A Home Equity Conversion Mortgage (HECM) loan can be used by a senior borrower to mitigate so-called “rate of return” risk on investments, something that many reverse mortgage product proponents have a tendency to overlook.
This is according to a column published at Forbes this week by Jack Guttentag, aka the “Mortgage Professor,” who also repeats the idea that a reverse mortgage can be used in concert with a deferred annuity in order to provide maximum utility for a borrower.
“[I] described how the HECM program allows eligible homeowners to benefit from unusually large house price appreciation without bearing the risks associated with low or no appreciation,” Guttentag says, referring to a previous article he had written. “The bad news is that rate-of-return risk is a much greater threat to retirees than property value risk. The good news is that the HECM program can be used to hedge against that risk as well.”
In a hypothetical scenario, Guttentag asks readers to consider a situation involving a 64-year old retiree with $500,000 of financial assets, and home equity of an additional $500,000.
“The division of his financial assets is 25% in common stock and 75% in fixed-return assets,” Guttentag says. “He wants to convert as much of the financial assets as possible into spendable funds during his remaining years but without the risk of running out if he lives too long. The model used to meet this challenge was developed by my colleague Allan Redstone.”
The first step would be to use part of the financial assets to purchase a deferred annuity, which would not start payments until a deferment period has elapsed.
“Step 2 of this approach is to factor in the risk that the rate of return will be lower than the median return,” Guttentag explains. “For example, assuming the same 25%/75% portfolio, there is a 2% probability that the rate of return over a 20-year period will be 3.60% or lower. That is not very high, but we purchase insurance to protect against lower probability hazards than that.”
If that retiree assumes a return rate of 5.9% but only gets one at 3.6%, then the senior will need to find a way to get from that point until the end of the deferment period on the annuity.
“This can be prevented using a HECM credit line as a buffer, providing draw mounts that exactly match the shortfall in the draws from financial assets,” Guttentag says. “The focus of this article on spendable funds available to the retiree says nothing about estate value, which may or may not be of concern to the retiree.”
Read the column at Forbes.