Study Makes Case for $1 Million Reverse Mortgage Retirement Strategy

Several studies have already demonstrated the potential benefits to be reaped when using a reverse mortgage as part of a coordinated retirement strategy, but one recent case study further expounds on the efficacy of the reverse mortgage line of credit.

With the arrival of new program changes and consumer protections in recent years, the reverse mortgage industry has strived to assert the legitimacy of the Home Equity Conversion Mortgage (HECM) as a viable retirement income planning tool.

A variety of financial planning research published within the last decade has added layers of credibility to reverse mortgages as a financial resource that can help “buffer” against volatility in investment markets, increase retirement spending and, above all, significantly improve the longevity of a retiree’s retirement income.

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The crux of these strategies invariably requires retirees to obtain a reverse mortgage line of credit early in retirement. By doing so, retirees can accumulate a greater share of home equity over time, which they can use to supplement their retirement spending and help shore up losses in their investment portfolio during years of negative market returns.

“In this strategy, the reverse mortgage credit line is used to offset the ‘adverse sequence of returns,’” states a case study published by Barry Sacks and Mary Jo Lafaye this year and further discussed by Tom Davison, a wealth manager who has frequently researched and written about reverse mortgages in the context of financial planning.

In demonstrating the coordinated planning strategy, which was previously introduced by Barry and Stephen Sacks in the Journal of Financial Planning in 2012, Sacks and Lafaye establish a retiree with a $500,000 equity/bond portfolio split 50/50. Beginning in 1973, the case study examines a 30-year spending horizon, incorporating an initial 5.5% withdrawal rate increasing at a 3.5% inflation rate.

Sacks and Lafaye then compared two scenarios involving the same retiree: one scenario in which the retiree obtains a reverse mortgage only after his investment portfolio is depleted; and a scenario in which the retiree takes a reverse mortgage line of credit early in retirement, only drawing from the credit line after suffering negative returns on his portfolio.
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Utilizing a reverse mortgage as a last resort strategy, the retiree ends up depleting his portfolio in 1996—six years short of the 30-year retirement horizon, according to Sacks and Lafaye.

On the other hand, by tapping into the reverse mortgage loan proceeds after suffering negative returns, the same retiree is able to fund their retirement for the full 30-year period. What’s more is that in this scenario, the retiree’s total portfolio value has grown in excess of $1 million after 30 years.

Taking the difference between the total portfolio value and the accumulated reverse mortgage loan balance, the retiree ends up with a net $394,991, whereas under the “last resort” strategy the same retiree is left with a $538,773 reverse mortgage loan balance and no money in the investment portfolio to offset this debt.

“Using the simple coordinated strategy has dramatic results: they don’t run out of money,” Davison writes in a recent post on his blog, Tools for Retirement Planning. “Their estate size increases over $900,000. Rather than the portfolio exhausting in the 24th year, it lasts through the 30th year, with a $1,000,000 balance.”

Taking the reverse mortgage was critical to the long-term sustainability of the retiree’s portfolio, especially during the first decade of retirement when the portfolio suffered various years of negative returns in close succession.

“The strategy is simple to state and simple to use,” Davison writes. “It is a direct attack on investment risk, and especially sequence of returns risk. Individual homeowners can do this!”

As the research shows, homeowners need to obtain a reverse mortgage line of credit as early in retirement as possible for the coordinated planning strategy to be effective.

“Naturally, the larger the reverse mortgage line of credit is, the more it can help the homeowner,” writes Davison.

Written by Jason Oliva

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  • What a great article written by Jason. I know I sound like a Parrott, repeating myself but articles like this are what we all need to be making copies of to show are potential clients, financial planners and advisors.

    These are actual statistics that can be the greatest sales tools we can use, especially with financial planners!

    Great Job with this article Jason, timing is great!!!

    John A. Smaldone
    http://www.hanover-financial.com

    • John,

      These are not actual anything. It is best we do not mislead or overall projections as fact.

      They are merely projections based on various assumptions and scenarios. They have nothing to do with reality other than in a historical context. But they are sound computations with a reasoned set of assumptions.

      Could the positive results be true? As of yet we have no empirical evidence of such findings. We have no person who has demonstrated in a live scenario the financial discipline the projections with positive findings require. As an auditor, there is no evidence to verify, just computations to test for accuracy.

      This is like a medical study based on pigs. The findings may be true but until the more positive results can be verified to evidence, the findings are highly interesting but they are not ACTUAL statistics. They have yet to be shown to have been achieved by any HECM or other reverse mortgage borrower.

      We need to be careful overselling stats like this. We must constantly remind ourselves that they are well thought out and useful examples but they are not actual results. No one has even taken on that project.

  • (I’ve also posted as “Travel”)

    I agree. As a reverse mortgage recipient, I view the line of credit as hugely significant with regard to the benefits of a reverse mortgage.

    And yes, I’d bet that it’s one of the least understood aspects of the reverse mortgage among prospective reverse mortgage clients; and using financial planner language like: “sequence of returns risk” doesn’t help. This is the first article I’ve read that actually explains in layman’s terms what this equivocal phrase means “in real life.”

    By all means, print-out this article and give it to clients.

    Also, although I do appreciate the fact that the growth of the line of credit isn’t technically “getting interest on the money,” if clients were asked to think of it as interest, just for the sake of clarity, it would go a long way with the “understanding of” the benefits of the line of credit.

    • Ed,

      By taking the route you are suggesting of calling the growth in the line of credit as interest only potentially adds to the confusion there is with HECMs. (I am not aware of any current other reverse mortgages that have a line of credit.) So by discussing this as an attribute of reverse mortgages, you include fixed rate HECMs and all other reverse mortgages. Please remember this is not an industry limited website.

      This product is by its nature complex. It became even more complex when HUD separated the growth of the line of credit from the principal limit growth rate in the model loan documents. From a reasonability position, AARP is right to attack the growth of the line of credit as it is but wrong to suggest its elimination. It just needs to be tamed by limiting the growth in the line of credit by tying it to the growth in the principal limit as it was in the past.

      If it is interest then what is the matter with calling it interest but it is not. I know of no credit card company which increases the credit available with the card and names that increase “interest.”

      I absolutely agree with your criticism of overemphazing “sequence of return risk.” There is also sequence of return benefits and unfortunately we have found emphasizing fear to be more effective than giving equal weight to sequence of return potential benefits.

      What is strange with this argument about calling it interest is that there is a simple way to explain. “Based on your available line of credit throughout the prior month, HUD increases it through the amount available to you through a computation that is very similar to computing interest.” If the prospect(s) want to know the computation, I then give it them. Since the MIP rate is involved, it is not like computing interest. But I also point out the growth in the line of credit on what we misname, the amortization schedule.

      • I know it’s not interest, but just more money available from a loan. However, it’s “like” interest if the reverse mortgage recipient has no plans of selling the property; therefore doesn’t view the capital as a loan to be paid-back (by the alive recipient himself), but rather capital that can generate more capital.

      • It is never like interest since the borrower does not own the increase, the lender does until the borrower exercises his/her right to take the increase.

        Sadly some people have the attitude you describe but they are living in a dream world where debt has mythically turned into capital, i.e., the equity of the borrower. I have met such a person who was both a HECM borrower and a HECM originator. He also had been a Major as a helicopter pilot during the first days of the air cav in Nam. When he dies he left his wife and daughter with some real financial issues that had to be resolved. He was a great and honorable guy who made some real financial messes for his wife and only daughter that only came to roost when he died. His wife and he thought she would be the first to go so he ignored the warnings of a friend who was a PFP and my own.

        Another danger point came when the last LIVING borrower possessed his full faculties but physically his newly detected but every advanced leukemia no longer allowed him to live on his own and he had to sell his home. Because he lacked the equity to enter the care facility of his choice, he spent the rest of his life regretting how he viewed the cash available to him in the past through the HECM line of credit. Now imagine if that person was a relative you really care for. While those events did not come to fruition, they nearly did.

        It is best not to encourage anyone to live in a fantasy that a HECM is anything other than a nonrecourse mortgage.

      • Ed,

        You say seniors see growth in the line of credit as “capital that can generate more capital.”

        But neither the available line of credit nor its growth are capital. They are debt. The related cash does not belong to the borrower until it is taken and then the balance due rises by the amount of cash taken.

        I heard your representation of how this segment of seniors thinks but is that the justification for not questioning that position? This position has no foundation in fact nor can it justified by a nonexistent ROI.

        While the HECM line of credit and its growth are not common, they are easily understood as the principle of negative amortization applied to the available line of credit.

        Senior consumer groups would love to get their hands on your reasoning. It has the air about it that HECM originators have little concern for any sense of being a fiduciary.

    • Mr. McSherry,

      Where is the sample of seniors who have experienced this growth in the line of credit and have incorporated it into their retirement plan to improve their retirement years?

      We have those who have improved their cash flow through tenure payments and even more seniors from paying off debt. But it is unclear how the growth in the line of credit by itself has improved any seniors retirement.

      No one doubts that a HECM line of credit grows but that growth alone unless used in some type of strategy seems rather futile unless taken as some type of insurance against insufficient cash flow in retirement. The cost of that insurance was less costly with an adjustable rate Saver than with today’s adjustable rate HECM.

    • Mr. McSherry,

      After reviewing the case study and as explained in the comment earlier today, I can no longer recommend the use of this case study.

  • The case study was interesting but has some areas of weakness that need exploration. The first area is the assumptions related to earnings (interest and dividends), and market (recognized) gains and losses. Second is the decumulation amounts which need no further discussion since they were reasonably accurate based on their assumptions. Third are the HECMs and their balances due. Finally, this comment concludes with some overall comments on the case study.

    As to the reasonableness of the earnings, gains, and losses, several significant questions arise. While there are no errors as to math mechanics, one must question if these rates were experienced by the vast majority of those with portfolio assets of $500,000 and a 50/50 split between equities and bonds back in 1973. Also using the US inflation factor of 540%, the value of those same assets would be $2,700,000 in today’s dollars which brings into question the decumulation rates indicated covering the period in question. (Also many of the losses which arose in the 1970s had to do with high interest rates; yet those rates are not reflected in the HECMs at all.)

    Next we come to the HECMs. The first and obvious comment is that there were no HECMs in 1973. Also prior to 2000, the lending limits on HECMs would not have produced the principal limits needed to generate the amounts shown as taken from the line of credit. Using 1990 PLFs, the value of the home would have to have been at least $225,000 if the youngest borrower was 69 years old and the expected but unrealistic interest rate was only 3.75% back in 1973. Of course if the “expected CMT” interest rate of that era had been in play, the home would have had to have been much, much more as explained later in this paragraph. While APRs of 5% exist, it must be questioned since the case study authors failed to provide the assumed note interest rate, the ongoing MIP rate,the expected interest rate, or the closing and other upfront costs. Before fiscal 2009, rarely was the uncapped 2% origination fee waived or lowered in any way so closing costs before 2008 would have been at least $11,000 and most likely even more. Back in that era, we had the horrible residential interest rates associated with both the Carter and early Reagan Administrations. So a 5% APR seems to be a gross understatement from a historical prospective and even from the current one where typical margins run almost about double what they were prior to 2006.

    The case study seems to be a historical presentation using atypical returns for the average consumer on the portfolio side but a very modern HECM with today’s lending limits on the HECM side. Based on today’s HECM, the ongoing MIP rate would be 1.25% leaving less than 3.75% for the average effective interest rate on an adjustable rate HECM for a period of 30 years.

    As a CPA, I have great difficulty with consistency, reasonableness, applicability to the average asset manager’s client having a portfolio of $2.7 million today and a home at closing appraised at about $300,000 back in 1973. There are just too many unusual factors about this case study to be useful to a competent financial advisor. If the advisor reviews at all, questions should arise about those who bring to his/her attention.

  • Well, my point is that, although I knew that the line of credit generated a growth aspect , I didn’t realize exactly how that growth would manifest. The “growth” could have meant “on paper,” as in the amortization schedule showing property value increases over a period of years; and maybe you only realize the profit when you sell the property. It was obscure.

    In other words, after one year I had many thousands of dollars more in the line of credit than I had upon signing, a year earlier. Which of course, is a good thing.

    That’s about five times the ROI of letting that same amount sit in a bank “collecting” a bank-rate-of-interest.

    I didn’t realize that it “worked” that way. It’s not explained that way, anywhere throughout the reverse mortgage application process.

    I doubt many prospective clients understand this impressive feature. That’s my point.

    • Mr. McSherry,

      Per se there is no ROI on the HECM line of credit; that is but an illusion. While taking that increase will increase your inheritable assets, it will also increase your debt on the home so that the net asset base of the borrower will go up and down by exactly the same amount.

      With ROI, not only do assets go up but so does a temporary equity account(s) called income or gain or it could be a combination of the two. This never happens with a HECM unless the balance due exceeds the value of the home at termination.

      You state: “…and maybe you only realize the profit when you sell the property.” When the home is sold, any available HECM line of credit is extinguished as is its growth. It is also extinguished at the death of the last borrower to occupy the collateral as his/her principal residence.

      There is a name for this kind of cash, it is called a contingent asset. It belongs to the bank until taken by the borrower. Upon possession by the borrower, legal ownership passes to the borrower, removing any contingency but debt follows it. Up til the taking, the borrower has a legally binding contract allowing the borrower to take the available line of credit until the earlier of loan termination or the actual taking of the related cash.

      There is a story in Southern California about an originator who explained the growth in the line of credit as interest to a California Superior Court Judge. The Judge was busy preparing for retirement and saw that the explanation provided by the originator clearly created ROI. The judge was sold on getting the HECM. Each month of the loan he banked the growth in the line of credit until after he retired. When he actually retired he began going through his HECM monthly statements. He then noticed that everything was how it was represented except his balance due was growing by exactly the growth he was taken monthly the interest and MIP he was fully expecting. He had a home worth far more than the lending limit at that time (2004). He went through the roof over the balance due growing by the amount he had been told was interest income. The Judge ordered his bailiff to demand that the originator appear in his chambers the next day at a specific time. When the originator walked in, the Judge sternly told the originator that if he was ever brought in that court under any charges including a traffic ticket, he would personally meet with the DA or State Attorney and tell them to go after the originator to the greatest extent provided under the law. His bailiff expressed his relief that he was not the originator.

      Tread carefully with your descriptions of the growth in the line of credit, they could easily come back to bite you.

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