I suppose the answer to that question is relative. I bought a house in 1980 with a mortgage rate of 13.875%. That priced in a lot of expected future inflation.
About that same time, I bought a 5-year CD from a bank in Rockville, MD that yielded 14%. That's right, a 5-year bank certificate of deposit paying 14%. Today's CD rates probably make you wonder if I got the decimal point in the right place.
Inflation expectations declined rapidly during that five years and when I went back to the bank on Rockville Pike to cash it in, the banker took one look and shook his head.
"Is something wrong?" I asked.
"No," he replied. "I just can't imagine that we were ever willing to do this."
Those of us who lived through 70's and 80's inflation know how it can wreck your finances. Some of us learned to deal with it and even to profit from dis-inflation. I bought that house cheap because not many buyers were willing to take out a mortgage then and I refinanced several times over the next twelve years as mortgage rates declined precipitously. The price of that house more than doubled and my mortgage payment just kept getting smaller. It worked out nicely.
Compared to those decades, inflation since 2000 has been a relatively tame 2.73% a year. The long-term average since 1913 has been 3.22% a year. So, for those who retired around 2000, inflation hasn't been much of a problem, right?
Actually, it has.
Robert Powell's Retirement Weekly newsletter this week pointed out the results of an analysis entitled Annual Survey of Senior Costs released by The Senior Citizens League (TSCL) that shows inflation has reduced the buying power of retirees by nearly a third since 2000.
How is that possible if the Consumer Price Index (CPI) has increased only 2.3% a year in that time according to the Bureau of Labor Statistics? There are two reasons.
First, Nixon-Carter era inflation ran from 8% to over 10% and hit our buying power in Katrina-like fashion. Inflation over the last 14 years, however, ate into our wealth more gently but more persistently, sort of like the Colorado River eating into the Colorada Plateau. Give rivers or moderate inflation enough time and you will end up with a really big hole like the Grand Canyon somewhere.
Second, the TSCL study calculates inflation in a way that is more representative of the spending of retirees, weighing medical and other expenses more heavily than does the CPI. This "retiree's inflation" averaged 2.6% a year from 2000-2014 while the widely-use CPI averaged a smaller 2.3% a year increase.
How can a retiree hedge against "retiree inflation"?
It isn't easy. TIPs bonds and inflation-protected fixed annuities are based on the CPI. They won't hedge for price inflation of products and services more heavily purchased by retirees.
Social Security benefits are adjusted for inflation under present law. Since 2000, the Social Security Cost of Living Adjustment (COLA) has
increased benefits just 41 percent while typical senior expenses have
jumped 84 percent, more than twice as fast, according to The Senior Citizens League. It's those faster growing "senior expenses" that increased inflation from 2.3% to 2.6% for retirees.
Investing more in stocks is probably the only way to outpace retiree inflation and stocks do so only indirectly. Over time, stocks do tend to earn more than the rate of inflation, but they don't typically do so when the inflation occurs. Stocks don't do well when inflation is high, but their subsequent returns might help you catch up later if you have time to wait.
On the positive side, the typical spending of retirees tends to decline about 3% a year over the long run, which is conveniently near the long-term rate of inflation in the U.S.
My recommendation to retirees would be that they not just worry about 80's-style hyperinflation. Be aware that even a little inflation will eventually cause a big problem.
Because you can't completely hedge against inflation doesn't mean that you can't plan for it. Plan for less spending power as you age. Adjust your spending to reflect your inflation expectations and the natural tendency for spending to decline as you age, anyway. E$Planner is a good tool for this.
Make sure that inflation, tame or not, is a risk that your retirement plan addresses.
Wednesday, May 28, 2014
Posted with Blogsy
Thursday, May 22, 2014
Zero Capital Gains Tax
A reader recently asked me about the zero capital gains tax rate and how it applies to deciding whether to pay off your mortgage. I wrote about this decision in multiple posts that began with Investing the Mortgage.
Retirees can have a broad range of tax situations, so I excluded taxes from those analyses. To adapt the analysis to your own financial situation, you should include tax considerations. You can do that by using your own after-tax mortgage cost, but you also have to use your after-tax expected portfolio returns.
In other words, you will be subtracting a lower mortgage payment from a lower expected portfolio rate of return to determine your expected after-tax return for the mortgage-to-invest strategy. The risk (variance) of this strategy, however, remains the same as that of your stock and bond portfolio, just as it did with the before-tax analysis.
The zero capital gains tax part of his question, however, deserves some discussion. Here are some important points.
I often read in the financial press that taxpayers will pay no capital gains taxes if taxable income does not exceed the upper limit of the 15% tax bracket, which will be $73,800 in 2014 for joint returns and $36,900 for single returns. While this is correct, it omits the fact that those capital gains will be added to your taxable income, possibly pushing some or all of your gains out of the zero capital gains tax bracket.
The maximum amount of capital gains that will go untaxed depends on the amount of your taxable income before the capital gains are added. The net effect is that tax-free gains are limited to the upper 15% tax bracket amount ($73,800 for joint returns in 2014) less your other taxable income.
Let's look at how the tax is calculated. Adjusted Gross Income (AGI) includes salary, taxable interest, ordinary dividends, traditional IRA distributions, income from pensions and annuities, and capital gains. From AGI, we subtract exemptions and deductions to arrive at taxable income. This is the figure we take to the tax tables to calculate how much tax we owe.
Let's say that Joe has $93,800 of combined annuity income, traditional IRA distributions, interest, and dividends and $20,000 of exemptions and deductions. His taxable income before selling stocks will be $73,800. Should Joe sell stocks with a long term capital gain of $10,000, all of the gain will be taxed at 15%, not zero. That's because his other $73,800 of taxable income has already pushed him out of the zero percent tax bracket before the capital gains are added.
Now, let's assume that Joe has just $20,000 of adjusted gross income but still has $20,000 of exemptions and deductions. His taxable income is zero. Now, if he sells stocks with a long term capital gain of $10,000, he will pay no capital gains tax on that sale. In fact, he could sell stocks with gains up to $73,800 and still pay no capital gains tax.
Any sum of "other taxable income" and capital gains exceeding $73,800 will have no capital gains tax due for the first $73,800, but the excess will be taxed at 15%.
Also, keep in mind that the zero capital gains tax bracket applies to Federal taxes. You may also be subject to state taxes and many (perhaps most) states tax capital gains the same as ordinary income. No break there.
Retirees receiving Social Security benefits should also be aware that increasing AGI by selling capital assets for a gain might trigger or increase taxes on Social Security benefits. You may pay no Federal capital gains tax on the stock sale only to see your Social Security taxes increase.
Of course, any withdrawals from a traditional IRA are taxed as ordinary income and don't receive capital gains preference, anyway. If you would pay the mortgage from those IRA investments, the zero capital gains tax would be irrelevant to the decision.
It's a fairly complicated tax issue and I recommend you discuss it with a tax pro before you sell. That's what I do.
Mostly, I recommend that you not simply assume that you won't have to pay capital gains taxes after you retire. Even if you have room to squeeze some tax-free gains under the 15% income tax bracket limit, other Federal taxes, like Social Security taxes, or state income taxes might come back to bite you in the butt.
Best to check with your tax guy before you sell and to keep this in mind when developing your retirement plan.
Retirees can have a broad range of tax situations, so I excluded taxes from those analyses. To adapt the analysis to your own financial situation, you should include tax considerations. You can do that by using your own after-tax mortgage cost, but you also have to use your after-tax expected portfolio returns.
In other words, you will be subtracting a lower mortgage payment from a lower expected portfolio rate of return to determine your expected after-tax return for the mortgage-to-invest strategy. The risk (variance) of this strategy, however, remains the same as that of your stock and bond portfolio, just as it did with the before-tax analysis.
The zero capital gains tax part of his question, however, deserves some discussion. Here are some important points.
I often read in the financial press that taxpayers will pay no capital gains taxes if taxable income does not exceed the upper limit of the 15% tax bracket, which will be $73,800 in 2014 for joint returns and $36,900 for single returns. While this is correct, it omits the fact that those capital gains will be added to your taxable income, possibly pushing some or all of your gains out of the zero capital gains tax bracket.
The maximum amount of capital gains that will go untaxed depends on the amount of your taxable income before the capital gains are added. The net effect is that tax-free gains are limited to the upper 15% tax bracket amount ($73,800 for joint returns in 2014) less your other taxable income.
Let's look at how the tax is calculated. Adjusted Gross Income (AGI) includes salary, taxable interest, ordinary dividends, traditional IRA distributions, income from pensions and annuities, and capital gains. From AGI, we subtract exemptions and deductions to arrive at taxable income. This is the figure we take to the tax tables to calculate how much tax we owe.
Let's say that Joe has $93,800 of combined annuity income, traditional IRA distributions, interest, and dividends and $20,000 of exemptions and deductions. His taxable income before selling stocks will be $73,800. Should Joe sell stocks with a long term capital gain of $10,000, all of the gain will be taxed at 15%, not zero. That's because his other $73,800 of taxable income has already pushed him out of the zero percent tax bracket before the capital gains are added.
Now, let's assume that Joe has just $20,000 of adjusted gross income but still has $20,000 of exemptions and deductions. His taxable income is zero. Now, if he sells stocks with a long term capital gain of $10,000, he will pay no capital gains tax on that sale. In fact, he could sell stocks with gains up to $73,800 and still pay no capital gains tax.
Any sum of "other taxable income" and capital gains exceeding $73,800 will have no capital gains tax due for the first $73,800, but the excess will be taxed at 15%.
Also, keep in mind that the zero capital gains tax bracket applies to Federal taxes. You may also be subject to state taxes and many (perhaps most) states tax capital gains the same as ordinary income. No break there.
Retirees receiving Social Security benefits should also be aware that increasing AGI by selling capital assets for a gain might trigger or increase taxes on Social Security benefits. You may pay no Federal capital gains tax on the stock sale only to see your Social Security taxes increase.
Of course, any withdrawals from a traditional IRA are taxed as ordinary income and don't receive capital gains preference, anyway. If you would pay the mortgage from those IRA investments, the zero capital gains tax would be irrelevant to the decision.
It's a fairly complicated tax issue and I recommend you discuss it with a tax pro before you sell. That's what I do.
Mostly, I recommend that you not simply assume that you won't have to pay capital gains taxes after you retire. Even if you have room to squeeze some tax-free gains under the 15% income tax bracket limit, other Federal taxes, like Social Security taxes, or state income taxes might come back to bite you in the butt.
Best to check with your tax guy before you sell and to keep this in mind when developing your retirement plan.
Friday, May 16, 2014
De-Leveraging
You've probably known people that you assume have about the same income as you but seem to live much more extravagantly. Maybe they own a bigger house, drive two new cars or take a couple of exotic vacations a year.
Although we can't know their financial situation for sure — maybe they do have more wealth than us — these households are sometimes described as having a "highly-leveraged lifestyle." What we typically mean is that they may be spending most of their income and not saving much. In a financial emergency, like a job loss or medical crisis, these families might burn through their savings pretty fast.
Before we retire, we could measure our "lifestyle leverage" by the number of months our savings would last if we suddenly lost our job. Fewer months means higher leverage and more risk.
We might cut back on discretionary spending in an emergency, but non-discretionary spending (the mortgage, food, etc.) often makes up the bulk of our budget and it could be difficult to significantly extend our savings in an emergency by cancelling HBO.
Furthermore, discretionary spending reduces savings, so being able to eliminate some of it in an emergency only solves half the problem.
The greater our lifestyle leverage, the greater our risk of a financial crisis or mortgage foreclosure before or after we retire.
There is a different way we can look at lifestyle leverage after we retire by using the calculations from sustainable withdrawal rate studies. The greater the percentage of our savings we spend annually, the greater our risk of outliving them.
Following is a chart of this data. As you can see, risk increases exponentially with the spending rate. That means that a small decrease in spending results in a disproportionately large decrease in risk, the probability of portfolio failure.
Retirees spending 5% of their portfolio value each year have a 24.7% probability of depleting their savings in thirty years. Those spending 10% less, or 4.5% a year, lower their probability of portfolio depletion to 8.2%. A 10% reduction in spending reduces the risk of portfolio depletion by 66.7%.
This works on a smaller scale, too. Reducing spending 2.2% from 4.5% to 4.4% reduces risk 29%.
Risk is highly leveraged when spending changes. Trimming spending a little can reduce risk a lot. And conversely, of course, spending a little more can increase your risk more than you might expect.
(An important point about these calculations. Wade Pfau showed in Say Goodbye to the 4% Rule, that future safe withdrawal rates may be closer to 3% than 4%. That will shift this curve significantly to the left. But while you may be able to spend less to get the same risk of portfolio depletion in the future, lowering that spending should still show an outsized reduction of risk.)
There are a number of ways to de-leverage our lifestyle, or said differently, to reduce the amount of spending from our stock and bond portfolio as a percentage of portfolio balance, after we retire. We can decrease the numerator (spending) or increase the denominator (savings).
Any reduction of spending, including cancelling HBO and limiting lattes will help by lowering the numerator (spending), but it will probably be difficult to meaningfully reduce risk by minor trimming.
Leverage is also reduced when we have a good year in the stock market (increasing the denominator) and increased when we don't.
Downsizing our home may both increase the denominator by converting home equity to more liquid investments and reduce the numerator by lowering house payments.
Paying off the mortgage may also reduce leverage, sometimes significantly. Paying off the mortgage will reduce spending, but it will presumably reduce the current portfolio balance by the amount of the mortgage payoff. Whether and to what extent the leverage ratio will be improved depends on whether the ratio of the current principal and interest portion of your annual house payments to the mortgage payoff amount is greater than your current spending ratio. You can usually find these numbers easily at your mortgagor's website.
(Downsizing your home may result in lower principal and interest payments, property taxes and insurance costs, but paying off the mortgage will only lower principal and interest payments.)
Here's an example.
Assume your current mortgage payoff amount is $100,000 and you pay $5,000 a year in principal and interest (P&I). The ratio is 5%. If you currently spend 4% a year from your stock and bond portfolio and have an adequate balance to pay off the mortgage, doing so will improve your lifestyle leverage, meaning it will lower your withdrawal rate and decrease your probability of portfolio failure.
Any P&I-to-Payoff ratio of 4% or less would not improve lifestyle leverage in this scenario.
The ratio of mortgage P&I to the mortgage payoff amount changes over time with a fixed rate mortgage. The payoff amount continually declines as you make payments and P&I remains constant, so the ratio grows over time, making it more likely that paying off the mortgage will improve your withdrawal rate.
For example, assume you take out a 30-year, $100,000 mortgage at 4%. Your annual payments would be $5,729. The first year of the mortgage, you would pay about $3,970 interest and $1,764 in principal. At the end of year one, the payoff balance would be $98,239 and the relevant ratio would be $5,729 / $98,239, or 5.8%.
At the end of year 10, the payoff would have declined to $78,784 and the P&I-to-Payoff ratio would have increased to $5,729 / $78,784, or 7.3%. When this ratio of P&I to payoff balance exceeds your portfolio spending rate, paying off the mortgage will improve your lifestyle leverage and reduce your chances of outliving your savings.
Any reduction of spending as a percentage of your current portfolio balance will lessen your risk. That means you have to also keep a careful watch on your remaining savings. Even with constant spending, your withdrawal rate will move up and down with your portfolio balance.
What does this mean in a nutshell? Portfolio depletion risk increases exponentially with the spending rate. Cutting costs even a little can have a big impact on your financial security. This is one more reason to consider downsizing your home or paying off the mortgage, but any spending reduction will help.
De-leveraging is an important tool for managing retirement financial risk. For under-savers, de-leveraging and maximizing Social Security benefits are likely to be the two most effective ways to maximize your assets.
Although we can't know their financial situation for sure — maybe they do have more wealth than us — these households are sometimes described as having a "highly-leveraged lifestyle." What we typically mean is that they may be spending most of their income and not saving much. In a financial emergency, like a job loss or medical crisis, these families might burn through their savings pretty fast.
Before we retire, we could measure our "lifestyle leverage" by the number of months our savings would last if we suddenly lost our job. Fewer months means higher leverage and more risk.
Furthermore, discretionary spending reduces savings, so being able to eliminate some of it in an emergency only solves half the problem.
The greater our lifestyle leverage, the greater our risk of a financial crisis or mortgage foreclosure before or after we retire.
There is a different way we can look at lifestyle leverage after we retire by using the calculations from sustainable withdrawal rate studies. The greater the percentage of our savings we spend annually, the greater our risk of outliving them.
I calculated the following portfolio survivability rates using the spreadsheet at the Retire Early Homepage. (This website has been around so long they call it a "homepage". That's a good thing. It's time-tested.)
This works on a smaller scale, too. Reducing spending 2.2% from 4.5% to 4.4% reduces risk 29%.
Risk is highly leveraged when spending changes. Trimming spending a little can reduce risk a lot. And conversely, of course, spending a little more can increase your risk more than you might expect.
(An important point about these calculations. Wade Pfau showed in Say Goodbye to the 4% Rule, that future safe withdrawal rates may be closer to 3% than 4%. That will shift this curve significantly to the left. But while you may be able to spend less to get the same risk of portfolio depletion in the future, lowering that spending should still show an outsized reduction of risk.)
There are a number of ways to de-leverage our lifestyle, or said differently, to reduce the amount of spending from our stock and bond portfolio as a percentage of portfolio balance, after we retire. We can decrease the numerator (spending) or increase the denominator (savings).
Any reduction of spending, including cancelling HBO and limiting lattes will help by lowering the numerator (spending), but it will probably be difficult to meaningfully reduce risk by minor trimming.
Leverage is also reduced when we have a good year in the stock market (increasing the denominator) and increased when we don't.
Downsizing our home may both increase the denominator by converting home equity to more liquid investments and reduce the numerator by lowering house payments.
Paying off the mortgage may also reduce leverage, sometimes significantly. Paying off the mortgage will reduce spending, but it will presumably reduce the current portfolio balance by the amount of the mortgage payoff. Whether and to what extent the leverage ratio will be improved depends on whether the ratio of the current principal and interest portion of your annual house payments to the mortgage payoff amount is greater than your current spending ratio. You can usually find these numbers easily at your mortgagor's website.
(Downsizing your home may result in lower principal and interest payments, property taxes and insurance costs, but paying off the mortgage will only lower principal and interest payments.)
Here's an example.
Assume your current mortgage payoff amount is $100,000 and you pay $5,000 a year in principal and interest (P&I). The ratio is 5%. If you currently spend 4% a year from your stock and bond portfolio and have an adequate balance to pay off the mortgage, doing so will improve your lifestyle leverage, meaning it will lower your withdrawal rate and decrease your probability of portfolio failure.
Any P&I-to-Payoff ratio of 4% or less would not improve lifestyle leverage in this scenario.
The ratio of mortgage P&I to the mortgage payoff amount changes over time with a fixed rate mortgage. The payoff amount continually declines as you make payments and P&I remains constant, so the ratio grows over time, making it more likely that paying off the mortgage will improve your withdrawal rate.
For example, assume you take out a 30-year, $100,000 mortgage at 4%. Your annual payments would be $5,729. The first year of the mortgage, you would pay about $3,970 interest and $1,764 in principal. At the end of year one, the payoff balance would be $98,239 and the relevant ratio would be $5,729 / $98,239, or 5.8%.
At the end of year 10, the payoff would have declined to $78,784 and the P&I-to-Payoff ratio would have increased to $5,729 / $78,784, or 7.3%. When this ratio of P&I to payoff balance exceeds your portfolio spending rate, paying off the mortgage will improve your lifestyle leverage and reduce your chances of outliving your savings.
Any reduction of spending as a percentage of your current portfolio balance will lessen your risk. That means you have to also keep a careful watch on your remaining savings. Even with constant spending, your withdrawal rate will move up and down with your portfolio balance.
What does this mean in a nutshell? Portfolio depletion risk increases exponentially with the spending rate. Cutting costs even a little can have a big impact on your financial security. This is one more reason to consider downsizing your home or paying off the mortgage, but any spending reduction will help.
De-leveraging is an important tool for managing retirement financial risk. For under-savers, de-leveraging and maximizing Social Security benefits are likely to be the two most effective ways to maximize your assets.
Monday, May 12, 2014
Pay Off the Mortgage, Right?
My last two blogs, Investing the Mortgage and Selling Stocks to Pay the Mortgage, delved into the mechanics of holding a mortgage and simultaneously holding an investment portfolio. My intent wasn't to advise that you should or should not pay off the mortgage, but rather to explain the bet, and to show that it changes after retirement.
The proposition is essentially this:
So, everyone should rush to pay off the mortgage, right?
Not necessarily.
If a wealthy client asked me if she should take out a mortgage on an unencumbered home for the sole purpose of leveraging her stock portfolio, I would not hesitate to say, "Absolutely not." Had she already retired, there is an even stronger case for forgoing a mortgage.
On the other hand, for a less wealthy household, paying off an existing mortgage might convert most of her liquid assets into illiquid home equity. Freeing up cash from home equity can be challenging. (A fixed rate mortgage, it should be noted, is a temporary solution to that problem.) Maybe I would recommend keeping the mortgage.
But, maybe I wouldn't.
Lawrence Kotlikoff, who built E$Planner, says that he has analyzed many mortgage payoff scenarios and he most often sees an improvement to the household's standard of living, though not always. This is more of a cash flow than a profitability analysis and I would see what consumption smoothing says about the client's finances before making that recommendation.
Regardless, many retirees will eventually pay off their mortgage and have to face the illiquidity problem. They may find that most of their wealth is tied up in home equity. Better to plan for it up front. The most effective solution may be downsizing or relocating. It may not be a mortgage issue, at all.
Should you pre-pay the mortgage instead of investing? I wouldn't advise my son to pre-pay instead of investing in a 401(k). The amount of money we need to save to retire comfortably is so large that investing in risky assets is the only realistic way to get there. Pre-paying the mortgage is too conservative an approach. You have to take the risk. But, once you feel that you have saved enough for retirement, or you actually retire, you no longer need that risk.
After you retire, however, if you hold investments that could pay off the mortgage, you're relying on future stock returns instead of a paycheck to pay the mortgage and that's riskier. You're betting your home that you will succeed in exchange for a net expected return that is lower than your expected portfolio return by the amount of your mortgage. Your net expected return will be sharply lower than that of your portfolio return, but your risk will be the same1.
As sustainable withdrawal rates studies showed, the higher the spending rate from your portfolio, the greater your risk of outliving your savings. Paying off the mortgage will probably reduce your withdrawal rate and thereby decrease your risk of depleting your savings. (I'll go into this "lifestyle leverage" in greater detail in a future post.)
Taxation may also be a consideration, though frequently a second-order problem after retirement. Consider taxes part of the calculation, not a certain justification for keeping a mortgage.
Lastly, there is a risk tolerance issue to consider. While many retirees will be comfortable with a higher withdrawal rate and more exposure to foreclosure risk, many will not. To quote a recent commenter on this blog,
If you're very wealthy, paying off the mortgage seems like a no-brainer. If you insist on portfolio leverage, open a margin account.
If you can't afford to pay it off, I suppose that's a no-brainer, too.
It's always the group in between that has the tough call. Investing the mortgage may not be the best bet, but sometimes it's the best bet on the table.
----------------------------------------------
1 Mathematically, we are subtracting a constant mortgage payment from a random variable representing our portfolio return. That random variable might have an expected return of 8% and a standard deviation of 12%, for example. The result of the subtraction is another random variable with an expected return of 8% minus the annual mortgage payment, but the standard deviation (risk) of the initial portfolio return random variable will remain unchanged. Lower return, same risk.
The proposition is essentially this:
"I bet that I can earn enough money investing in stocks and bonds to equal my mortgage payments and, further, to provide enough profit in excess of those payments to adequately reward me for exposing my home to greater foreclosure risk."History shows this isn't a great bet, that it certainly isn't easy money, and that it becomes a worse bet after retirement.
So, everyone should rush to pay off the mortgage, right?
Not necessarily.
If a wealthy client asked me if she should take out a mortgage on an unencumbered home for the sole purpose of leveraging her stock portfolio, I would not hesitate to say, "Absolutely not." Had she already retired, there is an even stronger case for forgoing a mortgage.
On the other hand, for a less wealthy household, paying off an existing mortgage might convert most of her liquid assets into illiquid home equity. Freeing up cash from home equity can be challenging. (A fixed rate mortgage, it should be noted, is a temporary solution to that problem.) Maybe I would recommend keeping the mortgage.
But, maybe I wouldn't.
Lawrence Kotlikoff, who built E$Planner, says that he has analyzed many mortgage payoff scenarios and he most often sees an improvement to the household's standard of living, though not always. This is more of a cash flow than a profitability analysis and I would see what consumption smoothing says about the client's finances before making that recommendation.
Regardless, many retirees will eventually pay off their mortgage and have to face the illiquidity problem. They may find that most of their wealth is tied up in home equity. Better to plan for it up front. The most effective solution may be downsizing or relocating. It may not be a mortgage issue, at all.
Should you pre-pay the mortgage instead of investing? I wouldn't advise my son to pre-pay instead of investing in a 401(k). The amount of money we need to save to retire comfortably is so large that investing in risky assets is the only realistic way to get there. Pre-paying the mortgage is too conservative an approach. You have to take the risk. But, once you feel that you have saved enough for retirement, or you actually retire, you no longer need that risk.
After you retire, however, if you hold investments that could pay off the mortgage, you're relying on future stock returns instead of a paycheck to pay the mortgage and that's riskier. You're betting your home that you will succeed in exchange for a net expected return that is lower than your expected portfolio return by the amount of your mortgage. Your net expected return will be sharply lower than that of your portfolio return, but your risk will be the same1.
As sustainable withdrawal rates studies showed, the higher the spending rate from your portfolio, the greater your risk of outliving your savings. Paying off the mortgage will probably reduce your withdrawal rate and thereby decrease your risk of depleting your savings. (I'll go into this "lifestyle leverage" in greater detail in a future post.)
Taxation may also be a consideration, though frequently a second-order problem after retirement. Consider taxes part of the calculation, not a certain justification for keeping a mortgage.
Lastly, there is a risk tolerance issue to consider. While many retirees will be comfortable with a higher withdrawal rate and more exposure to foreclosure risk, many will not. To quote a recent commenter on this blog,
"I am SO glad, now that I am retired, that we didn't load up on mortgage debt that we'd now have to service. Our house got paid off 6 years ago and wow, does that make a difference in retirement security. "As you can see, there is significantly more to consider than expected portfolio returns and current mortgage rates when you consider paying off the mortgage. I would want to answer the following questions:
- Will paying off the mortgage significantly improve my standard of living? (Calculate with E$Planner.)
- Will I have adequate liquid assets after paying it off?
- What is my foreclosure risk before and after a payoff?
- What is my portfolio withdrawal rate and risk of portfolio failure before and after payoff?
- Will I sleep better knowing my home is paid off?
- What are the tax implications of paying off the mortgage and of not doing so?
- If I am still accumulating retirement savings, will paying off the mortgage leave me with too little market risk to achieve my goals?
If you're very wealthy, paying off the mortgage seems like a no-brainer. If you insist on portfolio leverage, open a margin account.
If you can't afford to pay it off, I suppose that's a no-brainer, too.
It's always the group in between that has the tough call. Investing the mortgage may not be the best bet, but sometimes it's the best bet on the table.
----------------------------------------------
1 Mathematically, we are subtracting a constant mortgage payment from a random variable representing our portfolio return. That random variable might have an expected return of 8% and a standard deviation of 12%, for example. The result of the subtraction is another random variable with an expected return of 8% minus the annual mortgage payment, but the standard deviation (risk) of the initial portfolio return random variable will remain unchanged. Lower return, same risk.
Monday, May 5, 2014
Selling Stocks to Pay the Mortgage
In my last post, Investing the Mortgage, I showed that the profit from borrowing a mortgage and investing the proceeds in the stock market is far more complicated to predict than simply subtracting the mortgage rate from the expected rate of your portfolio return. In fact, historically, this strategy would have resulted in a wide range of outcomes, the financial definition of risky.
I repeat the chart of outcomes from that post below. Note that the worst case outcome was a $37,333 loss, the best case was a $133,287 gain, and the median profit from this strategy would have been $26,937. (If you haven't read Investing the Mortgage, I suggest that you do so first. It explains the analysis in more detail.)
Once we retire and begin paying the bills from a portfolio of stocks and bonds, there are two subtle changes in our finances that can have a significant impact on the profitability of mortgage-to-invest.
The first difference is that we can't really borrow money and invest it in the market — not all of it, anyway — because we have to start paying it back almost immediately from our investments. If we borrow a 4% fixed rate thirty-year mortgage of $100,000, the payments will be about $5,724 a year and we will reduce our portfolio by that amount annually. The average amount of the $100,000 that would remain invested each year over a ten-year period would be a little more than $74,000. With less money invested, of course, our portfolio will grow more slowly.
When we pay the mortgage from future paychecks, as I modeled in the last post, we have the luxury of leaving all of the borrowed funds in the market for the entire 10-year period. If the market goes up, as we hope, holding more stocks will earn more money.
The second difference, which may be less obvious, is that spending from a stock portfolio over time, to pay the mortgage or anything else, creates sequence of returns risk. (See my posts on the topic if this is unfamiliar to you.)
Here's an example.
The following table shows the historical sequence of returns a 50/50 portfolio would have experienced from 1981 through 1990. The second row shows the least advantageous sequence of those same returns (sorted smallest to largest) for an investor spending down a stock and bond portfolio. The third row shows the best case sequence for this investor (returns sorted highest to lowest).
(Double-click to enlarge the table.)
In all three scenarios, the compound growth rate is the same, 8.7%, and that would be our return if we didn't sell stocks along the way to pay the mortgage. Without portfolio spending, there is no sequence of returns risk. The terminal portfolio value will be the same regardless of the order of the returns.
However, if we assume that the retiree has a portfolio valued at $100,000 and is spending say, 4% of the initial portfolio value each year ($4,000), then her portfolio value at the end of this 10-year period would be different in all three cases. The historical value of the portfolio would be $168,470, the best possible outcome would have been $184,820, and the worst $147,988.
This range of values that results from reordering the returns is sequence of returns (SOR) risk. It isn't "good" risk. It can't be diversified away and we aren't compensated for it by the market. And like SOR risk in retirement portfolios, early losses have a disproportionately bad impact on the mortgage-to-invest strategy outcome.
The combined impact of reducing stock exposure and adding sequence of return risk can be fairly dramatic. I altered the model from my last post such that mortgage payments are made each year by selling stocks and bonds from the portfolio, as a retiree might do, instead of paying them from salary and only selling stocks at the end of ten years, as someone still working would.
In the following chart, I compare the historical outcomes of the mortgage-to-invest strategy using a $100,000 mortgage assuming the investor is still working and paying the mortgage from salary (the blue columns from my last post) with the historical outcomes assuming a retiree pays the mortgage by spending down a portfolio of stocks and bonds (red columns).
The median profit from this strategy during the 10-year rolling periods from 1928 through 2013 declined from $26,937 to $9,374 when the mortgage is paid from stock sales instead of one's salary. This isn't surprising, given that this strategy significantly reduces the amount we have invested in the market over time. The best and worst cases are shown in the table below.
The analysis is pretty much the same, by the way, if we inherit $100,000 and decide to invest it rather than pay down the mortgage, or if we simply decide to continue to hold a stock portfolio and owe a mortgage simultaneously.
A couple of observations. First, many people will find it difficult, before or after retirement, to pay off the mortgage by selling their investments. Maintaining some reserves and liquidity are important, too. We can argue that if paying off the mortgage requires converting too much of your wealth into illiquid home equity that you should consider downsizing, but life isn't always that neat. Paying off the mortgage isn't the right answer for everyone.
Second, for many households, mortgage-to-invest isn't an intentionally chosen strategy, but one that simply developed over time. You bought a house with a mortgage. You invested in a 401(k). You retired and began paying the mortgage and other bills with portfolio spending. Your risk increased unnoticed.
In either case, it is important to understand the risks and rewards and at least consider the alternatives of downsizing or paying off the mortgage if those are options for you. The analysis isn't as simple as "I have a 4% mortgage and I can earn 8% on my investments."
Regardless, as I mentioned in Investing the Mortgage, this strategy increases the chances both before and after retirement that you will lose your home to foreclosure risk, which, in my opinion, trumps any other home financing risk.
I have another basic concern with this strategy after retirement. While it makes perfect sense to borrow a mortgage when we are young, expecting to pay it back with future job earnings, it is a riskier proposition to borrow a mortgage and expect to pay it back with future stock market earnings.
I often point out that our finances change significantly after we retire and we can't view them through the same set of guidelines as before. This is a prime example.
In my next post, I'll discuss when you might want to make this bet.
I repeat the chart of outcomes from that post below. Note that the worst case outcome was a $37,333 loss, the best case was a $133,287 gain, and the median profit from this strategy would have been $26,937. (If you haven't read Investing the Mortgage, I suggest that you do so first. It explains the analysis in more detail.)
The first difference is that we can't really borrow money and invest it in the market — not all of it, anyway — because we have to start paying it back almost immediately from our investments. If we borrow a 4% fixed rate thirty-year mortgage of $100,000, the payments will be about $5,724 a year and we will reduce our portfolio by that amount annually. The average amount of the $100,000 that would remain invested each year over a ten-year period would be a little more than $74,000. With less money invested, of course, our portfolio will grow more slowly.
When we pay the mortgage from future paychecks, as I modeled in the last post, we have the luxury of leaving all of the borrowed funds in the market for the entire 10-year period. If the market goes up, as we hope, holding more stocks will earn more money.
The second difference, which may be less obvious, is that spending from a stock portfolio over time, to pay the mortgage or anything else, creates sequence of returns risk. (See my posts on the topic if this is unfamiliar to you.)
Here's an example.
The following table shows the historical sequence of returns a 50/50 portfolio would have experienced from 1981 through 1990. The second row shows the least advantageous sequence of those same returns (sorted smallest to largest) for an investor spending down a stock and bond portfolio. The third row shows the best case sequence for this investor (returns sorted highest to lowest).
In all three scenarios, the compound growth rate is the same, 8.7%, and that would be our return if we didn't sell stocks along the way to pay the mortgage. Without portfolio spending, there is no sequence of returns risk. The terminal portfolio value will be the same regardless of the order of the returns.
However, if we assume that the retiree has a portfolio valued at $100,000 and is spending say, 4% of the initial portfolio value each year ($4,000), then her portfolio value at the end of this 10-year period would be different in all three cases. The historical value of the portfolio would be $168,470, the best possible outcome would have been $184,820, and the worst $147,988.
This range of values that results from reordering the returns is sequence of returns (SOR) risk. It isn't "good" risk. It can't be diversified away and we aren't compensated for it by the market. And like SOR risk in retirement portfolios, early losses have a disproportionately bad impact on the mortgage-to-invest strategy outcome.
The combined impact of reducing stock exposure and adding sequence of return risk can be fairly dramatic. I altered the model from my last post such that mortgage payments are made each year by selling stocks and bonds from the portfolio, as a retiree might do, instead of paying them from salary and only selling stocks at the end of ten years, as someone still working would.
In the following chart, I compare the historical outcomes of the mortgage-to-invest strategy using a $100,000 mortgage assuming the investor is still working and paying the mortgage from salary (the blue columns from my last post) with the historical outcomes assuming a retiree pays the mortgage by spending down a portfolio of stocks and bonds (red columns).
As you can see from the chart above, mortgage-to-invest can be a fairly risky strategy. You can lose a lot of money even when you pay the mortgage from salary. Even if you're still working, a $100,000 bet could have resulted in a profit of $133,287 if you executed it from 1989 to 1998, or a loss of $37,733 if you employed it from 2000 to 2009. That's pretty risky.
After you retire and begin selling stocks to pay the bills, the outcomes are even worse. You lose more in worst cases and your expected return on this strategy dropped 65% over the studied period.
The analysis is pretty much the same, by the way, if we inherit $100,000 and decide to invest it rather than pay down the mortgage, or if we simply decide to continue to hold a stock portfolio and owe a mortgage simultaneously.
A couple of observations. First, many people will find it difficult, before or after retirement, to pay off the mortgage by selling their investments. Maintaining some reserves and liquidity are important, too. We can argue that if paying off the mortgage requires converting too much of your wealth into illiquid home equity that you should consider downsizing, but life isn't always that neat. Paying off the mortgage isn't the right answer for everyone.
Second, for many households, mortgage-to-invest isn't an intentionally chosen strategy, but one that simply developed over time. You bought a house with a mortgage. You invested in a 401(k). You retired and began paying the mortgage and other bills with portfolio spending. Your risk increased unnoticed.
In either case, it is important to understand the risks and rewards and at least consider the alternatives of downsizing or paying off the mortgage if those are options for you. The analysis isn't as simple as "I have a 4% mortgage and I can earn 8% on my investments."
Regardless, as I mentioned in Investing the Mortgage, this strategy increases the chances both before and after retirement that you will lose your home to foreclosure risk, which, in my opinion, trumps any other home financing risk.
I have another basic concern with this strategy after retirement. While it makes perfect sense to borrow a mortgage when we are young, expecting to pay it back with future job earnings, it is a riskier proposition to borrow a mortgage and expect to pay it back with future stock market earnings.
I often point out that our finances change significantly after we retire and we can't view them through the same set of guidelines as before. This is a prime example.
In my next post, I'll discuss when you might want to make this bet.
Thursday, May 1, 2014
Investing the Mortgage
Can you borrow a mortgage at 4%, earn 8% in the stock market with the borrowed funds and pocket a fairly certain 4% annual profit?
This comparison suggests that the two percentages (growth rate and interest rate) are applied to the same balance each year. The math isn't nearly that simple. After the first year, those balances are unlikely to ever be the same again.
Mortgage interest is calculated by multiplying the interest rate (4% in this case) by the current principal balance, which declines predictably and gradually for the first ten years or so, but is paid down faster over time. Portfolio returns are calculated by multiplying a highly variable annual rate of return by a current balance that can grow or decline substantially over time. They're two very different animals.
The simple math would work better if the earnings were risk-free. But, when the annual returns vary as stock returns do, the math switches from simply subtracting percentages to dealing with random variables.
To explain my point, I modeled real stock and bond returns and historical mortgage rates1 for 76 ten-year rolling periods from 1928 to 2013. Each year, I assumed that an investor borrowed a 30-year fixed rate mortgage (FRM) at the average mortgage rate that year and held the mortgage for 10 years. (The average mortgage gets paid off after about 7 years.)
I assumed that the investor then invested the $100,000 in a portfolio of 50% S&P 500 index and 50% 10-Year U.S. Treasury Notes. At the end of ten years, the investor cashes in the portfolio, pays off the mortgage balance and I calculate his profit or loss, as shown in the chart below.
Although the annual FRM mortgage payments remain a constant dollar amount throughout the term, I converted those payments to the value of dollars from the first year of the period. In inflationary times, mortgage payments get paid with cheaper dollars over time, and with more expensive dollars over time when there is deflation. The model accounts for this.
The answer you get when you subtract a constant 4% mortgage from a random variable like 8% expected market returns is not 4%. It's another random variable with an expected return of 4% but the same standard deviation (risk) as the market. In other words, a significantly lower expected return than the market, but the same amount of risk.
As the chart shows, there will be a lot of winners and a lot of losers when you look at the entire sample results. Using this strategy, however, you will become one or the other, not the average.
1Mortgage rates were downloaded from FRED back to 1972. Prior to 1972, mortgage rates are estimated from 30-year US Treasury Bond rates.
This comparison suggests that the two percentages (growth rate and interest rate) are applied to the same balance each year. The math isn't nearly that simple. After the first year, those balances are unlikely to ever be the same again.
Mortgage interest is calculated by multiplying the interest rate (4% in this case) by the current principal balance, which declines predictably and gradually for the first ten years or so, but is paid down faster over time. Portfolio returns are calculated by multiplying a highly variable annual rate of return by a current balance that can grow or decline substantially over time. They're two very different animals.
The simple math would work better if the earnings were risk-free. But, when the annual returns vary as stock returns do, the math switches from simply subtracting percentages to dealing with random variables.
To explain my point, I modeled real stock and bond returns and historical mortgage rates1 for 76 ten-year rolling periods from 1928 to 2013. Each year, I assumed that an investor borrowed a 30-year fixed rate mortgage (FRM) at the average mortgage rate that year and held the mortgage for 10 years. (The average mortgage gets paid off after about 7 years.)
I assumed that the investor then invested the $100,000 in a portfolio of 50% S&P 500 index and 50% 10-Year U.S. Treasury Notes. At the end of ten years, the investor cashes in the portfolio, pays off the mortgage balance and I calculate his profit or loss, as shown in the chart below.
Although the annual FRM mortgage payments remain a constant dollar amount throughout the term, I converted those payments to the value of dollars from the first year of the period. In inflationary times, mortgage payments get paid with cheaper dollars over time, and with more expensive dollars over time when there is deflation. The model accounts for this.
The average mortgage rate during this time was 7% and the annualized real return on the 50/50 portfolio was 4.6%. The annualized nominal 50/50 portfolio gain was 7.8%.
If portfolios returned 7.8% and mortgages cost 7%, you might expect this mortgage-to-invest approach to generate a 0.8% a year profit and if lots of people had tried this at lots of times since 1928, the average gain from this strategy for all of those investors combined would have been about 0.8% annually.
But, if you were one of those investors, you might have seen gains much different than 0.8%. A $100,000 investment earning 0.8% for 10 years would generate a gain of $8,294. Instead, you would have ended up with one specific outcome from the chart above. Those outcomes range from a loss of $37,733 to a gain of $133,287. The median profit was $26,937.
Nearly 40% of the outcomes were below the return you might expect when portfolio returns exceed mortgage rates by 0.8%.
A range of outcomes that broad is far from risk-free.
If we sort the periods by mortgage rates, about 8% of the negative outcomes occur when the mortgage rate is below the median of 5.8%, demonstrating that the strategy can lose money about one out of twelve times even when the mortgage rate at which we borrow is historically low.
The failure rate, however, increases to 17% when mortgage rates are above the median. This suggests an obvious strategy: don't mortgage to invest when mortgage rates are historically high, but that should be obvious.
The failure rate is 22% when the market return for the 10-year period is lower than the median 4.74%, and only 3% when returns fall into the upper half. These returns aren't knowable when you invest, of course, so this information doesn't help with your investment decision. Market returns explain about 90% of profitability and mortgage rates explain about 20%.
The worst case outcome was the 10-year period beginning in 2000 when 30-year mortgage rates were 8% but the market would only return a real 1% per year for the following decade. The mortgage-to-invest strategy would have shown a $37,700 loss.
The best outcome came from executing the strategy in 1989 when mortgage rates were at 10.3% and the market would return 11.4% annually over the boom decade of the nineties. The strategy would have shown a profit of more than $133,000. That's an enormous range of outcomes, which is to say that it's a risky investment.
William Bernstein has noted that an individual's success in financing retirement is largely dependent upon the year when he or she is born. The magnitude and sequence of investment returns can change dramatically if those returns are shifted a single year.
Starting a ten-year period with this mortgage-to-invest strategy can also be greatly impacted by a shift of a single year. Take a look at the ten-year period beginning in 1987, in which this strategy netted a profit of $59,388 and the one beginning in 1988 that netted a $106,937 profit, an increase of $47,549. Why such a large difference?
As you can see from the following table, the period beginning in 1988 jettisoned the 3.18% portfolio loss in 1987 and added the 19.22% gain from 1997, resulting in an improvement of outcomes near $48,000 if you started a year later. The strategy worked much better from 1988 to 1997 than from 1987 to 1996, even though mortgage rates were nearly identical at 10.2% in 1987 and 10.3% in 1988.
Don't overlook foreclosure risk.
If you mortgage your home so you can invest in stocks, you increase the risk that you will not be able to repay your mortgage and lose your home to foreclosure. The risk is multiplied when the failure of your mortgage-to-invest strategy coincides with an economic downturn, which is highly probable. Failure of this strategy means you probably had a high mortgage rate and/or experienced low market returns. Your chances of losing your employment increase at those times, as well.
Late in 2007, home values crashed, stocks crashed and unemployment soared simultaneously. A lot of people lost their homes.
I am not recommending that you do or do not "mortgage to invest". I only suggest that you understand the risks and rewards before you do. This strategy is far from a sure thing.
This is not ground-breaking analysis. I present it for two reasons. First, many readers will not have read the previous studies and should be advised of the risks. And, second, this example builds the foundation for what I really want to talk about: the difference between implementing this strategy while you're still working and executing it after you retire.
I'll cover that in Selling Stocks to Pay the Mortgage.
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FOOTNOTES:
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