Why debt can be so dangerous in retirement

Think hard before adding a mortgage or HELOC.

  • By Mark Hulbert,
  • MarketWatch
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  • Living in Retirement
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For retirees, at least, debt may be the new scourge.

That's because those who are on the verge of retirement today have more debt, on average, than at any other time in recent U.S. history. And retirees' increased indebtedness comes just as the various asset classes' expected returns are well below average.

Should you move in retirement?

The home and where you retire can have a big impact on your finances.

Consider the debt-to-income ratio, which is a standard measure of someone's debt burden. In 1998, the median debt-to-income ratio was just 0.01 for those in their final years before retirement (aged 62 to 66). By 2008 the comparable ratio for those in that age range had grown to 0.19, and despite significant deleveraging during the Great Recession, was even higher in 2014—0.26. (See accompanying chart.)

Those data are courtesy of a just-published study from the National Bureau of Economic Research. It was conducted by Annamaria Lusardi of George Washington University, Olivia Mitchell of the Wharton School, and Noemi Oggero of the University of Turin in Italy. Note that those in the 62-66 cohort presumably are at their greatest earning potential of their lives, and even so the ratios have grown markedly. Furthermore, note that the ratios reflect the median, which means 50% of soon-to-be retirees have ratios that are even higher.

The researchers conclude in academic-speak that is nevertheless alarming: "Debt among older persons may increasingly be a factor in elder bankruptcy, and even in determining lifetime wealth sufficiency and retirement security."

Let's do the math. Let's assume that the bulk of retirees' debt is a mortgage; that's generous because the interest rates on mortgages and home equity lines of credit (HELOC) are lower than on almost all other forms of debt. Currently the national average rate on a 30-year fixed mortgage is 4.0%, according to Bankrate; on home equity lines of credit the comparable average is 5.4%. Insofar as retirees' debt is in unsecured loans, and even if their credit score is excellent, the average interest rate they pay on their debt is in the double digits.

The question for all investors, but especially retirees, is whether they can earn enough on their investments to equal the rates even on home-related debt.

To be sure, in most cases the interest paid on home-related debt is tax deductible. Assuming retirees are in a 20% tax bracket, the after-tax equivalent rates on such debt could be as low as 3.2% and 4.3%, respectively, for mortgages and HELOCs. Note carefully, however, that in some of the versions of the tax reform legislation currently being discussed in Congress, some or all of this deductibility is eliminated.

Since home-related debt is collateralized by the real estate bought with the debt, a good place to focus first is the likelihood that real estate will earn enough to pay these after-tax interest rates. To be sure, forecasting future investment returns is an inexact science. But the prospects are sobering.

One clue comes from Research Affiliates, the investment advisory firm founded by Robert Arnott. Based on current valuations, the firm projects that U.S. commercial real estate and REITs will produce annualized inflation-adjusted returns over the next decade of 2.4% and 1.8%, respectively. Add in the 10-year breakeven inflation rate of 1.9%, these projected returns are barely enough to service home-related debt.

These are just one firm's forecasts, of course. Furthermore, note that these projections are for commercial real estate and REITs, which are only rough proxies for residential real estate. And individual homes' valuations are highly idiosyncratic. But suffice it to say that there is not much room for error here in hoping that real estate's appreciation rate will exceed the interest rate on the home-related debt.

This wouldn't be so alarming if other asset classes were poised to pick up the slack. But they're not. Given today's high stock market valuations and low interest rates, "the cruel reality of today's investment opportunity set is that… there are no good choices from an absolute viewpoint," according to Boston-based GMO. "You are reduced to trying to pick the least potent poison."

Arnott's firm, for example, projects that the S&P 500 (.SPX) will produce an annualized return after inflation of just 0.4% over the next decade. Small-cap U.S. stocks will do barely better, at 0.6% annualized. The picture the firm paints of bonds is even more discouraging.

How should retirees respond if they have a heavy debt load as they approach or enter retirement? They may want to seriously consider paying off that debt sooner rather than later. Even on an after-tax basis, doing that provides a guaranteed return of between 3.2% and 4.3% annualized. And doing so provides an extra psychological benefit: Not having to worry about servicing your debt during the next bear market and economic downturn.

Only if you are willing to gamble with your retirement, and are confident that your retirement portfolio and real estate will produce high-enough longer-term returns, would you not want to reduce your debt burden sooner rather than later.

As always, of course, consult your financial planner as you consider your various options. However, make sure that your planner is focusing on projected returns going forward for the various asset classes, rather than the average historical returns that are almost certainly higher than what the next decade will produce.

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