The primary risk that retirees and those approaching retirement face is an obvious one: running out of money. However, a study published in the Journal of Financial Planning suggests reverse mortgages can help retirees protect their portfolios from market dips and extend their savings.
Rather than relying exclusively on distributions from investments, retirees can temporarily replace those withdrawals with income from a reverse mortgage line of credit when their portfolios lose value during downturns. Doing so minimizes sequence of returns risk – the danger posed by taking distributions during a down market – and lowers the chances that a retiree runs out of money.
Sequence of Returns Risk in Retirement
For investors with a longer time horizons before retirement, market volatility does not automatically equate to risk. After all, an investor in her 30s has decades to recoup losses that her 401(k) incurs during a market selloff or full-blown bear market.
But retirees and those quickly approaching retirement do not have the same luxury. Even short-term market volatility can dramatically eat into a retiree’s nest egg, the person’s primary source of income now that he or she is no longer working.
If the market dips at the same time a retiree begins making portfolio withdrawals, the person’s portfolio will presumably lose value. As a result, these regular withdrawals take a larger bite out of the pie compared to if the money was withdrawn during a bull market. This is known as sequence of returns risk and it can be a particular concern for retirees reliant on the income their portfolios will produce.
“The important point, indeed the essential point, is that the sequence of returns risk only applies to a portfolio from which distributions are being taken,” Philip Walker, Barry Sacks and Stephen Sacks wrote in their white paper, “To Reduce the Risk of Retirement Portfolio Exhaustion, Include Home Equity as a Non-Correlated Asset in the Portfolio.”
It should be noted that Walker is the vice president of strategic partnerships for the retirement strategies division at Finance of America Reverse, a reverse mortgage lender. Meanwhile, Barry Sacks is a practicing tax attorney in San Francisco and Stephen Sacks is a professor emeritus of economics at the University of Connecticut.
As part of their study, the trio of experts examined the impact that skipping withdrawals can have on the longevity of a retirement portfolio. To do this, they considered how a portfolio comprising S&P 500 stocks worth $750,000 would have fared during the 30-year period between 1990 and 2019. Assuming the retiree withdrew 6.15% ($46,125) of his or her portfolio in 1990 and increased subsequent withdrawals by the rate of inflation, the study found that the portfolio would have been exhausted by 2018.
However, if the hypothetical retiree had skipped an annual withdrawal twice during the 30 years, his or her portfolio’s long-term health would have significantly improved. More specifically, by skipping withdrawals in just two years that followed negative investment returns, the retiree would preserve more of his or her portfolio and benefit from market’s eventual rebound. By forgoing withdrawals in 2009 and 2016, the trio of researchers calculated the portfolio would be worth $300,000 in 2019. If the skips occurred even earlier, in 1995 and 2003, the retiree would have even more money in 2018: $500,000.
“In one sense, it is intuitively obvious: If two years of distributions are skipped, the portfolio will last two years longer,” Walker, Sacks and Sacks wrote. “But think again: If the two years’ distributions that are skipped are distributions that follow years in which the portfolio has had negative or weak investment returns, perhaps the subsequent recovery of the portfolio (richer by the amount that was not distributed) might cause the extra duration to be more than two years. And that’s exactly what happens.”
How a Reverse Mortgage Can Protect Your Portfolio
While skipping distributions can extend the life of a portfolio, most retirees will need a way to replace the deferred income. Home equity is one way to do so, especially for retirees who own their homes and have between $500,000 and $1.5 million in retirement assets, according to the study.
“If home equity is included in the portfolio, it can serve as the source from which to distribute income while skipping distributions from the volatile securities,” the authors wrote.
A reverse mortgage is a common way for people age 62 and older to convert home equity into cash flow. By borrowing against the value of their home, a retiree receives cash or a line of credit and doesn’t have to make monthly loan payments. However, the loan balance is due when the borrower moves or dies. As a result, a reverse mortgage can diminish the value of a retiree’s estate and reduce the amount of money beneficiaries may inherit one day.
But they’re an effective way to protect against sequence of returns risk, according to Walker, Sacks and Sacks.
“It is reasonable to conclude that a way of reducing a retiree’s risk of cash flow exhaustion when a securities portfolio is the retiree’s primary source of retirement income is to skip some distributions from the volatile securities in the portfolio after the securities have had negative or weak investment returns,” they wrote. “Of course, the retiree must have income to live on, which will come from the other asset in the portfolio, i.e., the home equity.”
The researchers compared an income strategy reliant solely on portfolio withdrawals and one that replaces those distributions with reverse mortgage payments in years that follow negative or weak investment performance. The analysis found that risk of cash flow exhaustion under the former is approximately 10 times as high as the latter when the initial home value is twice the value of the investment portfolio.
When the values of the home and portfolio are equal, the risk spread is less dramatic, but still substantial. In this scenario, the securities-only strategy is approximately seven times as risky as the strategy that uses a reverse mortgage.
As a result, retirees (and their financial planners) should incorporate home equity into their withdrawal strategies, the trio of experts concluded.
“Within the last year or two before this writing, financial planners, including some large organizations, have begun to recognize the value of home equity in retirement income planning,” they wrote. “It is hoped that many more will in the near future.”
Market volatility is a significant risk factor for retirees and those who are approaching their golden years. A market downturn in the early phase of a person’s retirement can increase the probability that their portfolio runs out of money within 30 years.
However, a study published in the Journal of Financial Planning illustrates how income from a reverse mortgage can help retirees avoid taking distributions during downturns and bear markets, at least until required minimum distributions kick in.
Tips for Your Withdrawal Strategy
Consider allowing a financial advisor to help you devise a strategy for withdrawing your retirement assets. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
How much you plan to spend in retirement is a key consideration that will inform how much you regularly withdraw. Fidelity’s 45% rule states that your retirement savings should generate about 45% of your pretax, pre-retirement income each year, with Social Security benefits covering the rest of your spending needs.
Photo credit: ©iStock.com/Kameleon007, ©iStock.com/StefaNikolic, ©iStock.com/Rawpixel Ltd
The post This Strategy Can Preserve Your Retirement Savings in a Down Market appeared first on SmartAsset Blog.