Defending Systematic Withdrawals

Jonathan Guyton and Michael Kitces are both leading advocates of systematic withdrawal strategies for retirement, as Wade Pfau pointed out in a recent post. Pfau observes that "it is somewhat uncommon to hear rigorous intellectual defenses of systematic withdrawals." Most academics prefer other strategies with greater downside protection.

The video is informative and I suggest you watch it regardless of how you feel about "safe withdrawal rates." Guyton and Kitces are two very bright people, but I am not a fan of systematic withdrawals except for households who have a lot of savings.

When I say "a lot", I'm referring to those over-savers who need to spend perhaps 3% or less of their savings every year in retirement. They probably have adequate risk capacity to manage the downside of SW.

As I watched this interview, I realized that I am perhaps not as far from Michael's position as I had thought. If you're wealthy enough, I have no problem with SW, and that is the target market for most financial planners. I focus my attention more toward retirees who are not over-savers, for whom I believe SW is often a very risky approach.

Risk tolerance, or how much risk lets you sleep at night, is different than risk capacity, or how much risk you can afford to take. (Here's a cute analogy to explain the difference.) Risk capacity is the limiting factor when choosing a retirement strategy and the more wealth you have relative to your annual spending, the greater your risk capacity.

Kitces notes in the video that in many cases the overall portfolio constructed with a floor-and-upside strategy (or "discretionary - non-discretionary strategy", as it is called in the video) is practically identical to what would be required for a SW strategy. This is technically accurate, but omits important points.

First, a major purpose of floor-and-upside and time-segmentation strategies is to make retirement finances more transparent and manageable. We could, using the same logic, organize our household budget into just two categories: "income" and "stuff I need to pay for". That wouldn't provide much transparency into our budget, however, so we create subcategories for food, rent, transportation and the like.

In this same way, floor-and-upside and time-segmentation strategies create subcategories, or "buckets", to help us visualize where the money will come from to pay our living expenses in future years, or whether a shortfall will jeopardize groceries and housing, or just the cable bill.

In other words, these strategies help us manage our retirement plan.

Time-segmentation attempts to minimize the risk of needing to sell assets when they are cheap and to provide a safe source for near-term spending. Floor-and-upside tries to ensure that in the worst case we can still pay for non-discretionary expenses. SW lumps them all into one large "total return" bucket, much like the "stuff I need to pay for" category.

The second important but unmentioned point is that SW recommends a spending rate that some might consider safe or sustainable. Life annuities also determine a spending rate based on the payout rate of the annuity we purchase. The SW rate is probabilistic while the annuity payout is contractual.

Time-segmentation and floor-and-upside strategies, to the contrary, do not inherently calculate a spending rate. SW rules of thumb and consumption-smoothing are two ways one could establish such a rate for these strategies.

Lastly, these strategies rebalance asset classes differently. The asset allocations may start out being quite similar, but they will most likely drift apart over time.

These are important differences  — the strategies provide different spending, different risks and different asset allocations over time. The initial portfolio allocations may be "practically identical", but the strategies are not.

I find comfort in the observation that the strategies frequently have similar initial portfolio allocations because I would have a hard time explaining why they wouldn't.

One of them will perform best for you over your lifetime. Unfortunately, we can't predict which one that will be. That's the bet you have to make.

Kitces also mentions in the interview his personal quandary, which he has stated before, that a retiree who expects a wonderful retirement might consider it a failure if that retirement only turns out to be OK. This is the tradeoff one makes when forgoing the possible upside standard of living with the SW strategy in order to mitigate the risk of going broke in old age with a floor-and-upside strategy.

Personally, I don't understand the quandary. If I were offered the opportunity to take the worst-case scenario off the table (dying broke) by giving up the possibility of more trips to Europe and a second home, I'd jump at it.

But, that's a decision retirees with a lot of wealth will get to make for themselves.

Retiring with Children

Some of us have children at an early age and they are self-supporting when we enter retirement.

Many of us don’t.

For us late starters, having children who are young adults when we enter retirement is a substantial financial risk. I was reminded of that fact by an article written by Adam Davidson in the New York Times Magazine entitled “It’s Official: The Boomerang Kids Won’t Leave”.

Davidson writes, "One in five people in their 20s and early 30s is currently living with his or her parents. And 60 percent of all young adults receive financial support from them. That’s a significant increase from a generation ago, when only one in 10 young adults moved back home and few received financial support."

Davidson goes on to argue that this isn't a temporary financial blip, but may be a longer term trend.

I am also reminded by clients who plan on their children graduating from college in four years. Good luck with that one.

A Time magazine article from 2013 entitled, “The Myth of the Four-Year College Degree”  reports that, "According to the Department of Education, fewer than 40% of students who enter college each year graduate within four years, while almost 60% of students graduate in six years. At public schools, less than a third of students graduate on time.”

Each additional year that child remains in college means not only more tuition and books, but more rent and groceries and another year of not earning income. Losing early years of income can have a significant impact on your child's lifetime earnings, so it’s not exactly a bonus for  him or her, but tens of thousands of dollars for unplanned college expenses may be difficult for many retirees to deal with.

The surprises may not be college-related and, in fact, may appear long after your child's college years. I have spoken with several retired couples whose children (or grandchildren) had their own financial crisis. Not helping wasn’t an option.

Retirees with middle-aged children are often called upon to help after a health crisis, a substance abuse crisis, or extended unemployment.

Additional unplanned years of college and parental support don’t always happen when something goes wrong. They can also happen when something goes right.

My oldest son decided to go to med school and, after his third year, elected to take leave for two years to earn a masters degree. I’m very proud of my son and don’t regret one penny that I have spent on his education, but it wasn’t in my retirement plan.

The point is that those of us with children will retire with greater financial risk than will childless couples. When I think about the major risks of retirement, I think longevity risk, market risk, healthcare risk and long term care risk, but our children also represent a major financial risk that our plans need to consider.

I would start by planning for at least five years of college, if your kids haven’t already graduated. Then, I’d recommend reading the Davidson article and considering the distinct possibility that your children won’t simply go to college for four years, get a job right away, and become largely self-supporting.

Maybe you and I did it that way, but nowadays it isn’t that common.

A Summer Break

I'm taking a few weeks away from musing about distribution strategies and risk tolerance to celebrate a most amazing week that I recently enjoyed. I'd like to take this opportunity to remind us all that there is more to life than money.

(I will hastily add that the more money you have, the easier it is to say that.)

A couple of weeks ago, within a seven-day span, my daughter was married, my wife and I celebrated our fortieth wedding anniversary and . . . OK, maybe a little about finance . . . I paid off the mortgage. We spent last week in Paris, a place we last visited not long after our wedding, celebrating our time together.

Some things money can't buy, like finding the love of your life at a young age and getting to live with her for a very long time.

Before long, I'll be writing again from my favorite neighborhood coffee shop, though I'll probably be daydreaming about those along Paris boulevards.

I wish you all the joys life can bring and I suppose I could drop one piece of retirement advice while I'm at it.

If you're looking for a place to retire with a reasonable cost of living. . . Paris ain't it.

 

 

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Is Inflation Tame?

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.

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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.

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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.

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.)

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.

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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:

"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?

When is the right time to concurrently hold a mortgage and investments that could pay off that mortgage?

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.

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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.

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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.

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.

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