The HECM reverse mortgage is an ingeniously designed instrument with multiple possible uses, but its full potential has yet to be realized. A major reason is that it has been treated as a stand-alone, rather than as part of an integrated retirement plan. Reflecting its use as a stand-alone, HECMs have been used most heavily by retirees in desperate financial circumstances. This has subjected the FHA insurance reserve to adverse selection, resulting in large losses.
Eventually, losses will kill the HECM program unless its use is broadened across a much wider spectrum of borrowers. Retirees who have HECMs that are integrated into plans that provide assured flows of spendable funds throughout retirement will not be imposing significant losses on the program. Such integration is one of the purposes of the Retirement Income Stabilizer (RIS), which is now under development.
Last week I discussed a component of RIS called Combined Asset Management and Annuity (CAMA), which uses a portion of the retiree’s financial assets to purchase a deferred annuity, with the remainder of those assets used to generate spendable funds during the deferment period. CAMA eliminates the low probability of financial catastrophe –running out of money at an advanced age — for retirees who depend largely on draws from financial assets. CAMA also reduces the extent to which transfers to a retiree’s estate are an unplanned consequence of mortality.
CAMA, however, leaves the retiree vulnerable to instability in the rate of return on assets during the deferment period. If that rate falls below the rate used to calculate the amount the retiree can draw, the draw amount will decline during the deferment period.
Potential Draw Amount Instability During Deferment Period
Consider a woman of 64 who has a $1 million portfolio of financial assets, half in common stock and half in Government securities, who wants her retirement plan to last her through age 104, or 40 years. The median rate of return over 40 years on this kind of portfolio is estimated at 7.8%. If that return is earned during a 15-year deferment period, assuming a 2% annual increase to keep pace with inflation, her draw amounts will follow the smoothly upward sloping line in Chart 1.
However, if her assets yield not the 7.8% assumed but a worse case 4.7%, which has a probability of occurrence estimated at 2%, her draw amounts will decline during the first 10 years instead of rising – as per the dotted red line in Chart 1. This would not be a catastrophe, the annuity puts her back on track after 15 years, but it would be a considerable inconvenience.
Offsetting Draw Amount Instability With a HECM Term Payment
A retiree using RIS who has equity in an owned home can protect herself against the risk of a decline in the return on assets by taking a HECM term payment with a term equal to the annuity deferment period. If the retiree referred to above has a house worth $400,000, she could draw a monthly payment of $1,375 for 15 years. Then, if the worst case materialized, her monthly draw amount would be $1,375 higher during the period her draws from financial assets were declining.
Offsetting Draw Amount Instability With a HECM Credit Line
An even better way to deal with a rate of return on assets that falls below the rate assumed in calculating monthly draw amounts is to use a HECM credit line. With a credit line, the amount drawn can be adjusted each year to the exact amount needed to offset a reduced rate of return on financial assets.
Chart 2 shows monthly spendable funds using a 15-year deferred annuity subject to a worst case shortfall in draws from financial assets during the first 15 years. The rising credit line draws at the bottom, when added to the declining draws from financial assets immediately above, reestablishes the smoothly rising line of total draws at the top.
Another advantage of the HECM credit line is that if it is not needed as insurance against a decline in spendable funds, it will grow over time, becoming available for other purposes. One purpose could be to enlarge the retiree’s estate, which is where the retiree’s home equity will go if the credit line remains unused.
To reduce losses to the mortgage insurance reserve fund, HUD should encourage the inclusion of HECMs in retirement plans, and discourage stand-alone uses. One way to do this is to lower the insurance premium on any HECM transactions in which retirees document assured funding sources that equal or exceed the sum of their property taxes and homeowners’ insurance premiums.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Direct comments and questions to http://www.mtgprofessor.com.