Last month, I wrote about the Seven steps Dave Ramsey followers really need to thrive financially. I was astonished with the amount of interest and debate the piece sparked. To the many who support our voyage, thank you and I’m excited to walk with you down this path, holding America’s Favorite Finance Coach accountable for his investment advice. To the critics who believe anyone disagreeing with the guru means they haven’t read his books, listened to his show, or attended his FPU … you’re wrong, wrong, and right. I have not attended FPU nor do I intend to. I don’t need to smoke a cigarette to know they stink, cost lots of money, and are negative for my long-term health. Financial Peace University is taught by those who’ve mistakenly taken a myth for a truth.

This sort of mix-up is one that Dave is familiar with.

«I have heard it said that if you tell a lie often enough, loudly enough, and long enough, the myth will become a fact. Repetition, volume, and longevity will twist and turn a myth, or a lie, into a commonly accepted way of doing things.»

-David L. Ramsey III “The Total Money Makeover” (TTMM)

Hmm … 12 percent annualized rates of return, 8 percent safe withdrawal rates, no debt EVER, 7 percent mortgage rates used to debunk the tax benefits of mortgage interest, 100 percent stock-based mutual fund portfolios, asset allocation is a dupe, term insurance is better than permanent … I could keep going but I think you get the point.  Many of Dave’s truths are actually myths, but they’re said often enough and passionately enough that their validity is accepted without challenge.

Myth No. 1: The Ramsey brand of endorsement benefits clients and advisors.

Let’s turn our attention toward a classic Ramsey-backed idea: the endorsed local provider, or ELP. To be or not to be an ELP, that is the question.

Working with an ELP or an investing advisor (Dave’s fictitious title, not mine) is recommended in Step 4 of Dave’s seven-step plan. Please note that an investing advisor is not the same thing as an investment advisor representative (IAR). They get paid to sell you something not give you advice. But that’s not the real issue here. The real issue is I don’t think Dave actually believes in some of the core teachings he spouts with, as he puts it, “extreme confidence.”

It’s important to note up-front that Dave’s entire marketing plan points to the fact that his recommended advisors must be commission-based, rather than fee-based. Instead of going into his reasons, let’s take a look at the facts.

Fact: Investment advisors are prohibited from using endorsement. SEC Rule 206(4)-1(a)(1) of the Investment Advisers Act of 1940 determined testimonials or endorsements are a form of misleading advertising since they only share positive experiences.

Fact: The statement found on Dave’s site, “98 percent of users highly recommend using an ELP” would most likely be in violation of SEC Rule 206(4)-1(a)1.

Fact: The very term Endorsed Local Providers would also most likely violate the above rule.  I suppose you could argue he could rename them Dave’s Elite Squadron of Advisors. (Dave, if you’re reading this, feel free to use this term. No royalties needed.)

Fact: If ELPs were IARs they would have to disclose they pay a fee for the clients referred to them by the Ramsey system. 

Fact: Working in a fee-based relationship would make it nearly impossible for ELPs to take on the types of clients Dave sends their way. 

Fact: Dave states he at some point held the appropriate investment, insurance, or real-estate licensing to give advice in the applicable areas. I could not find a currently registered or previously registered IAR or FA whose full name matched or was from the Tennessee area.

OK, so, if the name is no longer ELP and we remove Dave’s endorsement (he could still use his name in the agency titling, or advertise the firm on his site and his workshops with much success, I’m sure) and we omitted that 98 percent of users highly recommend an ELP, then his team could work as fee-based advisors, right? Not quite. Even if the necessary changes were made to Dave’s marketing approach, a fee-based advisor would very likely starve by working as an ELP.

Let’s look at the math behind all of this. While it was impossible to find the exact referral fee paid to Ramsey for the endorsement, multiple Google searches revealed fees ranging from a few hundred dollars well into the thousands. For the purpose of this column, let’s settle on a referral fee of $100 dollars, which seems reasonable compared to other lead sources.

Now, here’s the math for an American household with an annual income of $48,000 (the average annual wage for U.S. households, as provided by Dave) that is looking to invest 15% of said annual income, per Dave’s Step 4.

Average American household income: $48,000.

Example of 401k Employer Match: 3%

$48,000 x 15% = $7,200

$48,000 x 3% 401k employee contribution (to max out employer match): $1,440

$7,200- $1,440 = $5,760 left to invest with ELP per year, or $480 per month.

In scenario one, let’s consider an ELP who is fee-based at 1 percent AUM.  ELPs must have the heart of a teacher, not a salesperson. So we can assume they’d meet with the client a few times prior to making any recommendations. After investing 2–3 hours (roughly 1 hour per appointment) the ELP accepts a check from our client in the amount of $480. For the purposes of our example, let’s assume the initial investment takes place at the beginning of a quarterly billing cycle. Over the cycle, there’s $1,440 invested, but only an average balance of $960. The ELP would be entitled to one quarter’s advisory fees of .25% (1% divided by 4 quarters). In other words, our ELP would make a whopping $2.40 for 3+ hours of work.

But Mike, you’ve forgot these fees add up! Why, yes, they do. One full year later the client’s balance will be $6,087. (I used the conservative, widely-agreed-upon, historical S&P 500 12 percent average rate of return.)  If billed at that amount, our ELP would make a meager $15.22 for the first quarter billing. I even rounded up.

First year total fee compensation: $37.48

Second year total fee compensation: $103.11

Total compensation, first two years combined $140.59

I know ELPs are supposed to have the heart of a teacher, but in a fee-based relationship they certainly wouldn’t be compensated as much as one. If the ELP were to meet with the client a few times at the beginning and once a year for the first two years, then our ELP would have at least 5 hours invested with them.  If we subtract $100 from the total fees paid to the advisor of $140.59 (remember, this is going to Dave for the referral), then our ELP is left with $40.59 for two years’ worth of work.

Let that sink in for a moment, then we’ll move on to scenario two.

This time, our ELP is commission-based and uses mutual funds with 5.75 percent upfront sales charges. Every month, the ELP will make $27.60. He or she will also have some ongoing compensation from the funds sold and kept. Yet just the commissions will equal $662.40 over the two-year span. Subtract the $100 referral fee and you’re left with $562.40. That’s $521.81 greater than our first scenario.

Here are a few other things to consider. Will the ELP convert every referral? Not likely. Let’s say he or she converts 70 percent of referrals. Most referral services, and presumably this one as well, charge per referral sent, not per referral captured. So, 10 referrals equals seven clients.

Here’s the fee-based total over two years:

7 x $140.59= $984.31 minus $1,000 (10 referrals at $100/ea.) = ($15.69)

Here’s the commission-based total over two years:

7 x $662.40= $4,636.80 minus $1,000 (10 referrals at $100/ea.)= $3,636.80

Our fee-based ELP is in the red after two years. This person has worked for FREE for two years! What if they got two referrals per month rather than 10 referrals over two years?  I’m not going to bore you with prorating them, let’s just use the same math as above. Two referrals leads to 16 clients (yes, 70 percent of 24 is 16.8 however you can’t have a partial person; we only count whole people here) which gives us a loss of $150.56.

How many 100-percent altruistic advisors do you expect are out there?

Myth No. 2: Invest Dave’s way, and you can expect a 12 percent annualized rate of return.

I said earlier Dave doesn’t even believe his own math. He defines long-term investing as five years or longer. He then says to pick out a “good” mutual fund. Dave says never finance a car, yet today you can finance a used car for 1–3 percent. (Dave and I agree new cars are highly depreciable and often a poor choice.)  If you can make a 12 percent average on your good ole mutual funds, then why wouldn’t you invest the $10,000 car fund and make payments? Oh, because if you play with snakes you will get bitten! But here’s the thing: We’re talking about folks who have completed Steps 1–3 and are midway through Step 4. They’ve got a robust emergency savings now and no debt. Couldn’t they afford to do this?  Haven’t they proved they have the discipline to be financially responsible?

Dave clearly doesn’t believe in the 12 percent returns fallacy. Why? Ask this question: What about a mortgage? You don’t ever want a mortgage longer than 15 years, according to the guru. What about the tax deduction CPAs tout? “I can do the math,” Dave says. Why pay $7,000 in mortgage interest (7 percent is his number, not mine) on a $100,000 mortgage to save $2,100 in taxes (he uses 30 percent).  Um … I can do math, too. One hundred thousand dollars will make 12 percent. Twelve percent interest on $100,000 is $12,000. Mortgage rates are 4 percent, not 7 percent. And let’s use the more typical federal bracket of 15 percent, since the 30 percent pertains to higher income individuals who are certainly NOT using his advice.

OK, so $12,000 in interest. We’ll assume gains are taxed as capital gains, since I can’t imagine how he’d argue for using IRA dollars to pay off the mortgage. So, here’s what we have:

$12,000 ­– $4,000 in mortgage interest paid + $600 tax deduction = $8,600 (capital gains tax should not be applicable)

That’s right: If you believe in 12 percent long-term averages, you do not pay off your mortgage early.  And you will not be bitten by snakes because you have discipline. You have proven your discipline by accumulating 3–6 months’ worth of expenses in cash savings and by paying off all of your debts, according to the earlier steps in Dave’s plan.

If all of this is true, Dave Ramsey doesn’t believe in 12 percent returns for long-term averaging and neither should anyone else.

The big picture

There are many great advisors out there.  Many of these hardworking, honest, sincere, and genuine advisors also happen to be ELPs. ELPs are not bad. Commission-based investing has its place. The collage of contradictions and inaccuracies related to Dave’s “investing advisors” and his “investment” advice are what bother me.

I’m very lucky to be walking this journey with you all. Thank you for your support.  Help me hold America’s Favorite Finance Coach accountable to his words by emailing my editor nmorford@alm.com with any thoughts or questions.  And, in the words of all of our mothers, “words hurt people; choose them wisely.”

It’s no secret that many financial professionals don’t agree with much of the advice Dave Ramsey gives. This is because his financial assumptions are often false. Yes, he’s entertaining, but truly helpful … not always.

About a year and a half ago, Ramsey used Twitter to lash out at several financial professionals who had been chastising his investing advice. He tweeted:

“@ScottTruhlar @BasonAsset @behaviorgap @CarolynMcC// I help more people in 10 min. than all of you combined in your ENTIRE lives #stophating

— Dave Ramsey (@DaveRamsey) June 1, 2013

These comments strike me to the core. Many financial professionals help more people in the course of their career than Dave Ramsey ever will. So this column is for you, the thousands of financial professionals who strap on your boots (boots sounds tougher than nice leather oxford shoes), and spend their days, nights, sometimes their weekends helping everyday Americans struggling with poor spending and savings habits. Every month, I will dissect a piece of Ramsey’s financial advice and hold him accountable to providing sound financial principals instead of idealistic fallacies. If the pen is actually mightier than the sword, then, Sir Dave, I challenge you to a duel of math and wit.

7 baby steps to getting out of debt

Let’s start at the beginning. On his website, Ramsey lists “7 baby steps to getting out of debt.” These steps are the cornerstone to his popular book Total Money Makeover. Like so much of his advice, they sound good until you dig in and challenge the assumptions.

There are savers and spenders in this world. Ramsonites are inherently spenders. If they were savers they wouldn’t need his seven-step system. Spending is an addictive habit, which leads to less and less contentment as time goes by. Other addiction counseling services have found it takes 12 steps to recovery, not seven, but I digress. The table below outlines Dave’s seven steps, and what I believe they should be:

Now, let’s go through these step by step to illuminate the strengths and weaknesses.

Step one: Save $1,000 for an emergency fund. Ramsey calls for this $1,000 emergency fund to pay for “… those unexpected events in life that you can’t plan for: the loss of a job, an unexpected pregnancy, a faulty car transmission, and the list goes on and on. It’s not a matter of if these events will happen; it’s simply a matter of when they will happen.”

This is a good first step, considering that you can’t save $1,000 before you’ve saved $10 or $100. However, what does $1,000 really prepare you for? By Ramsey’s definition the loss of a job — but if you’re making $12 per hour, then you’ve managed to save a whopping 2 weeks’ worth of wages (cut it in half for a dual earning household). How far will $1,000 go towards an unexpected pregnancy or a faulty car transmission? Dave, when was the last time you paid attention to the actual costs for these sorts of expenses? I’ve got good insurance, yet our last child was still over $3,000 in out of pocket expenses. (And let’s not forget the fact that giving birth typically translates into time off from work, which isn’t always paid.)

This step starts with a few dollars but needs to continue to at least $5,000. Five thousand dollars can help protect families from unexpected life events. One thousand dollars doesn’t come close.

Step two: Pay down debt using the Debt Snowball. Ramsey’s rational is this: If you target the smallest debts first and ignore the ones with the highest interest rates then you’ll be encouraged by the psychological effect of lowering the total number of open accounts. He goes on to recommend that we re-allocate the funds used to pay off each card to the next smallest debt that you owe, so that over time your payments become larger.

Common sense tells us this is a good idea, just like common sense tells us driving faster to an appointment will get us there more quickly … unless of course you happen to go past a police officer. But ask yourself this: Is paying down debt the same as saving? No. Paying down debt is spending your money in a different way. Spenders have debt because they’re spenders.  Spending down debt is not the same as saving. As we pay down debt it relieves stress, but it does NOT teach us how to save. What happens if you follow Mr. Ramsey’s advice and suddenly lose your job? Great, you have $1,000 saved and you’ve made extra payments on your Macy’s credit card — remember, the debt snowfall rule says target lowest balances first which would most likely be retail store cards, not universal credit cards or auto loans — but you have no job and no money. Don’t worry, though; you can go buy a nice new Chaps blazer for your job interview.

Step two should be to give. You might be thinking that giving prior to paying down debt only further prolongs a debt-ridden life. It doesn’t, and here’s why. First, at this point you’ve created a reasonable safety net of $5,000. Second, gifting — or tithing, as some call it — is fundamental to becoming a saver. Giving is voluntary; paying down debt is not. As a voluntary practice, it takes discipline to habitually do this each and every month. If you have the discipline to gift every month then you’ve created a lifestyle change. The discipline of gifting is the same as the discipline of saving. Gifting at step two helps yourself and those around you.

Step three: Save 3–6 months’ worth of expenses. I agree with Dave here. I review too many financial plans where people only have a month or so in cash or cash equivalents, with the rest of their assets invested. I always ask, “What would you do in an emergency?” They usually respond with something like, “We’ll put it on the credit card.” While I understand they have the assets available to liquidate after the fact to pay the card balance back off, it’s still more conservative to have this amount of expenses stashed away in the bank. If you’re like me, you’ll even keep this fund partially in cash.

Step four: Invest 15 percent of household income AFTER debts are paid.

I heartily disagree here. Investing and paying down debt should occur simultaneously because, again, you only learn how to save by SAVING and continuing to save. While I’m not advocating debt is good or leveraging is appropriate, I am suggesting that habits are often lost if not continued. Think about the number of New Year’s resolutions to eat and drink healthier that are broken during the Super Bowl weekend and never adhered to again. Don’t stop saving. Instead, invest and pay down debt.

Continuing with step four, Ramsey says to use commission-based investing and to work with an “investing advisor.” While I don’t want to go into great detail on this now, it’s important to note that there’s no such thing as an investing advisor. I guess if you’re not a licensed advisor or an insurance agent, you can make up any title you want. Notice how “investing advisor” sounds very close to “investment advisor;” in fact, Google “investing advisor” and you’ll only get results for “investment advisor.” Ramsey intentionally uses a similar term, since investment advisors are held to a fiduciary standard, whereas investing advisors (who I can only assume are stockbrokers/financial advisors considering the commission structure) are held to a suitability standard as well as the Ramsey standard (#YesI’mHating).

Ramsey calls his legion of investing advisors ELPs, or endorsed local providers. Wonder why he doesn’t believe in a fee-based model? Consider Rule 206(4)-1(a)(1) of the Investment Advisers Act of 1940. (If you don’t recall the specifics, don’t worry. Next month’s column will use facts and math to prove why ELPs can only work in a commission structure.)

Step five: College funding for children. I’m not going to argue about college funding. That’s a choice for each individual to make, and there are good points for each side. Ramsey thinks parents should pay for college, and that’s fine. I think kids will appreciate college more with every one of their own dollars that goes towards it. Additionally, there are practical considerations at stake. If a parent has three children and they don’t start saving until the parent has reached age 30, then they’ve only got 12 years to recoup/save for these expenses per child (36 years until retirement divided by three). On the other hand, each child probably has 40+ years using the same retirement age. But to each their own on this step. I’ve met some people who take great pride in the fact they were able to help their children through school and their kids graduated with no student loans. I don’t think there’s a right answer here.

Step six: Pay off the mortgage. Eliminate the biggest debt most people have … it makes sense, right? This should help individuals need less income in retirement. Again Ramsey almost got it right but missed a very important point. Retirement is about income, not assets. You must have assets to have income, you say? Wrong. Social Security is not an asset, is it? It’s only income.  Think about it this way. Many of the people whom I serve would have a very nice retirement with $2,000,000 in assets — unless $1,950,000 is tied up in their home. If that’s the case, then they’re broke. But good news: They’d still have completed Ramsey’s steps 1-6 (assuming Social Security and $50,000 covers 3–6 months’ worth of expenses).

Here’s an example of when step six doesn’t make sense. Last year I helped a husband and wife, one still working and the other retired, but both taking Social Security. They had previously followed the advice of an advisor who I can’t say for certain was an ELP but his plan certainly stunk of one. He had them refinance their home to a 10-year mortgage so they’d pay less interest and get the house paid off in their lifetimes. In order to cover this larger monthly mortgage payment they had to do two things. The husband had to continue to work and they had to withdraw money from their retirement savings each month. We did some simple forecasting using reasonable rates of return based on a Morningstar report and found that, yes, they would get their house paid for in full by their early 70s. At that time, they’d have a $350k house free and clear and about $100k in retirement savings. In the process, they converted a liquid asset (retirement savings) to pay off an illiquid asset (home equity).

I asked if they ever want to leave their home. They replied no, especially not after working the extra years to pay it off.  Yet somewhere between their late 70s and early 80s, they’d have to sell or tap into their equity. They weren’t concerned with leaving the house to the kids mortgage-free. They needed to take care of themselves first. The only thing this plan accomplished was more years of working and a debt-free inheritance for the kids … oh, the good life.

Paying off the mortgage can be a noble thing, but it can be absolutely the wrong thing if you’re in retirement or close to retirement. Tying up most of your assets into the place you love and never want to leave is just as harmful as having too much debt. You may have no debt, but you also have no money.

Step seven: Build wealth and give. I agree with Dave that we should give back. The more we get, the more we should give. Again, I think this should happen much earlier because when you learn how to gift you learn how to save. Gifting should really be step two, as I previously stated.  This is especially true when you consider that Ramsey preaches much of his advice is faith-based. How on earth can he suggest to give only once someone has received so much? By the time he suggests you give, you’ve saved tens of thousands of dollars for emergencies, you’ve paid off all your debt, you are investing 15 percent of gross wages, you’ve paid or are paying for your children’s college, and you’ve either paid your house off or are close to it. Only then are you supposed to give. In other words, don’t go without so you can help someone else first. Take care of steps 1–6, then learn the word generosity.

This was just the beginning. Today we debunked several of the 7 baby steps, which are core to Dave Ramsey’s “Total Money Makeover.” While the advice wasn’t entirely bad, there are certainly some glaring deficiencies.

I like math — strike that, I love math — and I don’t particularly care for opinions. Remember, this column is for you. If you notice any particular financial advice from Dave you’d like to refute, please email my editor at nmorford@summitpronets.com. I appreciate your help holding America’s favorite finance coach accountable to good, sound financial advice and not just the entertaining garble that most won’t take the time to validate.

Source: Life Health PRO.

More information:
Two great Dave Ramsey myths, debunked