HECM Reverse Mortgages Can Reduce Retirement Income Instability
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 $1,375for 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
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
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.