Are HECM Reverse Mortgages Best Viewed As A Stand-Alone? Or As Part Of An Integrated Retirement Plan?
The practice, almost without exception, is to deliver HECMs as a stand-alone. HECM reverse mortgage lenders are barred by HUD rule from delivering HECMs in conjunction with any other financial instrument. And every annuity provider we have queried has an internal rule that prohibits annuity sales when the funds used for the purchase have been obtained from a reverse mortgage.
The rationales for these restrictions are flimsy, and their cost to the retirees who are affected by them is enormous.
Restrictions on Integration by HUD
HUD bars HECM lenders from “involvement with any other financial or insurance product.” The origin of HUD’s hostility to HECM integration appears to be an incident early in the history of the program where elderly homeowners were offered HECM/annuity combinations at extortionate prices. The HUD rules prevent collusion between lenders and insurers at the borrower’s expense. In addition, HUD guidelines require counselors — all HECM applicants must be counseled by a HUD-approved counselor — to warn HECM applicants that an annuity may not be in their best interest.
The HUD rules, however, do not create a competitive market in HECMs. These are very complicated instruments that most homeowners encounter only once, and not necessarily at a stage of life when they are at their sharpest. There is little to no price shopping because few applicants would know how to do it, and the topic is not considered by counselors. As a result, significant price differences exist on transactions that are otherwise identical. The HUD rules do nothing to fix this problem.
Restrictions on Integration by Annuity Providers
Annuity providers restrict annuity sales when the funds used for the purchase are acknowledged to come from a reverse mortgage. The reason seems to be a fear of legal actions by children of the annuitant, who may be aggrieved by the loss of some or all of the home equity they had expected when the annuitant died. There may also be concern that annuities financed by reverse mortgages might violate the rule that annuity transactions must be in the best interest of the annuitant.
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The restriction is largely pro forma. A borrower can draw on a HECM credit line, transfer it to a bank account, and report the bank account as the source of funds for the annuity. Nonetheless, the restriction (along with those of HUD) discourages the explicit integration that would generate important benefits for seniors. These benefits take several forms that apply to seniors with varying needs and preferences.
A Major Benefit of Integration: Higher Monthly Payments
By combining a HECM credit line with an annuity, the mortality-sharing feature of annuities allows retirees to draw larger amounts over their lifetimes. This is particularly valuable for house-rich/cash/poor retirees who have negligible financial assets.
Chart 1 applies to a retiree of 63 who owns a $700,000 house but no financial assets. He draws a HECM credit line and uses a portion of it to purchase an annuity on which payments will begin after 10 years. The balance of the line is used for monthly draws during the first 10 years. The monthly payment on the integrated instrument is shown by the higher of the two flat lines on the chart. [Note: The math underlying the seamless transition from HECM draws to annuity payments was developed by my colleague Allan Redstone.]
The lower horizontal line is the HECM stand-alone, termed a “tenure payment” because the payments cease if the borrower moves out of the house. This is not quite as good as a payment that continues until death.
Both measures are based on competitive prices. The integrated instrument is based on the highest annuity quoted by a network of A-rated annuity providers. The stand-alone HECM is the highest tenure payment quoted by any of the lenders who report their prices to my web site.
The lower line in Chart 1 is the highest HECM tenure payment quoted by any of the same lenders. Tenure payments are for a fixed amount and cease if the borrower moves out of the house. With a stand-alone HECM, this is the best the retiree could do.
Integration Also Provides Rising Payments
While HECM tenure payments are fixed, annuity providers will quote prices based on different rates of payment increase, This is indicated by the upward sloping line in Chart 1, which increases by 2% a year. Despite lower payments in the early years, most retirees will prefer the rising payment option to the fixed payment option.
Integration Allows Selection of the Best Annuity Deferment Period
HECM term payments, where the borrower receives payments for a pre-specified period, are not much used. Few stand-alone borrowers have the means to replace the payments when the term expires, or want to gamble on the possibility that they will die before it happens.
With integration, however, HECM terms can apply to the annuity deferment period, which is the point when the annuity payments begin. The term selected would be the one that maximized payments over the borrower’s life span. This is most beneficial to a senior who has significant financial assets as well as equity in a home.
Chart 2 applies to the identical twin of the borrower in Chart 1, except that this twin has been more successful and has financial assets of $1 million on which he expects to earn 6%. The chart shows that he will do much better with a 15-year deferment period than with a 5-year period. This is because the rate of return assumed by annuity providers in December 2020 is well below 6%. At a rate on financial assets of 2%, assuming the same annuity prices, payments with the short and longer deferment periods are about the same.
Integration to Reduce Risk: The Credit Line Backup Option
This option is for the retiree with a high return/high risk asset portfolio. For example, using historical data compiled by Ibbotson, a portfolio of 75% common stock and 25% fixed income securities has a median return of 9.5% over 10 years but it carries a 2% probability of yielding -2.7% or lower.
If the retiree draws funds from the asset pool on the assumption that the return will be 9.5% but it turns out to be -2.7%, the asset pool will be depleted before the end of the annuity deferment period and payments will cease altogether until annuity payments begin. The prudent retiree needs a game plan for dealing with this risk.
The most widely used response is to shift the asset portfolio to less equities and more fixed-income securities, which reduces the risk but also reduces the expected return. Integration provides a better option.
This is to retain the high-risk portfolio but use a HECM credit line as a backup, drawing from the line as needed to restore the retiree’s financial assets back to the planned level. This is illustrated in Chart 3, on which the top line is spendable funds as restored by the HECM backup credit line, and the lower line shows the required draws from the HECM credit line.
The adequacy of the credit line to restore the spendable funds line fully, as in Chart 3, depends on the value of home equity relative to financial assets, and on the divergence between the assumed and the realized rate of return on assets. In the case illustrated, the HECM credit line is more than sufficient to fund the deficit.
In the event that actual asset returns exceed the median return used in the retirement plan, both financial assets and the HECM credit line will grow. (The line grows at the HECM mortgage rate). Excess credit line and/or financial assets can be used to increase spendable fund draws, to purchase additional annuities, or left in the estate.
Integration to Accommodate Partial Retirement
One result of deficient retirement planning has been a growth in “partial retirement,” which involves continued employment past the usual retirement ages but at a reduced scale at reduced income. A retirement plan to accommodate them should provide a payment jump when partial retirement becomes full retirement.
This can be accomplished by purchasing an annuity on which payments are deferred until the planned date of full retirement. During the partial retirement period, the retiree would draw smaller amounts against a HECM credit line. The unused part of the line would grow at the HECM interest rate plus insurance premium, accruing a reserve. The reserve would be used to purchase a second annuity beginning at the same time as the deferred annuity, generating the desired jump in spendable funds
As a stand-alone, HECMs are subject to severe adverse selection. Their greatest appeal has been to those in financial distress, which has resulted in large losses to FHA’s mortgage insurance reserve fund. As an integral part of retirement plans, in contrast, HECMs would draw a much wider segment of retirees, which is bound to strengthen the fund.