Integrating the Components of a Retirement Plan

December 18, 2020

A core deficiency of existing retirement programs is that the three major components of a program -- financial asset management, annuities, and HECM reverse mortgages -- are organized, managed and marketed separately. As a result, important potential synergies from combining them are unrealized.

The potential synergies vary with the characteristics of the retiree. Those whose wealth is largely or entirely in their home do best by taking a HECM reverse mortgage credit line, using part of it to purchase a deferred annuity, with the balance drawn on monthly during the deferment period. The synergy in this case, resulting in more spendable funds than a HECM stand-alone, was described here in Retirement Finance In A Low Interest Rate Economy (Homeowner Retirees Can Benefit If They Select The Right Reverse Mortgage).

Retirees whose wealth is largely or entirely in financial assets can avoid having to shift into lower-yielding but safer assets by creating an asset set-aside, which is not used in calculating the amount the retiree draws monthly from his assets. Instead, it offsets any difference between the expected rate and the worst-case rate. If such differences do not occur, which is highly likely, the set-aside becomes available for additional draws by the retiree. The role of the annuity is to provide a terminal date for the set aside. This case was described here in Retirement Finance In A Low Interest Rate Economy (Retirees Can Shift To Higher Yielding Assets Without Increasing Risk). 

This article is about retirees with financial assets who are also homeowners who want to include home equity in their retirement plan. The challenge to these retirees is to select from three HECM options that have different uses, as described below. The choices will be illustrated for a single male retiree of age 63 with financial assets of $1.5 million and home equity of $500,000. It is assumed that the lifetime level of spending increases by 2% per year and house value rises by 4% a year. 

The Credit Line Backup Option

This option is for the retiree with a high return/high risk asset portfolio. For example, using historical data compiled by Ibbotson, a portfolio of 75% common stock and 25% fixed income securities has a median return of 9.5% over 10 years but it carries a 2% probability of yielding -2.7% or lower.

If the retiree draws funds from the asset pool on the assumption that the return will be 9.5% but it turns out to be -2.7%, the asset pool will be depleted before the end of the annuity deferment period and payments will cease altogether until annuity payments begin. The prudent retiree needs a game plan for dealing with this risk.

One option is to adopt a “belt-tightening” procedure to reduce spending gradually rather than abruptly, as displayed in Chart 1.  While this is better than complete cessation, replacing a rising payment with a declining payment has got to be painful.

Bad Case causes shortfall in spendable funds

A much less painful option is to use a HECM credit line as a backup, drawing from the line as needed to restore the retiree’s financial assets back to the planned level. This is illustrated in Chart 2, on which the top line is spendable funds as restored by the HECM backup credit line, and the lower line shows the required draws from the HECM credit line.

Using a HECM Credit Line as protection against downside risk

The adequacy of the credit line to restore the spendable funds line fully, as in Chart 2, depends on the value of home equity relative to financial assets, and on the divergence between the assumed and the realized rate of return on assets. In the case illustrated, the HECM credit line is more than sufficient to fund the deficit, with approximately $60,000 remaining at the end of the annuity deferment period.

In the event that actual asset returns exceed the median return used in the retirement plan, both financial assets and the HECM credit line will grow. (The line grows at the HECM mortgage rate).   Excess credit line and/or financial assets can be used to increase spendable fund draws, to purchase additional annuities, or left in the estate.

The Term Payment Option

In contrast to the other HECM options where the retiree has discretion to draw funds or not draw funds, the term payment option fixes the monthly payment for a period equal to the annuity deferment period. This may be an attractive option for retirees who want the discipline of a fixed HECM payment during the annuity deferment period, while minimizing the need for future plan adjustments.

The term payment option used in this way “frees-up” financial assets that would otherwise be needed to provide draws during the deferment period – hence these financial assets become available to purchase a larger annuity.  This approach is illustrated by Chart 3 below:

An integrated HECM term payment can raise a retiree's level of spendable funds

In this chart the orange section shows the HECM term payment, the blue section shows draws from financial assets, and the purple section shows the annuity payments.

More detailed information is provided in tabular form, which includes the estate value of the plan.

An integrated retirement spending plan in tabular form

The drawback of the HECM term payment option is that it reduces flexibility in dealing with a shortfall caused by lower than expected asset returns. One way to cope with this hazard is to use a lower expected rate of return on financial assets, which reduces the probability of a shortfall. Using the 75/25 stock/fixed asset portfolio over 10-year periods, a rate of 9.5% carries a 50% probability of a shortfall, a rate of 4 % has a 20% probability, and a 0.4% rate has a 5% probability.

An alternative approach, referred to above, is to create a financial asset set-aside.  

The Credit Line/All-in Option

As discussed earlier, the CL/All-in option is instrumental in meeting the needs of retirees who have no financial assets. The retiree takes a credit line, part of which is used to purchase a deferred annuity while the remainder is used as a fund source during the deferment period. When the retiree has financial assets, a wider range of possibilities opens up because there are now two sources of funds that can be used at different times.

RFI determines whether to use the credit line or financial assets first on the relationship between the rate of return on financial assets and the growth rate on the unused line.  If the rate of return on financial assets is larger, spendable funds are drawn from the credit line first, and visa-versa. 

The credit line growth rate, which is based on the HECM interest rate plus mortgage insurance, is currently about 3.5%. If the retiree’s asset portfolio is currently yielding 2%, the assets are used to purchase the annuity and fund monthly draws while the credit line grows at the HECM mortgage rate. If interest rates rise thereafter, the growth of the credit line will accelerate until it is constrained by the maximum rate,

On the other hand, if the retiree has a portfolio of assets yielding 5% for 10 years, the credit line should be used to purchase the annuity and fund monthly draws. The retiree who develops a retirement plan after market rates have increased significantly should do the same.

The retiree who expects a high rate of return, such as the 9.5% median rate over 10 years on a portfolio that is 75% common stock, should be advised to establish a set-aside as protection against the risk of a lower return.    

Note that many insurance carriers (and state insurance regulators) look askance at an annuity that has been funded by a reverse mortgage.  In the case at hand, however, the retirees who fund annuities with a credit line have sufficient assets for that purpose but have elected not to use it. Retaining the assets strengthens their financial status, eliminating any cause for regulatory concern.

Note that the data used in this article and the two previous ones are based on the Retirements Funds Integrator, a program developed by the author and his colleague Allan Redstone.

In or near retirement? The Professor’s Retirement Funds Integrator (RFI) might enhance your life during retirement.

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