Retirees who own a valuable home but little else are a large but underserved minority who worry about running out of money before they die. Their major need is for an effective way to convert their housing wealth into spendable funds.
The two potential approaches toward meeting this need are debt-based and equity-based. The first has the retiree borrowing funds, with the house serving as collateral to guarantee repayment. The second approach provides funds for an equity investment that includes a share of the future growth in the value of the home.
This article compares versions of both. The HECM reverse mortgage program is debt-based, and Federally-sponsored and regulated. EquiFi Equity Access EFI tm is an emerging equity-based program that is privately owned by a Public Benefit Corporation. Unlike other equity-based firms, it is geared broadly toward retirees rather than home buyers and has no mandatory termination date. EquiFi has kindly provided me with the information used in this article.
These different approaches will be compared using the Retirement Funds Integrator (RFItm), a program I developed with Allan Redstone. RFI generates retirement plans that can cover both debt and equity-based programs.
Components of a Retirement Plan
In making decisions about a retirement plan, retirees should focus on two major plan components: monthly spendable funds and estate value. They should also see how the plan components change over time. An illustration for a male of 64 with $400,000 of initial home equity but no financial assets, is shown in Table 1.
The HECM program can generate a retirement plan in two ways. In one, the borrower draws the maximum credit line available and invests it, drawing spending funds monthly from his assets. In the example, payments are calculated to rise 2% a year and last until year 104 at the assumed 5% earnings rate. The risk is that the rate will fall short, which would result in the earlier depletion of the borrower’s assets. This risk can be minimized by assuming a lower earnings rate.
The second approach is to take a tenure payment, which is a guaranteed fixed amount that lasts for as long as the borrower lives in his home. The downside is the absence of any inflation-based adjustment in spendable funds, and the cessation of payments if the borrower is forced to move out of the house permanently.
A retirement plan based on the EFI program involves the retiree investing the funds paid him for the share in future equity growth. Spendable funds are drawn from those assets based on the same assumptions as those used in the HECM credit line plan.
In the example, the HECM credit line generates the most spendable funds but the EFI-based equity share plan provides the largest estate value in later years. This is not an unusual outcome, as we will see in other comparisons of the debt and equity-based plans.
Retirees can reduce the risks of retirement plans dependent on rates of return on financial assets by using some of the assets to purchase an annuity, payments on which are guaranteed for life. In both the debt and equity-based examples, I assume that the retiree uses part of the cash drawn at the outset to purchase an annuity on which payments are deferred for 8 years. The balance of the assets are drawn as spendable funds during the annuity deferment period. My RFI program calculates the annuity purchase amount that results in a smooth transition of spendable funds between draws on assets and annuity payments. As before, monthly payments are calculated to rise by 2% a year.
The annuity payments generated by RFI are based on the best prices offered by a network of highly-rated insurers. The procedure for the debt-based and the equity-based plans are identical.
The inclusion of annuities in the EFI equity-based case increases spendable funds while reducing estate values. In the HECM tenure payment case, spendable funds and estate values are unaffected, since there is no cash available to purchase the annuity.
In the HECM credit line case, in contrast, the rise in spendable funds and decline in estate values are even larger than in the EFI case, as shown below.
Note: In Table 2 spendable funds are programmed to rise 2% a year except for the tenure case, home values are assumed to rise by 4% a year, and assets drawn from the HECM credit line and the sale of future home appreciation are assumed to rise by 5% a year.
Unfortunately, the option of purchasing an annuity with funds drawn on a HECM credit line is not currently available except by subterfuge. Insurers will not write annuity contracts that are known to be funded by reverse mortgages, a policy reinforced by HUD’s hostility to annuities. The result has been to shut down an option that has the greatest potential value to non-affluent homeowners.
HUD’s policy of requiring HECMs to be a stand-alone product arose out of a few incidents of exploitative pricing by HECM lenders in collusion with insurers some years ago. It is long since time that HUD recognized the value of combining HECMs with annuities, provided that the annuities are competitively priced. In the process, HUD should also consider ways to improve the HECM market, in which identical transactions can be offered at significantly different prices. The RFI program provides competitive pricing of both reverse mortgages and annuities.
Retirement Plan Determinants
The plans shown in the tables above are based on many conditions and assumptions that could be different. For example, the retiree might be 70 years old instead of 64, or have $500,000 in financial assets instead of none, or be indifferent to an estate instead of being committed to it. In addition, the retiree could elect an annuity deferment period of 5 years instead of 8 years, and could elect an early-death rider on the annuity. RFI was designed to capture these and other features in creating individual retirement plans.
Debt-Based Versus Equity-Based Plans
While every retirement plan is unique, retirees will make an early decision of whether to use a debt-based or an equity-based approach. One important difference between them, which is evident in the tables shown above, is that debt-based plans generate more spendable funds while equity-based plans generate larger estate values. This could be the most important factor guiding retiree decisions, but there are other differences that could be compelling.
One disadvantage of debt-based plans is that in the current regulatory climate, annuities can’t be funded with reverse mortgages. This is a serious drawback for the least affluent retirees. A second disadvantage is that in the event the retiree must move out of the house for any reason, the HECM must be repaid and the credit line on which the retiree has been drawing disappears. This is not an issue with EFI since the retiree is drawing from financial assets that were augmented by EFI proceeds at the time the EFI was taken out – moving out the house at a later date has no effect on their ability to draw spendable funds.
On the other side of the ledger, greater than expected house price appreciation can be converted into increased spendable funds by refinancing the HECM. There is no such option on an equity-based plan.
The retirement literature is full of tips – one advisor offers 80 of them – but tips are often inconsistent with other tips and they don’t add up to a plan. A retiree’s objective should be to develop a single plan that will cover her remaining life, adjusting it as needed to meet changing conditions and preferences. The RFI system was designed to develop and support that process.