How to decide whether to make a big purchase in retirement

A recently retired client called to say they had the chance to buy the townhome attached to their vacation property on a popular lake. It was exciting for them to be able to control who their neighbors would be. What was much less exciting was what that purchase would do to their ability to live comfortably.

Remember, when you are retired, you are usually switching your investment priority from maximizing growth to creating cash flow while allowing for some growth. To buy the property, this couple would have to take out a mortgage or pay cash. Both create the same issue. A mortgage is a monthly cost you must pay from earnings on assets; cash is a reduction in assets, which corresponds to a reduction in cash flow.

Converting investments to cash flow is relatively simple. You are going to be able to spend roughly 4 to 6 percent of your assets, depending on your life expectancy, how much you wish to leave to others, your asset allocation, and whether you inflation adjust your annual spending.

This means that every $10,000 of investments will create $400 to $600 a year in annual spending. Sure, assets could grow much slower than that or do much better, but these are useful parameters.

A home is a use asset that often, but not always, appreciates. Use assets require upkeep and ongoing costs. The key determinant in whether you should buy a use asset (beyond the pleasure it gives you) is what you are willing to give up to get it.

If you bought a $500,000 house that has operating costs and taxes of $15,000 a year, you are dedicating roughly $750,000 to $875,000 of your assets to owning it. You will get a chunk of those assets back when you sell the house. Equivalent rent (depending on what is included) would be between $3,000 to $3,750 a month, and you maintain control over the investment needed to generate the rental costs. These numbers represent a pretty high hurdle for a purely financial justification of second homes.

Understanding how much you need in investments to generate cash often gets ignored when looking at things such as the value of your pensions, Social Security or part-time work. Getting $24,000 a year in Social Security payments is equivalent to having $400,000 to $600,000 dollars of investments. Part-time work in which you earn $10,000 a year means the earnings on assets between $167,000 and $250,000 can be spent on other things.

I suggest viewing these numbers as illuminating rather than intimidating. We are always using assets for spending. Clients are often worried about the costs of paying for a long-term care facility. If they own their home, it is likely that they will substitute selling the no longer needed home to pay for several years in a long-term care facility.

These calculations also give you some wiggle room. Clients recently bought an RV that they intend to use for the next few years to travel the country and then sell it when they want to settle down. The RV is a temporary use of their assets, some of which they will get back when they sell it. The longer they hold the RV, the more assets are dedicated to that lifestyle, but the impermanence of the transaction makes it possible for them.

Translating assets into spending is also why it is so important to get started on a systematic saving plan when you are young. The two most critical aspects of investment success are time and compound interest. By putting money away today, you will receive multiples of that back tomorrow.

The clients who were looking at the townhome felt that the cost of what they would be unable to do by making this purchase was higher than the potential disruption a bad neighbor may cause. This was especially true because their association doesn't allow short-term rentals, eliminating those loud bachelor and bachelorette parties. Their choice became clear when they understood how much of their assets would be dedicated for this protection.

Ross Levin is founder of Accredited Investors Wealth Management in Edina. He can be reached at ross@accredited.com.