How Reverse Mortgages Improve Sustainable Withdrawal Rates
By Joe Tomlinson
March 18, 2014
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Standby reverse mortgages (SRMs) have been viewed as a product only to be utilized late in life, after other retirement funds have been depleted. But new research shows that SRMs are a useful tool during retirement to increase sustainable withdrawal rates. I’ll describe how the SRM works and highlight key findings from the research.
Retirement challenges
Home equity will become a more significant source of funds to support retirement, because increasing numbers of retirees will face a double challenge: inadequate savings and the prospect of lower-than-historical investment returns. This MarketWatch article by Brett Arends highlights research from the Center for Retirement Research (CRR) at Boston College and the Employee Benefit Research Institute (EBRI) on the state of retirement savings. CRR estimates that half the country is at risk of being unable to maintain its standard of living in retirement, and EBRI found that 43% of baby boomers and Generation Xers are at risk of running out of money in retirement. EBRI also noted that 66% of workers have saved less than $50,000 for retirement.
The 4 Percent Rule is Not Safe in a Low-Yield World, by Michael Finke, Wade Pfau and David Blanchett, shows the effects of low yields on return prospects. A 4% inflation-adjusted withdrawal rate, which would have produced a 30-year failure rate of 6% under historical investment returns, would have produced a 57% failure rate in the low-yield environment of early 2013 when the research was done. The authors also demonstrated that even if bond rates returned to historical levels over the next five or 10 years, failure rates would still be in the range of 20-30%.
The 2012 Survey of Consumer Finances published by the Federal Reserve and based on 2010 data demonstrated that housing is the most important category of wealth for average Americans. For example, for 65–74 year olds, the average value of primary residences was $165,000, while the average value of their financial assets was $71,300.
Growing numbers of Americans will need to tap home equity to support retirement.
Using home equity
Increasing the Sustainable Withdrawal Rate Using the Standby Reverse Mortgage,1 by Shaun Pfeiffer, John Salter and Harold Evensky, provides an innovative approach that uses home equity to support higher withdrawal rates. The basic idea involves using a reverse mortgage to set up a standby line of credit that the retiree can use to support withdrawals when investments underperform.
1. The article is available for free for Financial Planning Association members, while others may access this PowerPoint presentation covering the same material.
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