Incorporating Home Equity Into A Retirement Income Strategy
The American College; McLean Asset Management
November 3, 2015
Abstract:
Strategic use of a reverse mortgage can improve retirement outcomes. The benefits are non-linear in nature, as they relate to the synergies created by reducing sequence risk for portfolio withdrawals and to the non-recourse aspects of reverse mortgages that can potentially allow a client to spend more than the value of their home. This article explores six different methods for incorporating home equity into a retirement income plan through the use of a reverse mortgage. Generally, strategies which spend the home equity more quickly increase the overall risk for the retirement plan. More upside potential is generated by delaying the need to take distributions from investments, but more downside risk is created because the home equity is used quickly without necessarily being compensated by sufficiently high market returns. Meanwhile, opening the line of credit and that start of retirement and then delaying its use until the portfolio is depleted creates the most downside protection for the retirement income plan. This strategy allows the line of credit to grow longer, perhaps surpassing the home’s value before it is used, providing a bigger base to continue retirement spending after the portfolio is depleted. Use of tenure payments or one of the coordinated spending strategies can also be justified as providing a middle ground which balances the upside potential of using home equity first and the downside protection of using home equity last. A key theme is that there is great value for clients to open a reverse mortgage line of credit at the earliest possible age.
Incorporating Home Equity Into A Retirement Income Strategy – Introduction
The use of a reverse mortgage to supplement portfolio withdrawals as a part of retirement income strategy is a fascinating topic and a number of counterintuitive findings are slowly entering into the financial planning profession. Since 2012, the Journal of Financial Planning has served as the primary outlet for a series of research articles demonstrating the potential use and value of reverse mortgages as part of a comprehensive retirement income strategy. The studies published in this journal could very well lead to the strategic use of home equity in a retirement income plan to become the next hot topic for client and advisor education, similar to how webinars and seminars about Social Security claiming strategies have been ubiquitous in recent years.
For most Americans, home equity and Social Security benefits represent the two biggest assets on the household balance sheet, frequently dwarfing the available amount of financial assets. Even for wealthier clients, home equity is still a significant asset which should not automatically be lumped into a limiting category of last resort options once all else has failed. It is a great shame for the financial planning profession that the conventional wisdom about reverse mortgages continues to remain so negative and to be based on so many misunderstandings about their potential uses.
Regarding the advances made in this journal, Sacks and Sacks (2012) led the way with their demonstration for how a strategy which coordinates draws from a reverse mortgage line of credit throughout retirement can significantly increase the probability of success relative to the conventional wisdom strategy that a reverse mortgage line of credit only be opened and used as a last resort option once other resources have been depleted. Salter, Pfeiffer, and Evensky (2012) and Pfeiffer, Salter, and Evensky (2013) followed suit, independently confirming how their coordinated glidepath strategy for home equity use could also increase the success probabilities for a variety of withdrawal rates. Wagner (2013) represents a fourth key study which garnered greater respect for the reverse mortgage term and tenure options in addition to draws from the line of credit. Pfeiffer, Schaal, and Salter (2014) later provided a more detailed analysis about two options using home equity last in retirement, with the difference being whether the reverse mortgage is opened early or when it is first needed. They found that establishing the HECM line of credit early is especially advantageous in low interest rate environments.
Despite the significant contributions found in these past studies, there is still room for another investigation of the government’s Home Equity Conversion Mortgage (HECM) program. This study aims to bring further clarity to what these past studies found by pushing deeper into the underlying analysis about how these strategies impact spending and wealth. Past studies have generally struggled with how to explain the combined impacts of home equity use on sustaining a retirement spending goal as well as preserving assets for legacy. When describing the impacts on legacy, past articles have generally focused on the median amount of legacy wealth and struggled with how to make proper comparisons in cases when the full spending goal was not met. One objective for this article is to focus on the wider distribution of potential outcomes to better understand the combined impacts for spending and legacy.
Past studies have also struggled with how to simulate the random future fluctuations for all the key variables which will impact the results. While past studies have employed Monte Carlo simulations for stock and bond returns, none of these studies simulated the future paths of interest rates, nor did they link future bond returns to future interest rates. This misses the ability to see how changing interest rates impact line of credit growth, the amount of credit available when delaying the decision to open a reverse mortgage, and the interplay of growth in the line of credit or loan balance for the reverse mortgage and the return on bonds in the investment portfolio. While some studies also provide scenario testing with regard to whether interest rates are fixed at high, medium, or low levels in the future, the present study allows a deeper analysis by simulating interest rates and linking them to future bond returns.
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