The proportion of U.S. homeowners who owe more on their mortgages than the properties are worth has swelled to about 23%, threatening prospects for a sustained housing recovery.
Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic, a real-estate information company based in Santa Ana, Calif.
These so-called underwater mortgages pose a roadblock to a housing recovery because the properties are more likely to fall into bank foreclosure and get dumped into an already saturated market. Economists from J.P. Morgan Chase & Co. said Monday they didn't expect U.S. home prices to hit bottom until early 2011, citing the prospect of oversupply.
Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home's value, the First American report said. More than 520,000 of these borrowers have received a notice of default, according to First American.
Negative equity "is an outstanding risk hanging over the mortgage market," said Mark Fleming, chief economist of First American Core Logic. "It lowers homeowners' mobility because they can't sell, even if they want to move to get a new job." Borrowers who owe more than 120% of their home's value, he said, were more likely to default.
Mortgage troubles are not limited to the unemployed. About 588,000 borrowers defaulted on mortgages last year even though they could afford to pay -- more than double the number in 2007, according to a study by Experian and consulting firm Oliver Wyman. "The American consumer has had a long-held taboo against walking away from the home, and this crisis seems to be eroding that," the study said.
Even recent bargain hunters have been hit: 11% of borrowers who took out mortgages in 2009 already owe more than their home's value.
Many borrowers are so deeply under water that they can't take advantage of lower rates and refinance their mortgage. "We're declining hundreds of loans each month," said Steve Walsh, a mortgage broker in Scottsdale, Ariz. "The only way we will make headway is if we allow for a streamlined refinance where the appraisal is irrelevant."
The rule of thumb is that you'll need to replace 70% of your pre-retirement income on average once you retire, but evidence continues to mount that this assumption by many professionals and retirement savers is way off base.
Now, a new study by two professors casts further doubt on the idea that the widely used replacement-rate figure is a sound basis for building a retirement plan.
"The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed," wrote John Karl Scholz and Ananth Seshadri, two University of Wisconsin-Madison professors, in their paper "What Replace Rates Should Households Use?"
In fact, no more than 15% of the population Scholz and Seshadri studied need to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.
In short, the authors said: More refined guidance is needed to serve households well.
Target replacement rates are less than 100% for three main reasons, according to the study published by the Michigan Retirement Research Center.
"First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement."
Still, that ignores a whole host of issues related to coming up with the right replacement rate.
For instance, consider what effect children likely have on your expenses prior to and in retirement, the authors wrote. Most calculators use the same replacement rate regardless of the number of children in a household, the authors said. But the number of children you have matters when it comes to calculating your replacement rate. In fact, all things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working. (Of course, the kids' ages at the time of retirement will affect that calculation.)
What is needed for your real number is not back-of-the-napkin calculations but something the authors refer to as the life-cycle model. To be fair, the author's study did note that replacement rates -- even when using the life-cycle model -- did confirm some commonly held beliefs. Specifically, "replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families."
But even then you still need to take into account the effect of federal taxes, medical expenses, education, and what the authors call earnings shocks or -- in laymen's terms -- layoffs and big salary increases.
When all is said and done, the authors suggest that optimal replacement rates could range anywhere from 23% (for single parents with several children and a negative late-in-career earnings shock) to 240% (for low-income, married households with a few children and a substantial positive late-in-career earnings shock).
In other words, "conventional advice may overstate optimal targets by a factor of two, or understate retirement consumption needs by a factor of three depending on the idiosyncratic experiences of households," Scholz and Seshadri said in their study. See the study (PDF).
That's especially the case when it comes to online calculators, the authors said. With the life-cycle model, the replacement rate depends on factors often ignored by online calculators. "The savings requirements of two households with the same earnings profile, retirement age and life expectancy would be given an equivalent target by the online planning tools regardless of whether one household raised five children and other had none," the authors said. They said the optimal replacement rate for married couples is 75%, but just 55% for singles.
Put another way, if you're using an online calculator to plan your retirement, you might be under-saving or over-saving by a wide margin, though the consequence of over-saving might not be as bad as under-saving.
'Rules of dumb'
Experts, meanwhile, seemed to agree with the conclusions reached by Scholz and Seshadri.
"The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard," said Larry Kotlikoff, a Boston University professor.
"Rules of thumb are, quite simply, rules of dumb," he said. "Their use violates the financial planner's Hippocratic oath: First do no harm."
Kotlikoff also said the model used in Scholz and Seshadri's study is not without its warts. "But it's fine for its purpose, which is comparing conventional financial planning with economics-based planning."
Rick Miller, a certified financial planner with Sensible Financial Planning, cautioned against using any rules of thumb. "Using rules of thumb can be very dangerous, if they significantly understate the requirement, or can risk significant regret, if they overstate the requirement."
Pay now or pay later? That is the question if you're weighing the pros and cons of converting your traditional individual retirement accounts to a Roth. The benefit of a Roth is simple: Once you're in, you don't have to worry about paying taxes on that account, ever. Tax-free income down the road, though, comes with a price. And that price can be hefty: In the eyes of Uncle Sam, what you convert is taxed as ordinary income.
A bigger tax bill is probably the last thing you need right now. But ironically, this tough economic environment may make it an ideal time to convert to a Roth. Those smaller IRA balances means you’ll owe less tax. (Talk about a silver lining.) Think your income disqualifies you? As of 2010 the $100,000 adjusted-gross-income cap on Roth conversions will disappear. And, next year — and next year only — investors will have the option of spreading their tax liability over two years.
Despite all of the excitement surrounding the Roth, converting doesn't make sense for everyone. At a minimum, says Chris McDermott, a certified financial planner and senior vice president of investor education at Fidelity Investments, investors should be able to answer “yes” to three key questions: Do you expect to pay a higher tax rate when you retire? Do you plan to hold the account for at least 10 years? Can you pay the taxes owed without tapping a tax-sheltered account?
Even if you do answer yes to all three, there are other considerations, notes Barbara Steinmetz, a certified financial planner in San Mateo, Calif. Among them, how will the conversion affect your overall tax situation? “Just a small amount could make the difference to bump you from one bracket to another,” she says. “My advice is to always run the numbers.”
“There is a sense of denial among the pre-retirees,” said Lynne Ford, head of Wells Fargo Retail Retirement.
Even after suffering significant losses last year, many remain overly optimistic about their investment returns and the ability of their savings to fund their expenses after they stop working.
Only 23 percent of pre-retirees are saving more for their retirement than they were a year ago, the survey found. Most, some 57 percent, are saving the same amount, and 20 percent are saving less.
Perhaps even more startling is the extent to which their savings are falling short of their goals. On average, these pre-retirees expected they would need $800,000 to fund their retirement. However, most had only saved about $300,000.
Despite their inadequate savings, nearly two-thirds of the group lack any formal plans for retirement savings or spending strategies.
Of the 35 percent of those who had a written plan for retirement, only slightly more than half — about 52% percent — say they had updated it in the past year during the market downturn.
Among the biggest mistakes people are making is over-estimating their investment returns and the amount of money that can safely be withdrawn each year in retirement.
In the survey, both those who were about to retire and those who already had said they expected their savings to grow by 8.7 percent each year, on average. However, the compound annual growth rate of the S&P 500 from 1958 through 2008 was only 6.6 percent.
People also under-estimate how long they will live in retirement, she said. A healthy person in their mid-sixties can easily expect to live into their eighties or even nineties. However, few people are prepared to support themselves in retirement for more than twenty years.
The U.S. government is spending $787 billion to stimulate the economy, the deficit is $1.4 trillion and Congress is debating costly changes to health care. The taxpayers’ bill to pay for it isn’t far behind.
“Something is going to have to be done to raise revenue unless entitlement spending is cut,” said Gerald Prante, senior economist for the Washington-based Tax Foundation.
While the final resolution of the competing aims is being debated, what is under discussion has pundits opining that Federal tax rates may rise in 2011 to as high as 39.6 percent, up from 35 percent (for those earning more than $373,650). The House version of the health reform bill sets an additional 5.4 percent surtax on adjusted gross income for high- income individuals. Long-term capital gains rates may reach 28 percent, from 15 percent today, Prante said.
“For many of our clients, particularly those who run their own businesses, there may be an opportunity to accelerate significant amounts of income -- even as much as $50 million to $100 million of taxable income,” said Mark Nash, a Dallas partner at New York-based PricewaterhouseCoopers Private Company Services, whose average client has assets of $150 million or more. The tax savings from moving income into 2009 or 2010 would be 4.6 percent of that amount, he said.
US CAPE and q chart
The US Flow of Funds data (“Z1”) have just been published (17th September, 2009) for Q2 2009. We also have 99% of the EPS on the S&P 500 for Q2 2009. On the basis of these data, and allowing for the 16% rise in the stock market since 30th June, 2009, US non-financials on 17th September, with the S&P 500 @ 1069.45, were 40.6% overvalued (using q) and the total market including financials was 36.5% overvalued (using the cyclically adjusted PE “CAPE”).
From being around fair value at the end of March, the US stock market has become significantly overvalued again. In the case of q this is largely because of the rise in the market, aided to a small extent by falling asset values, largely of real estate, and rising liabilities.
In the case of CAPE the increase in the overvaluation of the market is also largely due to the change in share prices but, as current EPS, measured at constant prices, are around half those recorded 10 years ago, the cyclically adjusted EPS is also on a downward path, which is likely to continue for some time.
