Reverse mortgages have been the subject of much financial planning research over the past few years, the emphasis of which has focused on how these products add to the value of a retirement income plan. While planners have largely focused their research on the line of credit option, few have explored the effectiveness of the reverse mortgage tenure option in the context of financial planning.
Reverse mortgages provide a means to generate more retirement income than can be obtained from retirement savings alone—and the tenure option does so in a direct way, says a recent report published in the Journal of Personal Finance.
The report, “Reverse Mortgages, Annuities, and Investments: Sorting Out the Options to Generate Sustainable Retirement Income,” was written by Joseph Tomlinson, FSA, CFP, managing director of Tomlinson Financial Planning in Greenville, Maine; alongside Shaun Pfeiffer, Ph.D., CFP, associate professor of finance and personal financial planning at the Edinboro University of Pennsylvania; and John Salter, Ph.D., CFP, AIFA, associate professor of personal financial planning at Texas Tech University and a partner and wealth manager at Evensky & Katz Wealth Management in Coral Gables, Fla. ad Lubbock, Texas.
The study examines how using either reverse mortgage option (line of credit or tenure) can generate improvements in sustainable retirement income, particularly when combined with single-premium immediate annuities (SPIAs).
Although the popular financial approach to generating retirement income has been to rely on systematic withdrawals from investments, such as stocks and bonds, the researchers suggest planners have two additional options worth considering: reverse mortgages and annuities.
“Such options may be particularly useful for clients whose finances are constrained and they need to either generate more retirement income or make the income more secure,” write Tomlinson, Pfeiffer and Salter.
An issue for planners, they suggest, is how to choose among these two options and how to combine these alternatives in a way that best meets client needs.
Ideal candidates for annuities, particularly SPIAs, are those who need more security so that their retirement income will last for life, and can tolerate the illiquidity that a SPIA entails, according to the study. Whereas for reverse mortgages, ideal candidates are those who need additional retirement income, plan to stay in their home for life, have adequate long-term care insurance and do not plan on leaving a bequest.
“With the reverse mortgage options, purchasing a SPIA improves the security of retirement income, but does not increase the income,” the study states. “Combining SPIAs with reverse mortgages provides a way to gain additional retirement income security, but without much impact on the overall level of retirement income.”
Researchers ingrain their analysis around a scenario involving a husband and wife as borrowers, a couple which they believe presents a more typical situation for financial planners. Specifically, researchers assume the couple lives in a $400,000 home and that the husband is 65 and the wife is 63.
Based on August 2015 interest rates, for this couple the initial principal limit they would receive from a Home Equity Conversion Mortgage (HECM) would be $212,000, according to researchers’ calculations based on the reverse mortgage calculator provided by the National Reverse Mortgage Lenders Association.
Under this scenario, a borrowing couple utilizing the reverse mortgage tenure option would be able to obtain $1,130.36 per month. Assuming setup fees were financed ($212,000 – $10,826), the available amount for borrowing would be $201,174.
By comparison, researchers note that a SPIA purchased with $201,174 would pay $955.21 per month, based on market rates as of August 2015 for SPIAs sold directly.
“The SPIA advantage is that payments continue until both members of the couple are dead, whereas tenure payments only continue until the home is vacated,” the study states. “For couples who can put plans in place to utilize home care if needed and keep their home as long as possible, the tenure option can be expected to provide payments for a duration similar to a SPIA.”
The term tenure payment calculation is based on an interest rate that is the sum of the annual Mortgage Insurance Premium of 1.25% and the HECM Expected Rate, which is the sum of the 10-year LIBOR swap rate—about 2.3% in August 2015—and a Lender’s Margin, which may vary by lender, but was set at 2.5% in the NRMLA calculator as of the date of the research’s publication. The researchers’ example of the 65-year-old husband and 63-year-old wife assumes a 4.8% HECM Expected Rate.
“The tenure payment calculation uses a higher expected duration than the SPIA, which would lower the payout rate, but a higher interest rate, which would raise the payout, and the interest rate more than offsets the duration,” the study states. “So based on current pricing, tenure payments ($1,130.36) will exceed SPIA payments ($955.21) when the SPIA purchase amount is set equal to the HECM Net Principal Limit.”
Researchers then move onto how the reverse mortgage options and SPIAs, either separately or together, can be integrated with systematic withdrawals to improve retirement outcomes.
Per the already established scenario featuring the 65- and 63-year-old husband and wife, researchers also assume this couple—who have a $400,000 home with no mortgage—also has $1 million in tax deferred savings.
Additionally, their Social Security income is $30,000, which will increase each year for inflation, and is assumed to reduce to $200,000 in real dollars when either member of the couple dies. It is also assumed that this couple has their savings allocated 60/40 in stocks/bonds and rebalanced to this allocation annually.
Compared to relying only on systematic withdrawals from investment accounts, the use of either reverse mortgage option (LOC or tenure) was found to greatly increase consumption—$70,881 median consumption for the line of credit, compared to $74,735 for tenure payments and $64,287 for systematic withdrawals.
Because of the assumption that withdrawals are taken from savings before tapping the line of credit, the line of credit option depletes savings but leaves some home value. Tenure, on the other hand, depletes home value more and leaves remaining savings.
“Overall, the tenure option does somewhat better than the LOC in terms of both consumption and bequest measures,” researchers state. “This reflects tenure not depleting savings and thereby leaving more money invested in stocks, the potentially highest return asset.”
Because the tenure option pays out a higher rate than the SPIA, the study indicates it is necessary to allocate $238,061 for SPIA purchase, compared to the $201,174 borrowing limit used to generate tenure payments.
The SPIA option leaves median consumption about the same, but does reduce consumption risk, according to researchers who note that under the SPIA home value is preserved for late-in-life needs or a bequest.
“If the goal is to maximize consumption without a bequest concern, the reverse mortgage options win out over the SPIA,” the study states. “If bequests are important, the decision requires evaluating tradeoffs between consumption and bequest.”
The research from Tomlinson, Pfeiffer and Salter is the first to seriously consider how the reverse mortgage tenure payment option compares with the use of a SPIA.
Besides the need for more research on this topic, the researchers conclude that there will also be a need for planning software capable of handling combined analysis of reverse mortgages, annuities, and systematic withdrawals on a customized basis for financial planning clients.
View the report in the Journal of Personal Finance.
Written by Jason Oliva