Improving Retirement Income Efficiency Using Reverse Mortgages
by Wade Pfau, Ph.D., CFA
Originally published in FORBES
Maintaining higher fixed costs in retirement increases exposure to sequence risk by requiring a higher withdrawal rate from remaining assets. Drawing from a reverse mortgage has the potential to mitigate this aspect of sequence risk by reducing the need for portfolio withdrawals at inopportune times.
An HECM line of credit provides a tool that can be used to mitigate the impacts of sequence of returns risk. Since 2012, this has been the focus of a series of research articles highlighting how the strategic use of a reverse mortgage can either preserve greater overall legacy wealth for a given spending goal, or can otherwise sustain a higher spending amount for longer in retirement.
The holy grail for retirement income strategies is improved efficiency: being able to spend more while preserving a larger legacy. The synergies created by strategic use of an HECM line of credit can support a higher spending level in retirement and/or support a greater legacy value for remaining assets.
The conventional wisdom on how to treat housing wealth in retirement was to preserve it as a last resort option. If it did not need to be used, the home may be left as part of the legacy for the next generation.
However, starting in 2012, a series of articles published in the Journal of Financial Planning investigated how obtaining an HECM reverse mortgage early in retirement and then strategically spending from the available credit can help improve the sustainability of retirement income strategies.
We can think of legacy value at death as the combined value of any remaining financial assets plus the remaining home equity once the reverse mortgage loan balance has been repaid:
Legacy Wealth = Remaining Financial Assets + [Home Equity – minimum(Loan Balance, 95% of Appraised Home Value)]
If we do not worry about the percentage breakdown between these two categories, research reveals the possibility of sustaining a spending goal while also leaving a larger legacy at death. Strategically using home equity can lead to a more efficient strategy than the less flexible option of viewing the home as the legacy asset that must not be touched until everything else is gone. This analysis provides a way to test whether the costs of the reverse mortgage—in terms of the upfront costs and compounding growth of the loan balance—are outweighed by the benefits of mitigating sequence risk. Strategic use of a reverse mortgage line of credit is shown to improve retirement sustainability, despite the costs, without adversely impacting legacy wealth.
Based on his personal research going as far back as 2004, Barry Sacks got the ball rolling and received widespread recognition for ideas presented in a research article he published with his brother Stephen in the February 2012 issue of the Journal of Financial Planning. William Bengen is to the 4% rule what Barry Sacks is to supplementing retirement income with a reverse mortgage line of credit. He was thinking over a decade ago about how one could use housing wealth as a type of volatility buffer to help mitigate sequence of returns risk.
The aptly named article these brothers wrote—“Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income”—set out to present the reverse mortgage option as something more than a last resort.
The title states their objective clearly. They investigated sustainable withdrawal rates from an investment portfolio coupled with home equity, and determined whether asset depletion takes place when using three different strategies for incorporating home equity into the retirement income plan:
Use a reverse mortgage as a last resort to continue spending only after the investment portfolio is depleted (i.e., the conventional wisdom).
Open a reverse mortgage line of credit at the start of retirement and spend it down first, then transition to using portfolio withdrawals for the remainder of retirement.
Open a reverse mortgage line of credit at the start of retirement and draw from it during any years that follow a negative return for the investment portfolio. This is their “coordinated strategy.”
They reversed the conventional wisdom by using Monte Carlo simulations to quantify how spending strategies (2) and (3) enjoyed a higher probability for success and could be sustained longer than (1).
They also found the remaining net worth of the household (the value of their remaining financial portfolio plus any remaining home equity) after thirty years of retirement is twice as likely to be larger with an alternative strategy than with the conventional wisdom of saving home equity to be used last.
For withdrawal rate goals of between 4.5% and 7% of the initial retirement date portfolio balance, the residual net worth after thirty years was 67% to 75% more likely to be higher with a coordinated strategy than with a strategy using the reverse mortgage as a last resort. In other words, spending home equity did not ruin the possibility for leaving an inheritance. Instead, the opposite was true.
How is this the case? Essentially, scenarios (2) and (3) provide a cushion against the dreaded sequence of returns risk that is such a fundamental challenge to building a sustainable retirement plan. When home equity is used last, retirees are spending down their volatile investment portfolio earlier in retirement and are more exposed to locking in portfolio losses, more easily leading them on the path to depletion.
With option (2), if home equity is spent first, the financial portfolio is left alone in the interim, providing a better chance to grow so that by the time home equity is spent, retirees will be able to continue a given spending amount in their retirement using what is likely be a lower withdrawal rate from a now larger portfolio. They quantify that the costs and interest paid on the reverse mortgage, while substantial, are less than the benefits the strategy provides to retirees and their beneficiaries.
And option (3) provides a more sophisticated technique to grapple with sequence of returns risk by only spending from the reverse mortgage line of credit when the retiree is vulnerable to locking in portfolio losses. That is, spend from the line of credit after years in which the financial portfolio has declined.
Sacks and Sacks make clear that their point is not that all retirees should take a reverse mortgage, but that retirees who wish to remain in their homes for as long as possible should view it as more than a last resort. If a retiree decides to spend at a higher level, which could lead to portfolio depletion and then possibly require them to also generate cash flows from their home equity, there is indeed a better way.
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