At first glance the article title seems to suggest that a home equity conversion mortgage (HECM), also known as a reverse mortgage can be used to hedge or mitigate some of the more common risks of retirement. But I realize that for some advisors, the very notion of reverse mortgages being implemented in financial planning is absurd.
Suppose the oft-maligned and seldom suggested, red-headed stepsister of financial planning had more to her than you imagined? Could her beauty and brilliance be veiled by mythology and misperception? What if the lowly 30-year-old reverse mortgage could help your clients preserve more assets, improve cash flow, ensure liquidity and mitigate risk? What if it allowed you to differentiate your practice, impact more clients, and make more money, would you want to take a closer look?
Historically, the more affluent retiree and their advisor have either simply dismissed the reverse mortgage or relegated it to use as a last resort. However, much has changed in the last few years. Recent research suggests that the appropriate and strategic use of the newly restructured reverse mortgage may be helpful in positively impacting retirement outcomes. For many in the boomer generation, to survive and thrive in retirement requires new thinking and a clear understanding of all the options.
The Department of Labor ruling has made it abundantly clear that all advisors have a responsibility to do what is in the best interest of their clients. Part of that responsibility means staying informed about current thoughts, trends and legitimate tools that could have a positive or negative effect upon their ability to help their clients’ meet their overall goals.
Housing wealth has become one such tool. No longer can it be relegated to the back room or basement strategies. It has come forward to center stage thinking.
Retirement Planning Has Changed
Financial planning in the generic sense is a recent phenomenon. Retirement, in its current context, is fairly new. For centuries, most people worked for as long and hard as they could and then died soon thereafter. The contemporary notion that you stop working with enough saved money to last 20, 30, 40 years is a product of modernity.
For the last 75 years (at least since the advent of Social Security), people were expected to live on their personal savings, a company pension, and Social Security during retirement. But the erosion of private pensions, the dismal lack of personal savings, and the strain on the current Social Security system has created an outlook for today’s retirees that will require financial ingenuity and new tools in order for them to protect and preserve their nest eggs.
Born just after midnight, on January 1, 1946, Kathleen Casey-Kirschling, will forever be known as America’s first baby boomer. Nearly 70 million more after her would be born up until 1964. No other group has so thoroughly changed the landscape of America quite like the boomers. Now nearly 10,000 boomers a day are turning 70.
The boomers will leave a legacy both positive and negative, the historians opine. At the onset of retirement, there are three issues they must confront. They will live longer than previous generations, have not saved enough to sustain their longer life span, and are more in debt than any other known previous generation. It is estimated that nearly 68 percent of new retirees will be carrying some sort of mortgage servicing debt into their retirement. This does not take into account credit cards, car payments, or student loans for which they served as a cosigner.
Surprisingly, there is one thing that boomers have in their favor—87 percent of them own a home. As a matter of fact, the average, married, retiree today will have $92,000 in savings but $192,000 in home equity. This “housing wealth” as my friend, Dr. Sandy Timmerman, founder of the Met Life Mature Market Institute, says, “will become the boomers’ salvation!”
Now if all of this was not bad enough, the new retirement paradigm is filled with unforeseen dangers.
In times past, retirement was likened to ascending to the summit of Mt. Everest. Clients braved the elements and proceeded with discipline until finally they set foot atop the grand mountain of accumulated assets. There they pulled out their flag and staked it in the ground, proclaiming “mission accomplished,” thinking the danger had passed and the hard part was over.
Unfortunately, that is not the true danger in climbing Mt. Everest. Nearly two-thirds of all mountain climber deaths transpire on the descent.
Similarly, the most dangerous part of the retirement mountain occurs after the flag is planted when our clients begin to live on what they accumulated. This is the true threat in retirement and the opportune place where skilled financial Sherpas showcase their knowledge.
Good retirement income planning focuses on the dangers of descending the mountain and using all available tools to help the client arrive safely back at base camp.
Risks in Retirement
As baby boomers move into retirement there are significant apprehensions and a slew of frightening questions. Will they have enough money to last through their golden years? Will they be able to enjoy the lifestyle they imagined? Will unexpected expenses throw off their retirement plan? Could a market crash decimate their carefully built nest egg and leave nothing for the next generation? These concerns are considered to be the 5Ls:
There are more than just those five concerns. There are genuine and perilous risks underlying each one of them. The Retirement Income Certified Professional RICP® course (of which I am an instructor) at the American College lists and clarifies the 18 risks in retirement income:
- Longevity risk |Inflation risk |Excessive withdrawal risk |Health expense risk |Long-term care risk |Fragility risk |Financial elder abuse risk |Market risk |Interest-rate risk |Liquidity risk |Sequence-of-return risks |Forced retirement risk |Re-employment risk |Employer insolvency risk |Loss of spouse risk |Unexpected financial responsibility risk | Timing risk |Public policy risk
You can download an expanded summary of these risks at www.18Risks.com.
Four Risks in Particular
Clearly identifying and managing risks in retirement income is on every advisor’s mind. Let’s look at four risks in particular and see if the reverse mortgage can add value.
In 1935, when Social Security was first established, the average life expectancy was only about 61 years. Today, it has risen to in excess of 78 years and is growing steadily. Living to age 100 could soon be the norm. The necessary financial preparedness for such a length is daunting. Running out of savings in retirement is the number one concern of most retirees because of all the unknowns that exist. In consideration of all the risks that exist in retirement, longevity is the most significant because it is a risk multiplier that only serves to magnify the others.
The inevitable increase in the cost of goods and services will slowly erode your client’s purchasing power. With as little as a 3 percent a year inflation rate, your clients would see a 50 percent reduction of purchasing power over 20 years.
Excessive Withdrawal Risk
Life is short and capricious. Retirement for most will be long, expensive and yes, unpredictable. Clients will face emergencies, unexpected expenses or simply want to experience some extra enjoyment. They may be forced to choose to cannibalize and/or annuitize assets prematurely. Consequently putting increased pressure of their ability to have those funds when needed most—later in retirement.
Sequence of Returns/Market Risk
Sequence risk involves the actual order in which investment returns occur. When you regularly invest in a retirement plan the movement of the market up or down will not have nearly as much significance as it will when you begin to withdraw funds. Unfortunately, when you withdraw money from your portfolio during retirement, the volatility of markets can inflict substantial damage. If you take a set amount in distributions each month, you end up selling more shares when the market is low—locking in your losses rather than giving the market a chance to recover.
Let’s take a look now at how a reverse mortgage can help.
Reverse Mortgages Have Come of Age
If you ever wanted to ruin a good barbeque, family reunion, office party, or Thanksgiving dinner, just let someone mention that they are thinking about getting a reverse mortgage and watch what happens.
Once considered the “Rodney Dangerfield of financial products,” this lowly and maligned resource is now coming center stage. For nearly two decades, I have shared the simple truth that a reverse mortgage “is just a mortgage!” That’s it. When we boil it down to its essence, that’s all it is.
Quiz: Which Client got a Reverse Mortgage?
- Two clients go to their respective advisors and ask about the wisdom of obtaining a home equity loan or home equity line of credit (HeLOC) so they don’t have to use savings for emergencies, expenses, or simple things they want to enjoy.
- The advisor responds that setting up a HeLOC is very common and wise.
- So each of the retirees finds a lender, produces qualifying documents and obtains a $100,000 line of credit.
- They both go out and promptly spend all of the money and the following month, they both begin to make the same monthly payment at the same interest rate.
- Finally on the same day, with their final payment, they both pay off the loan balance and the accounts are closed.
Does anything seem unrecognizable or spooky so far? Here’s the truth: One of those clients got a reverse mortgage and the other one did not. Can you tell the difference?
A reverse mortgage is a federally insured loan for people aged 62 or better that allows them to convert a portion of their home’s value into tax-free money. They are not required to make a monthly mortgage payment or be removed from the title to their home. They must continue to pay all property related charges such as taxes and insurance. The amount of money they receive is based on their age, the home’s value (up to the lending limit of $636,150), and the current interest rates. Today a 65-year-old could receive around 40-50 percent of the home’s value. For more information on rates, go to www.HECMAdvisorsGroup.com.
What’s So Special about the Line of Credit?
The proceeds of a reverse mortgage can be received in a lump sum, monthly payments, or as a line of credit. The difference with the reverse mortgage line of credit (ReLOC) versus a traditional HeLOC is that the reverse mortgage has a built in contractually guaranteed growth factor. (Currently, the rate is around 6 percent.) This means the unused portion of the ReLOC will continue to grow year by year. As long as the borrower lives and maintains the home and keeps their taxes and homeowner’s insurance in force, the line of credit cannot be frozen cancelled or reduced. This is regardless of the home’s future value, the income, assets or credit of the borrower. Don’t miss that line. The ReLOC has a:
- Built in contractually guaranteed minimum growth factor
- Allows the unused portion of the line to grow
- Regardless of the home’s future value
That is the secret, the one mechanism that changes it all, the eighth financial wonder of the world, the Swiss Army knife of financial planning, and the one truth that encouraged FINRA to change their position that reverse mortgages should be used only as a “last resort.” The table below shows a $200,000 home creating a $100,316 line of credit that grows to $608,000 over a 30-year period; $204,000 grows to $1.2 million; and $311,000 grows to nearly $1.9 million.
How the HECM Line of Credit Can Mitigate Retirement Income Risks
Longevity Risk and Inflation Risk
To guard against inflation and protect from longevity risks, advisors have traditionally moved clients into more aggressive allocations measures or inflation-protected securities and annuities etc. Imagine adding a ReLOC, early in retirement with a strategy to simply “set it and forget it” allowing it to grow for future use down the road.
Today’s ReLOC is growing at around 6 percent (with a minimum guarantee growth factor of 4 percent). With inflation at 2 to 3 percent today and perhaps averaging 4 percent over time, the HECM line of credit not only gives tremendous growth potential but is also nearly 3 percent greater than today’s inflation rate. This is a powerful hedge against both longevity risk and inflation risk.
The chart below developed by my teaching colleague, Dr. Wade Pfau, shows a $250,000 home growing at 3 percent (top line) and a $125,000 ReLOC growing at 6 percent (middle line) with the lower line showing the impact of setting up the line of credit later in retirement. This data highlights the advantages of establishing the ReLOC as early in retirement as possible. As noted recently by Dr. Pfau, “There is great value for clients in opening a reverse mortgage line of credit at the earliest possible age, particularly in a low-interest-rate environment like today.”
Excessive Withdrawal Risk
The behavioral aspect of this excessive risk cannot be underestimated. Life happens, emergencies come, and often times our clients simply want to enjoy the rewards of retirement. These desires are expressed in purchasing or providing money for some life event, a dream trip, a granddaughter’s wedding etc. It is precisely these activities and the subsequent future withdrawal or withdrawals that come during a bear market that are beyond the client’s current budget. These withdrawals can have devastating future results.
Most advisors are keenly aware that it’s hard to keep their clients on a budget and even harder to stop them from taking out assets when they really want something.
The good news is that by having your client establish a ReLOC early in retirement, they can access this pool of funds and allow the investments to remain intact. This gives the client the retirement satisfaction and safety they desire.
Market Risk/Sequence Risk
The market will always have uncertainty. Some advisors, like Dr. Harold Evesnksy, advocate setting aside two years’ worth of living expenses as a buffer against down markets. What happens when we simply add a reverse mortgage line of credit to the conversation? Consider these scenarios.
Couple A has $500,000 at the onset of retirement and takes a first-year withdrawal of $27,500. This amount is adjusted each year for inflation. Their advisor has a “reverse mortgage as a last resort” position. As the table shows, in the early years of their retirement, the clients are experiencing some negative returns. This sequence now puts constraint on their portfolio so that by year 24 they have run out of savings. They can then establish a HECM and tack on another 7 years of retirement income—bringing them to a 30-year retirement. By most standards, this would be considered a success.
Couple B had the same starting point and withdrawal plan. The difference for them is their advisor suggested they do three things to mitigate both sequence risks and market risks:
- Establish a ReLOC at the onset of retirement.
- Don’t withdrawal any money from their retirement portfolio in the year following a negative return.
- Use a noncorrelated asset to supplement the income they would normally draw from their portfolio.
The client’s home was valued at $500,000 so they established a $250,000 growing line of credit. In the years following a negative return, they drew from the ReLOC. By doing this, they eliminated the need to withdraw during a down cycle, thus preventing them from locking in the losses.
Notice in the chart that by implementing this very simple strategy the clients has substantially mitigated the sequence risk and, unlike the other couple, have not run out of money in year 24. Instead, they have in excess of $1 million 30 years later. An extra million dollars!
With the implementation of a reverse mortgage, the client had a much more enjoyable retirement, the estate was greatly enhanced and the advisor kept more assets under management for significantly longer and earned three times the fees earned by Couple A’s advisor. This was a win/win/win scenario.
By establishing a ReLOC for Client B, the investor no longer had to set aside 2 years’ worth of living expenses. Instead the reinvesting of those assets allowed for better returns than having them in a cash position. The ReLOC creates a much better buffer than having money in nonmarket performing positions.
There is estimated to be more than $3 trillion dollars in home equity for leading edge boomers and current retirees. The average person is not prepared for a long retirement. Currently those who are don’t have a backup plan in place to hedge against risks. We know that 87 percent of boomers own their homes. Here is the simple truth: Advisors can no longer ignore home equity when advising their clients on meeting their retirement income goals. The HECM line of credit is perhaps one the most powerful financial planning tools available today. The research, metrics, and illustrations all bear to these facts. The advisors who know how to implement housing wealth into retirement income plans will surely differentiate themselves, impact existing clients, attract new clients, and make more money.
For information on advisor training and client workshops on this topic, go to www.hecmadvisorsgroup.com/training.
Don Graves, RICP, is the president and founder of the HECM Institute for Housing Wealth Studies and an adjunct professor of Retirement Income at The American College of Financial Services. He is one of the nation’s leading educators on HECM reverse mortgages in retirement income planning. Don has been quoted in Forbes and has been featured on PBS. Don holds an undergraduate degree in Finance from Temple University. He lives in Greater Philadelphia, is married, and has three children. He can be contacted at AskDonGraves@Gmail.com.