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Ecology of Money

Is the 'Fourth Leg' of Your Retirement Stool Wobbly?

Investors can no longer rely on home-equity growth as part of their retirement plans, writes contributor John Wasik.

For many retirees, home equity has traditionally been a steady fourth leg of their retirement stool. In the past, growing home values could prop up one's total wealth when the other legs (Social Security, pensions, and savings) appeared wobbly.

But changing demographics, the housing crash of 2008, and the future of U.S. residential real estate are leading many to reconsider how to view home equity in a retirement plan. That fourth leg of home equity may not be all that sturdy for future retirees, who number some 44 million between the ages of 50 and 60.

History and Prospects
To understand the dynamics of this potential source of retirement wealth, you need to understand what has been going on in the housing and labor markets over the past decade or so.

In order for home equity to grow, housing prices need to increase faster than the cost of living. Land becomes scarcer as more homes are built--especially on the coasts, where land is in greatest demand--then prices rise. The price ascension is aided by a steady stream of buyers who are getting older, wealthier, and more inclined to buy ever-larger homes.

That favorable supply-and-demand formula has worked for more than a century. In fact, from 1890 through 2010, home prices in the U.S. only appreciated at an annual average rate of 3%, according to Nobel Prize-winning economist Robert Shiller. Uncle Sam has done his part to prop up demand with mortgage interest and property tax breaks, mortgage guarantees, and public goods like free highways and other amenities. And finally, the demographic explosion called the baby boom added more than 77 million souls to the population and made single-family homes even more desirable.

Yet, as the baby boomers retire and they and their parents move out of their family homes, there may not be enough buyers for the influx of properties coming on the market. That could put a brake on home price increases.

To make matters worse, the 70-million-plus millennial generation isn't buying homes the way their parents or grandparents did. Saddled with some $1.2 trillion in student debt (according to the U.S. Department of Education) and lackluster job opportunities, they are reluctant about homeownership. That reluctance could be a long-term party-stopper for home-equity appreciation.

Nevertheless, there are pockets where residential real estate values are expected to buck the odds. The Local Market Monitor, a national real estate information service, predicts the following markets will have the strongest growth during the next three years: Dallas (33%); Houston (31%); Austin (30%); Tacoma (29%); and Miami (27%).

How Do Diminished Home Values Impact a Retirement Plan?
How much lower home-equity values pinch your retirement depends on how well you've saved and invested in other areas. If you've created a solid diversified investment portfolio, a decline in your home-equity value may not matter to your retirement.

"I don't necessarily view a home as a retirement investment," says Liz Revenko, a certified financial planner with Mosaic Financial Partners in San Francisco. "It's your personal residence--the place you live in, not a diversified, liquid investment. It can be risky to count on a home's equity for spending needs until it's sold. It continues to be important to save adequately for retirement outside of your home value."

Nevertheless, the idea of looking at reduced home equity some seven years after the housing bust is vexing. What can you do if you have, in fact, been relying on growth in your home's value as you approach retirement? You can work longer, reduce your consumer debt, save more, and spend less. All will help build up your nest egg as you near retirement.

You might also consider buying a lower-priced home and pocket the difference to bolster your retirement fund. Dave Demming, a financial planner in Aurora, Ohio, maintains that most Americans don't take this route. "It's a myth that people buy smaller, cheaper homes in retirement," he says. It is, nevertheless, an option.

Relocating is another option. There's still a palpable hangover from the housing crisis in some of the areas where price gains appear to be strongest, with millions of foreclosed and bank-owned properties available. The Local Market Monitor notes that prices in most parts of the U.S. are "still 15% to 20% lower than where they ought to be."

Bargain-seekers might look in areas hurt most from the downturn in Florida, Arizona, and Nevada. Homes on Florida's west coast lost up to 50% of their value in the housing bust, according to Local Market Monitor. There are also still good values to be found in the Carolinas, Florida's east coast, and Savannah-Brunswick, Georgia.

Like most financial planners, Demming says you need to focus on cash flow in retirement. How much will you need to withdraw from your nest egg to live comfortably? Can you trim your withdrawals by spending less? If you need money to live on, refinancing and doing a cash-out or obtaining a reverse mortgage is possible. But those options require that you go into debt and pay closing fees. As such, these are really last-resort alternatives to obtain cash. They are inferior substitutes to prudent portfolio planning.

Residential real estate isn't the "sure bet" it used to be. Housing values can get derailed by credit bubbles, overbuilding, job declines, and recession. At the end of the day, don't rely on your home to provide an engine of growth for your retirement. That's what a diversified portfolio is for.

John F. Wasik is a freelance columnist for Morningstar.com and author of 14 books, including Keynes's Way to Wealth: Timeless Investment Lessons from the Great Economist. The views expressed in this article do not necessarily reflect the views of Morningstar.com.