Updated: Aug 18, 2020
A strong workplace retirement plan and owning a paid-off home, have long been considered two pillars of a healthy retirement plan.
Over the last several decades, two trends have converged to set a trap for millions of middle-class workers.
A rise in homeownership and home prices.
The death of the defined benefit pension.
In this article, I’ll explain how rising home prices have set a trap for millions of middle-class homeowners and how you can avoid the trap and begin building financial freedom.
Defined benefit pensions are the perfect retirement tool
The entire point of saving for retirement is to one day provide yourself with enough reliable income that you would be able to stop working and still be able to fund your lifestyle.
Keeping that in mind, the defined benefit pension is the ultimate retirement savings tool for two reasons:
It is designed to provide workers a predictable stream of income in retirement.
It removes decision paralysis from retirement savings.
A defined benefit pension will replace a percentage of your income for each year you work. If you had a workplace pension that replaced 2% of your income for each year of service, and you worked at your company for 30 years, your pension would replace 60% of your income in retirement.
The second reason pensions are such a useful retirement savings tool is that they only require the employee to make one decision; what age they would like to retire.
Enrollment in a workplace pension is often mandatory, or at the very least, the employee must choose to opt-out.
Employees with pensions don’t need to make decisions about how to invest their money.
When the employee retires, they do not need to figure out how to convert their retirement savings into income. They receive a fixed amount of income each month fro the pension.
Contrast this with a defined contribution retirement plan like a 401k.
Often times, employees must choose to opt-in to the plan. As a result, many never even bother enrolling.
Employees are forced to manage their investments on their own. Since most people are not cut out to be DIY investors, they wind up making errors that undermine their retirement nest egg.
Once workers decide to retire, they have an even more difficult task of converting their retirement savings into a source of income that will last the rest of their lives.
Defined benefit pensions are the best retirement savings valuable to workers, there is only one problem.
Hardly anyone has access to a pension anymore
In sports, there is a saying that “the best ability is availability.” A player can be the most talented person to ever play a sport, but if they are always injured and unable to get on the field, their value is severely limited. If Lebron James could only play in 10% of his games, he would not be a very impactful player.
That is how I think about defined benefit pensions. They are the best retirement savings tool that exists, but very few workers in the private sector have access to them, so they have limited impact.
In 2018 nearly 80% of government workers had access to a pension, according to the Pension Rights Center.
Only 12% of private-sector workers had access to a pension.
In the early ’80s, 60% of private-sector workers had access to a pension according to a report from CNN.
Today’s retirement plans assume all workers are expert investment managers
The sad reality is that pensions are expensive and represent a significant liability to employers, so they are nearly extinct in the private sector. Pensions have mainly been replaced with defined contribution retirement plans like 401k’s in the U.S.
On paper, a defined contribution retirement plan is a fantastic retirement savings tool.
For every dollar the employee saves, the employer will typically match (up to a certain percentage of income.)
Often times, the employee contributions receive preferential tax treatment.
The investments inside the plan can grow on a tax-deferred basis. Allowing for returns to compound for years or decades.
These new retirement plans have a fatal flaw; leave too many decisions for the employee to make.
Employees must often actively choose to enroll in the plan (which many fail to do.)
Once enrolled, employees must choose how much to save (typically, they don’t save enough.)
Once they start saving, employees must choose how to invest their money (most people do a poor job of investing.)
When the employee retires, they must figure out how to convert their retirement savings into a stream of reliable income that will last them through retirement (very few people know how to do this.)
The more decisions the employee has to make, the more opportunity they have to make a mistake. These mistakes compound over the years and decades, and as a result, many workers don’t have nearly enough saved for retirement.
According to a report from the Federal Reserve, the median balance of financial assets, which include retirement accounts is $23,500 for U.S households.
To illustrate how insufficient $23,500 in financial assets is for someone without a pension, consider that to fund a $50,000 per year income in retirement using a 4% withdrawal rate would require total savings of $1,250,000.
Clearly, the average worker has not been made better off by transitioning from defined benefit pensions to defined contribution retirement plans.
The rise of homeownership
The demise of pensions has coincided with the rise in homeownership.
In 1940 44% of people in the U.S owned their home.
By 2018 that number past 65%.
The process has been very gradual, but over the past several decades, the number of people with pensions has dropped dramatically, and the number of people who own their homes has continued to rise.
As home prices rise so has the net worth of homeowners
One of the first things that you learn in economics 101 is that holding all other factors equal, a rise in demand will lead to an increase in price.
As demand for housing has rapidly increased over the decades, so have the values of homes. This has made many middle-class workers who own their home wealthier.
At least on paper.
Why you don’t want your house to be your largest asset
Don’t get me wrong, owning a home can be a great long term decision, especially if you have your mortgage paid off by the time you retire. There is no denying that homeowners, on average, are much wealthier than renters.
However, not all wealth is created equal. This is especially true if you want to achieve financial independence, the point where you are no longer dependent upon your paycheck to fund your lifestyle.
Home equity does not move you closer to financial independence in the same way that owning financial assets like stocks and bonds do. The reason is that accessing the equity in your home is very difficult.
If you have a house worth $500,000 and a $100,000 mortgage, you have $400,000 in equity (wealth) in your home. The problem is that to access that $400,000 and spend it on funding your lifestyle, you have two choices.
Sell your house.
Take out another mortgage.
Both of these options present obvious problems.
If you sell your home, you still have to find somewhere to live. That means buying another home or renting.
Taking out another mortgage adds to your debt and reduces your monthly cashflow.
Both options add to your monthly expenses and eat away at your equity.
Given how difficult it can be to access the equity in your home, if your goal is to achieve financial independence, you don’t want your house to represent too large a portion of your net worth.
Which is precisely where many people find themselves.
According to data from the Federal Reserve;
The median value of houses was $185,000 in 2016.
The median value of financial assets was $23,500.
The value of the average person’s house in the U.S is nearly 8 times the value of their total financial assets, which include deposit accounts, retirement accounts, stocks, bonds, rental properties, and business equity.
U.S households are getting wealthier, but a disproportionate level of that wealth is tied up in their primary residence.
Here is the financial trap; people’s net worth has increased which makes them feel rich. But since the majority of that wealth is tied up in housing, the dream of financial independence has become nothing more than a mirage for many.
This would not be a problem if everyone had a pension
Back when most people had a workplace pension, houses made up the majority of a person’s net worth, and it was not a problem.
If you retire with a fully paid off house and a reliable source of income from a pension, you’ll be in good financial shape.
If you retire with $200,000 in a 401k and a fully paid-off house, you might be in trouble. Using a 4% withdrawal rate, you could expect to safely generate $8,000 per year from a $200,000 portfolio.
Even with a paid-off mortgage, that only amounts to $666 per month. If that is your only source of retirement income, you’ll be dependent on government programs and family members to get by.
That is why the demise of defined benefit pensions and the outsized role of houses in people’s net worth has set a financial trap for many middle-class workers approaching retirement.
To avoid this financial trap focus on your “Accessible Net Worth”
If you don’t have access to a workplace pension, it’s critical that you focus on increasing your accessible net worth. Your accessible net worth is simply equal to your net worth minus the value of your primary residence.
Net worth= Total assets — Toal liabilities
Accessible net worth= Net worth — The value of your house.
Your accessible net worth emphasizes the need to diversify your assets by taking your primary residence out of the equation.
An example illustrating the difference between traditional and accessible net worth
Let’s say your assets and liabilities are as follows.
Retirement account: $55,000
Total assets: $427,000
Car loan: $10,000
Credit cards: $2,000
Total debt: $162,000 Net worth: $265,000
To calculate your accessible net worth, you include all of your assets and liabilities except for the value of your house.
Retirement account: $55,000
Total accessible assets: $77,000
Car loan: $10,000
Credit cards: $2,000
Total debt: $162,000 Accessible net worth: -$85,000
In this example, taking out the value of your primary residence dropped your net worth from $265,000 to negative $85,000, a $350,000 swing. There are millions of people who may be retiring as millionaires but whose accessible net worth is a fraction of their traditional net worth.
Since it is accessible net worth that will determine your level of financial freedom, the overreliance on our primary residence is a cause for concern.
How to increase your accessible net worth
There are two ways to increase your accessible net worth.
Invest in assets (other than your primary residence.)
Pay down debt.
The entire point of tracking your accessible net worth is to focus on the need to diversify your assets by investing in any of the following.
Financial assets like stocks and bonds.
Real estate (rental properties, not personal properties.)
I’ve referred to these in the past as the three pillars of wealth creation.
To maximize your accessible net worth, focus on acquiring these three types of assets while saving an adequate amount in a cash emergency fund, and paying down debt.
Avoiding the housing trap
Defined benefit pensions provide retirees a credible stream of income without having to make any decisions. For that reason, they are the perfect tool to help workers save for retirement. Sadly, pensions are hard to come by unless you work for the government.
Pensions have mainly been replaced with defined contribution retirement plans that require employees to make critical and complex decisions at every point in the process. As a result, workers have not been saving enough in these plans.
Over the same time, more people have become homeowners, and the price of homes has skyrocketed. This has made many middle-class homeowners, richer on paper.
However, since the majority of wealth in the middle class is tied up in home equity, it becomes difficult to access that wealth and turn it into retirement income. That means many people are retiring with a high-net-worth, but with limited sources of retirement income.
To achieve financial independence, it’s important to focus on increasing your accessible net worth, which is merely net worth minus the value of your home.
To maximize accessible net worth, you will need to diversify your assets beyond your primary residence and pay down debt.
It can be a long journey to build a strong, accessible net worth, but it is worth it, and you have what it takes.
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