Friday, July 19, 2019

Debt In Retirement for the 401(k) Generation

Does being in debt in retirement make any sense?  Not for anyone, but in particular for our generation.

A reader writes asking to interview me about debt in retirement.   I can save the interview and just write my thoughts here.   Debt is never advantageous to anyone, but it is particularly toxic to anyone who entered the workforce after 1978 and has to rely on a 401(k), IRA, or other self-funded retirement vehicle to get by in old age.

I wrote before about friends of mine who are retired government workers, both with nice pensions that, combined, are over $150,000 a year.   They live well, but not much above a standard middle-class existence, mostly because a huge chunk of their retirement income is taken up by interest payments.   The husband confided in me that they only have $30,000 in savings, and when they want to buy anything - a car, a boat, or an RV, it is off to the credit union to borrow, based on their income.  Oddly enough, they are both staunch Republicans, too.

But it is a game played by Democrats, as well.  On our retirement island are a host of retired New York State school teachers, who between the husband and wife, drag in about a hundred-fifty-grand a year, because, you know, school teachers are scandalously underpaid.   And like my Republican friends, they too, borrow to buy a car or a house or whatever.   So while they have huge incomes, most of it goes to monthly payments, servicing debt, including mortgage interest.

And under the old tax laws, maybe this "made sense" as their relatively high incomes meant they had high taxes, which could be offset by mortgage interest tax deductions.   But never use the IRS tax code as an investment guide - that is a classic middle-class chump mistake.   Take a deduction if you qualify, or better yet, a tax credit.  But don't alter your behavior based on these elusive deductions, it never ends well.

For our generation, we don't have much choice.   Thanks to Congress, we have to save up a million bucks or so to retire.  Yes, a million bucks.   You see, in order to have a paltry $50,000 in retirement income each year, you need a million dollars, if you withdraw using the 5% rule.  Do the math.  This also means that our "middle class" pension friends with $150,000 annual pensions, have the equivalent of $3M in the bank but if asked, would never admit to being one of those evil 1%'ers.  But I digress.

The point is, it makes no sense whatsoever, if you've saved up that mythical million bucks, to fritter it away in retirement on interest payments.  In fact, you can't afford it - you'd be broke in no time.  Even if you could "afford" it, it is an awful risk to take.  Let me explain both issues.

I "make" just over $25,000 a year in taxable income, withdrawing from my 401(k).   This means my tax bill is nonexistent, for the most part.  It beats the hell out of a mortgage interest deductions.   The rest of my "income" is another $25,000 or so I withdraw from after-tax savings, and thus I "make" (spend) about 50 grand a year, the median income in the United States.   Yet, I live in an identical house to my schoolteacher friends down the street, who have $150,000 in annual pension income.  We both drive late-model cars, and have pretty similar spending habits (well, they go out to eat more than I do).   Our lives look pretty interchangeable, yet our incomes are radically different.  How is this even possible?

Well, to begin with, even with mortgage interest deductions, they pay taxes - a lot of taxes - whereas I pay hardly any.   We tax income but not wealth (thank God!  And no, AOC, you can't touch my pile!) in this country, which is a good thing.  So my pensioner friends have to worry about taxes and such, and chase after deductions as a result.    Second, they have a mortgage and car loans and other debts, which represent a substantial cash-flow requirement that doesn't exist for me, as we are debt-free.  That's at least another $20,000 a year or so, just in monthly mortgage payments.  Throw in the car payments, and whatnot (including long-term credit card debt, home equity loans, etc.) and pretty soon, their hundred-grand advantage in "income" is pretty much wiped out.

Of course, we live a little more frugally (the entire point of this blog).   They hire a guy to remodel their house, we do it ourselves.  They go out to eat and put it on a credit card.   We buy groceries and invite friends over for dinner.    They go to the barbershop and hair dresser, we cut our own hair (and that of two friends) in the garage, serving inexpensive champagne to make it a party.   Our lives are different, but yet we live on the same block and have the same relative standard of living.

If we had to service debt, it would be a different story.   We would not be living here, but rather in a much less expensive home, somewhere else.   Debt for the 401(k) generation is simply not an option and it is risky.   That is the second aspect of it, as I noted above.

Our (former) investment adviser at Fidelity (boo! hiss!) wanted us to not pay off our mortgage when we sold our vacation home in New York, but rather keep our primary mortgage and invest that cash with him.   From his perspective it "made sense" on a number of levels.  As a young guy in his 30's, he was mired in the debt culture - he had a mortgage, a home equity loan, two car loans, student loans, and maybe even credit card debt.   He knew no other way of living.   He had a fancy car and house, of course.     And of course, if I invested the money with him, he would get some sort of commission out of the deal (although Fidelity is never clear how much these guys are being paid or how, which is why I no longer do business with them).

He tried to use the opportunity cost argument  on me.   I was giving up the opportunity to make 10% in the stock market in favor of saving 4.5% in mortgage interest.   A neat argument that works in his favor of course, but the reality is, comparing risky potential returns of 10% in the market with guaranteed saving of 4.5% in interest is comparing apples and oranges.   And what if the market goes down?   That would never happen of course, as we all know that returns on the stock market are guaranteed and what's more the market never goes down.   Well, except in 2008, and 1995, and 1989, and 1929, and so on and so forth.

What happened to the people who bought into the "opportunity cost" argument, was that in 2008 their investments in the stock market tanked, while at the same time, the value of their house declined.   They still owed all that money on the mortgage though.   So overnight, they went from being millionaires on paper to being utterly insolvent.   Worse yet, many cashed in money from their 401(k) to make payments on these underwater houses or cashed in their IRA entirely (resulting in horrific tax bills) only to lose the mini-mansion in foreclosure a few years later.   Some people are still making payments on these underwater houses, a decade later.

It's just too much of a risk to take in retirement.   Most rational investment advisers suggest that you use  your age as a "rule of thumb" to decide how much to put into relatively "safe" investments.  Thus, at age 60, I should have 60% of my investments in safe harbors - cash, money market accounts, government bonds, and so forth.   Paid off debt is the safest investment you can make - safer than even government bonds.   Maybe it isn't as sexy as some new dot-com startup IPO, but it is 1000% safer, and in old age, you can't afford to lose it all - or even some of it - in risky investments.

Besides, at this point in your life, time is no longer on your side.   When you are 20, you can afford to invest in long-shot deals or long-term payoffs.   At age 60, 70, or 80, the payback simply isn't there or isn't as great.   Yes, I am losing potential gains by leaving money in a savings account.    But it will likely be spent by next year, so am I really losing all that much?

The sad thing is, of course, that a lot of people in the 401(k) generation have little saved for retirement, have huge mortgage debts (having refinanced again and again), car payments, and even credit card debts.   At age 55 or thereabouts, retirement will be thrust upon them, and not only will they be broke, they will actually have a negative net worth.

The problem is, we are applying debt philosophies from the old paradigm to a new one.   Investment advisers, like my Fidelity guy, are using borrowing advice that might have "made sense" for the pensioner generation, but is toxic advice for the self-funded retirement age.   One purpose of the 401(k) and IRA laws was to encourage people to think as investors, not as pensioners or dependents.   The other purpose, of course, was to avoid further meltdowns with underfunded pension plans, and bankruptcies and high taxes generated when municipalities have to pay out on these long-ago made promises.

The IRA generation has to think like investors, and this isn't easy to do.   People who have been getting weekly or bi-weekly paychecks for decades become dependent on their jobs and their employers.  They view money as something that passes through their hands, not something they own.  It is funny, but these concepts are so ingrained in our society that when I Google to find my article on "owning money" Google replies, "You meant owing money.  Showing results for owing money instead!"   Because as Google knows, everyone owes money to someone and no one actually owns it.

Changing this mindset will be nearly impossible to do.   In fact, it may never change.