Integrating Retirement Plans – It Is Long Since Overdue
Suppose that automobiles were marketed like retirement plans. Then the chassis, engine and tires would be marketed by different firms, and the buyer would have to put them together. Yes, this would be absurdly inefficient, yet that is exactly the case with retirement plans. The three major components – financial asset management, annuities and HECM reverse mortgages – are marketed by different firms which, with few exceptions, do not talk to each other. The result is absurdly inefficient.
On top of that, the markets for both annuities and reverse mortgages are extremely inefficient, a result of their complexity, the lack of sophistication of most buyers, and the absence of multiple transactions from which buyers can learn. In both markets, the range of prices on identical transactions is obscenely large.
The inefficiency of the piecemeal approach doesn’t much matter to retirees who are wealthy enough not to bother. But it is critically important to the larger and growing number whose home equity comprises a large part of their wealth, and those who are forced to delay retirement in order to make it financially feasible.
The major benefits of integration to such retirees are increased spendable funds during the retirement years, and protection against running out. The benefits stem from the synergies from integration, and competitive pricing on annuities and reverse mortgages. To make this happen, I developed the Retirement Funds Integrator (RFI) with Allan Redstone. RFI is used in developing the illustrations below.
The Educational Challenge
Developing retirement plans that integrate financial asset management, deferred annuities and HECM reverse mortgages, each of which is rife with complexities, for retirees who are past their intellectual prime, posed a major educational challenge. To meet it, RFI incorporates a strategy of “targeted education”, which is consistent with the best practices developed by the the U.S. National Strategy For Financial Literacy 2020, but adds one more feature.
RFI breaks the educational process involved in the development of a retirement plan into two phases. Phase 1 is designed to allow a retiree to design a preliminary retirement plan using a simple calculator that simplifies the amount and complexity of the information required. In this way, the retiree learns what a retirement plan is, how the components fit together, and what a first approximation of her financial future looks like.
In phase 2, the retiree in consultation with a financial advisor who has access to the more powerful version of RFI, converts the preliminary plan into a final plan that takes account of additional features and options that reflect the retiree’s preferences but had been left out of the preliminary plan. This paper is largely focused on phase 1, but a transition to phase 2 is described.
Spendable Funds and Protection Against Running Out
Consider a retiree of 64 who has financial assets of $500,000 and home equity of $400,000. The RFI approach integrates asset management, a deferred annuity (10 years in the examples) and a HECM reverse mortgage credit line. This is compared to a stand-alone approach based on the 4% rule that is widely used by financial advisors. The 4% rule involves draws of 4% of the original asset portfolio amount increasing by 2 percent a year. To make it comparable to RFI, we add a HECM tenure payment, which is a fixed monthly amount. In contrast to the annuity which runs for life, the tenure payment ends if the borrower moves out of the house.
Chart 1 compares the spendable funds available to the retiree under the two approaches, assuming a 4% rate of return on assets. The integrated approach provides more spendable funds over the retiree’s life, and complete protection against running out as a result of living too long. At a 4% rate of return, the 4% rule runs out of assets at age 98, with only the tenure payment remaining. Higher rates of return will avoid calamity under the 4% rule but increase the advantage of the RFI schedule.
Impact of Competition on Spendable Funds
To assure that retirees using RFI were getting the best competitive prices, we developed networks of both annuity providers and reverse mortgage lenders. The RFI system automatically selects the best deal from those offered, unless the retiree wants to use another provider, in which case RFI will show the cost of indulging the preference.
The importance of this is illustrated in Chart 2, where the top line is calculated at the best terms in both markets, as it was in Chart 1, and the lower line uses the worst terms in both markets. But note that even using the worst terms, RFI beats the 4% rule.
Rescuing the HECM Program
The HECM program could be killed by Congress because of large deficits in the mortgage insurance reserve fund that might require a fund infusion from the Treasury. The causes of the deficits are very clear. The existing stand-alone model has resulted in an excessively large proportion of borrowers drawing maximum cash in the first year, leaving nothing to cushion rising tax and insurance payments in later years. The integrated model, in contrast, includes a life annuity in every case, and in most cases the annuity will rise over time. Foreclosures arising from failure of borrowers to pay their taxes and insurance in their later years will drop like a rock.
Transition to Phase 2: Converting the Preliminary Plan to a Final Plan
- The role of the financial advisor is to convert the preliminary plan selected by the retiree into a final plan that takes account of additional features and options that were not in the preliminary plan. The following list is illustrative:
- The retiree might want a different future pattern of draw amounts rather than the 2% a year rule built into the exhibits. (This particular modification is illustrated below).
- The retiree might want to see how the plan is affected by different rates of return on financial assets.
- The retiree might want to include a death benefit in the annuity, which would reduce the annuity amount.
- The retiree might want to create a “set-aside” for the estate, with or without a provision that would make it available for an emergency.
- The retiree might want to compare plans with and without a HECM.
- The retiree might want to see the plan with draw amounts net of taxes, and/or inclusive of other income sources that are not otherwise included.
These and other adjustable features of retirement
plans are executed in consultation with RFI-certified
financial advisors who have access to a full function
version of RFI. For example, the retiree who plans to travel
the world for several years before settling down might opt
for a plan that provides increases in spendable funds early
on, followed by smaller draws in later years. In the
opposite case, the retiree could prefer to spend less in the
early years in order to have more later on. These cases,
illustrated in Chart 3, show these cases as modifications of
the retiree’s preliminary plan.
Transition to Phase 2: Partial Retirement
Consider the same retiree but with one difference. He plans a partial retirement for 6 years during which he will work part time before taking full retirement. The purpose of partial retirement is to enhance the amount of spendable funds that become available when he swings into full retirement.
Using RFI, one plan that would meet his needs is illustrated in Chart 4. His financial assets are used to purchase a deferred annuity with a deferment period of 6 years, so that annuity payments begin at the onset of full retirement. This is the purple block of the chart. During the 6-year period of partial retirement, his spendable funds consist of his employment income (the blue block) plus withdrawals from his HECM credit line (the red block). Only a small part of the credit line is used, however, and when he retires, the leftover balance of the line is used to purchase a supplemental immediate annuity, which is the green box.
The RFI plan illustrated provides a modest increase of spendable funds during the period of partial retirement, and a larger increase during the period of full retirement. Of course, every retiree is different and an RFI-crafted plan should and can be tailored to the circumstances of each.
Barriers to Integration
Given the substantial benefits of integration, it is reasonable to ask why it hasn’t already happened? One major reason has been regulatory over-reach. HUD limits the ability of reverse mortgage lenders from participating in ventures with other types of financial institutions, and they instruct HECM counselors to warn borrowers about the hazards of annuities. HUD’s concern seems to be that reverse mortgage lenders and annuity providers would collude to cheat retirees. While this is a well-justified concern, it should not apply to RFI transactions, which assure that retirees enjoy the most competitive terms available in the markets for both annuities and HECMs.
State insurance agencies, in turn, fear that annuities funded with reverse mortgages could make the insurers responsible for depleting the estate values of annuitants. However, retirees using RFI to include HECMs make an informed judgment that they want to convert home equity into spendable funds. The system allows them to set-aside funds for their estate, if this is what they want, and to see the implications of any retirement plan for their estate value. An outright prohibition on use of a reverse mortgage to fund an annuity should not apply to RFI-based transactions.
Resistance comes from the private sector as well. Many advisors who manage assets for clients are hostile to annuities, which reduce a retiree’s financial assets on which the advisor’s fees are based. They argue that they can offer better yields than those earned by insurers on funds provided by annuitants. This is likely to be the case most of the time because investment policies of insurers are very conservative. The difference, which they ignore, is that insurers guarantee a specified return, but financial advisors do not.
Payments to an annuitant, furthermore, include a mortality component, which are the payments not received by those who have died. Insurers are able to continue payments to the retiree who lives to 105 because they can stop payments to those who die at 65. This is what makes annuities unique, and why they should be a central part of retirement plans designed for retirees who are not wealthy.