A Reverse Mortgage To Protect Your Retirement Income

home mortgageMy Comments: Confused? Skeptical? A normal response. But as someone with 40 years of experience as a financial planner, a reverse mortgage can be a significant tool to promote financial freedom as we live out our retirement years.

Nov 11, 2015, by Robert Powell

Advisers have long looked down on reverse mortgages: Only the most desperate of Americans — those who failed to save enough for retirement or those who spent unwisely in retirement — would ever need to use such loans.

But a growing body of research is showing that homeowners of all stripes should consider using a reverse mortgage in conjunction with their portfolio-withdrawal strategy. Such loans, where you borrow from the equity in your home, can help you preserve your nest egg, leave a legacy, or both.

The latest research on the subject comes from Wade Pfau, a professor of retirement income at the American College of Financial Services in Bryn Mawr, Penn. In his study, Pfau examined six ways to use a reverse mortgage as part of retirement-income plan and the upshot is that homeowners now have a framework for deciding which strategy might be best for them.

“Strategic use of a reverse mortgage can improve retirement outcomes,” Pfau wrote in his just-published paper, Incorporating Home Equity into a Retirement Income Strategy. “The benefits are nonlinear in nature, as they relate to the synergies created by reducing sequence risk for portfolio withdrawals and to the non-recourse aspects of reverse mortgages that can potentially allow a client to spend more than the value of their home.”

Other researchers, we should note, are also praising the use and value of reverse mortgages, and the need to incorporate housing wealth into a retirement-income plan. Read Robert Merton on the Promise of Reverse Mortgages and the Peril of Target-Date Funds and No Portfolio is an Island.

But before delving further into the strategies examined in Pfau’s study, a bit of background: The financial advice industry is fond of focusing on financial wealth. After all, that’s how most advisers get paid — on assets under management. But the truth of the matter, according to Pfau, is that home equity and Social Security benefits represent, for most Americans, the two biggest assets on the household balance sheet, frequently dwarfing the available amount of financial assets.

“Even for wealthier clients, home equity is still a significant asset which should not automatically be lumped into a limiting category of last resort options once all else has failed,” Pfau wrote. “It is a great shame for the financial planning profession that the conventional wisdom about reverse mortgages continues to remain so negative and to be based on so many misunderstandings about their potential uses.”

Also, be sure to brush up on all things home equity conversion mortgage (HECM) before using one in your retirement-income plan. Thankfully, there are plenty of government websites with plenty of information about HECMs that will give you the working knowledge you need. Those include the Department of Housing and Urban Development’s website, Home Equity Conversion Mortgages for Seniors and the Consumer Financial Protection Bureau’s website, What is a reverse mortgage?.

For now, here’s what you need to know. To qualify for a reverse mortgage:
• You must be at least 62 years old
• Your home must be your primary residence
• You must have paid off some, or all, of your traditional mortgage

In addition, there’s a limit on how much equity you can tap; there are upfront costs to consider; and you’ve got to get a handle on how the loan balance grows and how it gets repaid. And, you ought to know that distributions from a HECM are treated as loan receipt and are not taxable, which could come in handy if you’re trying to manage your income-tax bracket.

The bottom line is this: With a HECM, you get access to a portion of your home equity as cash: either as a line of credit; in monthly payouts, or as a lump sum.

And that, in essence, is what Pfau researched: What happens to your wealth when you use the different reverse mortgage strategies to tap the equity in your home. In his study, he examined six different methods:
• Use home equity first: With this strategy, you’d open a line of credit at the start of retirement, and use this line to pay for all your retirement expenses until the line of credit was fully used up. “This allows more time for the investment portfolio to grow before being used for withdrawals after the line of credit is depleted,” wrote Pfau.
• Use home equity last: Here, you’d open a line a credit at the start of retirement and only use it after your investment portfolio was depleted.
• The Sacks and Sacks Coordination Strategy: With this strategy, you’d open a line of credit at the start of retirement, and use the line of credit, when available, following any years in which the investment portfolio experienced a negative market return, wrote Pfau. “No efforts are made to repay the loan balance until the loan becomes due at the end of retirement,” he wrote.
• The Texas Tech Coordination Strategy: This method is a bit more complicated. With this one, you’d open a line of credit at the start of retirement and then each year you’d analyze whether you can keep withdrawing money from your investment portfolio at the desired rate over a 41-year time horizon. If the remaining portfolio balance is less than 80% of the required wealth you’d tap the line of credit, when possible. And if the portfolio balances is greater than 80%, you’d pay down — provided your portfolio didn’t fall below the 80% threshold — the balance on the reverse mortgage balance. This, Pfau wrote, would provide more growth potential for the line of credit.
• Use tenure payment: Here you’d open a line of credit at the start of retirement and a receive a fixed monthly payment for as long as the borrower is alive and lives in the house. And spending needs over and above that reverse mortgage payment would be covered by the investment portfolio when possible, Pfau wrote.
• Ignore home equity: This strategy makes no use of home equity, and Pfau only examines it to show the probability of a retirement-income plan succeeding when home equity isn’t used.

So what did Pfau find?

“Generally, strategies which spend the home equity more quickly increase the overall risk for the retirement plan,” he wrote. “More upside potential is generated by delaying the need to take distributions from investments, but more downside risk is created because the home equity is used quickly without necessarily being compensated by sufficiently high market returns.”

“Meanwhile,” he wrote, “opening the line of credit and that start of retirement and then delaying its use until the portfolio is depleted creates the most downside protection for the retirement-income plan.”

This strategy, Pfau noted, allows the line of credit to grow longer, perhaps surpassing the home’s value before it is used, which provides a bigger base to continue retirement spending after the portfolio is depleted. Using home equity last does reduce upside potential because when markets are strong the portfolio will grow faster than the loan balance. “Frequently, this line of credit growth opportunity serves a stronger role than the benefits from mitigating sequence risk through the use of coordinated strategies,” he wrote.

See a diagram outlining the strategies Pfau studied.

Nonetheless, use of tenure payments or one of the coordinated strategies can also be justified as providing a middle ground which balances the upside potential of using home equity first and the downside protection of using home equity last, Pfau wrote. “These coordinated strategies can occasionally provide the best outcomes for legacy in some simulated cases when they best balance the tradeoff between using home equity soon to provide relief for the portfolio, and delaying home equity use so the available line of credit is larger,” he said.

But no matter what method you use, do consider the advantages of opening a reverse mortgage line of credit at the earliest possible age. There’s great value, wrote Pfau, in that.

Robert Powell is editor of Retirement Weekly, published by MarketWatch.