The Problem
As longevity continues to increase, it gets harder and
harder for investors without large fixed benefit pensions (which are becoming
rarer and rarer) to come up with a "foolproof" plan for being sure
that they do not outlive their money. This problem is compounded by the fact
that – as the length of retirement increases – the potential for large-scale
inflation over the course of the retirement period grows. In addition, massive
changes in the economy can occur over such a long period, leading to
unpredictable portfolio returns.
These problems are relatively "new" in that many
of our parents did not really have to address them. First of all, there has
been a massive increase in longevity (living beyond 90 is increasingly common)
without much of an increase in the average time at which retirement commences
and this results in a much, much longer expected period of time that has to be
financed.
Secondly, there has been (partly for the very reason of
increased longevity) a dramatic decline in private defined benefit pension
plans. More and more private employers have switched to defined contribution
plans such as 401(k)s and have phased out the old defined benefit plans.
There is no easy answer to the problems created by this new
situation but there may be some utility in organizing one's thinking and
focusing on some of the more important decisions that one will make either
explicitly, or implicitly by inaction.
Social Security Timing
A big issue for many retirees is the question of when to
take social security. As a general rule, once full retirement is reached, a
retiree can elect to defer social security for a term up to age 70 and will
receive an additional 8 percent per payment for each year of deferral.
Many pundits come down strongly on one side or another of
this issue. In fact, there are a number of individual circumstances that may
vary the result in different cases.
As an example, take an individual entitled to receive
$30,000 per year at age 67. If he defers, he foregoes the $90,000 he would have
received between ages 67 and 70 but will receive an additional $7200 per year
for the rest of his life by waiting. Is it a good decision to wait? An
economics professor of mine always asked the question "compared to
what?" And that is a big consideration here. Just what will our retiree be
doing with the $90,000 if he does not wait? Depending very much on the answer
to that question, it can be a good decision or a terrible decision to wait.
For example, our retiree may take the $90,000 and buy an
annuity. If he does, he will be essentially exchanging the $90,000 for a
lifetime stream of benefits. The only problem is that that stream of benefits
obtainable in an annuity will almost invariably be considerably less attractive
than the additional $7200 per year (plus inflation) that the Social Security
Administration will pay him for waiting. So, for that retiree, the answer is
almost certainly that it is better to wait.
As an alternative, our retiree may be one of the very large
number of investors who like to keep a large portion of their portfolios in
cash or cash-like assets returning a taxable rate of less than 1%. Once again,
if our retiree plans to do that with the $90,000, then he is probably better
off waiting and getting the higher social security payments.
On the other hand, if our retiree plans to invest the
$90,000 in a well-designed portfolio of dividend investments and preferred
stocks, it is very possible that he can earn a yield of 7% or more. Thus, by
age 70, he may have piled up as much as $100,000 with compounding. At this
point, he can earn $6,000 a year in yield, and - while this is less than $7200
- he has the advantage of holding the $100,000. Unless he sets some new records
for longevity, he is quite likely to come out ahead.
So, there is no real answer to the question. It all depends
upon what the retiree is planning to do with the $90,000 if he or she does not
defer social security.
It should be noted that there are other considerations that
vary - the health of the retiree, the age of the retiree's spouse, and the
spouse's social security situation. A very healthy retiree or one with a much
younger spouse who will assume the retiree's level of social security may lead to
a situation in which the higher benefit achieved by waiting is collected for 40
or even 50 years. As this becomes more probable, the case for waiting gets
stronger.
The Housing Decision
One of the most important decisions in retirement is housing
- the choices between owning and renting, staying and moving, paying off the
mortgage or not, etc. Again, individual circumstances vary and lead to
different optimal choices. For many retirees, with a home that they have owned
for 20 or more years in a metro area with rising real estate prices and a
paid-off mortgage, the home may be their most valuable asset. It may be
possible to raise a considerable amount of money by selling the home and moving
to a less expensive area or a smaller residence.
This decision should be approached with care and there often
is not necessarily a big rush. Especially now, homes in desirable metro areas
are appreciating in value so that - although delaying a year or two while you
research some alternatives may increase out-of-pocket costs - it is also likely
to lead to a higher sales price.
Rent or Own
I have seen some retirees make decisions they regret in this
area. Some retirees forget some of the disadvantages they experienced as
renters in their younger years. The annoyance of getting repairs arranged, the
dilemma of an improvement that would really enhance your lifestyle but that the
landlord is unwilling to pay for, the noisy neighbor, and the risk that you may
be required to move at just the worst time are all distant memories for people
who haven't rented since they were in their twenties.
So, a choice between owning and renting has a lot of
"hidden" factors that don't necessarily show up on a spreadsheet. If
you are unhappy with a series of rentals and move frequently, moving costs may
eat up a lot of your savings.
Where to Live
Another key consideration is the choice of venue. Some very
inexpensive choices are inexpensive for good reasons - in some situations,
there isn't easy access to top-notch medical care, and certain
"amenities" you have become used to are not available at any price.
Then, there are choices that seem idyllic but require flood insurance,
expensive fire insurance, and other protections.
On the other hand, there are some wonderful locales with
reasonable prices. Living in or near a university town can provide access to a
top-notch hospital, great amenities, inexpensive lectures and events, and other
satisfactions. Unfortunately, the "secret" seems to be out and prices
have begun to move up in some of these locales.
The choice to change the area in which you and your spouse
live has to be a joint one and should be considered carefully. You should
ideally spend some time in the new location and be sure it really works for
both of you. It helps a great deal if you have friends or relatives in the new
area and can look to them for guidance and a "soft landing" when you
migrate.
The possibility of living overseas is also worth some
consideration. I have seen comments by retirees indicating extraordinarily
inexpensive housing and other costs in reasonably safe and modern foreign
countries. This probably works best if the retiree or the spouse has some
"roots" - relatives, friends, work experience, etc, in the new venue.
But in some areas, there has emerged a vibrant "ex-pat" community
that may introduce one to a group of enterprising and interesting individuals.
Paying Down the Mortgage
Given current extremely low interest rates, the imperative
to pay down a mortgage may not hold. If you can get a long-term fixed, 2.5%,
then it is very likely that you will be able to take whatever cash drain is
displaced by the decision to continue with the mortgage, and use the funds to
earn a much higher return. Again, the decision of whether to pay down the
mortgage depends upon the key question "compared to what?" If you are
just going to hold the cash in money market funds, then it may make more sense
to use the cash to pay down the mortgage.
On the other hand, a well-designed portfolio of dividend
stocks can generate a return much higher than the interest rate on many
currently available mortgages. You can reasonably build a yield of well over 7%
with a combination of dividend-paying stocks, preferred stocks, baby bonds, and
closed-end funds. So again, it depends a bit on what a retiree plans to do with
the funds made available by continuing or even increasing the mortgage.
Returning to our first topic above, let's consider the case
of a retiree planning to pay down a 2.5% mortgage using the $90,000 generated
by taking social security at age 67 rather than age 70. It may well be the case
that he would be better advised to defer social security, continue with the
mortgage and take advantage of higher social security payments at age 70. Again
this decision may depend upon expectations of longevity and spousal longevity.
Conclusion
It is generally best to manage both social security and
mortgage issues in such a way as to generate cash and to then use the cash to
invest in a well-designed portfolio of high dividend stocks. This portfolio
will generate a better return than the alternatives of delaying social security
or paying down a mortgage. However, for retirees who are unwilling to invest in
this manner, there may be situations in which it is better to defer taking
social security in order to generate higher yearly payments in the future
and/or to consider paying down a mortgage.
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