A Liquid Tale
“The wealth paradox”
I call this A Liquid Tale because it instructs us of the importance of liquidity. Liquidity means you have enough money to pay your bills. If you don’t, you are illiquid. Sometimes people find themselves in a situation in which despite a growth in their net worth or the value of their business, they can’t generate enough income to pay their bills. Most people can borrow money when this happens, and since their wealth or, in the case of a business, the value of their business is growing, they can pay the loan back later. But what happens when you can’t borrow money or you don’t want to borrow money? Let me tell you what happened to the parents of one of my friends. Let’s call them Tom and Judy Smith.
The Smiths retired in 1992, sold their house and bought an oceanfront house on the Delaware shore. They paid a little over $200,000 in cash for their new home and fully intended to live there for the rest of their lives. Their thinking, flawed thinking I might add, was that with the interest they were making on their certificates of deposit (or CDs) and their Social Security benefits, they could live out their days worry-free. They calculated that at slightly more than $3,000/month in income and with no mortgage on the house and with no other debt they could manage very well.
This couple had a net worth of approximately $500,000 in 1992 when they retired. The new home they purchased was worth slightly more than $200,000 and they had slightly more than $300,000 in CD’s. They had no pension and needed to live on the income from their investments and Social Security. As I mentioned, they were generating income between the two sources of roughly $3,000/month.
As we flash forward to the summer of 2005, I get a call from Tom. He explains his current situation and asks for my opinion as to what they should do. Since this couple was, in 1992 and still is in 2005, completely risk-averse, they were not part of my investment management clientele. Our relationship was on a personal level. As he explained, I immediately knew what the problem was. The problem was interest rates had gone down and expenses had gone up. It seems their house, due to its excellent location, had appreciated significantly since their original purchase to about $1.2 million. Furthermore, they still had their original $300,000 in CD’s. The Smiths had almost tripled their net worth in 13 years, but they couldn’t pay their bills from what they earned in interest on their CDs and the income from Social Security. They had a liquidity issue.
I congratulated Tom on the significant increase in net worth, assuring him that there weren’t many retirees in America who could say the same thing. Then we got down to business. His problem was that now, in 2005, the income his CDs generated along with his Social Security was still about $3,000/month, while his expenses had gone up considerably. What had happened? What happened is that interest rates fell, and so his CDs were earning about half of what they earned in 1992, and Social Security had not kept up with the rise in cost for their particular situation. Specifically, their cost of living had increased mostly in the form of higher real estate taxes, since their house had appreciated so much over the 13-year period. A secondary expenditure increase was the cost of health care. As a result, this couple didn’t have sufficient monthly income to pay their bills. They had too much house and not enough liquid assets. They were wealthier, but they had insufficient income.
So what should they do? I told him there were four alternatives. Since they were both in their mid-70s, it was a high-probability bet they would only need to provide income for the next 25 years at best. They calculated they were short by about $1,000 month based on the expenses of the past year. I suggested they consider one of the following:
· Sell their house and move to a cheaper one.
· Open a home equity line of credit.
· Take advantage of a reverse mortgage.
· Start dipping into the $300,000 principal they had in CDs.
I felt that any one of these four alternatives would solve their problem. What did they do? As you recall, the Smiths were a very risk-averse couple. Dipping into principal was out of the question, as was borrowing money to pay bills. This left them two options—sell the house or borrow money on a monthly basis through a reverse mortgage. Once they discarded the reverse mortgage alternative as too risky as well and since they were afraid that real estate prices would fall, they decided to sell the house. I could not argue with their decision or, better yet, I was not persuasive enough to explain the finer points of the other alternatives. However, I respected and understood their decision because it was consistent with their risk aversion. They sold the house and moved inland to a $400,000 home that they paid for in cash, and invested the after-tax profits from the sale of the beach house in CDs. By doing this, they had solved their liquidity problem without borrowing money or spending their principal.