Role of a primary residence in a retirement plan

This article is about the possible role of a primary residence in a retirement plan. About 70% of Canadians aged 65 and older own a principal residence. It is the largest asset in the net worth of Canadians aged 65+, at 35% on average across the country (including the effect of non-homeowners), rising to 40% in Toronto and 47% in Vancouver.

The conventional wisdom used to be that a home was mostly a place to live, and also a buffer asset that could perhaps be sold or remortgaged as a last resort, typically late in retirement, in case of portfolio depletion or for contingencies such as health issues or long term care. However, Canadians are increasingly planning on funding part of their retirement using their homes.

This article first discusses what is the potential issue with relying on an increase in a principal residence value to fund one’s retirement. It then briefly mentions the concept that a home typically generates no cash income but provides housing services (imputed rent). The article then discusses what is the ideal proportion of a primary residence in a retirement income plan, if any. Finally, different ways of using your home as a retirement asset are presented, with pros and cons.

What is the issue?

Substitute for lack of actual retirement savings?

The apparent increased reliance of Canadians on their primary residence to support their retirement may signal a lack of actual retirement savings, planning and preparedness in some cases. In a survey conducted for the Ontario Securities Commission, 53% of Ontarian homeowners aged 45+ without an actual retirement plan were found to rely on an increase in home equity to finance their retirement. In contrast, only 34% of those that have a formal written plan for retirement saving rely on home equity appreciation. Similarly, 60% of Ontarian homeowners aged 45+ who have not started saving for retirement at all are relying on their homes to compensate.

Treating principal residences as an investment?

In yet another survey, 17% of recent home buyers expect their homes to fund “the majority” of their retirement, whereas almost half of buyers aged 18 to 34 “admit to stretching their budget to buy a home in anticipation of home equity one day funding part of their retirement”.

These buyers may be extrapolating the recent housing price increases into the future, but over the longer term, these increases may not continue at the same pace.

Principal residences versus portfolios

In 2023, the median net worth of what Statistics Canada calls “senior families” was about $1.1M. Most of those families own a principal residence, with a median value of $0.5M in 2023. But from a retirement income perspective, owning a $500k primary residence is not the same thing as owning a $500k investment portfolio. To give an order of magnitude estimate, a $500k investment portfolio, consisting of stocks and bonds, can potentially generate about $20k of income per year, indexed for inflation, over 30 years or more, based on the 4% rule of thumb. The income from an investment portfolio comes from interest and dividends, but can also be supplemented from easily selling small amounts of the portfolio at market prices on a regular basis. These small liquidations incur very limited costs (e.g., $0-10 at most discount brokerages).

In contrast, a principal residence is illiquid: it can only be sold in its entirety, which may take several months, and with large transaction costs (several percent of the home value). Also, unlike investing in very low cost vehicles like index exchange-traded funds (0.05-0.25% per year), owning a home leads to substantial ongoing costs (property taxes, maintenance, ...) and those costs tend to be larger for bigger residences. A principal residence generates no income (beyond housing services, see below) unless the owner is willing to rent part of it to someone else. Cash may be obtained by remortgaging the residence (home equity extraction), but taking a loan means paying interest one way or another (for a HELOC, on a regular basis; for a reverse mortgage, interest is added to the loan balance). A reverse mortgage is sometimes described as making the home a more liquid asset by allowing the owner to sell small parts of it regularly, but what is missing from this description is the interest that accumulates over time and makes the loan balance grow exponentially (consuming more home equity). Whereas selling a few units or shares from an investment portfolio has no impact on the rest of the portfolio.

Empirically, a US study has shown that holding a large fraction of one's net worth as home equity is correlated with less self-reported retirement satisfaction. The authors interpret this to mean that "holding a larger percentage of assets in the form of home equity creates resource constraints for retirees who may need access to capital to promote a fulfilling retirement experience".

The Ontario Securities Commission is concerned that “many Ontarians could be overestimating their ability to finance their retirement using their homes”. and the concern applies to the rest of Canada as well, where some retirees may find themselves house-rich but cash-poor.

Housing services

As stated above, a principal residence generates no cash income. Even worse, it has associated costs like maintenance, property taxes, the temptation to renovate, etc. On the other hand, the principal residence provides the owner a place to live, i.e. housing services.

One way to estimate the value of these housing services is called imputed rent (or implicit rent): how much would you have to pay to rent the same or a similar dwelling from a landlord. The housing services provided by the principal residence go up in value if spot rents go up, thus the owned home provides a hedge against rent risk (the uncertainty about future spot rents), as discussed in Owning vs renting.

Some ways to free up some home equity, like selling outright and then actually renting a dwelling, mean that monthly cash expenses will probably increase relative to the situation before; the investment portfolio got bigger due to the sale of the residence, but so are the monthly expenses that retirement income now has to cover. Since future investment returns, future rents and the investor's longevity are all unknown, there is more uncertainty involved relative to staying in the principal residence.

From this point of view, if the homeowner does not sell (stays in their owned residence) during retirement, the home equity is indeed ‘locked’, but since home ownership lowers the necessary monthly cash outlays, it is still playing a very useful role by providing housing services and acting as a buffer asset.

What is the ideal proportion of a primary residence in a retirement income plan?

One financial advisor consulted by the Montreal daily La Presse puts the ideal proportion of the home value in retirement income plans at 0%: a solid plan does not require home equity extraction, because people need a place to live and many prefer to stay in their homes during retirement (“aging in place”). Instead, the principal residence is a buffer asset, and unencumbered home equity can serve as a source of funds for contingencies, like long term care. This is the conventional wisdom, or it used to be.

Two other investment advisors/financial planners interviewed in the same publication put the upper limit of the primary residence value at 30% or 40% of global household “retirement assets”, with the rest made up of company pension plans, government pensions and programs, investable assets (stocks and bonds), etc. The idea of an upper limit is to avoid excessive reliance on a single illiquid asset. But there might still be a role for principal residences in retirement plans beyond imputed rent.

Using your home as a retirement asset

Canadians, asked which method they would be the most likely to use to fund their retirement using their home, if they had to, responded:

• 46% would downsize,
• 20% would use a HELOC
• 15% would consider a reverse mortgage
• 11% would rent a portion of their home

We look at those options in that order.

Downsizing or renting a dwelling

Downsizing: Moving to a smaller home, and/or to a less expensive market, can free up some cash to bulk up retirement portfolios that can then generate more income. Housing-related costs may also decrease.

Pros

• No debt involved
• Opportunity to declutter
• Less home maintenance

Cons

• Will only free up a portion of the home value
• Downsizing costs (real estate commissions, legal fees, moving costs land transfer taxes…) can represent up to 10% of the original home value
• If renovations are needed/desired in the new location, how much cash will actually be left?

Renting a dwelling: Some homeowners sell their property to free up all of their home equity and then rent an apartment or retirement residence afterwards for themselves, which they pay for by investing the proceeds of the sale (or buying a life annuity).

Pros

• Frees up the most cash to invest
• No debt involved
• Opportunity to declutter

Cons

• The rent paid to a landlord will increase monthly expenses, and the rent may go up over time
• In practice, many retired homeowners don’t actually want to sell when they reach that age, perhaps due to emotional reasons, or a lack of suitable renting options
• Renters may need to vacate and move again for various reasons (potential instability and stress)

Home equity lines of credit

Main article: Home equity line of credit

HELOCs are loans secured against a home, and can reach 65% of the home's value. During retirement, borrowing from a HELOC could potentially be done to supplement retirement income. As of 2019, only 6% of Canadians aged 65+ had a HELOC.

A common recommendation is to secure the HELOC before retirement, as the limit amount will be based on a larger income. However, that limit amount may erode over time (as a percentage of current home value) with increased house prices.

Pros

• Simple and flexible (no fixed repayment schedule, except current interest payments)
• Interest rates lower than on unsecured loans or reverse mortgages

Cons

• Involves regularly paying interest on the borrowed amount
• A bank can lower the HELOC limit because of falling real estate prices, or a smaller income in retirement than during working years
• Credit can be frozen or closed for non-usage
• The remortgaged portion of the residence can’t also be used as a buffer asset (e.g., for contingency planning)

Reverse mortgages

Main article: Reverse mortgage

A reverse mortgage is a type of loan which allows homeowners, usually aged 55 or older, to access some home equity without having to sell the property. Borrowers pay back their loan when they move out of the home, sell it or the last borrower dies. The initial loan can reach 55%+ of the home value depending on age and other factors. As of 2019, only 1% of retired Canadians received income from a reverse mortgage.

Pfau (2016), writing in a US context (where details are different), suggests that a reverse mortgage could potentially be used to mitigate sequence-of-returns risk. If the investment portfolio suffers a bad year (negative returns), the retiree can draw on home equity through the reverse mortgage while the portfolio recovers. Alternatively, the retiree could make regular withdrawals from the reverse mortgage to supplement income, or use the reverse mortgage as a last resort, among other strategies. Pfau’s simulations show success rates that are higher for these strategies than the baseline of ignoring home equity in retirement plans. On the other hand, if home equity is being consumed to pay for current expenses during retirement, the same home equity dollars can't also be used for potential contingencies like long term care down the road.

Pros

• Alternative to downsizing or renting: you stay in your current home
• No payments on a reverse mortgage until the loan is due

Cons

• High setup costs
• The interest rate is higher than on a traditional mortgage or HELOC
• The loan might consume most or all of the home equity over long time periods
• The remortgaged portion of the residence can’t also be used for contingency planning

Renting out a portion of the home to tenants

Some homeowners may decide to rent out a portion of their property to a tenant to generate income, especially if the residence is too big for their current needs. This could range from providing a bedroom to a tenant (with access to common areas), to turning the whole basement into an rental apartment. Another option may be to build a small detached house (“granny house”) in the backyard, if the local municipality allows it. This smaller dwelling could then be rented out, or the owner could decide to live there but rent out the original house.

An alternative would be to move out of the home and rent something smaller for yourself, then find short-term or long-tern tenants for the larger owned residence.

Pros

• Additional income without accessing home equity
• No debt involved (except if a mortgage is taken to build a granny house)

Cons

• Loss of privacy
• Extra management burden: you need to have the right mindset to be a landlord - it's not for everyone. For example, tenants may contact you in the middle of the night for a needed repair. The extra income may be overshadowed by the emotional stress of maintaining the property and managing tenants.

External links

• Financial Wisdom Forum topic: "Role of a primary residence in a retirement plan"