Do you have a vacation fund? A pizza party jar at work or home? A bank account reserved for a new house?
People set aside money for certain goals or expenses, sometimes even dedicating a specific bank account or credit card for them. This mental bucketing tendency is a quick way our brain scans to see if we have the resources we need.
When it comes to retirement planning, we should lean into this bucketing tendency. The bucketing approach, or time-segmentation planning, is where you set aside money into different investments for different time periods in retirement. Oftentimes there are three buckets of money designated for three different time periods during retirement.
Bucket one contains your safest assets, like cash.
This bucket is what you’ll use for the near term, or next year. It’s safe and provides certainty for expected expenses.
Bucket two contains more fixed income products and balanced investment strategies, like bonds, CDs and simple annuities.
This bucket fulfills your near-term expenses of the next two to 10 years. We don’t want to rely on volatile assets for our income in the coming years.
Bucket three is filled with your growth assets to use for expenses in the long term.
Stocks can be volatile but will provide solid returns if we set them for 10 or more years. To some degree, this helps retirees avoid sequence of returns risk, or the risk of selling off a portfolio early in retirement during a market downturn.
It’s natural to attach investments to time periods as it gives us a simple explanation for why we have each financial asset.
But what about assets that don’t seem to fit into one of the three retirement income buckets?
Home equity is often forgotten as a potential retirement income source. If you do bucketing correctly and in a holistic manner, your home should be in the plan. And here’s why.
For most people, the home is not only a financial asset, but a sentimental asset, too, filled with memories. Many homeowners will hesitate to use equity, downsize or borrow against their home in retirement.
A house is also a liability for many people. Housing expenses tend to be the largest expenditure for Americans at over 37% of their budget. So under one roof is an asset that has sentimental value, financial value, a liability aspect and provides shelter, a need everyone has.
When you try to figure out which bucket your home fits in, take into consideration all those roles a home plays.
Home for the long-term investment
A lot of people want to leave their home as a legacy asset to their children. If you put it in bucket three, attach a projected growth rate on it.
A home in bucket three will bring down your average total returns on net worth in that bucket. It’s fine to leave your home as a legacy or long-term care funding vehicle, just take note of that expected return on your total wealth. The house can also sit in bucket three if it’s going to be sold to pay for a long-term care facility or costs.
Jason Smith, CEO of Clarity 2 Prosperity, said he typically starts by looking at home equity as a legacy asset or a long-term bucket asset because most people don’t plan on utilizing it for a long time horizon. However, Mr. Smith notes that they will use home equity lines of credit as a tool to refill a soon or now bucket as essentially an emergency or backup cash flow vehicle. This can provide the cashflow to let buckets and the portfolio refuel and recover in case things had gotten off course.
Downsizing to free up equity
You can also use home equity in other ways than placing it in the long-term bucket. One way would be to downsize and free up equity. For example, let’s say you have a $500,000 house and you downsize in retirement to a $300,000 house. You have now freed up $200,000 that you can put into new investments in any of the three buckets.
If you did this, you would still need to figure out where to put the new home value of $300,000 – perhaps in bucket three. If you invest the $200,000 you freed up into bucket three for a long-term goal, you can likely increase your total net worth and retirement spending capabilities. The market returns in the long run on that $200,000 investment will likely outpace what your home would have returned in the long run.
Opening lines of credit
Another option you have is to borrow against your home through a reverse mortgage line of credit or a traditional home equity line of credit. One benefit of using a reverse mortgage line of credit or traditional line of credit in a bucketing approach is that you can lessen the money you need in bucket two. By having a line of credit open, you can borrow from it to fill income needs during a market downturn. This way, you won’t have to sell off any assets in bucket two to generate your cash flow. Instead, those assets can continue to grow, also protecting you from sequence of returns risk.
Because housing expenses are a large chunk of a retiree’s annual expenses, reducing what your immediate and near-term expenses are will lessen the amount of money you need in bucket one and two. This will allow a larger percentage of your overall wealth to stay in bucket three and grow for the long run.
If you refinance a mortgage to a lower rate, which is possible in 2020 because of low interest rates, you could lessen your payments and the amount of income you need from bucket one.
Another option is to refinance a traditional mortgage with a reverse mortgage. Once it’s refinanced to a reverse mortgage, you have no monthly required mortgage payments.
“Actually a reverse mortgage offers significant flexibility compared to a traditional mortgage,” according to Shelley Giordano, Founder of the Academy of Home Equity in Financial Planning at the University of Illinois. Since no monthly payments are required with a reverse mortgage, you can opt to never make a payment, or adopt an even more nuanced approach where you make voluntary payments to interest.
The voluntary interest payment strategy provides that you go ahead and make interest payments on the reverse mortgage when times are good. In doing this, you are managing the expense by making sure that the compounding interest doesn’t work against you. But when times are bad, cease making payments because cash flow will be most important while you wait for your savings to recover and start growing again. This two-pronged approach will significantly reduce your expenses and cash outflow. You won’t need to dedicate too many assets to bucket one and two.
Retirement income planning is challenging, but a bucketing approach can make the complex simpler. Understand that your investment goals and spending needs in the current year, coming years and long term define the three buckets. The more money you can leave to grow for the future, the better off you’ll be in the long run.
Using home equity to reduce expenses or increase cash flow can be a useful way to incorporate your home into a bucketing approach and improve long-term outcomes. But even if your goal is to not use home equity early in retirement, your home still can find a place in a bucketing approach, either by being a potential legacy or long-term-care funding vehicle. Lean into bucketing and remember to include your home in your retirement income plan.
Jamie Hopkins is the Director of Retirement Research at Carson Wealth and a Finance Professor of Practice at Creighton University Heider College of Business. He was a professor at the American College of Financial Services where he helped co-create the Retirement Income Certified Professional Designation (RICP®). He has written about, and published, a variety of articles on retirement. He frequently writes and publishes law review articles dealing with retirement issues, such as long-term care, taxation of insurance benefits, and estate planning. He is extremely passionate about the retirement security of Americans and believe that a better prepared public can enjoy a more secure and fulfilling retirement.