RFI User Guide - RFI Fundamentals


RFI - HECM Credit Line as Downside Protection



One of the basic ideas behind RFI is that a retiree chooses a level of risk they are comfortable with (specified as the "Assumed Rate of Return" in an RFI scenario) and then plans their spending and annuity purchase based on this risk assessment (see RFI Fundamentals). Of course, the actual rate of return that materializes may be lower (or higher) than this assumed rate; if it is lower the retiree will suffer a shortfall in spendable funds during the deferment period as describer in RFI Downside Risk Analysis.

Retirees can mitigate this risk in several ways (see RFI Set-Asides for one such option). Retirees with equity in their home can use a HECM Reverse Mortgage Credit Line as a powerful tool to protect against this downside risk.

To illustrate the use of the HECM Credit Line for this purpose, we will start with a retiree of age 63 with $1 million in financial assets and a home worth $500,000 (with no outstanding mortgages). We will then define two scenarios as follows:

In both scenarios the retiree will purchase a 10 year deferred annuity and financial assets are assumed to generate a 6.1% annual return (this is the 30th percentile rate of return for 10 year holding periods for a 50/50 portfolio of stocks and bonds - see Retiree Risk Profiles - Historical Returns on Portfolios for more details). In Scenario 1 the 6.1% return materializes; in Scenario 2 the 5th percentile historical return of 2.7% materializes. When the scenarios are calculated the following spendable funds chart is displayed:

The red line (which is covered by the green line after age 73 when the annuity payment begins) represents spendable funds that increase at a constant 2% inflation rate based on a rate of return that materializes equal to the assumes rate of 6.1%. The green line illustrates the downside resulting from a rate of return that materializes (in this case 2.7%) that is significantly below the assumed rate.

The retiree can protect themselves against this downside risk by taking out a HECM Reverse Mortgage and drawing against the HECM Credit Line as necessary to make up the shortfall. To see how this works, change the HECM Option on Scenario 2 to "CL / Backup" as shown:

 When Scenario 2 is recalulated the spendable funds chart looks like this:


There are several things to note about this chart:

You can also view the second chart (Financial Asset Balances) to see projections of outstanding HECM Credit Line as well as other details of the RFI plan.  In this case, not only does the HECM credit line make up the entire shortfall of financial assets during the deferment period; there is significant "left over" credit line that continues to grow at the defined HECM interest rate and can be drawn upon by the retiree during the annuity payment period (i.e. after age 73) for any purpose. This is illustrated below (outstanding HECM credit line is the dashed green line):

Of course, the HECM credit line may not always be sufficient to make up a shortfall in financial assets during the deferment period; this will depend on the relative amounts of the retiree's financial assets and home equity, as well as the length of the deferment period and the difference between the assumed and materialized rates of return. For the following chart we reduced the value of the home to $300,000, increased the deferment period to 15 years, and changed the assumed rate and materialized rate to 6.6% and 2.0% respectively (these are the 30th and 2nd percentile historical rates of returns for a 15 year holding period). When the scenario is recalculated projected spendable funds looks like this:


In this case the HECM credit line is only sufficient to make up the financial asset shortfall until age 73 at which point it is "maxed out"; the retiree has exhausted the borrowing power of the HECM. For the remainder of the 15 year deferment period (i.e. age 73-78) spendable funds decreases below the planned level until annuity payments begin at age 78. 

If the retiree's risk aversion is such that this projection is problematic, they could also consider using a set-aside for added downside protection.

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