 10-year basis.  

Is a 12% annual return achievable, yes? But is it a return that I would base my investment decisions on? No, especially when you consider that since 1922, the S&P 500 index achieved a 12% annualized return over a 10-year time period 41% of the time, and the broad index beat the 12% target on a 1-year basis 57% of the time. I cannot feel good about basing my investment decision making and spending on return expectations that have a 41% and 57% probability of occurring. Those odds don’t give me much confidence.

Let’s take a look at the 8% withdrawal rate. Historically, financial practitioners have earmarked a 4% annual portfolio withdrawal for their clients, while having fairly high confidence that their savings will not dry up. History shows that the income and growth generated from a portfolio consisting of bonds and equities typically covers the 4% annual withdrawal. We can again use Zephyr to run some Monte Carlo simulations to see how realistic an 8% annual withdrawal rate is without outliving your money assuming a 12% annual return.

Furthermore, we will set the standard deviation at 15.47, which is the historical average for the S&P 500 index. 

During our first scenario, we set the withdrawal rate at a flat 8% per year. Interestingly, the probability of the portfolio reaching a value of zero is zero. Meanwhile there is a 43% probability that the portfolio will maintain $1 million and 95% probability that the portfolio value will exceed $250,000 in year 30. Additionally, the likelihood that the annual withdrawal amount in dollar terms increases each year along with the growth of the portfolio. 

 As we discussed above, a 12% annual rate of return is no sure thing, so I ran the same scenario at a reduced rate of return. When running the scenario at a 10% annual return the portfolio still doesn’t go broke, in fact the portfolio doesn’t go broke at all when taking a percentage of the portfolio out as a withdrawal. However, the dollar amount of the withdrawal shrinks. The initial $80,000 withdrawal shrinks as the portfolio falls in value. The most likely outcome at a 10% annual return is that in year 30 your withdrawal will be $85,000, which is larger the initial $80,000 in year one, but that increase will not keep up with inflation and as a result will not buy the same amount of goods it did 30 years ago. So, this assumption that you can take out an 8% annual withdrawal starts to break down as your rate of return falls below 10%.

Speaking of inflation, the outcome is a lot different when we do an inflation-adjusted withdrawal, which is a more realistic scenario as the investor will want to make sure their withdrawal buys the same amount of goods in year 30 as it did in year 1. 

When setting the year one withdrawal at $80,000 with an annual inflation rate of 2.5%, the $1 million portfolio with an expected annual return of 12% has a 47% of returning a zero value in year 30, or stated differently, it only has a 53% probability of exceeding $0. Furthermore, the dollar value of your withdrawal begins to shrink in year 17, and it will become harder to maintain your current lifestyle as your withdrawal falls to $88,000 in year 30. Which is a far cry from the expected $160,000 annual withdrawal which is the initial $80,000 inflated at 2.5% after 30 years. I don’t think I am in the minority in thinking that if I am creating an investment portfolio to try and achieve an investment goal, I would prefer a higher degree of certainty than a coin flip. Let’s say you are looking to have a 75% probability of exceeding a portfolio value of $0 and continuing to maintain your style of living by having your portfolio produce an inflation adjusted 8% withdrawal. You would have to achieve a 14% annual return to have a 75% chance of exceeding a portfolio value of zero and producing an inflation adjusted 8% annual withdrawal.  Or, if you reduced your withdrawal from 8% ($80,000) to 6% ($60,000) during the first year you will have a 83% probability of exceeding $0.

While Dave Ramsey has helped thousands of households over the years in gaining financial freedom and helping them reduce their debt, I believe his proclamations that your return expectations should be 12% and you should withdraw 8% annually from your investment portfolios is too aggressive and the probabilities of achieving such aggressive targets is too low for my liking. It’s important to understand that every situation is different and some of these targets may work, but I would take a more conservative approach when determining the targets.