A friend stopped by for dinner last week. We spent a few minutes catching up on the weather, politics, and the usual chitchat. But as is often the case, the subject eventually turned to money.
Her situation is fairly typical for someone her age. She will turn 65 later this year and plans to fully retire at that time. Her significant other is 70 and retired several years ago.
Because they are both divorced with grown children, they will keep most of their financial assets separate for the remainder of their respective lives. However, they will split the cost of a house in retirement.
Originally, they were planning to pay cash for the new house. But a financial planner convinced them it would be wiser to rent instead. That way, they avoid the hassles and additional expenses of homeownership.
As a former financial planner, I can appreciate the appeal of that strategy. Buying a house is a major commitment. When you rent, you can walk away at the end of the lease term with no further obligation.
The problem I have with that strategy is that it relies on consistent stock market appreciation to make the numbers work. Heres what I mean.
Instead of each of them pitching in $250,000 to buy a $500,000 house, they would invest that money in a diversified portfolio. They will need to take withdrawals at a 6% rate to cover the $2,500 monthly rent.
Over time, the rent will go up. Hopefully, so will the value of their joint investment account. But if the stock market goes through a major correction before their accounts can appreciate then they may be in big trouble later on.
Lets assume that the stock market appreciates 20% during the first two years of their retirement. In that case, their $500,000 investment will have grown to $540,000 ($100,000 stock market appreciation minus $60,000 in total rental payments).
So far, so good.
But suppose in the third year the stock market drops by a third. That happens more than most people realize. Over the past 21 years, the stock market has gone through three corrections of at least 34%.
If that were to happen, their investment account would lose $180,000 in principal value. Plus, they’d still have to pay the rent.
That means that at the end of the third year their account is only worth $330,000 after paying that years rent. At that point, their $30,000 in annual withdrawals now equates to more than 9% of the principal value of the investment account.
That’s when the trouble begins.
Three years into retirement, my friend would be only 68 years old with an expected lifespan of another 15 years. One more major stock market correction during her lifetime could wipe her out.
That is the scenario that must be avoided. I spent nine years of my career advising employees of a Fortune 500 company that were eligible for early retirement. In nearly every case, their single biggest fear was outliving their money in retirement.
It isnt just the possibility of having to significantly downgrade their lifestyles that scares them. It is also the fear of becoming a burden on their children or other family members for the rest of their lives.
If it were possible to safely earn interest income of 6% 9%, it might make sense for my friend to rent. Unfortunately, historically low interest rates mean bond yields are also very low. For example, the Fidelity Investment Grade Bond Fund (FBNDX) pays an annual dividend yield of just 1.7%.
Even junk bonds dont pay enough to cover the rent. The Vanguard High-Yield Corporate Fund Investor Shares (VWEHX) ETF pays only 4.5%. And if our economy goes through a protracted recession that triggers a stock market recession, some of those bonds may go into default.
As for my friend, I suggested that she pay cash for the house. That way, even a stock market crash cant cause her to run out of money later on.
Sure, the house may also depreciate under that scenario. But that is an asset that will pass to her children upon her death. In that case, her standard of living would not be affected.
[URGENT] Have you seen this "Dividend Map" yet?! [sponsor]
I call it my "Dividend Map", and I'll show you exactly where to find the safest companies that pay the highest yields. (HINT: Texas has 6 of these companies sending huge payouts that average 69%!). I'm willing to send you my Map... but only if you click here right now. If I don't have your name on my list in the next 2 hours, I'll assume you don't want to make monster dividends.
Click here right now.