Inadequate Retirement Account (IRA): Home Equity

Note: This is the fourth installment of a series of posts with advice for households that haven’t been able to save enough for retirement. The first post was Inadequate Retirement Account (IRA).

If you're approaching retirement and haven’t saved enough in retirement accounts, it's likely that the majority of your wealth is home equity[1]. You may find yourself in your early 60’s with the prospect of living primarily off Social Security benefits while residing in your largest financial asset.

Maybe you’ve had the thought in the back of your mind that you saved for retirement by paying off the mortgage. If so, you have some serious planning to do because home equity is difficult to spend. Even if you sell the house to free up the equity, you will still need a place to live. If the new place doesn’t cost significantly less than where you live now, you’re back where you started.

Should you sell your house when you retire? Should you pay off the mortgage? Should you buy a smaller house or rent?

Housing and mortgages in retirement are complicated issues because there are several factors, financial and non-financial, to consider, including:

• Emotional value. Houses are often more than a financial asset; they’re our homes. It may be impossible to put a price tag on the memories. Is it important to you to leave your home to your children?
• Changing housing needs. You may need a larger home for the children and grandchildren to visit for several years after you retire. You may find at some point that you don’t need all that room and you could do without the maintenance chores. Later in life, you may find that your home isn’t well suited to your physical limitations. Can it be modified to work for you? Your housing needs may change significantly once or even twice during a 30-year retirement.
• Taxes. The tax deductions you enjoyed before retirement may have far less value after you retire. You may have to pay a capital gains tax when you sell your home, though the first $250,000 of gain is excluded ($500,000 for a married couple) in most cases. If your home has lost value since you purchased it you cannot deduct a capital loss on your main home sale.
• Liquidity. Real estate is highly illiquid, which means that an asset can take a long time to sell or that it has large costs associated with selling, or in the case of your home, probably both.
• Risk. A home with a mortgage is exposed to foreclosure risk.

The issues surrounding the emotional value of your home are purely personal. Only you can know if keeping your home has more value to you than moving and thereby gaining the ability to spend some of your wealth that is currently in the form of home equity.

The income tax deductions for home mortgage interest and property taxes are the most popular deductions among the middle class. Should your income tax rates drop after you retire, which is likely if you have limited savings to invest, those deductions will be less valuable and your after-tax housing costs will increase accordingly. Furthermore, you may have been paying mortgage payments for many years by the time you retire so that those payments will consist largely of principal and will provide diminishing tax savings.

You also need to be aware of property tax costs and home insurance costs if you continue to own a home after you retire. Paying off the mortgage doesn’t make these go away and both increase fairly constantly along with inflation and property values. Check your latest mortgage payment statement to see what percentage of it is escrowed to cover these two costs. The principal and interest will go away when you pay off the mortgage but taxes and insurance remain and grow over time.

The biggest housing issue for retiring homeowners who haven’t been able to save enough for retirement may be one of liquidity.

I have a client who has been able to save enough for retirement and he recently asked if I thought he should pay off his mortgage. Doing so would take a third to a half of his liquid assets (mostly stock investments) and convert that amount into illiquid home equity. As he pointed out, though, he would reduce his spending by the amount of interest on his mortgage (currently under 4%).

I asked him if he might one day need the cash he would use to pay off the mortgage for living expenses.

"Probably," he replied.

“How, then,” I asked, “will you get the money back out of your home to spend?”

There aren’t a lot of fast and cheap ways to get the cash back once it becomes home equity. He could sell his house and buy a smaller one or rent. He might take out a reverse mortgage. A home equity line of credit doesn’t make much sense because you have to start paying it back immediately and the rates are higher than a mortgage.

He realized that if he paid off his mortgage he would lose access to a lot of liquid assets and it wouldn’t be easy to get that liquidity back. If he could pay off his mortgage with say, 10% or less of his wealth, the mortgage interest savings might have been worth it. He decided it was not in his case.

On the other hand, Laurence Kotlikoff, an economist I respect and the creator of E$Planner software, uses a tool called consumption smoothing to calculate the amount of consumption (the amount you can spend) over your lifetime. He claims that he has run many scenarios through E$Planner and rarely finds one where paying off the mortgage isn’t a winner.

It isn’t always a big winner, though.

You might want to run your scenario through E$Planner's free web software and see what works in your situation[2]. The amount of annual spending you might free up from home equity may help you make up your mind about selling or staying.

Keep this in mind, though: $100,000 of home equity isn’t the same as $100,000 in a retirement savings account. You don’t live in your 401(k).

You can spend your 401(k) or IRA savings on whatever you please, but after you sell your home to free the equity, you’ll still need to pay for somewhere to live, unless you move in with the kids. Presumably, part of that replacement housing cost will be paid from the home equity you just liquidated.

A reverse mortgage is an alternative that frees up home equity and allows you to remain in your home. According to the Federal Trade Commission, "In a regular mortgage, you make monthly payments to the lender. In a reverse mortgage, you receive money from the lender, and generally don’t have to pay it back for as long as you live in your home. The loan is repaid when you die, sell your home, or when your home is no longer your primary residence."

There are pros and cons to reverse mortgages, though, so analyze them carefully before making them part of your retirement plan.

One last thing to consider is foreclosure risk. Anytime you have a mortgage there is a possibility that it will be foreclosed in bad economic times, as happened in the recent housing crisis.

People without mortgages rarely lose their home to foreclosure, but it happens. People have lost their homes for relatively small amounts of unpaid back taxes. Still, a paid-off mortgage may give you a sense of financial security that helps you sleep at night.

E$Planner or a similar consumption-smoothing tool can help you determine if selling your house, renting, downsizing, or paying off the mortgage or keeping it will increase the amount of money you will be able to spend in retirement.

Whether or not you want to sell your home and how much financial risk you can live with is something software isn’t going to help you with.

My advice regarding homes and mortgages for households with inadequate retirement savings is that you create some possible scenarios like “pay off the mortgage and stay put”, “sell the house and relocate at age 65”,  “sell the house and relocate at age 75”, and “reverse mortgage and stay put”. Then run E$Planner to get an understanding of your maximum potential spending in each scenario before you exclude any of the alternatives. The results may surprise you.

With the numbers in hand, you have an objective way to decide how important keeping your home really is to you and the value of paying off your mortgage (or not).

What to do with your home and home equity may be the biggest financial decision you make if you don’t have much retirement savings, with the possible exception of what to do about your Social Security benefits.

We’ll talk about that next.

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[1] Home equity is the amount of cash you would have if you sold your home and then paid off all encumbrances (first mortgage, second mortgage, home equity line of credit, etc.). To calculate home equity, we don’t usually subtract home selling expenses such as realtor fees or taxes, but in this case I do because we’re considering the net cash you could take away from the sale to fund retirement.

[2] Please don’t let my multiple references to the product give the impression that I have an incentive for hawking E$Planner. I mention it repeatedly because it is one of the few software packages I know that performs consumption smoothing. A free Excel spreadsheet, created by Sherman D. Hanna, Professor, The Ohio State University, is also available but I find E$Planner far easier to use. A free (but simplified) version of E$Planner is available here.

Inadequate Retirement Account (IRA): Spending Less

NOTE: This is the third post of a series suggesting ways families who haven't saved enough can improve their retirement finances. The initial post was "The Inadequate Retirement Account (IRA)".

For households who weren't able to save enough for retirement one thing is certain: they will spend less after retirement than they did before, simply because they will have far less to spend. A reduced standard of living is inevitable. In fact, many households will drop out of the middle class after they stop working.

Social Security benefits alone won't keep them there. Social Security is intended to replace only about a third of a family's pre-retirement income. For households at the lowest pre-retirement income levels, the number may approach 50%, but that is simply replacing a larger percentage of a much smaller income.

The goal of Individual Retirement Accounts, 401(k) plans and other retirement savings tools is to help families generate enough personal wealth to fill the shortfall between Social Security benefits and the family's standard of living while they were working. For more than 90% of American households, that savings goal wasn't met over the past three decades. 

About half of that 90% has no retirement savings, at all, and living off Social Security benefits alone is a harsh prospect, as is chronicled in this 2012 New York Times article, "The Tightwire Act of Living on Social Security". 

There are thousands of ways to reduce your living expenses after you retire, some useful suggestions and some not. I suggest you Google the topic and see where browsing the Web takes you.

Here is an MSN Money article, for example, entitled "Retiring? Two Dozen Ways to Cut Costs". However you do it, plan to spend a lot of time thinking about cutting expenses because you can't make retirement work with inadequate savings unless you do some serious cost cutting.

How much will you need to cut? Take your current annual income and subtract any amount you are saving for retirement. Then subtract your annual amount of FICA taxes. This is roughly your current annual spending.

Now go to the SSA.gov benefits calculators and estimate your annual Social Security benefits. The difference between these two numbers is roughly the amount your spending will need to decline, for example:

Some of the cuts you will need to make are necessarily large. Relocating to a less expensive locale has long been recommended. Strongly consider that option if you are in even a moderately expensive region now. (I have a friend who recently retired in Ecuador and seems to be happy with it, though I'm not sure I would recommend something quite that extreme.)

A major expense that you will need to address is health insurance and healthcare. When I retired seven years ago, I was very concerned about how I would pay for my family's healthcare. In fact, it was my biggest concern. Nonetheless, it turned out to be even more difficult to obtain coverage and far more expensive than I expected.

Medicare isn't available until you turn 65, so if you retire early by choice or for reasons beyond your control (there's around a 50% chance that you will have to), finding affordable healthcare will be important. Line it up before you leave the job.

And don't simply decide to risk your finances by betting that you'll stay healthy. By some estimates, more than half of personal bankruptcies begin with catastrophic medical expenses.

Another major expense in retirement will be housing, but mortgages are a complicated issue that deserves its own blog post in the near future.

Still another critical expense in retirement is consumer debt. Don't stop working until you have paid off all credit cards, car loans and similar expensive debt.

Debt is deadly in retirement. Pay it off before you retire and severely limit it after you retire.

So, there you have my recommendations for spending less after you retire. I have intended my suggestions primarily for families who weren't able to save enough for retirement, but the spending part of the advice applies almost equally to those who have:

• Look everywhere for places to cut expenses
• Consider moving somewhere with a lower cost of living
• Figure out where you'll find healthcare until you are eligible for Medicare at age 65
• Don't stop working until all consumer debt is paid off

I'll cover housing expenses in my next post.

The Inadequate Retirement Account: Working Longer

This is the second post of a series suggesting ways households that weren't able to save enough can improve their retirement finances. The series began with "Inadequate Retirement Account (IRA)".

One of the ways to compensate for inadequate retirement savings is to work longer. Working longer is actually a highly leveraged strategy because it helps in several ways at the same time. Working longer can:

·       Reduce the cost of retirement by shortening it,

·       Give you time to save more,

·       Give your savings and investments more time to grow,

·       Extend your healthcare benefits, and

·       Increase your eventual Social Security benefits.

First, the longer you work, the longer you can delay spending down your savings and that makes them last longer. Your retirement will be shorter. While shortening your “golden years” may not be the most fun strategy, retirement will cost less.

(The bad news is your vacation is going to be shorter; the good news is it will cost less.)

Second, you may be able to save more while you’re working. Perhaps your employer will have a 401(k) plan, for example, and you can contribute to that. Maybe your employer will even match your contributions.

Third, postponing retirement will provide more time for your retirement savings to earn interest and grow. Fourth, your employer may provide healthcare benefits, one of the largest expenses you will have after retiring.

Finally, working longer may allow you to postpone receiving Social Security retirement benefits and each year you do that increases your eventual benefits by about 8%. (Maximizing your Social Security benefits will be covered in greater detail in a subsequent post.)

Working longer is not the ideal fix, however, for inadequate retirement savings for several reasons. First and foremost, working longer simply means not retiring. It’s like telling you that the solution to your problem of not being able to retire is to not retire.

Furthermore, most households will find that their retirement savings shortfall is far too great to fix by postponing retirement a year or two. The initial response of the financial trade press to the 2007-2009 stock market crash that devastated the retirement savings of millions of Baby Boomers was, “No problem — you’ll just have to work a few years longer.”

Upon further review, as they say, the problem is often too big to fix by working longer, even if you can work longer. See, for example, “Work to Age 70? For Many, That Still Won’t Pay for Retirement” from the Employee Benefit Research Institute.

According to EBRI, the lowest-earning 25 percent of Americans would have to work until age 84 so that 90 percent of them would have even a 50-50 chance of having enough money to afford basic living expenses and out-of-pocket medical care.

Perhaps the biggest problem with the “work longer” strategy will be your ability to do so. Also according to EBRI, “consistent with prior Retirement Confidence Survey findings, half of current retirees surveyed say they left the work force unexpectedly due to health problems, disability, or changes at their employer, such as downsizing or closure”.

In other words, half of retirees consistently report that they wanted to work longer but were forced to retire for reasons beyond their control. You may plan to work to age 70 or beyond, but whether you will be able to or not is a coin toss.

If you decide to work and collect your Social Security retirement benefits at the same time, you need to be aware of two potential Social Security-related problems.  For workers who begin receiving retirement benefits before full retirement age and continue to work, SSA may withhold some benefits¹ under the Earnings Test rule.

Once you reach full retirement age, the SSA will permanently increase your benefit to compensate for the benefits that were withheld. You won’t get back a lump sum, though. The withheld benefits will come back in drips and drabs.

Regardless of the age you elect to receive benefits, if you earn enough money from non-benefit sources, a portion of your Social Security benefits will become taxable.

It is even possible to have both some portion of your benefits withheld because you claimed early benefits and earned more than the Earnings Test limit and some portion taxed because you earned more than the tax-free limit.

These are issues to discuss with your tax professional, but you can generally avoid the Earnings Test withholding by:

·       Earning less than the limit ($15,120 annually in 2013),

·       Not claiming benefits until after you stop working, or

·       Not claiming benefits before you reach your full retirement age.

Your benefits won’t become taxable if most of your income comes from Social Security benefits. I wrote more on the topic in “Will Your Social Security Benefits be Taxed?”.

Working longer won’t fix the retirement savings problems facing most American households, but it can certainly help. My first piece of advice to families who find themselves approaching retirement with inadequate savings would be to work as long as you can, postpone Social Security benefits as long as you can get by without them, and save as much as you are able.

If you expect to earn more than the Earnings Test limit or the benefits taxability limits (see links above), then talk to your professional tax planner. It may pay to postpone claiming Social Security benefits.

And invest conservatively while you’re doing it — don’t risk making your shortfall worse.

In my next post, I’ll talk about the spending side of the retirement equation.

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¹ If you begin receiving benefits before your full retirement age and earn more than a set limit ($15,120 in 2013), the Social Security Administration (SSA) will withhold $1 for every $2 you earn above the $15,120 limit.

Inadequate Retirement Account (IRA)

If you’re about to retire with a 7-figure retirement savings portfolio, you can find plenty of people to “help” with financial advice. In fact, they’ll find you.

With $30,000 saved, probably not so much.

There are two problems, really. There isn’t a lot of money to be made managing portfolios totaling 5-figures and, with such limited savings, there aren’t nearly as many options for you to improve your finances. If you don’t have much money, there’s only so much a financial adviser can do.

There are still a few levers to pull, though, if you find yourself approaching retirement without adequate savings and that’s my real goal for this blog, to help people who aren’t rich retire as comfortably as possible.

What constitutes “inadequate” retirement savings? Technically, it means that you won’t have enough savings when augmented with Social Security or other pension benefits to maintain your pre-retirement standard of living after you stop working.

The amount of savings you'll need varies a lot depending on your individual household’s situation, but we’re almost certainly talking about any household approaching retirement with less than $100,000 in retirement savings and probably those with less than $200,000. In some cases, though, a million and a half won’t do the trick.

The actions available to households with less than $200,000 or so in retirement savings — I’ve mentioned in several previous posts that more than 90% of American families approaching retirement have saved less than that amount — are primarily:

• Working longer
• Reducing living expenses
• Investing conservatively
• Postponing Social Security benefits as long as possible, and
• Managing home equity.

If these are the four most important considerations for improving your retirement finances when you don’t have enough savings, the most important option to not consider is putting more of your wealth at risk in the stock market.

If your investment skills didn’t win the day for you during the greatest bull market in history over the last three decades, they aren’t going to pull your buns out of the fire in the last five years before you retire. 

Try to invest your way out of a savings shortfall and odds are you’ll only make your situation worse.

In my next post, I’ll talk about dealing with your shortfall by working longer.

A Million Six Ain't What It Used to Be

An article in the March 2013 issue of Money magazine, entitled “Quittin’ Time”, should be eye-opening if not downright depressing for more than 90% of American workers hoping to retire one day. It discusses the challenges facing two couples that hope to retire with a mere $1.3M and $1.6M in savings.

According to the Employee Benefit Research Institute, about 90% of American workers approaching retirement have less that $200,000 saved for retirement, and about half of those have no meaningful savings, at all. I suspect those households will have difficulty mustering sympathy for the Vick and Edwards families.

Two things should catch your eye. First, households that have saved $1.3M and $1.6M are struggling with retirement financing. And second, the family with $1.6M is actually in worse shape.

I recently worked with a client who is nearing retirement and on track to save about $1.2M if the stock market gods don’t get angry in the next few years. We found that family is in pretty good shape and probably better off than the Vicks or the Edwards.

What’s the difference?

The amount of money that you need to save for retirement depends heavily on two factors: how large your Social Security benefits will be and how large a percentage of your savings you will need to spend each year in retirement.

(It also depends greatly on how long you and your spouse will live, but that is beyond our control so we need to assume we will live 30 years or more in retirement just in case we do.)

Notice that successful retirement savings doesn’t depend directly on the amount you save, but on the percentage of that amount you will need to spend annually after you retire.

That should make sense. The math isn’t rocket science. If you spend too much, it doesn’t matter how much you save. But this is one of the reasons we can’t set a general target savings amount for retirement and why $1.2M is plenty for one household and $1.6M isn’t enough for another.

If you live in an area with a low cost of living, have the mortgage paid off and maximize Social Security benefits, you might maintain your pre-retirement standard of living with $300K of retirement savings or less. Different households have different standards of living and the same standard of living has different costs depending, among other things, on where you live.

The Vicks save 12% of their $130,000 annual income every year, or $15,600. They also probably pay about $9,950 a year in FICA taxes. They won’t have either of these expenses after they retire, so let’s assume they will need about $104,000 a year to maintain their standard of living after they retire.

I’m guessing the Vicks will receive somewhere around $36,000 a year in Social Security benefits, which leaves them with about $68,000 a year of expenses to replace from personal retirement savings. That $68K is 5.2% of $1.3M, and 5.2% is a lot of spending if a portfolio needs to last 30 years. If they live long lives, their savings won’t last.

Current studies show that future safe retirement spending rates, based on current capital market forecasts, will range anywhere from 2.5% to 4.5% and, in either case, 5.2% is outside that range. Consequently, the Vicks do have a challenge, even with $1.3M saved.

The article doesn’t provide enough data to run the same numbers for the Edwards family with $1.6M, but his financial planner suggests that at their current rate of spending, they have little chance of meeting their retirement goals. That tells me their spending rate is a good bit higher than the Vick family’s 5.2%, and there’s the difference.

The Vick family is in better shape than the Edwards family, even though they have saved $300,000 less, because they need to spend a smaller percentage of their savings after they retire to maintain their lower standard of living.

The household I recently counseled that is on track to save $1.2M for retirement in the next few years will only need to spend around 4% or less of their savings each year because they live in an area with a relatively low cost of living, so they’re in better shape than either the Vicks or the Edwards.

Still, that’s a butt-load of money, and a lot more than 90% of American workers will have when they retire. If you need a 4% spending rate of your savings in retirement, then you need to save $25 for every $1 you will spend annually for a thirty-year retirement. If you need to spend 2.5% of your savings then you need to save $40 for every dollar you will spend from savings after you retire. You might get by on the former, but even that is more saving and investing than most families are capable of achieving.

Unfortunately, the obvious alternative for inadequate savings is to lower annual spending until it reaches the 2.5% to 4% range on top of Social Security or other pension income, and that means a lower standard of living for the majority of American families after they retire.

(There are other steps you may be able to take if you have inadequate retirement savings and I will cover those in future posts.)

Neither the Vick’s $1.3M nor the Edwards’ $1.6M is anywhere near a retirement slam-dunk for these families.  How much does your household need to save for retirement? It depends on how much Social Security you will receive and how much you will need to spend.

For some households, that will be under a million dollars, but maybe not as far under as you would guess. $200K will rarely do the trick.

The Money article finishes with the Stevens family, who has accumulated about $5M for retirement. You won’t be surprised to learn that their retirement is looking rosy.

I think Jim Edwards summed the situation up pretty well.

“I thought I could retire next week. Evidently, $1.6 million doesn’t go as far as it used to.”