Retirees who own a valuable home but nothing else are a significant but underserved minority who worry about running out of money before they die. Their main need is to find an efficient way to convert their real estate assets into usable funds.
The two potential approaches to meeting this need are debt-based and equity-based. The first has retirees borrowing funds, with the house serving as collateral to secure repayment. The second approach provides funds for an equity investment that includes a share of future growth in the value of the home.
This article compares the versions of the two. The HECM Reverse Mortgage Program is debt-based, federally sponsored and regulated. EquiFi Equity Access EFI tm is an emerging equity-based program owned by a public benefit corporation. Unlike other equity-based companies, it largely caters to retirees rather than homebuyers and has no mandatory termination date. EquiFi 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 pension plans that can cover both debt-based and equity-based programs.
Components of a pension plan
When making decisions about a retirement plan, retirees should focus on two main elements of the plan: monthly usable funds and estate value. They should also see how the components of the plan change over time. An illustration for a 64-year-old man with $400,000 in 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 line of credit available and invests it, drawing funds from their assets on a monthly basis. In the example, payments are calculated to increase by 2% per year and last until year 104 at the assumed pay rate of 5%. The risk is that the rate falls below, which would result in an earlier depletion of the borrower’s assets. This risk can be minimized by assuming a lower rate of pay.
The second approach is to take a tenure payment, which is a guaranteed fixed amount that lasts as long as the borrower lives in their home. The downside is the absence of any adjustment based on inflation of available funds and cessation of payments if the borrower is forced to leave the house permanently.
A retirement plan based on the EFI program involves the retiree investing the funds paid to them for the share of future equity growth. Usable funds are drawn from these assets based on the same assumptions used in the HECM line of credit plan.
In the example, the HECM line of credit generates the most usable funds, but the EFI-based stock plan provides the greatest estate value in subsequent years. This is not an unusual result, as we will see in other comparisons of debt-based and equity-based plans.
Integration of annuities
Retirees can reduce the risks of retirement plans dependent on rates of return on financial assets by using a portion of those assets to purchase an annuity with guaranteed payouts for life. In the debt-based and equity-based examples, I assume that the retiree uses some of the money initially withdrawn to purchase an annuity with payments deferred for 8 years. The balance of the assets is withdrawn as funds to be used during the annuity deferment period. My RFI program calculates the annuity purchase amount that results in a smooth transition of usable funds between asset drawdowns and annuity payouts. As before, monthly payments are calculated to increase by 2% per year.
The annuities generated by RFI are based on the best rates offered by a network of first-rate insurers. The procedure for debt-based and equity-based plans is identical.
The inclusion of annuities in the equity-based EFI case increases available funds while reducing estate values. In the case of the HECM tenure payout, usable funds and estate values are not affected, as there is no money available to purchase the annuity.
In the case of the HECM line of credit, on the other hand, the increase in available funds and the decline in real estate values are even greater than in the case of the EFI, as shown below.
Note: In Table 2, usable funds are programmed to increase by 2% per year, except for tenure, house values are assumed to increase by 4% per year, and assets drawn from the line HECM credit and the sale of future home appreciation are assumed to increase by 5% per year.
Unfortunately, the option to purchase an annuity with funds drawn from a HECM line of credit is currently only available 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 was to close an option that has the greatest potential value for non-affluent homeowners.
HUD’s policy requiring HECMs to be a standalone product grew out of a few incidents of price gouging by HECM lenders in collusion with insurers a few years ago. HUD has long recognized the value of combining HECMs with annuities, provided the annuities are competitively priced. In the process, HUD should also consider ways to improve the HECM market, in which identical trades can be offered at vastly different prices. The RFI program offers competitive pricing for reverse mortgages and annuities.
Determinants of the pension plan
The plans presented in the tables above are based on many conditions and assumptions which could be different. For example, the retiree may be 70 instead of 64, or have $500,000 in financial assets instead of none, or be indifferent to an estate instead of committing to it. In addition, the retiree could choose a pension deferment period of 5 years instead of 8 years and could choose an early death rider on the pension. RFI was designed to capture these and other characteristics in the creation of individual pension plans.
Debt-based or equity-based plans
Although every retirement plan is unique, retirees will decide early whether to use a debt-based or equity-based approach. A key difference between them, which is evident in the tables above, is that debt-based plans generate more usable funds while equity-based plans generate larger estate values. This might be the most important factor guiding retirees’ decisions, but there are other differences that might be compelling.
A disadvantage of debt-based plans is that in the current regulatory climate, annuities cannot be funded with reverse mortgages. This is a serious disadvantage for less well-off retirees. A second disadvantage is that in the event that the retiree has to leave the house for any reason, the HECM must be repaid and the line of credit the retiree has drawn on disappears. This is not an issue with EFI since the retiree is drawing on financial assets that were augmented by the proceeds of the EFI at the time the EFI was withdrawn – leaving home at a later date has no effect on its ability to withdraw usable funds.
On the other side of the ledger, greater than expected house price appreciation can be converted into increased available funds by refinancing the HECM. Such an option does not exist in a share-based plan.
The retirement literature is full of advice – one advisor offers 80 – but the advice is often inconsistent with other advice and doesn’t add up to a plan. A retiree’s goal should be to develop a single plan that will cover their remaining life, adjusting it as needed to meet changing conditions and preferences. The RFI system was designed to develop and support this process.