Traditional retirement advice typically calls for paying off the mortgage and reducing debt as much as possible before moving on to what’s sure to be a smaller paycheck.
Tom Anderson says that’s a big mistake.
Anderson, author of “The Value of Debt in Retirement,” says people should think more like corporations by balancing debt with the cash they have on hand. While some debt should be paid off as soon as possible, he says, not all debt is bad.
The trick is to keep the money in the bank or to invest it in something that would pay more than the cost of the debt you’re carrying, he says. The strategy is not for those short on willpower.
Anderson, a wealth manager in Chicago, recently spoke with The Post. This has been edited for length and clarity.
Tell us about your strategy.
All that I’m doing is taking corporate finance ideas and applying them to the individual. I spent a long time studying finance and optimal debt structures. If you take on too much debt, your company is going to go bankrupt.
People can have too much debt or be very debt averse. Few have an optimal debt ratio. There is no middle ground. All I do is take corporate debt ratios and make them more conservative and apply that same framework to the individual balance sheet.
For an individual, what would be an example of that optimal balance?
When you’re getting close to retirement or in retirement, I like a range of 15 to 35 percent. Most people are way above or way below that. So if I have $100,000 of net worth, I could have $150,000 in assets and $50,000 worth of debt.
If you have more than $50,000 in debt, then you are really counting on things going your way. If you have a lot less than that, you may not get that optimal approach.
That ratio must be very important.
Right. What we do in America is start out with a whole lot of debt and try to rush to come down to zero. There should be more balance.
Is there such a thing as “good” debt or “bad” debt?
There are different types of debt. There’s what I call oppressive debt, working debt and enriching debt. Oppressive debt is going to be things like your credit card debt or any debt that is over a 10 percent interest rate, payday loans, all of that stuff. Get rid of it as fast as you can.
Then there is working debt. Many mortgages can have a rate of 3, 4 or 5 percent and they might be fully tax deductible for you as well. Then you have enriching debt, which is debt that you’re choosing to strategically have but that you can pay off at any point in time.
When would it not be a good idea to pay off your mortgage in retirement?
I would argue that unless you have enough money to pay off all of your house, don’t pay off any of your house. The second you pay down your house, it’s a one-way liquidity trap, especially for retirees. Let’s say I have a $100,000 mortgage and I put down $50,000 on it and I retire. Can I access that $50,000? I can’t.
Not paying it down can increase your liquidity. It can increase your flexibility. It can increase your overall rate of return. It can maximize your tax benefits. And it can actually reduce your overall risk. Companies do this all the time. Why? Because they value liquidity and flexibility.
Can’t people tap that equity by taking out a home-equity loan or line of credit?
It definitely makes sense to have that home-equity line of credit in place, but you may need more liquidity than that. And if we think about 2008, which is my base case, many home-equity lines of credit were canceled or reduced. Nothing buffers you like having money in the bank.
Does this approach only make sense when rates are low?
A famous economist said that interest rates are never good or bad. They’re a function of the economy at any given time. In 1980, maybe you had mortgage rates at 12, 13 or 14 percent. You maybe could have invested in a Treasury bond at 15, 16 or 17 percent. So you would still have a positive spread.
The problem today is there’s an illusion that low rates are good, and, therefore, they’re pushing people to take on more debt and to reach for return. If I’m paying 3 percent for my mortgage, but Treasurys are only paying 1 or 2 percent, that’s actually a negative spread.
How do you measure the value of that liquidity?
Let’s say I have $100,000 mortgage and that my after-tax cost of that is 2 percent. If I had that $100,000 invested at a rate of return of 4 percent, I would have incoming cash flow of $4,000. I would have spent $2,000 on mortgage interest. I would have $2,000 a year coming into my pocket. If you capture a spread, it’s good. If you don’t capture a spread, it’s bad.
I would argue that money in the bank is a way of protecting myself. It’s an insurance policy.
Can you give me an example of when someone would benefit more from having that cash on hand?
So many people do exactly what my grandfather did. He had a fabulous job with the federal government and a conservative, middle-class family. He paid off his house and had a pension and Social Security. Then he had a long battle with Alzheimer’s, a battle he ended up losing. When that battle got particularly complicated, he needed to move into an elder-care facility.
So how do you do that? You can’t get a mortgage for that. He couldn’t access the equity in his home. He needed to go right away, and what he wanted was to sell that house and go in. Instead we used my parents’ assets to bridge that, just until that house sold. But that’s another strategic use of debt. An elder-care bridge loan is a situation that many retirees end up having to face. You can protect yourself from it by keeping your own liquidity.
Let’s talk about someone who is trying to save while paying down debt, which is a big thing for anyone who has student loan debt or credit card debt. How do they balance those two?
I think what you need to figure out is am I under-saved or over-saved for retirement? Then you look at if you have debt or don’t have debt.
If you have debt, you say, what’s the rate on that debt? If it’s over 10 percent, say I have a credit card that charges 20 percent. I know of no investment that will give you a guaranteed rate of return of 20 percent, so pay it off.
But debt that gets between 5 and 8 percent, you might want to see whether it has tax benefits. Generally, I still want that to get paid off, but I do need to make sure I have liquidity.
I think people should value liquidity. Do not pay down debt that is less than 5 percent if you’re not on track for retirement.
If somebody has no emergency savings, should they put everything they have into paying off that 20 percent debt before they save?
First, people need to have a three-month cash reserve – whatever money you need on a bottom-line, after-tax basis. You need to have some oil in the engine.
Even if I have debt, I need to have some liquidity to survive. Once I get to liquidity, I want to start to reduce that credit debt. Then I want to come back to that liquidity and build it up to six months and, at the same time, I want to be building up my retirement savings. So a lot of people will have credit card debt and they’re putting money into their 401(k). And I understand why people do that, but it is mathematically unusual.
We all have limited resources that are coming in that we’re trying to stretch. How do we prioritize that?
To be clear, this strategy only holds up when people are saving the money that they aren’t using to pay down debt, correct?
Yes! That is the most important central premise. My plan is you can either pay off the debt or you save. If you go out and buy a Maserati, all bets are off. This is not about buying things that you can’t afford. It’s about finding better ways to pay for things that you can afford.
Debt can increase your rate of return. It can reduce your taxes. The question is are you able to implement those ideas effectively?