Are retirement assumptions about home ownership fundamentally flawed?

For many Australians home ownership is synonymous with financial success. This is not surprising. Older generations have ridden the wave of rising home values as the key driver of building wealth. Their advice to younger generations scrambling to get on the property ladder reflects this reality. Tax policy that is advantageous to homeowners is ingrained within the statutes. ASFA’s Retirement Standard assumes that retirees own their home outright.

There is no doubt that owning a home outright in retirement is a substantial advantage. A mortgage or rent payment is the largest expense for most Australians. Eliminating that expense makes it easier to save for retirement and provides significant flexibility. Yet the standard of owning a home outright at retirement is no longer an assumption that can be relied upon.

The changing nature of home ownership at retirement

First the facts. It should be no surprise that decades of housing prices appreciating significantly faster than income growth is changing the nature of home ownership in Australia. In most countries home prices have appreciated roughly in line with income growth. The reason that Australia hasn’t followed this standard is irrelevant. But take your pick. The not in my backyard (“NIMBY”) attitude of many homeowners and councils that is preventing rezoning and increased density. A lack of workers in construction. An influx of migrants. Vacant properties. Regulatory decisions that have allowed higher loan to income ratios. Government policies that make housing “more affordable” while not decreasing prices by allowing first time homebuyers to put less down and raid their super. They all no doubt played a role.

What isn’t in dispute is the impact. More people are entering retirement with mortgage debt. There is a lag in the data. However, in the 2019 fiscal year 54 percent of homeowners between the age of 54 and 64 had a mortgage. This compares to 23 percent in 2002. The portion of homeowners older than 65 with mortgage debt was 4 per cent in 2002-03 and 13 per cent in 2019-20.

And this will get worse. The high price of housing relative to income means people are buying houses later. Loan sizes are bigger in comparison to income. All of this makes it harder to pay off a mortgage prior to retirement.

Homeowners over the age of 54’s average mortgage debt to income ratio tripled from 71 per cent to 211 per cent between 1987 and 2015. This article is about the financial impact. Yet it is worth acknowledging the other impacts. According to the Australian Housing and Urban Research Institute increased repayment risk is associated with worsening symptoms of mental ill-health and increasing levels of psychological distress. I showed the mental health data to my wife who is a board-certified neuropsychologist. She rolled her eyes when I asked her for a quote. But she said it isn’t good.

The financial impact of mortgage debt in retirement

The first impact is that we need to provide context to the ASFA data for Australians that can’t retire debt free. If you own your home outright prior to retirement you can go with the current figures or whatever you deem an appropriate amount of retirement spending. As previously mentioned ASFA assumes people own their house outright.

ASFA has stated that for a modest lifestyle in retirement a single person needs $32,665 a year and a couple needs $46,994. For a comfortable retirement a single person needs $51,278 and a couple $72,148. We can translate this into a lump sum assuming a retiree will withdrawal 4% of their balance in the first year of retirement.

Things change when we add mortgage debt to these numbers. The average mortgage payment in Australia is $4,068. This of course varies by where you live. We can assume that people over 54 have lower payments since they likely purchased their home a while ago. To be conservative I will take a 50% haircut and assume a mortgage payment of $2,034. Here is an adjusted chart.

Across the board that is a difference of $610,200 in super to live the same lifestyle. To amass $610, 200 extra in super at a 7% return requires saving approximately $3,100 more a year for 40 years, $6,600 more a year for 30 years, $15,000 extra for 20 years and $45,000 annually for 10 years.

An argument could be made that the mortgage payment won’t last throughout retirement and this calculation is misleading. Fair enough. Yet withdrawing more from super early in retirement is still an issue. It increases sequencing risk which is one of the primary risks for retirees.

Many Australians approaching retirement have not amassed super balances approaching either the ASFA figures or the adjustment I made for carrying a mortgage. According to Aussie Super the average super balance for men between the ages of 60 to 64 was $338,700. Women came in at $261,000.

The aged pension is available to supplement retirement savings if the asset test is passed. The maximum amount for a couple including the pension supplement and energy supplement is currently $43,732 a year. This dramatically changes the financial position of individuals that qualify. However, if a retiree is still paying a mortgage and has just under the $451,500 super cut-off for a couple to receive the full aged pension they still wouldn’t be able to meet ASFA’s modest lifecycle after paying a mortgage at any reasonable withdrawal rate.

Where do we go from here

Mincing words doesn’t do any good. Let’s start with calling a spade a spade. Ever since inflation started rising there has been widespread delusion by economic commentators and the general public.

First inflation was transitory and would simply go away. Then each increase in interest rates had to be the last. The rationale for this optimism was that central banks didn’t want to inflict pain on heavily indebted consumers. Apparently, we forgot that the whole point of increasing interest rates to tame inflation is to inflict pain on consumers so they stop spending money.

There has been the perpetual belief that interest rate cuts are just around the corner. Those hopes are repeatedly dashed yet pop up again in matter of months. I don’t know when interest rates will be cut. Yet I think it would be foolhardy to expect them to go down to the levels we experienced during COVID – perhaps ever. That means the mortgage stress that many Australians are facing is likely to be the new normal.

It is also worth noting that different Australians are facing vastly different economic realities. The media has largely portrayed these differences along generational lines. Like any generalisation there is of course truth in the argument. Yet it papers over the different financial realities experienced by members of the same generation.

Higher interest rates benefit certain people. If a home is owned outright, they have no effect on monthly cash flows. If a person has a lot of cash higher interest rates help by increasing the nominal return on term deposits and savings accounts. The individuals benefiting from higher interest rates are largely older Australians. So far there is little downside as property prices and the share market have kept climbing.

The wealth effect from climbing markets and property prices is driving the Australians that have benefited from higher rates to keep spending. This in turn drives inflation and makes it less likely that interest rates will be cut. The AFR recently cited a study by credit card giant Visa that concluded that for each dollar increase in wealth from climbing markets and property prices a consumer will spend around 34 cents. This is the wealth effect. And it is powerful.

This is combined with political pressure to do “something” about the cost of living. Hence the reconstituted but still stimulative effect of the stage three tax cuts. There are the much publicised wage increases that have occurred for certain workers. There is the cut to indexation on HECs debt. There is the upcoming budget that is widely viewed as being expansionary. We seem to be getting further away from meaningful cuts to interest rates rather than closer to them. There are strong arguments for each of these policies in isolation yet in the aggregate they seem to suggest that homeowners are not going to get bailed out with lower mortgages.

What should a retiree do if faced with retiring with a mortgage

The generalisation about older Australians benefiting from rising interest rates ignores the increasing amount of retired and near-retired people with mortgages. The assumption that retired Australians will be debt free is no longer the reality for many current and future retirees.

There is no easy answer for current retirees and people approaching retirement with debt. The reality is that more assets are needed in retirement accounts if mortgage payments need to be funded. It is far easier to course correct with more time prior to retirement.

If it is too late to save more money drastic steps will have to be taken. These include downsizing or selling property to extract money from homes. Australians carry much of their wealth in property. According to the AFR $10.7 trillion of wealth is held in property and only $1.4 trillion in the share market. Willie Sutton famously said he robbed banks because “that’s where the money is”. Housing is where the money is.

The downside of having so much wealth locked up in residential real estate is that to benefit from it a homeowner needs to convert the asset into cash. That can be difficult to do.

Unlike other assets a house provides utility. A homeowner needs another place to live if they sell their house. It is also an all or nothing proposition. You can’t sell part of your house.

There is also an emotional component to a house. The financial realty of selling a house is warped by memories and a connection to a community. Selling a house involves high transaction costs including commissions, the cost of moving and stamp duty on a new residence.

Objectively a primary residence may be the worst place to build long-term wealth if it needs to be extracted to pay for living expenses. The lack of capital gains taxes helps. But there are several downsides. Avenues such as reverse mortgages are generally not available to a homeowner who still has a mortgage. Yet that is where the money is. As unpalatable as it may be to downsize or move to cheaper location many Australians will need to fund retirement by selling their home.

The irony is that owning your home outright is one of the best things somebody can do to help their finances. Removing your biggest expense is far better than having more money in super. The problem is that you need to be able to pay off your mortgage. Being close may count for horseshoes and hand grenades but it doesn’t work that way for a mortgage. You need to get that last payment in before reaping the benefits to your budget.

The other option is to keep working. Each year of avoiding super withdrawals, saving more and paying of a mortgage improves a retiree’s financial situation significantly. However, it is worth acknowledging that this is not always a choice. Older Australians going down this route may face age discrimination and need to be physically capable of work.

For homeowners with a longer time horizon to retirement there is the opportunity to course correct. As part of any retirement plan it is worth realistically assessing if paying off a home is feasible prior to retirement. If not, more money needs to be saved or a real effort needs to be made to paying off a mortgage. Something easier said than done given the cost of living.

One place to start is resisting the wealth effect. Instead of spending extra as asset prices rise the rational thing to do is to save more unless you have a plan of extracting cash from those assets.

Final thoughts

It can be argued that the unaffordability of residential real estate is a ticking time bomb for many members of the next generation to retire. A simple solution is elusive. A drop in real estate prices would benefit Australians looking to buy a home and would probably have a relatively benign negative impact on Australian retirees that own their homes outright. However, it would be disastrous for homeowners with large mortgages by wiping out much of their equity.

Inflating our way out of the high levels of consumer and mortgage debt is an option. However, that would crush the budgets of cash strapped mortgage holders and renters while harming retirees that don’t have the luxury of salary increases.

Perhaps the best option is for housing prices to just freeze in place or appreciate at a lower level than wage increases. This would take time to play out and is frankly very difficult to do from a policy perspective. It is also politically unpalatable in a country where two thirds of people own their home and have become accustomed – maybe even addicted - to appreciating real estate.

All each of us can do is to try and take a realistic view of the future and plan the best we can to be prepared for what we believe will eventuate. It is likely that less Australians will reach retirement debt free than in the past. This is not an insurmountable financial challenge. And it is not a universal challenge. But a challenge, nonetheless. This is the downside to the incredible run of Australian residential property and having so much wealth tied up in housing. Perhaps Aesop said it best in the Frogs who wished for a king, “Are you not yet content? You have what you asked for and so you have only yourselves to blame for your misfortunes.”

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As always, I appreciate your feedback. Write me at [email protected]