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When It’s OK to Retire With Debt

The key is understanding the difference between good and bad debt

By Robert Powell | MarketWatch | January 6, 2014

(This article appeared previously on MarketWatch.com)

Conventional wisdom suggests that you shouldn’t retire with any debt.
 
But Americans are seemingly ignoring that advice, according to a new research report from the Michigan Retirement Research Center.
 
Older Americans on the verge of retirement are more likely to retire with debt than in the past, according to that report, “Older Adult Debt and Financial Frailty.”
 
In fact, more than 70 percent of boomers held debt compared with a dozen years ago, when 64 percent did, according to the authors of the report, Annamaria Lusardi, a professor at George Washington University School of Business, and Olivia Mitchell, a professor at Wharton School, University of Pennsylvania.

(MORE: Laid Off, Near Retirement and In Debt)
 
Boomers are not only more likely to hold debt, but the value of that debt has also grown sharply, say the authors. In fact, median debt for those age 56 to 61 has more than quadrupled, from about $6,200 in 1992 to $28,300 in 2008 (in 2012 dollars).

A key reason that debt rose so rapidly for boomers is this: That group spent more on housing and took out larger mortgages, compared with earlier cohorts. And, the authors say, boomers retiring in the next several years are more likely to carry this debt into retirement, compared with previous cohorts.
 
But not all experts think that retiring with debt is an inherently bad financial plan. Rather, they say, there is good debt and bad debt and it’s OK to retire with good debt. So, what sort of debt might be good?

(MORE: Pay Down Debt or Save?)
 
Good Debt vs. Bad Debt
 
Well, take mortgage debt. Most folks suggest that you retire without a mortgage. But Larry Kotlikoff, a professor at Boston University and president of Economic Security Planning, says long-term mortgage debt is a smart thing to have in your portfolio if you face inflation risk, which may be the case if, for example, you have a retirement pension that is not indexed to inflation.
 
“When inflation takes off, you get to pay back your mortgage in watered-down dollars and this offsets the fact that your pension or other stream of fixed nominal income loses real purchasing power,” he said. “So retiring with debt can be a hedge against inflation, provided it’s long-term. fixed-term borrowing.”
Other Types of Good Debt
 
Other experts are OK with folks retiring with debt too, though only under certain circumstances.

For instance, Larry Cohen, a director at Strategic Business Insights, said retiring with a mortgage might be allright, provided it was less than one year from being paid off and assuming that you had the resources to pay it off.
 
And, Cohen said, “it probably would be OK to have some debt collateralized using the home to provide liquidity with deductible interest.”
 
In addition, Cohen said, debt that was held in joint tenancy with an heir with rights of survivorship might be OK, too. For instance, retirees who want to help their children buy a home or a car might consider co-purchasing those assets.
 
“As part of this arrangement, the child makes a monthly payment to his or her parents which is larger than any payment for the debt the parent has,” said Cohen. “The parent gets an income stream and, in the case of the mortgage debt, a tax write-off for the interest. When they pass away, the house or the car becomes the child’s, who may no longer have to make any payments.”

Check Your Insurance
 
One word to the wise if you use this tactic: Consider buying or have enough insurance to pay off the loan if the parent(s) should die.

Another benefit to this tactic: “If the debt was held in joint tenancy with an heir with rights of survivorship there is the benefit that this might pass outside of the estate,” said Cohen.
 
Other kinds of debt might be OK, too. For instance, debt in a margin account collateralized by one’s securities provides liquidity and a means of using an asset without having to sell it. But, Cohen noted, the proportion of this debt would have to be small and easily serviceable. Otherwise there would be a cascading effect if there was a margin call.
 
No Debt is Good Debt
 
There are, of course, those who say that having no debt in retirement is the ideal. “Shakespeare’s Polonius advises ‘Neither a borrower nor a lender be,’” said Jason K. Branning, a certified financial planner with Branning Wealth Management. “Not having the encumbrance of debt offers the maximum flexibility and security for retirees.”
 
So, before deciding whether to retire with debt or not, Branning suggests that pre-retirees ask how much flexibility and security do they seek in retirement and how would being encumbered with loans threaten flexibility and security?
 
“In spite of Polonius’ admonition, debt itself is usually not the problem, rather, it’s the excessive use, or misuse of debt that is,” he said. “Any good thing can be used unto a harm.”
 
Branning said debt can be classified as positive or negative and serves as an important component in wealth accumulation. “Generally, good debts have the ability to appreciate, while bad debts depreciate,” he said. “Whether classified as good or bad, typically, a healthy use of debt would be if your total debt was less than 36 percent of your total income.”

Not All Debt is the Same
 
Yet, not all debt is the same, he said. Housing expenses (principal, interest, taxes and insurance) including debt should be less than 28 percent of your total income, while any consumer debt should be kept below 20 percent of after-tax, take-home income. “Pre-retirees and retirees should strive never to violate these basic debt guidelines,” he said.
 
According to Branning, two primary goals of retirement are capital preservation and maximization of the assets that have been accumulated over a working lifetime. “I encourage pre-retirees (typically) not to fully retire with any debt,” he said. “Entering retirement with debt could erode retirement security and financial freedom as quickly as a financial market and/or a health decline. The difference between these three possible retirement issues is that the retiree can proactively control or eliminate debt, while often only responsively manage the market or health declines.”
 
Thus, said Branning, “I believe no debt in retirement is the optimal, recommended position for most retirees.”

An Exception for Some Retirees
 
To be fair, Branning said there are some retirees who may be able to use debt appropriately in retirement, through liability matching — offsetting a like-kind income source against a debt.
 
So, for instance, if the retiree has a source of income that meets or exceeds his or her anticipated base expenses for life, then using debt sparingly may be acceptable, said Branning. Most often, he said, base income sources that should be considered acceptable to cover ongoing and limited debt are Social Security, pensions, government bond income or annuities.
 
In the absence of those sources of income, and in the absence of any forethought and analysis, it might not be wise to retire with debt. But with those sources of income and with the appropriate forethought and analysis, our experts just might give you their blessing on retiring with debt.

Robert Powell is a MarketWatch Retirement columnist. He has been a journalist covering personal finance issues for more than 20 years. Follow him on Twitter @RJPIII.