When examining the totality of negative press that reverse mortgage products have to endure, many of the most persistent reputational hurdles faced by the products arise from people viewing the products themselves in isolation as opposed to a single part of a larger retirement strategy.
This is according to Dr. Wade Pfau, professor of retirement income at the American College of Financial Services and principal and director at McLean Asset Management in a new article at Advisor Perspectives.
Examined in isolation
“The reverse mortgage has helped to preserve a legacy for heirs. It must not be viewed in isolation, but rather as how it contributes to an overall plan,” Pfau writes. “The value of the reverse mortgage can mostly be found in its diversifying benefits for investment assets in retirement. Taking distributions from investments can dig a hole that is hard to recover from, and wise use of a reverse mortgage protects the investment portfolio in retirement.”
Looking solely at the products themselves as opposed to examining them as part of that larger retirement strategy is a trend in most of the negative publicity focused on reverse mortgage products and lenders, Pfau writes.
“Aside from pointing out relevant caveats, those writing negatively about reverse mortgages are treating them in isolation rather than viewing them as part of a whole financial plan,” he says. “They are missing this value that recent research has clarified.”
To illustrate his point, Pfau constructs two hypothetical scenarios featuring a senior with a $1 million IRA and a fully paid off home valued at $200,000, using economic data from a period between 1966 and 1995.
In the first scenario, this hypothetical retiree does not use a reverse mortgage, and after making regular draws from the IRA using the 4 percent rule and accounting for inflation, the retiree reduced the balance of her IRA to just $396 after 30 years, and her steadily growing home value allows her to pass a net worth of $992,666 at the end of her life.
In the second scenario, this same retiree does use a reverse mortgage, which she takes out at age 74 in 1975 in response to stock market volatility. With inflation more quickly diminishing IRA draws, the reverse mortgage allows some relief to the IRA balance during a period of market uncertainty, but a high origination fee and mortgage insurance premium would likely create “sticker shock” for the borrower, as Pfau describes.
By building the upfront costs into the loan balance and drawing from proceeds that cannot be taxed as income, she needs to utilize less than 17 percent of her home’s total accrued value by this time to fully cover her spending in age 74.
“By sourcing the age 74 retirement distribution from the reverse mortgage, the portfolio was protected from further decline at this key point in retirement,” Pfau writes. “Rather than entering into a downward spiral that left the portfolio essential depleted by age 95 as in [the non-reverse mortgage scenario], the portfolio was able to recover […] and $817,851 remained at the end of the retirement horizon.”
The portfolio balance is over $800,000 larger in the scenario using a reverse mortgage, which Pfau argues is illustrative of the fact that this portfolio gain is a benefit that is largely overlooked by people who criticize the high upfront costs of a reverse mortgage.
The ultimate result at the end of the retiree’s life is that the portfolio is also over $180,000 larger than had the reverse mortgage not been used, and any heirs wishing to keep the loan would have that much more money left over after repaying the loan by the sale of the home.
“Again, those only doing a partial analysis will focus on the reverse mortgage costs and conclude that the reverse mortgage is just too expensive. But even after repaying the loan balance, the net legacy value of assets is still $183,670 greater than in [the first scenario], which does not include the reverse mortgage,” Pfau says. “These gains are because the reverse mortgage protects the investment portfolio from incurring excessive distributions.”
For more details on the numbers and trends observed in the constructed scenario, read the full article at Advisor Perspectives.