HECMs can reduce retirement income instability
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 results, 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 wealth management plans that provide assured flows of spendable funds throughout retirement will not impose 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.
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 percent. If that return is earned during a 15-year deferment period, assuming a 2 percent annual increase to keep pace with inflation, her draw amounts will follow a smoothly upward sloping line.
However, if her assets yield not the 7.8 percent assumed but a worse case 4.7 percent, which has a probability of occurrence estimated at 2 percent, her draw amounts will decline during the first 10 years instead of rising. This would not be a catastrophe because the annuity puts her back on track after 15 years, but it would be a considerable inconvenience.
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.
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. Rising credit line draws, when added to the declining draws from financial assets, re-establishes the smoothly rising line of total draws to what it would have been if the rate of return that materialized equaled the rate that had been assumed.
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.
• Contact Jack Guttentag via his website at mtgprofessor.com.
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