Spring 2008

Reshaping Retirement Planning
By Neal E. Cutler, PhD
Aging Well
Vol. 1 No. 2

Important changes are occurring in the “three-legged stool” model of retirement income security—Social Security, employer pensions, and personal savings and investments. For many baby boomers, employment wages represent a dramatic change in their thinking about work, aging, and retirement, creating a “fourth leg.”

But what about home ownership, the “fifth leg” of the stool? What is the impact of paid-up mortgages on the personal perception of financial security, and why should such confident perceptions be tempered by the mortgage crisis of 2007-2008? The current mortgage situation is a dramatic red-flag warning to boomers—and their friends, families, and financial advisors—about banking on their home ownership as the core of their future retirement income.

Changing Retirement Perspectives
Baby boomers, born between 1946 and 1964 and now moving into and through middle age, are witnessing a transformation of all three of the traditional legs of the retirement income stool. With respect to the first leg, boomers are ineligible for full Social Security benefits until they reach the age of 66 or 67, rather than the traditional age of 65 they anticipated when they were younger.

The second leg has also been substantially and dramatically transformed. During the past 25 years, the American pension system underwent a transformation from a system in which the employer or union guaranteed in advance the amount of a retiree’s pension—known as a defined benefit system—to a system that relies largely on IRA, Keogh, and 401(k) accounts—known as a defined contribution plan. With these plans, the employee’s own investment choices and decisions shape the amount of the pension. For investments, future value, such as the future value of defined contribution pension plans, depends on the combination of the employee’s own financial literacy, risk tolerance, investment choices, financial advice, behavior of stock markets domestically and abroad, and luck.

Early Retirement — A Thing of the Past?
The three-legged stool model has itself morphed into a more complex piece of financial furniture. Some analysts have added a fourth leg: income from employment. For several decades, both the image and the reality of work in America have found Americans retiring earlier than the traditional age of 65. The traditional age has held since 1935 when legislation designated 65 as the age of eligibility for full Social Security benefits. From 1975 to 1993, the number of people aged 55 and older in the civilian work force declined from 35% to 29%. However, a recent study by the Employee Benefit Research Institute documents that this trend is reversing. More older workers are remaining in, or perhaps returning to, the labor force. By 2006, the percentage of older workers aged 55 and over increased to 38%. In looking at these trends in more detail, researchers at the Urban Institute predict that the combination of increasing health costs, with most families’ health insurance acquired as an employment benefit, and the shift to defined contribution pension plans will continue to make employment a source of older age income.

Home Ownership: The Fifth Leg
The fifth leg of the retirement income security stool rests on the accumulated equity of home ownership. Professional advisors who specialize in retirement planning (e.g., certified financial planners and registered financial gerontologists) typically identify three connections between home ownership and financial security in retirement: the prevalence of home ownership in the United States, the psychological impact of ownership on an individual’s perception of future financial security, and how the equity from ownership can be used to fund retirement. To these three we add a fourth: the current mortgage crisis as a warning flag.

Older Americans are a population of homeowners. A study by the National Council on Aging documented that among people between the ages of 54 and 64, 94% are homeowners and only 6% are renters. The parallel data for people aged 65 to 74 are 96% vs. 4%. Furthermore, most older homeowners have paid-up mortgages, although the numbers vary by age and family income. The bottom line is that home equity can be a major source of later life cash.

The same research documented that home ownership has both a financial and a psychological component. The survey asked for agreement or disagreement with this statement: “Money is a problem for me.” The actual level of agreement, as one would expect, varies by income: Less wealthy people are more likely to agree than disagree.

More to the point, however, is that within every subgroup polled—middle-aged and older, more and less wealthy, married and widowed, and Caucasian and African American—home owners who have a paid-up mortgage are less likely to respond that money is a very or somewhat serious problem for them. It is in this sense that home ownership plays a dual role in retirement planning; it is of both financial and psychological importance as it affects feelings of financial security.

Another aspect of the relationship among home ownership, retirement, and financial security involves the different methods by which home equity can be “released” as income. Each of these methods is fiscally complex, and the exploration of them is outside the scope of this forum, but each should be part of the larger picture of financial literacy and retirement advice. Perhaps the simplest method is the sale of the home and using the net proceeds after sales commissions, taxes, and the cost of new housing for retirement income. On the other hand, when health permits, continued independent living at home is almost universally desirable. In such a case, a home equity line of credit offers a solution but often requires the creditworthiness of the borrower, which in turn may be influenced by whether or not the borrower is employed.

An important but controversial alternative for retirees, or for any person aged 62 or older, is the reverse mortgage, in which the property rather than the borrower qualifies for the loan. The reverse mortgage offers a substantial advantage in that it does not have to be repaid as long as the older borrower or surviving spouse lives in the home, even if the total amount borrowed (i.e., the original loan plus accruing interest) grows to be larger than the market value of the house. After the borrower dies or moves into a nursing home, for example, the house is sold, and the net proceeds are used to pay off the reverse mortgage.

Even if the total amount then owed—principal plus interest—has increased beyond the home’s value, the older adult or the estate remains exempt from paying this larger amount. That is, the upper limit of the amount that must be paid back is the market value of the property. And in the event that the house sells for more than the amount owed, the remainder belongs to the older person or the estate.

However, the reverse mortgage process involves additional complexity because both the homeowner’s age and health and the home’s characteristics, market value, and location affect the amount that can be borrowed. Because a reverse mortgage is first and foremost a real estate transaction involving many legal, financial, regulatory, and investment decisions related to a traditional mortgage, it is both complex and expensive, despite its gerontological context. Financially, it may not be the best approach for many, especially middle- and lower-income homeowners and families, making it somewhat controversial.

The conundrum then is how the 2007-2008 mortgage crisis has emerged as a warning flag to boomers accumulating home equity and who may want to use this equity when they approach the age of 80. Using 80 for calculation purposes, the first group of boomers—those born between 1946 and 1955—may want to unleash their home equity somewhere between approximately 2026 and 2035. While predicting the real estate scenario for 2030 remains impossible in 2008, based on current research, we do know that owning a home with a paid-up mortgage promotes positive feelings of financial well-being. Knowledge of financial methods, such as the reverse mortgage, that are specifically designed for older adults who are cash poor but equity rich can inflate current perceptions of future financial well-being. Further, all this is incorporated within the traditional American dream of buying a house both for its value as a home and for its value as an appreciating investment. As our parents told us, “Don’t wait to buy real estate; buy real estate and wait!”

The potential fallacy in this calculus—and hence the warning that the current mortgage crisis offers—is that these future funding approaches depend on the existence of a reasonably robust real estate market and mortgage market at the time we want to liquidate our “equity-rich” real estate. What if there are no buyers? Or, more likely, what if there are fewer buyers, more houses for sale, and, just as in 2008, a decline in the availability of lendable money, either for reverse mortgages or to finance the loan sought by a prospective buyer?

None of this constitutes a doomsday prediction. Rather, the key lesson involves the traditional and fundamental pillar of financial literacy and investment decisions: diversification. Yes, today’s retirement financial planning should include the expected future value of the family home, whether it’s sold or used as the basis of a reverse mortgage. But boomers and advisors should anticipate that the home ownership environment of 2030 could look something like 2008 and integrate that possibility into current retirement financial planning.

— Neal E. Cutler, PhD, is executive director of the Motion Picture & Television Fund’s Center on Aging in Woodland Hills, CA. He is also vice president and dean of the American Institute of Financial Gerontology, which provides applied gerontology training to qualified financial professionals. He is a fellow of the Teachers Insurance and Annuity Association College Retirement Equities Fund Institute and the Gerontological Society of America. In 2002, he published Advising Mature Clients: The New Science of Wealth Span Planning.