New Research: Reverse Mortgages, SPIAs and Retirement Income

SPIA versus tenure

For the example above based on the NRMLA calculator, the tenure option would lend the borrower $709.89 per month for as long as the borrower continued to occupy their home. Payments would continue even if the loan exceeded the value of the home, and the borrower would not be responsible for the overage. For this particular case, the net principal limit after fees would be $127,199 ($135,500 - $8,301), so the annualized payout rate would be 6.70% ($709.89 * 12 / $127,199).

We can compare this payout rate to a level payment SPIA. Based on rates from Income Solutions®, a SPIA for a 65-year-old female purchased with $127,199 would pay a monthly income for life of $679.89, a payout rate of 6.41%. The advantage of the SPIA is that it continues paying for life, whereas the tenure payments require home occupancy. But for someone who hopes to stay in their home for life, the tenure payments are attractive.

Line of credit (LOC)

For anyone contemplating a reverse mortgage LOC, the biggest question is whether to set it up soon after age 62 or wait until later in retirement.  The popular choice is to wait because of the significant up-front fees. However, this may not be the best choice. Although the LOC principal limits increase with age, they decrease if interest rates go up. The current principal limit factor for our example is .541 times the home value. If a 65-year-old waits 10 years and rates rate rise by 200 basis points, the factor for a 75-year-old will be .460.

But there is an even more compelling, although subtle, reason for acting now rather than waiting. The interest rate charged on borrowed funds is a variable rate that combines the one-month LIBOR SWAP rate, the lenders margin and the annual mortgage insurance premium (0.174% + 2.5% + 1.25% = 3.924% in the NRMLA example). But the HECM program also guarantees that unused portions of the LOC will grow at this same rate. Think of a scenario where the LOC is set up now for later use. If interest rates stay at the current level, the available credit will grow at 3.924% and even faster if interest rates increase. Similar to the tenure option, the LOC can grow to exceed the home value and the borrower doesn't have to pay back the overage.

The advantages of setting up the LOC early were highlighted in this 2007 paper by Wei Sun, Robert K. Triest, and Anthony Webb, which was based on the old HECM program before 2013. In this May 2014 article in the Journal of Financial Planning, Shaun Pfeiffer, Angus Schaal and John Salter provided an extensive analysis showing the advantages of "now" instead of "last resort" in a level interest rate environment and that these advantages increase with increasing rates. In this December 2014 Advisor Perspectives article, Wade Pfau demonstrated the high probability of an unused LOC exceeding the home value in the later years of retirement, effectively providing free money.

There is a compelling case for not waiting to set up a reverse mortgage LOC. But then there's the question of how to think about the LOC in an overall asset-allocation context. Sun, Triest, and Webb provide the answer in that the LOC can be thought of as an alternative asset class. Think of it this way: assume the initial LOC is $100,000 and left to grow. Based on our example and current interest rates, the available funds at the end of one year grow by 3.924% to $103,924. In terms of retirement spending power, this is the same as a regular investment growing at that rate. In effect, we have an asset class with an impressive 3.75% spread over the one-month LIBOR SWAP and backed by a government guarantee.

If the primary goal is to generate retirement income, both tenure and LOC are attractive options. If leaving a legacy is important and the client has sufficient retirement savings, the reverse mortgage options become less attractive. In this example, the borrowing rate is 3.924%, which is considerably more than can be earned on safe fixed income investments, so this borrowing creates reverse leverage. However, if LOC or tenure loan balances grow to exceed the home value, the excess borrowing turns into free money.

Putting it all together

We are now ready to demonstrate how various combinations of reverse mortgages and SPIAs can be used to increase retirement income. I'll be using the same example discussed so far and also assuming that our 65-year old female has $500,000 in savings and annual Social Security of $15,000. Additional assumptions are that her savings are split 60/40 stock/bond, and stocks average a 7.25% nominal return with a 20% standard deviation and bonds average 2.11% (the current ten-year LIBOR SWAP rate used in other HECM calculations) with a standard deviation of 5.5%. I assume a 1.9% general inflation rate and that this same rate applies to home inflation. I use Monte Carlo simulations for her savings portfolio and run two scenarios for the one-month LIBOR SWAP (which affects the loan rate): level at today's 0.174%, and rising to 2.174% after the LOC or tenure option is set up at today's rates. I also model Monte Carlo mortality based on a life expectancy of 25 years.

All this analysis is pre-tax. A worthwhile future extension of this research will be to incorporate tax effects, with separate analysis for taxable versus tax-deferred savings.

Below is a chart of outcomes based on interest rates staying at today's level:

Reverse mortgage and SPIA outputs

I begin with a base case scenario not using a reverse mortgage or SPIA, and I take withdrawals from savings to supplement Social Security. I then show three different options, and the last two lines show combinations.

I calculate withdrawals using a consumption smoothing approach. I develop withdrawal percentages for each age based on an annuity calculation and apply the percentages each year to the remaining savings plus the LOC (if any).  The factors are similar to required minimum distribution (RMD) percentages, but somewhat more aggressive. I withdraw first from savings and then from the LOC after savings are depleted.

I do 10,000 Monte Carlo runs for each scenario and produce the following performance measures (all in real dollars, discounted for inflation):

• Median consumption level – For each of the 10,000 runs I calculate the average consumption over the stochastic lifetime and display the median of the 10,000 results.

• Ratio of 5th percentile to median – I do the same calculation as for the median, but take the 5th percentile and divide by the median. This provides a risk measure for how much consumption falls at the 5th percentile.

• Certainty equivalent consumption – I use a utility function that reduces the consumption measure based on year-to-year variability in consumption (under the assumption that individuals prefer level consumption). This captures year-to-year variability that doesn't get picked up in the 5th percentile measure.

• Median bequest – remaining savings plus the value of the house net of any reverse mortgage loan balance.

Based on the particular HECM parameters and the economic assumptions I used in this example, we see that both the LOC and tenure options increase consumption significantly over the base case. The median bequest drops, since we are now borrowing against the home to provide income. Tenure builds larger loan balances than the LOC and generates more income. The SPIA option uses a level SPIA generating the same payments as the tenure option. Because SPIA payout rates are lower than tenure payouts, I need to take $132,811 from savings to purchase the SPIA compared to the net principal limit for tenure or LOC of $127,199. The SPIA option also preserves the home value for the bequest. For an individual who wants to generate as much income as possible and is not concerned with leaving a bequest, the reverse mortgage options are clearly superior to the SPIA. If the individual has a bequest motivation, the decision comes down to evaluating the tradeoff between bequest and income.

Next, I combine the SPIAs with the two reverse mortgage options. I generate modestly more income this way. With the added income security provided by SPIA income or the reverse mortgage options, I could afford to take more stock market risk and boost income even more. There are many variations that could be tested.

Higher interest rates

In the chart below, I show a scenario where all interest rates increase by two percent after initial set up.

Reverse mortgage and SPIA outputs

Now the LOC option produces results much closer to the tenure option. This is because the funds available from the unused LOC grow faster with the higher variable interest rate, while the tenure payments have been locked in at inception. However, the higher LOC effectively eats up the entire home value, similar to the forecast in Pfau's article mentioned earlier. Again, if retirement consumption is more important than leaving a bequest, the reverse mortgage options are attractive.

I've only shown a few options here. Much more could be done with varying asset allocations and SPIA purchase amounts. Scenarios could also be run for different savings, home values and client ages.

Final word

This is an initial attempt to look at reverse mortgage and SPIA options in an integrated fashion. It points to a need for financial planning software that can handle this type of analysis, particularly for middle-income clients who cannot generate sufficient retirement income from savings alone. Such software would need to handle not only the HECM structures dealt with here, but also tax effects, adding an additional layer of complexity.

Acknowledgements: I would like to thank Shaun Pfeiffer of Edinboro University for his valuable input.

Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.

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