Your biggest financial asset may not be your best retirement tool

50+ Marketing points to a Fidelity Research report on home equity as a retirement asset that goes against the grain of conventional wisdom in terms of being a potential source of capital in retirement.

Home equity is Americans number one financial asset. As of 2005, equity of owner-occupied housing stood at $19 trillion dollars. Most individuals, including the writer of this post, consider home equity to be an important component of their retirement plans. This is rational and consistent with financial prudence, but the Fidelity report cautions against putting too much weight into this asset class or from taking the real estate returns of the past decade as an indication of future performance.

There are several things to look at when building a retirement portfolio, specifically risk, return, liquidity and income needs.

In terms of risk and returns, historical experience suggests that real estate investments can suffer serious and sometimes prolonged downturns. Furthermore, long-term returns to real estate have historically been lower than
returns to investments in equity.

The median price of new homes in the United States has averaged an annual appreciation rate of 5.9% since 1963. This factor is on a national level and regional and local rates can vary dramatically ("location, location, location."). Furthermore, "Returns on a dollar invested in residential real estate in 1963 have been only slightly better than returns on low-risk Treasury Bills. Of course, you can't live in a T-Bill, but the point is that one incurs a great deal of illiquidity and additional risk for only a marginal increase in real return.

For homeowners able to “ride out” these moves, the long-term trend has, of course, been immensely beneficial, especially since mortgage debt significantly leverages gains in a rising market. But when considering the home as a potential retirement asset it is well to note that the leverage magnifying home equity appreciation can cut in the other direction, too. Many of the short-term home price downdrafts have been in excess of 10%. That is more than enough to wipe out all of the initial equity of a homebuyer who puts a 10% down-payment on their home and is then forced (perhaps by a job move or divorce) to sell into a falling realty market.

Periodic and cyclical significant price drops are a fact of life in real estate and to think otherwise is foolish. A homeowner near retirement who relied excessively on the build-up of home equity as a future source for retirement income (and under-invested in other assets) could be seriously damaged by a market slowdown.

This does not mean that home equity is not useful in retirement and there are numerous tools aimed specifically for being able to tap this equity (including selling the home, reverse mortgages, and home equity lines of credit or "HELOCs") but warning about the over-reliance on home equity at retirement that is the point of the Fidelity research.

Anyone reading the WSJ or pretty much any financial magazine in the past 5 years has read about "asset allocation," which is defined as:

Inherent in asset allocation is the idea that the best-performing asset varies from year to year and is not easily predictable. Therefore having a mixture of asset classes is more likely to meet your goals. A more fundamental justification for asset allocation is the notion that different asset classes offer non-correlated returns, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. In this respect diversification has been described as "the only free lunch you'll find in the investment game."

Common sense dictates that you would never want to put all of your money in one stock. Taking this to the next level, financial advisers generally focus on insuring that any one asset class (e.g., real estate, large cap equities, fixed income, etc.) is not too heavily weighted in a portfolio. This is especially true when dealing with the money you will need to live on in your later years. Proper asset allocation will maximize returns while reducing risk. In addition to this, issues of income generation and liquidity needs will be factored in.

So what does this suggest for someone 40-55 in retirement planning? The most important message is that this is a complex issue that cannot be addressed by general rules of thumb, truisms, or what your neighbor tells you he's doing. Suffice to say odds are you are not going to want all your retirement money in any one class, even if it's the home you live in. The Fidelity article is a good starting point to your own research. Even better would be to have a financial adviser address your specific situation. Such advisers are not just for the super wealthy, can be hired by the hour, and can also help you with current financial issues.