Diversification & Asset Allocation: Where Does Home Equity Fit?

I came across this article in the FPA’s December 2021 Journal of Financial Planning during my research. It reinforces my beliefs and the solutions I continue to advocate for when reducing adverse risk in retirement. I highly recommend this paper for certified financial planners and wealth managers, and other trusted advisors who have clients contemplating retirement. Diversification & Asset Allocation: Where Does Home Equity Fit?

Key Takeaways

• Financial planners with clients nearing or already in retirement should review their understanding of portfolio volatility. Short-term volatility is not a significant risk for mid-career clients who are building wealth (not withdrawing from their portfolios).
• This paper guides financial professionals to better understand and communicate the concept of risk reduction to their colleagues and clients.
• Once-popular tools of diversification and asset allocation may no longer be as helpful for retirees who are dependent on regular income from their portfolios.
• Another important risk-reduction tool, but one that financial planners overlook, is the inclusion of home equity in the retirement portfolio. Using home equity as an asset alongside, and similar to, investment securities. A withdrawal strategy that uses home equity in a responsible way is an important part of the retirement portfolio.
• There is no real transfer of ownership, control, or management of the home when home equity is added to the portfolio. The equity serves as a source of retirement income just like the other assets in the portfolio.

Additional Takeaways

• This paper synthesizes the findings of several previously presented research papers. Redefining the findings into fresh perspectives on the meaning of “risk” for certain retirees. Their primary source of retirement income is a securities portfolio, usually a 401(k) or a rollover IRA, but not always. 
• Short-term volatility is a risk for clients who retire and rely on their securities portfolio for regular living expenses. When the algorithm determines it, using home equity instead of other portfolio assets to reduce regular distributions.
• In other words, a risk is a chance, probability, or event that could harm the person taking it. In retirement, risk means the likelihood of cash flow exhaustion or a significant reduction in lifestyle or spending. This paper’s risk measure is the probability of such an event.
• Examples are shown to show how home equity can be used in a portfolio. By increasing the percentage of the portfolio’s assets that can be sold initially, then to a level above the traditional 4%. While using home equity to keep the risk of running out of cash flow low.
• Financial planners who act in a fiduciary capacity should recognize the added value.  After all, adding home equity to retirees’ portfolios can increase diversification and reduce risk.