Brookings: How to Enhance Reverse Mortgages With Life Annuities

A possible path toward making reverse mortgages more enticing to both lenders and borrowers could be by enhancing traditional Home Equity Conversion Mortgage (HECM) to increase loan amounts at origination in order to allow the borrower to purchase a life annuity. That annuity can then be used to pay down principal and interest on the loan while the borrower remains in the home, reducing the risk that the loan balance grows to exceed the value of the mortgaged home.

By enhancing a HECM loan with the purchase of a life annuity, loan balances can be transferred from long after loan origination (when the borrowers’ home is more likely to be worth less than the total outstanding balance of the loan) to earlier dates when the home is most likely worth more money than is owed by the borrower.

This is according to a new research paper released last week during an event by the Brookings Institution, authored by University of British Columbia (UBC) Sauder School of Business researcher Thomas Davidoff.

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Past is prologue

A previous form that reverse mortgages had taken in the 1970s could help to serve as a possible path forward for enhancing the current product, Davidoff says.

“One way to make reverse mortgages less risky is to link them to life annuities in a way similar to older fixed-debt reverse annuity mortgages,” Davidoff writes. “In the 1970s, reverse mortgage proceeds were commonly converted to life annuities, and called reverse annuity mortgages (RAMs). Some RAMs featured rising balances as annuity payments were made to the borrower, akin to a HECM credit line. Some, however, were fixed-debt reverse annuity mortgages.”

Fixed-debt RAMs used a mortgage loan on the home to purchase a life annuity for the borrower, with payments being split between the borrower and the lender. The borrower would then receive the difference between them, attributable to a “mortality premium” that annuitants would receive in exchange for the loss of principal on death. However, there are differences between Davidoff’s new proposal and the way that RAMs worked in previous decades.

“The key difference with the proposal below is that the mortality premiums until death would be available to the borrower as a lump sum at the date of mortgage origination as proposed, and the rest of the loan proceeds need not be annuitized,” Davidoff writes. “Essentially, life annuities take money from people who die young and give it back to those who live a long time, and thereby transfer money from early retirement to late retirement.”

Links between life annuities and reverse mortgages

Part of the reason motivating this proposal, Davidoff says, is because of a “natural link” he has identified between life annuities and reverse mortgages. That link comes from the idea that the value of a home owned by a senior can be separated into two distinct parts.

“[First], the benefits that the current owner would derive by remaining in the home for the remainder of their life, plus [second] the benefits that accrue to all subsequent owners,” Davidoff writes. [The first part] is roughly equal to the discounted value of the net operating income (rent minus expenses like property taxes and maintenance) that the owner could receive if they rented their home to someone else.”

This flow of benefits will be larger, Davidoff says, the longer the owner’s life is and could be funded by a life annuity with payouts indexed to the property’s net rent.

Annuity-enhanced reverse mortgages

The key to Davidoff’s proposal is the addition of a life annuity on top of a HECM that remains largely the same as the current form of the product.

“Imagine a HECM with all other terms the same, so around 50% loan-to-value, same interest rate, same mortgage insurance premium potentially, although I think this will allow a lower upfront mortgage insurance premium,” he said when presenting his paper at the Brookings Institution. “You add a life annuity to the debt amount. It pays interest during the life of the loan and it reverts to the borrower if the borrower moves while they are alive. […] So, they can pay the normal interest rate on savings plus a mortality premium.”

Because of that, adding an annuity to the loan will allow the annuity payment to cover potentially more than the interest on the annuity, and will pay some interest on the principal which makes the total loan balance grow more slowly.

“You wouldn’t go all the way in practice because you would not want to start at 100% loan-to-value,” Davidoff says. “So, you take maybe half of the remaining equity and buy an annuity.”

Then, when the borrower moves out of the home while they are still alive, they can get an annuity payment that would allow them to cover the rent on a comparable home, a procedure that can serve in a scenario where a younger wife vacates a home she shared with an older, recently-deceased husband.

Cost reduction

When looking at the current reverse mortgage cost structure, the annuity-enhancement proposal would go a long way to reducing a common barrier cited by potential reverse mortgage borrowers: upfront costs.

“It would reduce upfront costs because with the life annuity, you’re not paying anything upfront,” Davidoff tells RMD in an interview. “It’s just being added to the debt on the house. As the debt sort of rotates, you are in more debt upfront and in less debt later. […] The MIP would be considerably lower, and I think you could plausibly save a couple of percent off upfront insurance costs, which is the entire MIP today.”

In comparison with a Life Expectancy Set Aside (LESA), which is designed to protect lenders, that is commonly structured to come off of the loan’s proceeds, Davidoff says. This makes the amount of cash a borrower can get upfront off of a LESA quite low, in comparison.

“If you have a big mortgage plus a LESA, that’ll do it for the cash proceeds,” he says.

How to implement

If the reverse mortgage industry saw a path forward for Davidoff’s proposal, the professor sees two possible paths to implementation. The first would be through a sale leaseback, where the borrower would get more cash upfront that they can do what they want with, and an offer of a life annuity would be made that would guarantee the home’s rent would be paid as long as they want to stay in the home.

“There wouldn’t be any risk of getting priced out or running out of cash, because [the borrower] could take that annuity component and turn that into a sale leaseback,” Davidoff says. “The problem with a sale leaseback is that’s a different originating clientele, it’s more supply side than you have with reverse mortgage, where you have lenders who do this all the time.”

The second path forward would be if FHA gave this pairing its “blessing” as a form of HECM contract, Davidoff says. This would make it easier for dedicated reverse mortgage loan officers to offer potentially better rates to borrowers by taking this possible path.

‘[That way,] there’s much less risk that [the borrower is] not going to have any equity when it’s time to sell,” Davidoff says. “However, the downside of this would be that if they die shortly after origination, the loan will have worked out poorly for them. But the trade-off is that if it’s a long term in the house, they’re going to perform better, and always have lower fees.”

This makes the idea of an option included in the HECM program “most helpful,” Davidoff says.

Read the full Davidoff research paper at the Brookings Institution.

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  • There are many difficulties in the following taken from the article above:

    “When looking at the current reverse mortgage cost structure, the annuity-enhancement proposal would go a long way to reducing a common barrier cited by potential reverse mortgage borrowers: upfront costs.

    ‘It would reduce upfront costs because with the life annuity, you’re not paying anything upfront,’ Davidoff tells RMD in an interview. ‘It’s just being added to the debt on the house. As the debt sort of rotates, you are in more debt upfront and in less debt later. […] The MIP would be considerably lower, and I think you could plausibly save a couple of percent off upfront insurance costs, which is the entire MIP today.”’

    While this sounds great, adding the upfront cost to the loan balance on a HECM that will terminate underwater means that HUD will not recover those costs because the debt is just that much bigger, plus interest costs will rise and MIP along with it; this only increase the losses in the MMIF on these HECMs, clearly a topic not addressed by the presenter.

    The higher ongoing MIP due to the upfront costs being added to the unpaid balance is no problem since HUD will have to pay for MIP they have collected over time but the additional accrued interest will be since it will be due to the HECM note holder until the HECM is assigned to HUD. HUD will lose reimbursement for those costs where if they reduced proceeds as they do, now the loss in the MMIF is not increased.

    Further, I have yet to see a US annuity known as a SPIA (or Single Premium Immediate Annuity) that pays a higher rate of interest than an adjustable rate HECM accrues ongoing costs of interest and MIP unless the effective interest rate index for the HECM after closing falls below the initial interest rate index at the time of closing. Remember the effective interest rate on a terminated adjustable rate HECM is rarely the same as its expected interest rate.

    In fact, the author never addresses adjustable rate HECMs as such. His focus is on fixed rate reverse mortgages.

    It is one thing to tell a story and an entirely different thing to present the proof on how it is supposed to work. Such has been the case for several of the examples supposedly providing proof that when used as a hedge against the risk in the sequence of returns on stock portfolios. The most these examples have shown is that in limited circumstances, HECMs can provide a hedge against such losses but certainly not anything close to all scenarios.

    While an interesting concept, it is something that must be developed to be relevant to most adjustable rate HECM borrowers. While the paper expands the presentation, it lacks sufficient pragmatic examples to be anything close to a proof of concept.

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