Even Your Portfolio Heals More Slowly as You Get Older

I mentioned in my last post that there is a larger message than “investing is really tough after you retire”. It’s about the amount of risk you can handle after retiring. It will be much harder to recover from steep portfolio losses after you simultaneously begin spending your savings and foregoing new savings contribution — and your employer’s match, if you get one.

The mantra of the financial services industry is “just hang in there through bear markets and you’ll eventually earn it all back.”

But it’s a different game after you retire. Your portfolio will recover much more slowly.

Your retirement savings account is like a rain barrel. Rains (stock market gains) fill the barrel. While you’re working, you dump in a little more water from the faucet (savings contributions) on a regular basis. You never take any out. The barrel fills relatively quickly.

After retiring, you not only stop dumping in regular additional water, you begin drinking the water daily (spending your savings). It’s a different equation.

The financial services industry will tell you that stocks get safer the longer you hold them. They don’t. To quote Zvi Bodie, stocks are risky no matter how long you hold them. And the longer you invest, the larger your portfolio becomes and the more money you lose when the market drops say, 15%.

They say that if you simply stay in the market long enough, your portfolio will eventually recover its losses. That part is probably true, so long as the U.S. economy continues to grow and you gloss over “long enough”.

The 2007 crash took about 5 years for the S&P 500 to correct, but that probably isn’t the same as your own portfolio. Most investors don’t see anywhere near market index returns or invest solely in an S&P 500 index fund, so your individual recovery time may be much longer. Also, working investors are probably adding new savings while retired investors are probably spending some of their savings.

Let’s look at Working Guy and Retired Guy and how each might have fared after 2007.

When the S&P 500 peaked in October 2007, Working Guy and Retired Guy both had retirement savings portfolios worth $100,000.

Working Guy saved $4,000 a year in a 401(k) plan and never had to spend any savings before retirement. His paycheck covered the bills. His employer contributed a matching $2,000 each year. He held 80% of his portfolio in an S&P 500 index fund (SPY) and 20% in Vanguard Total Bond Market fund (VBMFX).

Retired Guy no longer contributed to retirement savings and he had decided to spend 4.5% of his initial portfolio value each year, or $4,500. Retired Guy knew he should take less market risk after he retired, so he held only 20% of his portfolio in the same stock index fund as Working Guy and the remainder in the same Vanguard Total Bond Market fund.

In a year when the market breaks even, Working Guy’s portfolio increases $6,000 and Retired Guy’s portfolio shrinks $4,500. That $10,500 difference every year is a lot — 10.5% of a $100,000 portfolio.

The following chart from Yahoo! Finance data shows what happened to the S&P 500 index fund SPY. After peaking in October 2007, the index fell 54% by March 2009. It recovered its October 2007 peak value in August 2012, 4 years and 10 months after it peaked.

An investor who stayed fully invested in an S&P 500 index fund would have recovered his portfolio value in that 58 months if he neither continued to save nor spend from his savings.

But Working Guy saves $6,000 a year while Retired Guy spends $4,500.

As you can see in the next chart, Retired Guy’s 30% stock portfolio fell 17% and Working Guy’s portfolio fell 37% before heading back upward. Working Guy’s losses would have been even greater because of his larger stock allocation, but Working Guy and his employer shoveled $9,000 of new cash into the teeth of a gut-wrenching, money-shredding, 17-month decline while Retired Guy did not. Not only did Retired Guy not put more money into his portfolio, he spent $6,750.

Working Guy’s portfolio then moved upward and recovered in January 2010, 27 months after the market’s peak and 31 months sooner than the S&P 500 index.

In August 2012, media pundits were saying, “If you had only stayed in the market, you’d have recovered your losses by now.” But that wasn’t true for either Guy, was it?

Working Guy’s portfolio had actually recovered 31 months earlier and Retired Guy’s 20% stock portfolio wouldn’t recover for 9 more months. In fact, had Retired Guy held more than 30% of his portfolio in stocks, his portfolio still hasn’t recovered after nearly 6 years.

If the bull market continues, a “Retired Guy” 40% portfolio will probably recover in a year or so, taking twice as long as Working Guy’s. If the bull market continues.

On the other hand, the nature of retirement portfolios is that they will be spent down over the retiree’s remaining life and it’s quite likely that many retirees and near-retirees who endured the 2007-2009 crash will never recover their October 2007 portfolio value.

If they had it to do over, they would have held less stock.

My point in all this is that it is much harder to recover from a severe market decline after you retire than it is before. See that blue line on the chart? That ain’t you, anymore. That line is headed upward, probably, until retirement. Yours is probably headed the other way.

When you get older, everything heals more slowly. Even your portfolio. You have to think hard about not getting hurt badly in the first place.

In the decade before retirement, when we can make “catch-up contributions” to retirement savings, we become really spoiled by fast recoveries from crashes. We become confused about how much of our “investment skill” is actually just saving more.

When the super-saving stops and the drawing down of savings begins, our sleds hit that patch of dry pavement at the bottom of the hill. Our momentum dies quickly and then we have to carry the sled back up that hill.

The sled ride downhill is a lot more fun.

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Note: I must apologize for a spreadsheet error in the initial draft of this post that over-valued bond portfolios for Retired Guy.  The result was that the 63-month recovery period reported for Retired Guy's 40% portfolio should have been a 67-month recovery for a 30% portfolio. Correcting this mistake actually strengthens the arguments. Only a 30% Retired Guy portfolio has recovered its October 2007 value as of this writing, so the 40% portfolio used was replaced with the 30% portfolio.

Event	Date	Months after October 2007 Peak
S&P 500 peaks at 14,164	October 9, 2007
S&P 500 reaches a bottom at 6,6594, down 53%	March 5, 2009	16
Working Guy’s portfolio recovers	January 14, 2010	27
S&P 500, adjusted for splits and dividends, recovers to October 2007 level	August 16, 2012	58
Retired Guy’s 30% Stock Portfolio recovers	May 21, 2013	67

Retirement Changes the Game

The challenges of financing retirement change dramatically on the day you retire.

You may imagine that retiring with adequate savings one day will feel like winning. But you’re really just taking a lead into the locker room at halftime. In reality, the game will have changed and the challenges will be even greater in many ways when you return to the court for the second half. The goal shifts from accumulating a pile of money to making a pile of money last.

It’s a different game.

We refer to the period before retirement as the accumulation phase because our goal is to accumulate enough wealth to maintain our pre-retirement standard of living after we retire and the paychecks end. We call the period after retiring the decumulation, or spending phase because our objective then becomes stretching out our wealth to pay our bills for the rest of our lives.

The accumulation environment is very different than the spending environment. Here are some of the important characteristics of accumulation:

·       We have jobs and paychecks that cover our living expenses. The paychecks arrive, for the most part, during both bull and bear markets. A temporary loss in the stock market may not affect our spending at all.

·       We hopefully have some money left over to save in a retirement account and to increase its value.

·       We can take some risk with our investments, because we don’t need that money to live on (yet) and that generally means we can earn a higher return.

·       Our investment returns apply to a growing base of capital as our wealth grows. When we are 30, we might earn 8% a year on a $20,000 portfolio, or $1,600. When we are 60, we might earn that same 8% on a portfolio of $500,000, yielding $40,000.

·       Dollar Cost Averaging (investing the same amount of money every year) allows us to buy stocks at lower prices over time.

·       We could lose our entire retirement savings portfolio and possibly have time to rebuild it before we retire.

·       We may have health insurance paid for by our employer.

Here are some important characteristics of the spending phase:

·       No more paychecks. Expenses are paid from our savings.

·       No more savings contributions. Our portfolio increases only when our investments do well.

·       We need to reduce investment risk, because we no longer have paychecks to bail us out during bear markets. That generally means a lower return on our investments. We might expect a 6% portfolio return instead of 8%, for example.

·       Our investment returns apply to a shrinking base of capital as our portfolio is being depleted. Even if we earned 8% every year, it would return 8% of a (probably) smaller number every year.

·       Dollar Cost Averaging works in reverse. We spend roughly the same amount every year so we sell more stocks at lower prices and fewer stocks at higher prices.

·       We pay for health insurance out of our own pockets. It is very expensive.

·       Since we are no longer working, when the retirement savings is gone, it’s gone.

·       On the positive side, we no longer pay FICA taxes and no longer need to save for retirement.

If accumulation is like sailing a boat with fair winds and a following sea, as they say, with plenty of fuel for the engine if the winds die down, then investing in the spending phase is like pounding into the current with strong headwinds in a boat that’s growing heavier as it takes on water and has spent its fuel reserves.

During the accumulation phase, you’re contributing to savings and not spending from savings. In the spending phase, you’re doing the reverse. And probably earning a lower return to boot.

A retiree spending 4% of her savings each year adjusted for inflation has to earn 4% plus the rate of inflation plus the cost of taxes and commissions on her investments just for her portfolio to break even that year.

Let’s say John has a portfolio worth $100,000. His investments return 8% one year and inflation runs 3% for an inflation-adjusted rate of return of 4.85%. (This example is in constant dollars.)

This younger John contributes $4,000 at the first of the year to his 401(k) account. Before retirement, his portfolio increases to $104,854 plus $4,000 of new savings for a new value of $108,854.

Because John’s portfolio is growing, a 4.85% inflation-adjusted return next year will provide an additional $5,284 of real value (4.85% of $108,854).

If this scenario occurs after retirement, the older John still earns $4,850 in the market, but his portfolio shrinks a bit from spending $4,000. He is no longer contributing to his 401(k), so his portfolio value ends the year at $100,854.

Because older John’s portfolio is shrinking in the spending phase, an 8% return next year with 3% annual inflation will provide only $4,896 of real value, 7.4% less than younger John’s portfolio would earn.

And so it goes, on and on.

There is a larger message here than “investing is really tough after you retire” that I will address in my next post. It’s about the amount of risk you can actually handle after you retire, because it will be much harder to recover from large portfolio losses.

I used a sailboat analogy to describe the difference between accumulation and spending phase economics, but having just finished my eighth year of retirement and surviving the 2008 market crash, the real estate crash, seventeen grand a year for family health insurance, two kids still in college and a third in med school, I can think of a more visceral analogy for how investment feels after you retire.

Remember when you were a kid sledding on a hilly street of packed snow and near the bottom, at top speed, your runners ran into a patch of dry pavement?

Yeah, sort of like that.

Cashing Out

I recently received an interesting e-mail from a friend nearing retirement. He told me that he believed his portfolio had recently reached seven figures and wondered if I thought he should “cash out” soon.

I wasn’t sure precisely what he meant by “cash out”, though I assumed he meant sell his stocks and probably his bonds, so I asked, “What would you do with the money if you cashed out?”

“Retire,” he replied. “Maybe buy a bigger sailboat.”

Good answers, as the game show hosts like to say, but not what we were looking for.

“I meant to ask where you would hold your money until you need to spend it,” I responded. “In a savings account? Under your mattress? Mattresses are actually paying competitive returns on cash lately.”

If you believe “Safe Withdrawal Rate” (SWR) advocates, then you probably assume you might be able to spend about 4-½% of your retirement nest egg each year and have a 94% probability of your savings lasting 30 years or more¹. 

I don’t believe this for an instant, mind you. The so-called SWR analysis is fatally flawed, but I think it can serve as a comparison of the alternatives.

Using the same data, the analysis shows that if you hold your retirement savings in money market accounts, you have only a 31% chance of your money lasting 30 years or more with a 4-½% annual spending rate.

I have no confidence that a retiree today could invest in a 60/40 stock portfolio, spend 4-½% annually and remain solvent for thirty years, but I might be convinced that socking savings away in a money market account would be roughly three times worse.

SWR believers would say my friend could lower his spending rate to about 2.8% a year and get close to that 94% survivability rate. With a million dollar portfolio then, my friend could spend $45,000 a year if he stays in stocks, but only $28,000 a year if he “cashes out”. Of course, this is in addition to the income he and his wife will receive from Social Security benefits, so either way they’re better off than 95% of the retiring U.S. workforce in 2013.

Another alternative would be for my friend to sell his portfolio and buy a lifetime fixed annuity from an insurance company, but the last time I looked they were only paying around 3.5% annually for an inflation-protected annuity. If he were worried about market risk, that might be a reasonable thing to do, but he’d still have to worry about the financial health of the insurer.

Furthermore, the sweet spot for annuities is around age 70, so he might be better off staying in stocks for a few more years until he can get a better deal. Maybe interest rates will rise by then, helping even more.

So, you can’t just “cash out” your stock portfolio and declare victory on the day you retire. You may have made it through the accumulation phase with enough savings to maintain your standard of living in retirement, but in many ways the spending phase is tougher. You have to make that portfolio last for the rest of your life.

You might be able to do that with a portfolio of stocks and bonds, or by purchasing a lifetime annuity, but it will be nearly impossible to achieve with cash alone.

While “cashing out” your portfolio when you retire is probably a poor strategy, reducing your risk is not. A bear market just before or just after retirement can destroy your retirement plans, as many retirees learned in the 2007-2008 stock market and real estate crash. That means lowering your stock allocation to somewhere around 40% to 50%, in my opinion, and that’s probably what my friend should do, if he hasn't already.

According to William Bernstein's The Intelligent Asset Allocator, an 80% stock portfolio would probably suffer a decline of no more than 35% in a bad bear market, while a 40% stock portfolio should lose no more than 15%.

I typically cover topics that might help retirees who haven’t saved enough and this one obviously applies to people with significant retirement savings. The transition period just before and after retirement is very interesting for those with large portfolios, though, so I will digress a bit over my next few blogs to discuss that topic.

My point today, however, is that your investment challenges don’t end the day you retire. In fact, they become more difficult. Not only do you no longer have income from work, you're spending down your portfolio and you may need to take less risk with your investments, which more often than not means lower returns.

You'll need more help solving that problem than you're going to get from cash.

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¹Safe Withdrawal Rate calculations are based on the spreadsheet provided by The Retire Early Homepage.

A $2.5 Million Dollar Rant

I recently worked with a married couple to help them develop a retirement plan. They have no children and have been able to save a whopping 2.5 million dollars for retirement. Let’s call them John and Sally to respect their privacy.

Two and a half million dollars is a lot more than most families have been able to save. Less than 10% of U.S. families approaching retirement have even saved $200,000 or more and about half have been unable to save anything at all for their “golden years”. For most Americans, our retirement system doesn't work.

In our initial discussions, John and Sally told me that they believed they would need about $55,000 a year to retire on. I was able to show them that they can probably (a key word that I'll come back to) spend much more than that. Possibly twice as much.

So, I was quite surprised a week or so later to receive the following e-mail that John later described as a “rant”. (I tweaked it a bit to protect their privacy.)

“I feel a little discouraged with the $77K discretionary income figure (compared to our living expense today at $50K) especially considering 1) Sally's Social Security amount may be over-stated, though I hope not, 2) we have not set aside anything for long term care expense best I can tell, and 3) we're not paying the full freight on healthcare today. 

Not quite sure how the average Joe is supposed to prepare for retirement. We have not had any children (of course we weren't married until Sally was 48 and I was 55), I've saved about all I could most of my life. Sort of discouraging. Thanks for listening. We'll be back in touch with Sally’s Social Security verification. John”

I’m not sure how the average Joe is supposed to do that, either, John. A couple of kids would have pared down your savings a ton.

We were running some worst-case scenarios through E$Planner and the initial forecast of their discretionary income had dropped, not surprisingly, from $128K annually to $77K when we lowered the stock market return estimate to 2.5% per year. (Note that the “worst-case” forecast was still $22K per year higher than the $55K they believed they needed.)

On the plus side, Sally subsequently called the Social Security Administration and confirmed that the benefits estimate I provided her was correct and not overstated, even though it was significantly higher than what SSA had originally estimated for her. Furthermore, we showed that their long-term care risks were already well mitigated.

As for health insurance costs, I shared their concern. For people retiring before becoming eligible for Medicare (John wants to retire at 59), I believe health care costs are the greatest risk, but a retirement plan can’t completely eliminate all risks. If you retire, you will face some risk. If you can't live with that, you need to keep working.

All things considered, Sally and John are in better shape to retire than any client, family member or friend that I have ever spoken to on the subject.

Why, then, was John frustrated?

I’m pretty sure it’s because he wanted to be assured that no matter what might happen over the next 35 years, their finances would survive. All of us would like to think that if we could save two or three million dollars for retirement our worries would be over. 

And most of them would be. But retirement is a probability, not a certainty.

Sure, billionaires have an extremely low probability of going broke before they die, but it isn't zero. Nelson Bunker Hunt and his brother, William Herbert Hunt, were Texas billionaire brothers whose fortunes collapsed after they tried and failed to corner the silver market in 1980. Nelson was 54 at the time, just a few years younger than John.

Donald Trump has filed for bankruptcy four times.

Retirement has lots of risks, and big ones that are game changers. There are investment risks, the risk of living a very long time, health care cost risks, long term care risks, interest rate risks, inflation risks. There is a risk that Social Security benefits will be reduced.

All these risks are exacerbated by the fact that once you retire, you have little opportunity to recover from a financial catastrophe by going back to work.

It isn't possible to retire and completely mitigate all risks, no matter how much you've saved. At some point, you're going to have to hope you are as prepared as you can be and take the plunge.

But John and Sally are better prepared to deal with these risks than perhaps 99% of the U.S. population. They worked hard and saved a ridiculous share of their income. They didn't have kids. They live well below their means and their spending expectations in retirement are modest.

So, the question isn't “why are John and Sally discouraged and outraged?” 

The question is “why isn't everyone else?”

Have You Been Listening? Retirement is Broken.

If you aren’t aware that our retirement financing system in this country is broken, then you haven’t been paying attention. People have been shouting it from the rooftops for a long time now.

Google “retirement shortfall” and you’ll find a boatload of articles on the subject beginning a decade ago or even earlier. This shouldn’t come as a surprise to anyone at this late date.

How do we know it’s broken? Because most households will need to save at least $200,000 to maintain their pre-retirement standard of living after leaving the workforce and according to the Employee Benefits Research Institute (EBRI), only about 10% of workers will retire with that much. Almost one-half of Baby Boomers and Gen Xers were determined to be at risk of not having sufficient retirement income to cover even basic expenses and uninsured health care costs.

Lest you think this is a Baby Boomer problem, EBRI studies show that younger “cohorts” are even worse off.

Why haven’t people saved enough?  There are no doubt many reasons, but in general the problem is that out current “system” for retirement funding demands far more from most families than they can possibly save, investing skills that most don’t have, and a whole lot of luck.

Teresa Ghilarducci explained the problems quite well in “Our Ridiculous Approach to Retirement.” Wall Street money manager and former neurologist, William Bernstein put it this way in a Money magazine interview in September 2012:

“I did a little thought experiment in which I calculated how many years it took people starting work in different years to make their number. I realized that the cohort that started working during the worst of economic times is the one that did the best. The last cohort that actually was able to make their number started their careers in 1980, and they made their number in 19 years. And the graph ends in 1980, because no cohort that started work after 1980 actually made the number. “

In February 2011, the Wall Street Journal reported, “the 401(k) generation is beginning to retire, and it isn't a pretty sight.”

And in case you thought Social Security would bail you out, the New York Times ran a story on the prospects of living off the benefits alone.

It isn’t pretty, either.

Our retirement system is in deep trouble. It doesn’t work. And if you are still avoiding the issue, it isn’t because the media have been trying to keep it a secret. As two-time Pulitzer Prize-winning editorial cartoonist and columnist David Horsey recently put it, Time to Wake from the American Dream and Face Retirement Reality.

I’m not trying to scare you. . . well, maybe I am. If you’re still young I hope I scare you into saving every penny you can for retirement. As Bernstein says, “Save as much as you can as early as you can and don’t ever stop.” And who knows, conservative politicians have been trying to undo Social Security since it became law in 1935 and maybe one day they will.

If you’re closer to retirement, then scaring you isn’t going to help. There are things you can do, though.

Read my series, Inadequate Retirement Account (IRA), for ways to make the best of your situation.

Inadequate Retirement Account (IRA): Investing After You Retire

Note: This is the sixth and final installment of a series of posts with advice for the 90%-plus of American households that haven’t been able to save enough for retirement. The first post was Inadequate Retirement Account (IRA).

My feelings about post-retirement investment strategies (and for the decade prior to retiring, actually) for households who haven’t saved enough are based on four principles:

1.        If you weren’t able to save enough and invest successfully enough for retirement over three decades that featured the greatest bull market in history — while you were earning an income and not withdrawing from your portfolio — then it is unlikely that your previously unsuccessful investing skills are going to come to your rescue now.

If you found it difficult to accumulate wealth while you were working and adding savings to your portfolio constantly, you’ll find it tremendously harder to grow wealth with no additional savings coming in and constant withdrawals (spending) going out. To add to the pain, most economists forecast lower stock market growth ahead.

Over the past thirty years, you were in a sailboat with a strong, accommodating breeze. After retirement, you’re sailing into the wind and taking on water. There’s a world of difference.

2.        You should never, at any age, invest money in the stock market that you cannot afford to live without, because you may well end up having to.

You can lose money when you’re young and accumulating wealth without it having an impact on your standard of living. Losing wealth after you retire often means a permanent reduction in your standard of living. This is money you cannot afford to lose.

3.        William Bernstein says that after you win the retirement savings game, you should stop playing. I would add that once it becomes obvious that you can’t win, you should stop losing.

It takes a lot of stock market growth to improve your standard of living. One dollar of income per year for thirty years costs around $22. If you have minimal retirement savings, doubling that amount in the stock market probably won’t have a big impact on your standard of living, but losing half of it may.

The Bernstein recommendation is that you not risk losing your already-adequate retirement portfolio in a market crash just before you retire, as many households did in the 2007-2009 market crash.

4.        Retirees should first secure income to cover their non-discretionary spending needs, then set aside an emergency fund, and only then should they consider investing in the stock market.

Many economists recommend a “Floor and Upside” strategy, also known as the “Theory of Life-Cycle Saving and Investing”. In part, that theory recommends that you secure your non-discretionary retirement spending with safe investments (like government bonds) before investing what’s left over in riskier assets like the stock market.

In other words, when you go to Las Vegas, set aside enough cash for dinner and a plane ticket home and don’t bet from that stash. (Economists do, I confess, state this more eloquently.)

Retirees with inadequate savings, by definition, don’t have enough assets to secure a “floor” of spending that would let them live like they did before retiring, let alone having some left over to take to the casino.

When I consider my four principles, I conclude that retirees in this group should not invest any sizable portion of their wealth in stocks.

If you decide that you simply must bet on a better standard of living in the stock market — and I hope you don’t — then limit stocks to 40% or 50% of your portfolio at most and invest in low cost index funds. At least give yourself a fighting chance.

Ultimately then, my advice for households that have inadequate savings for retirement is:

·       Invest little or none of your savings in stocks after retirement

·       Begin investing less in the market about ten years before you retire

·       Make sure you have the equivalent of a couple of years of expenses saved in liquid assets for emergencies

·       Lastly, invest any additional savings in TIPs bonds and/or lifetime fixed annuities to generate a floor of secure income as best you can.

I realize that there are no attractive alternatives for safe income in the current environment, and that includes fixed annuities and TIPs bonds, but that won’t last forever. You have two choices in the meanwhile: take more risk or accept about zero percent interest for a while. Since zero gain is better than a loss, I’d wait. Keep your money in money market funds or short duration government bond funds until rates go back up.

So ends my six-part series of posts of retirement advice for the 90%-plus of American households who have been unable to adequately save for retirement. If you have lots of savings, then you have lots of options, but that’s usually the way things work, isn’t it?

That doesn’t mean there’s nothing you can do if you haven’t saved enough. In fact, it makes your decisions more critical. In a nutshell:

·       Work longer

·       Spend less

·       Manage your home equity and mortgage

·       Maximize your Social Security benefits, and

·       Don’t expect the market to save you.

How much difference can these decisions make? I ran a scenario through E$Planner Basic that consisted of a single male, age 60, who earns $50,000 a year and contributes 6% to his 401(k). His company matches 3%. He could retire at age 63 with a $12,708 per year standard of living. He could increase that amount 31% to $16,644 if he could work to age 66.

He could increase his standard of living 83% to $23,220 per year if he could work to age 70, but not many workers will be able to hold onto their job that long.

As someone commented on my last post, finding a competent, fee-only financial planner to help might be a great investment unless you're really good at these kinds of calculations. We're talking about tens or hundreds of thousands of dollars over your lifetime and you really need to get the decisions right the first time.

One last piece of advice: don’t beat yourself up if you haven’t been able to save the hundreds of thousands of dollars needed to maintain your standard of living after you retire. Fewer than one out of ten American families did.

Just make the best of it.

Inadequate Retirement Account (IRA): Claiming Social Security

Note: This is the fifth installment of a series of posts with advice for the 90%-plus American households that haven’t been able to save enough for retirement. The first post was Inadequate Retirement Account (IRA).

If you have lots of money saved for retirement, then my advice to you for claiming Social Security benefits would be pretty straightforward — delay claiming your benefits until you are 70 if you are single or are married and have a larger benefit than your spouse, and delay claiming until your full retirement age if you have a smaller benefit than your spouse. But, this is a series of posts for people who haven’t saved enough for retirement and that’s more complicated.

If you had lots saved for retirement, you could retire and live off your savings while you waited for your Social Security benefits to grow about 8% for every year you postponed claiming. That’s a deal that’s too good to pass up if you can get it.

Without huge savings, postponing claiming benefits probably requires working longer and, as I explained in my post Inadequate Retirement Account (IRA): Working Longer, that decision isn’t always up to you. Half of recent retirees report that they were forced to retire earlier than they had planned by unforeseen layoffs, closings, health problems or a need to care for family members.

With inadequate retirement savings, chances are very good that you will need to claim your benefits long before you turn 70, but I still recommend that you postpone as long as you can hold out.

I know that many people believe they should collect Social Security benefits at the earliest age (62), but that isn’t a wise decision for healthy people. Usually the basis for this belief is that Social Security benefits might be taken away at any time so you need to grab them while you can, but those arguments aren’t convincing. 

Conservatives have been trying unsuccessfully to kill the program since it was created in 1935. When George W. Bush tried to privatize part of it in 2005, in his words, “I did more than touch the third rail. I hugged it.” There is no political will to end the program and even proposed changes have always considered grandfathering for current participants.

The second argument for claiming early is that the break-even age is around 80. If you don’t live that long, you will receive less money by claiming later. I've heard many people say, "Heck, I probably won't live to 80, so I should take the money now."

I have no idea how those people know when they're going to die.

On the other hand, if you claim early and live longer than about age 80, you will receive far less in benefits. Since healthy people have no idea how long they will live, the best approach is to take the worst-case scenario (one or both spouses living a very long time) off the table by claiming as late as possible.

If claiming your benefits at the earliest possible age whether you absolutely need them or not will help you to sleep at night, go for it. But be forewarned that it isn’t the best bet from a financial risk-reward perspective. Many elderly widows will tell you that having their husband claim benefits at the earliest age possible was the worst financial mistake of their life.

T. Rowe Price has an online calculator that lets you play with a few different scenarios to find the best age to claim benefits for you (and your spouse, if married). I used it to calculate cumulative lifetime benefits for a married couple of the same age. The husband expects $2,300 a month in benefits at full retirement age and the wife expects $1,940 in monthly benefits at full retirement age.

If both spouses claim at the earliest age (62), and the husband lives to age 83 and the wife to 95, their cumulative lifetime benefits total $1,050,000.

If both spouses claim at the latest age (70), and the husband lives to age 83 and the wife to 95, their cumulative lifetime benefits total 28% more, or $1,346,000. 

The wife’s survivors benefit would increase from $20,700 per year if benefits are claimed at age 62 to $36,450 per year if claimed at age 70 — a whopping 76% more!
 
(Now you see why those widows are complaining.)

Postponing Social Security benefits as long as possible is a very powerful way to maximize your retirement income, and one of the few available ways if you have limited retirement savings.

Of course, maximizing Social Security benefits can be far more complicated than this example, and more complex than the T. Rowe Price website tool can handle. For example, the optimizers told me that my wife should claim and suspend benefits at age 66 and I should simultaneously claim spousal benefits. Two years later, my wife should claim her own benefit. Two years after that, I should file for my own benefit. As you can see, optimizing benefits can be very complicated. You’ll probably need help.

The company that provides the E$Planner software I mentioned in previous posts in this series also provides a package entitled Maximize My Social Security. While the T. Rowe Price tool is free, Maximize My Social Security currently costs $40. An alternative is to work with a financial planner, but that will likely cost more than the software. Reuters describes a number of other sources of help in this article, including AARP’s free tool.

My recommendations for claiming Social Security, which apply equally to those who have saved enough for retirement and those who have not, are first to not claim benefits at age 62 if you can live without them. And second, use one of the tools mentioned above or contact a financial planner to make sure you will get the maximum benefits to which you are entitled.

That leaves us one topic, investing, to conclude this series of posts on retiring with inadequate retirement savings.

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.