How the Decline in Housing Wealth Affects Financial Planning
The unprecedented decline in housing prices suffered as a result of the 2008 recession is still significantly affecting retirement wealth, but it also has great far-reaching implications for the future of retirement planning.
The reason: home ownership is the main engine for generating retirement wealth for most Americans. Housing wealth exceeds money held in retirement accounts, savings and other instruments.
As a result, the recent news that housing ownership has fallen to its lowest rate since 1967, accompanied by a rise in home owners being underwater on their homes, means that the next generation of Americans will face a difficult time meeting even modest financial retirement security goals.
This decline in home ownership is a bad sign for the future. According to the U.S. Census, home ownership rate fell to 63% in the second quarter of 2015. That is down from 64% in the first quarter and from 65% in the same quarter of 2014. It marks the lowest homeownership rate since 1967.
Homeownership peaked at 69% at the end of 2004, when the housing market was in the midst of an epic boom. The 50-year average is 65%.
A July 2015 report found that 7.4 million borrowers, or 13% of all properties with a mortgage, were “seriously” underwater on their mortgages at the end of June 2015, according to RealtyTrac. Worse, “All of the largest metro indexes are rising more slowly than they were a year ago,” according to Allan Weiss, founder and CEO of Weiss Residential Research.
How Housing Affects Investing
All of this fundamentally bad news about home ownership coupled with underwater mortgages in 2015 foreshadows bad news for wealth creation.
The question about the central role of residential housing as a wealth-generating engine has profound implications for investing patterns. At a larger level, housing price declines raise the question of whether renting is preferable to house ownership, and the related issue of whether mortgage payments should be minimized as home owners pursue a tax arbitrage strategy to invest in more liquid, tax-deferred investments.
Since housing plays such a critical role in the US economy and in domestic government policy, any change in home ownership patterns will have significant ramifications on future wealth creation.
For financial planners, this change should re-shape net worth evaluations and subsequent retirement plans as planners direct clients towards a combination of home ownership evaluation, mortgage debt consolidation, and an emphasis on tax-deferred investing. In short, re-visiting the role of home ownership reignites the role of liability management into the financial planning process.
Evaluating the Problem
Numerous academic and government studies show that home equity has a paramount role in determining overall household wealth, especially among people over age 55 who have the highest percentage of home ownership. A 2002 study found that 82% of those in the study who were age 60 to 64 owned their own residence, with a typical home equity of $120,000. A 2004 survey of consumer finances found that Social Security accounted for 42% of total wealth for a typical family approaching retirement (sample household headed by a person aged 55 to 64), followed by the principal residence (21% of total wealth).
The current housing devaluation has not only been a major cause of the current recession, but has raised the question of whether home payments (consisting of interest, principal and taxes) could have been better invested elsewhere. For baby boomers, the question is whether home-ownership borrowing proved to be a weaker strategy than redeploying those payments into tax-deferred retirement investing.
As the data shows, home prices peaked in the second quarter of 2006, as measured by the Case-Shiller Index. In 2007, prices began to fall in certain urban areas and then nationwide. This eventually resulted in a significant decline caused by a number of problems stemming from lax mortgage underwriting standards, the use of aggressive mortgage industry interest rate products, and a strong reliance on continued double-digit house price increases.
By July 2007, the deficiencies in the mortgage industry combined with such factors as steadily declining spread rates in the credit markets and the popularity of new structured debt products had all combined to create a worldwide credit crisis. As this affected the U.S. housing market, it is estimated that the decline (through early 2008) eliminated an estimated $400 billion in housing value nationwide.
As a result of its critical role in advancing democratic political values, home ownership benefits from the application of significant tax preferences, including the deductibility of home mortgage payments for households which itemize.
Arbitrage for the Masses?
Since housing wealth comprises the single largest asset for elderly homeowners, any decrease in this wealth has a disproportionate effect on retirement planning from both a financial and psychological perspective.
As a result, financial professionals should consider the following facts when creating or revising financial plans for clients who are approaching, or are in, retirement:
Increased Mortgage Debt Levels Among Seniors
Homeowners are taking on more mortgage debt in addition to rising levels of consumer debt. This trend has shown a significant increase since 1995 as the average debt per household increased by 45% over the decade, from $40,600 to $58,700. Some of the largest debt increases occurred among the older age group. This is a significant change and means that homeowners are carrying more housing debt into their later years, while the number of older homeowners who have paid off their mortgages is declining. This is partly the result of homeowners of all age groups who are tapping into their home equity as a source of current funding.
Housing Market Recovery Times and Scenarios
Economic recoveries have historically followed three basic patterns, and are classified by letters which also describe the pattern of expansions and contractions in the business cycle. A “U-shaped” recovery contains a trough that can extend until growth factors accelerate upward. A “V-shaped” recovery has a faster recovery period, while a “W-shaped” recovery would see a period of decline followed by a recovery and then another decline. This is also a known as a “double-dip recession” and is considered a more serious economic event, often accompanied by accelerating layoffs and falling demand for goods and services.
Housing recoveries may share the same patterns as economic recoveries; however, the key variable that affects both asset recovery patterns is time. Both are difficult to predict and can only be measured after the recovery has developed.
The current housing price decline came after a 14-year cycle of increasing prices, which was the longest continuous housing price increase since World War II. In the first quarter of 2008, prices fell by 14%, the largest year-over-year price decline in 20 years. This price decrease is happening at a rate that is fives times faster than the last housing recession, according to the Standard & Poor’s/Case Shiller National Home Price Index.
The severity of this decline has also generated significant attention. Some dire estimates say it will take between four to eight years to recover, while a more optimistic scenario projects a 12- to 18-month time frame. The estimated loss in housing could be between $460 billion to $1 trillion.
The following table illustrates the amount of time it takes to recoup a loss of 10%, 20%, and 30% on a hypothetical house priced at $250,000 if money was invested in a 60%/40% model portfolio. This example excludes taxes, depreciation, and any mortgage payments that would be paid on the house.
Recovery Times to Recoup a House Price Loss
|Amount of Loss||Dollar Amount of Loss||Time Period to Recover in Years||Time Period to Recover in Months|
|10% of $250,000||$25,000||10.3||123|
|20% of $250,000||$50,000||15.2||182|
|30% of $250,000||$75,000||19.2||230|
|Chart Assumptions:S&P 500 Composite Total Return: $6,000 initial amount on 12/31/1975. Transfers to maintain allocation at 60% will be made every twelve months. Fees attributable to any transfers made were waived. The effects of income and capital gains taxes are not demonstrated.Lehman Brothers Aggregate Bond Index: $4,000 initial amount on 12/31/1975. Transfers to maintain allocation at 40% will be made every twelve months. Fees attributable to any transfers made were waived. The effects of income and capital gains taxes are not demonstrated.Initial sales charge of 5.5%.Source: Thompson Financial.|
As this chart shows, the minimum recovery time needed to recoup a $25,000 loss on a house valued at $250,000 using a 60%/40% portfolio would be 10.3 years. This time period could be reduced in a more aggressive, and riskier, portfolio. However, it is often inappropriate for people close to retirement to assume more investment risk.
Since real estate recovery times vary greatly by location, this time period could be reduced. However, this is an unknown factor that could be exacerbated given the excess supply from other owners who have delayed putting their houses on the market.
Given the other behavioral finance and emotional factors that come into play when investors suffer a
financial loss, it is difficult to imagine whether a homeowner would voluntarily sell their house for a loss unless they were suffering from extenuating circumstances. This situation will create a difficult challenge for retirees who rely heavily on housing equity. It will also significantly impact retirement planning.
Strategies for Financial Planners
Obtain a new first mortgage accompanied by client’s debt consolidation. By re-structuring debt, the client pays down the mortgage, while creating new money for investing. A higher benefit can be derived if the money is invested in pre-tax dollars. This creates positive cash flow as long as the investment return is greater than the debt load.
Tax savings are generated through the interest rate differential times the client’s tax bracket. This money is worth more long-term than money paid on tax-deductible debt, as long as the debt burden is under control.
The arbitrage is based on the difference between what you are paying versus what you are earning plus the tax savings.
Since approximately 2003, reverse mortgages have become an increasingly popular way for homeowners who are over age 62 to access their home equity. The most popular form of reverse mortgages allows loans to be taken as a lump sum, line of credit, lifetime income, or payable for a certain time period. The most popular is a line of credit. Loan amounts depend on the age of the homeowner, interest rates, and the house price. If a loan is based on a National Housing Act of 1987 program, the loan amounts have limits ranging from about $200,000 to $362,000.
Other private reverse-mortgage programs allow some private homeowners to receive larger amounts since they are exempt from the federal housing act guidelines. While reverse mortgage amounts can be substantial, they alone are not considered sufficient to provide an adequate retirement income. Interest rate volatility and home price decreases also have an impact on determining reverse mortgage loan amounts.
Psychological and Emotional Considerations
Academic studies have found a shift in the attitude of elderly homeowners toward their primary residence. Numerous earlier studies, including one dating back to 2000, have found that older homeowners did not consider their home a source of wealth to be tapped in retirement and would prefer to remain in the house for as long as possible. They considered it a place to live and as part of a family bequest. As a result, consumption decisions were not based on accessing house equity.
However, a 2007 Harris Interactive-Boston College study of homeowners aged 50 to 65, whose main breadwinner was still working and planned to retire in the next 10 years, said they would not use their home equity if they had sufficient retirement income. However, if retirement income was insufficient, or if they had an outstanding mortgage, the survey group said they would be more inclined to access their home equity either through a downsizing, using a reverse mortgage, or a home equity loan.1 Another interesting fact is that having a child who lives nearby or being childless both significantly reduce the probability of selling a house.
Changes in Health Status and Death of a Spouse
While this topic is not fully explored in this paper, health considerations play an important role in the decision of elderly homeowners to sell their house. This is especially true if the husband is the surviving spouse. Declines in an owner’s health status, including a nursing home stay or a decrease in mobility, are also good predictors of a future house sale.
While the academic papers have not studied this effect, since housing wealth comprises such a large percentage of household wealth, any decrease in home sale prices should be reflected in bequest amounts.
The Role of Insurance
One of the greatest determinants of whether a house is sold occurs when the owner’s health declines or they enter a nursing home. If the homeowner has outside health, life, or long-term health care insurance to reduce the risk of uninsured medical expenses, they can reduce the probability of selling the house. This has a significant impact on preserving housing wealth and reducing psychological stress during a health event.
Obtaining Medicaid nursing home assistance also has a housing component since those rules disqualify housing assets from being used to cover the cost of Medicaid nursing home services. In these cases, the spouse who is not in the nursing home may be more likely to sell their house and use the proceeds to pay these expenses.
Action Steps for Financial Professionals
As a result of the decline in housing wealth that is affecting future retirees, here are a list of suggested questions that may help financial professionals gain more information about their clients’ status and whether they are changing their retirement plans:
- Have you estimated how much your house has depreciated within the past two years?
- If so, how much has it declined?
- How much did housing equity contribute to your retirement plans?
- How much did your housing equity contribute to your overall wealth?
- Has this housing price decline affected your planned retirement date?
- How long do you think it will take for housing prices to recover in your neighborhood?
- If so, how many more years do you plan to work?
- As a result of this decline, are you postponing any major medical treatments?
- Are you still making contributions to your 401(k) plan? Are you taking early withdrawals?
- Are you contemplating a reverse mortgage?
- Is it appropriate to re-consider your investment strategy in light of the decrease in housing wealth?
- How has this decline in your housing wealth affected your investment risk tolerance?
- Has the decrease in housing wealth affected your legacy planning?
- Do you have outside sources of health, life, or long-term heath care insurance to reduce the risk of incurring uninsured medical expenses?
- Are you staying informed about your client’s debt levels as part of your regular client reviews?
- Are you continuing to emphasize the need for long-term investment planning of an overall portfolio?
- What is your client’s source of retirement income? What portion, if any, of this income will be derived from a reverse mortgage?
These questions are dependent on a number of key factors, including your client’s marital status, health, residence location, number of real estate assets, investment assets, and overall wealth. These questions are suggested as starting points for further discussion.
Conclusion: How the Housing Market Decline Affects Future Retirement Planning Scenarios
Due to the disproportionate amount of personal wealth contained in housing values, any significant decrease in these prices will have a cascading effect on the plans of current and future retirees. This presents a number of challenges to retirees and financial professionals who must now adjust their retirement planning, including many of the key components of that plan, such as possible portfolio reallocations, strategies to tap into home equity, devising new savings plans, and downsizing.
Housing values are the cornerstone of wealth building not only in the United States, but in most developed nations worldwide. As a result, the current decline in housing wealth not only affects those planning to enter retirement, but current retirees as well. The current situation will prompt retirement planning professionals to use both proven and new strategies to find solutions to this significant, long-term problem.
This article was excerpted from my book, How 401(k) Fees Destroy Wealth and What Investors Can Do To Protect Themselves.
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