Retirement rule of thumb: why Dave Ramsey’s 12% limit might not be enough

However, market volatility on that same day, with the SPDR S&P 500 ETF (NYSEARCA:SPY) experiencing a 4% decline, highlighted a potential flaw in this approach. While Ramsey’s rule seems sound when returns are consistent, it falters when faced with unpredictable market conditions.

Ramsey’s advice hinges on the assumption that investment returns consistently match or exceed the withdrawal rate. Living off an income stream lower than portfolio earnings is generally advisable. The problem arises when those returns aren’t predictable.

Consider a retiree with $1 million, withdrawing $100,000 annually (a 10% withdrawal rate). If the portfolio consistently earns 12%, the principal remains untouched. However, a sequence of negative years can drastically alter the outcome.

For example, five years with returns of -20%, -10%, +34%, +34%, and +22% average to Ramsey’s 12% target. Yet, after the initial losses, the portfolio shrinks from $1 million to $558,000, forcing the $100,000 withdrawal to consume 18% of the remaining balance. Even with subsequent gains, the portfolio ends at just $718,000 – a significant reduction in principal.

This illustrates “sequence-of-returns risk,” where selling shares during a downturn locks in losses and prevents participation in a subsequent rebound. The order in which returns occur matters greatly.

Furthermore, the concept of an “average” return can be misleading, as it doesn’t accurately reflect the compounding effect when returns fluctuate.

Adjusting the withdrawal rate can mitigate this risk. Taking only $40,000 annually, even with the same negative returns, allows the portfolio to recover and ultimately exceed its initial value.

Recent market volatility, with the VIX hitting 21.15 on November 2, underscores the importance of this principle. Retirees who sold during the downturn missed out on subsequent gains.

To safeguard a retirement plan, individuals should calculate their actual withdrawal rate, stress-test their plan with a “bad years first” scenario, maintain a cash buffer, and establish pre-determined spending rules to adjust withdrawals during downturns. While Ramsey’s instinct to live on less than portfolio earnings is correct, a more nuanced approach is needed to account for the realities of market volatility.