This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on Dec 21 - 27, 2015.
CONVENTIONAL thinking would have it that to live a happy life, you must be debt-free in your retirement years. The idea is that you should be reducing your risk and focusing solely on preserving your hard-earned capital. But Thomas J Anderson, author of The Value of Debt in Retirement: Why Everything You Have Been Told Is Wrong, tells Personal Wealth in a Skype interview that he believes this mantra is one of the greatest myths about retirement ever told.
“[This is important,] especially when they get closer to retirement because that’s when people have the greatest conventional wisdom beliefs that I think need to be tested. We can learn a little from how companies use debt as a tool, and how that tool may be applied to people,” he says.
Anderson’s book, launched in March, is his second. His first, The Value of Debt, is a bestseller. It was released in September 2013.
In fact, not having debt at all increases one’s financial risk, he says. “We have all heard this saying: It takes money to make money. If you have a bigger pot of money cooking for you in your retirement, there is a lower chance that you will run out of money. If you have a smaller pot of money, then you have to have things really go right.
“It is a mathematical fact that debt can do three things: increase your rate of return, lower your taxes and reduce your risk. But it is also a fact that people can screw up the process and not get those exact results. When you are in retirement, what matters is the sequencing risk and the order of returns that you have.”
Debt helps one prepare for the rainy days ahead. According to Anderson, it creates the liquidity that is sorely needed to get through tough times. “Nothing creates a buffer like having money in the bank. Let’s say you don’t have debt but you own your house. If a crisis comes and you are retired, you can’t get access to that home equity because typically, you need to have a job to get a mortgage. So, the only way to do that is to move, and that is not a sign of a good plan,” he says.
The negative perception of debt often makes individuals want to pay down their loans as quickly as possible. This often happens at the expense of the power of compounding returns that could be obtained.
“I think what happens here, the power of compounding, is magical. The more money that you have working for you for a longer period of time is just truly incredible. But what happens is so many people take on debt early in life to buy things they want to have. When they want a house, they take on debt and then they spend their life paying down that debt as fast as they can,” he says.
“But they don’t get the power of compounding because all their money is tied in that house, which is going to be worth whatever that house is worth anyway. So, if the cost of that debt is less than what I feel gives a return in my investment portfolio, then it would not make sense to pay that down if I can get a higher return on those investments.”
He gives an example. “Let’s say the rate on your mortgage is about 5%. If you could borrow at 5% and are able to get a return of 10% from investing in the stock market, then you are capturing a spread. In the longer time period that you capture that spread, the power of compounding is very significant.”
Timing, of course, is everything. Anderson says that ultimately, investors will need to be careful about when they choose to take on debt.
“Investing is like baseball; you don’t need to swing at every pitch. There are times when things are at attractive prices, so you might want consider letting your debt ratio go a little higher. Sam Zell is a famous real estate investor in the US and he does this all the time. He takes on debt during a crisis and then sells things when they are priced very high. The goal is to buy low and sell high.”
Unfortunately, many people do the opposite and take on leverage when they shouldn’t, he says.
“For example, Americans are taking on leverage right now because they feel confident, but I feel things are expensive. [In contrast,] I think your market is cheap. People probably should be borrowing in dollars and buying in Malaysia. It is better than borrowing in Malaysia and buying in the US.”
Good debt, bad debt
Not all debts are good. Anderson divides debt into three categories — oppressive, working and enriching. Of these three, only working and enriching debt are considered good.
“Oppressive debt would be things like credit card debt and payday loans [short-term or cash advance loans]. Generally, any interest rate that is north of 10% or 15% is going to be oppressive debt. If you have high interest debt, pay that down and get rid of it.
“If you have low cost of debt, that’s working debt. Sometimes, mortgages can have low interest rates associated with them, and sometimes there can be tax deductibles too. Working debt can be beneficial, so you want to be cautious about paying down.
“The last type of debt is enriching debt, which you choose to have but can pay off at any point in time. An example of that would be Apple. That company has billions of dollars in cash but they also have billions of dollars in debt. Why do they do that? It is because the chief financial officer values the liquidity, flexibility and tax benefits that are associated with that debt. That’s why it chooses to embrace those strategies. So, we can learn from that as well.”
Examples of working debt are mortgages, small business loans and student loans, while the line of credit against your investment account is an example of enriching debt. A line of credit against one’s investment account can mean a securities-based loan or even a home equity loan. However, Anderson mostly refers to securities-based loans (the closest equivalent being share margin financing in Malaysia) in his book.
“Different markets around the globe are rolling out different solutions to this, so it depends on where your assets are custodied. It’s a way to borrow against your liquid investable assets at very low rates. You can borrow from global financial institutions in almost any currency as well,” he says.
Anderson notes that this does not necessarily apply to those in the lower income levels as they may not have access to low-cost debt. “You have to be able to have access to low cost of debt. If your cost of debt is high, my ideas don’t work. So the problem for low-income earners is that they don’t have that. But for the middle class and higher income earners, that access to low cost of debt through things like a mortgage, the rate is incredibly attractive.
“If you can borrow at 4% and are young, you have a long time ahead of you. Over the next 30 years, you are likely to have an average return of better than 4%. Imagine a person who accumulates US$1 million with no debt, whom we think is successful. But compare that with another person who has US$3 million including US$1 million worth of debt. [Effectively,] they are worth US$2 million. I would rather be worth US$2 million than US$1 million. So, the debt in itself isn’t bad if the assets are greater than the debt.”
Anderson, who worked in investment banking before moving into private wealth management, cautions that his advice does not apply to everyone, especially those who are happy with a return of 3%. “From my experience in the US, about a third of people don’t need a return of more than 3%. They could have a great pension. You don’t need to have debt because you have an income stream that’s coming to you during your retirement.
“But there is another third of the US who need a distribution rate of between 4% and 6%. In that zone, you could be alright without debt, but mathematically we actually prove that debt has its value on every rolling 30-year period measured backward.”
The last group of people who need a rate of return of more than 6% in retirement can achieve their objectives through debt. “They either have to take that risk through asset allocation, cut back on their lifestyle or take on debt. I look at this as arrows in a quiver to solve the problem. Debt is a powerful tool that can give me more money. If I can get a higher rate of return than my cost to debt, then it is a good trade,” says Anderson.
If debt can be part of one’s retirement, would this strategy fundamentally change the way you save and invest in the years leading up to retirement? Anderson disagrees, saying that the tenets of financial planning must still be followed.
“The goal is that by the time you retire, you have the ability to be debt-free but choose not to be. Just like Apple. That’s when you actually become more liberated and are a real flexible force. So, you have to have that choice,” he says.
In his book, Anderson mentions that risk tolerance should not play such a central role when it comes to targeting returns needed for one’s retirement. Instead, their needs should determine their risk appetite.
“Yes, people who provide financial advice usually ask, ‘What’s your risk tolerance and what’s your time horizon? What they should be asking instead are some of your goals. Then, come up with the best plan for them to accomplish those goals using all of the tools possible,” he says.
“For example, if I see a doctor for my heart, the doctor will say that I either need to take a pill or they may do an invasive procedure or they might crack my chest open. They don’t ask what’s my tolerance for pain, they figure out what my problem is and then they solve it.
“Debt is not a tool for everybody, but debt is an appropriate tool to help keep you on track. It is a tool planners should use as part of their arsenal to get people on track for retirement.”
At the end of the day, debt in itself can never, ever be good or bad, says Anderson. “All debt is, is a magnifier of investment decisions that you make. If you make good decisions, debt will make them look better. If you make bad decisions, debt will make you look worse.”
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