Reverse Mortgages from a Financial Planning Perspective
Reverse Mortgages in the area of professional financial planning have historically have been thought of as the last resort, where the only resource for additional retirement income is the home and would lead to an older borrower.
This “last resort” mentality was much due to the high setup cost, a cost at a level where a mainstream financial planning use was hard to justify. Innovations in the product, particularly the decrease in cost of the HECM Saver program, have sparked an interest in the financial planning and academic community to investigate real mainstream uses in financial planning. Ultimately, we feel reverse mortgages should be a tool in every financial planner’s toolbox, and used where appropriate.
We have embarked on this road to find and evaluate these mainstream uses of the product. We have recently published a research article in the Journal of Financial Planning entitled “Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions.” In this research project, we analyzed a reverse mortgage line of credit established at the time of retirement as an alternative source of cash in a cash reserve bucket strategy.
In short, one to two years of income needs are kept in cash in order to fund short-term living needs in order to hedge volatility risk in the portfolio. In the time this cash account needs to be refilled when the portfolio value is off due to a bear market, we simulate borrowing from the line of credit to refill the cash, and then pay the line of credit off once the portfolio has recovered.
We concluded this to be a very successful strategy by drastically increasing the probability the assets would fund goals. The strategy design allows for assets in a portfolio to last longer by hedging the risks of reverse dollar cost averaging, or selling assets at depreciated values, as well as a design to not carry debt in the reverse mortgage for a prolonged period of time.
The above research has been completed and published, and we are now on to new ideas that we believe will provide similar benefits to retirees in terms of assets lasting a lifetime.
The next idea will involve using term payments to provide an income benefit up to age 70, starting when needed, in order to defer the start of Social Security benefits to the latest age possible (70) when deemed the prudent strategy. The benefit of this strategy is of course to defer Social Security, but also to provide income from an alternate source other than the portfolio for the time of deferral. Much like the previous research strategy, this allows not only for assets to remain invested, but also hedges reverse dollar cost averaging risk in the portfolio from distributing a larger amount to cover this absence of the benefit. Recent research by Wade Pfau suggests the most sensitive time of a retirement portfolio in the distribution phase in terms of longevity is the first ten years due to market volatility, so this idea also has implications beyond deferring Social Security.
We are also planning to investigate the role of tenure payments as a supplement to retirement income. Much research has been completed on the role of annuitizing a portfolio and the benefits to portfolio longevity, and we believe this idea will be just as powerful, particularly due to incorporating the annuitization of a resource that normally remains untapped.
Beyond these research ideas, there are a number of ideas where a reverse mortgage could have a permanent place in a financial planning toolbox. A retiree can use a reverse mortgage to pay off a traditional mortgage, but a retiree can also basically refinance a forward mortgage with a reverse mortgage.
The recommendation may be to still pay off the mortgage much like a forward mortgage, but would allow flexibility of payments should financial needs arise or in periods of excessive and prolonged bear markets, the latter again hedging this reverse dollar cost averaging risk. Another basic use we see is simply establishing a line of credit as a replacement for a traditional HELOC.
The benefits of the reverse mortgage are the line cannot be reduced or cancelled, and the unused line grows over time. In the events of severe bear markets, such as the recent recession, a real risk is the line of credit being there, which we saw was not the case when home values declined.
Lines were decreased or all out cancelled, thereby defeating the purpose of having them in the first place as an emergency risk management tool. In summary, there are many legitimate mainstream financial planning reasons to have a reverse mortgage, many of which find their optimality establishing at early ages.
Some strategies have been tested, others remain to be tested, and some are alternatives to our traditional strategy. As a general statement, the idea of a full cash-out at an early age, particularly to invest and “beat the product” would be the least prudent idea, but just as much due to the borrower as the product. When borrowing and carrying a balance, the risk of having to move and the implications of a move must be considered before moving on with the strategy.
Much like any financial product, the use of reverse mortgages must be evaluated to the individual’s circumstances. There is no blanket answer that this product will always apply; the application must be on case-by-case basis. Reverse mortgages are a powerful tool, and may become more powerful as time goes on, in terms of supplementing retirement income and as a product to manage risks we all face in retirement.
(About the author: John is an Associate Professor of Personal Financial Planning at Texas Tech University. He teaches in the areas of retirement planning, investment management, and financial planning capstone, among other courses, and his research interest is in the area of retirement planning and income management. John is also a Vice-President and Wealth Manager at Evensky & Katz Wealth Management in Coral Gables, Florida and Lubbock, Texas. He is a Certified Financial PlannerTM practitioner and an Accredited Investment Fiduciary Analyst.)
All materials copyrighted © 2014 National Reverse Mortgage Lenders Association.