Trading Down to a Better Retirement

It appears that the number of articles mentioning a “real estate bubble” now far exceeds the number of news stories warning of a “stock market bubble” before the 2000 crash. Understandably, clients may be asking themselves if the same thing that happened to their investments when the stock market bubble burst can happen to their real estate assets.

Without preying on your clients' fears, you can use the concern over the real estate bubble to do something that financial advisors should have been doing all along: talk about real estate as part of the comprehensive investment plan.

Meanwhile, few Americans have adequate retirement savings. According to an analysis by the Brookings Institution, based on 2001 savings data, even among the richest members of the 55-to-59 age group (households in the top 10 percent of incomes), the median account balance in 401(k) plans was only $299,000. The median holding for all households with retirement accounts in that age group was $50,000.

Filling the Retirement Savings Gap

The only real solution to the retirement gap for such clients might be a large injection into their portfolios, the kind that would typically come from an inheritance. However, it could also come from the sale of a highly appreciated asset, now valued at its zenith. That asset, of course, is the house. A planned trade down is the sale of the primary residence to purchase a smaller property, which will free up cash to be repositioned in other investments.

We believe this strategy has increasing relevance for clients for several reasons. First, the average house in the U.S. appreciated 11.2 percent last year, compared to an average annual appreciation of 6.9 percent since 1945. There is no reason to believe that the rate will not eventually return to the norm — or, if the bubble alarmists are correct, that prices of residential housing in many markets will drop precipitously. Either way, it may be an excellent time to realize gains on home assets. Second, the average pre-retirement couple is rattling around in a house that is much larger than they need. Third, the cost of electricity, heating fuel, insurance and property taxes is growing at a pace that easily exceeds that of market investment returns; each year the house costs more to operate. Fourth, the current tax laws favor the house owner, who can use a $500,000 exemption on capital gains on the sale of a home, providing it has been owned in two of the last five years.

While the financial reasons should be persuasive, there are also emotional considerations: Many clients tell advisors that their house is bigger than they need, but they don't want to say goodbye to fond memories and face the hassle of moving. The answer, which must be tactfully transmitted, is that these emotional wounds are nothing compared with the pain that's in store if the client runs out of money in retirement.

Making a plan today to sell a highly appreciated house can not only help pre-retirees make the most of their final years of wealth accumulation, it can prevent a common disaster for older retirees — being forced to sell a house in a soft market, and perhaps in a state of disrepair, due to the age of the tenants, etc.

Clients can be shown that long-term financial security may be of more value than living with memories that are actually quite portable — and that life can be more enjoyable with the reduced burdens of maintenance, taxes and upkeep on a smaller home, townhouse or apartment. Instead of mowing the lawn, painting the house and replacing the roof, pre-retirees can build a financial legacy that will put their grandchildren through college.

Let's take a look at how one advisor handled a planned trade down:

A 57-year-old couple plan to work until they are both 65. With two children out of college, combined incomes of $150,000 and no current debt, they had been adding $4,000 per month in net savings to their existing retirement savings of $250,000. The advisor figured that $4,000 a month over eight years in a conservative portfolio will provide them approximately $775,000 at retirement. Based on market fluctuations, he estimated that the probability of achieving this is 55 percent. Plus, the plan didn't allow for potential threats, such as a debilitating illness — the couple lacked life insurance, long-term care insurance and adequate disability coverage.

But the couple was sitting on a potential solution: a $350,000 house with no mortgage. This asset was not part of their current financial plan. The advisor shared the concept of trading down now to a smaller brick townhouse that was listed for $200,000. One immediate benefit would be less time and money devoted to maintenance, lower utility and insurance costs, and a 50 percent reduction in property taxes. They met with a local real estate broker, visited the townhouse and decided to make a bid. After the agent's commission, the couple would net $333,000 from the sale of the old house.

The couple now had a second decision to make: how to deploy that money. They could pay cash for the $200,000 townhouse and move $133,000 to their portfolio. Or they could borrow the full $200,000 to increase tax deductions and move the entire $333,000 into their new portfolio. They decided to borrow 80 percent of the new house price ($160,000), using a 10-year interest-only loan at 5.5 percent. This payment, after deductions in their 34 percent bracket, yielded a net payment of $484 per month fixed for the next 10 years.

That gave the couple $293,000 to move into their retirement portfolio. As a result, the advisor told the couple they could reduce their monthly savings from $4,000 per month to $3,000, and calculated a 99 percent chance of reaching their retirement goals, because now they needed only a 1.56 percent annual return over the next eight years. The advisor then turned to the $1,000 per month that was no longer needed for retirement and counseled his clients to purchase a $150 per-day long-term care policy on both spouses, a $500,000 indexed universal life policy that would pay off the mortgage and increase their estate value and a disability policy on the husband. The 50 percent reduction in their property cost for taxes, utilities and maintenance and homeowners insurance would provide them an additional $750 per month, more than enough to pay their $484 per month house payment and provide some additional money for other lifestyle expenses.

In 10 years their mortgage will adjust to an amortizing adjustable note. At that time they can pay it off in full from their savings, pay it off by selling the property or refinancing the property or use any number of other alternatives given their liquidity and desires at that time.

Without increasing their income, this couple was able to increase their chances of success in retirement, diversify their savings, increase their future estate value, protect their retirement from disability or illness and decrease the time spent maintaining their house.

This was all made possible because the advisor opened up the clients to the idea of using their largest asset in a creative way. The market's message to the consumer is creating fear. Why not use the “bubble conversation” to improve your client's balance sheet and trade fear for a financial solution.

Trading Down