New Research: Reverse Mortgages, SPIAs and Retirement Income
Retirees need longevity protection and additional funds. Annuities and reverse mortgages can meet those needs. While annuities have been researched extensively, reverse mortgages haven’t received as much attention. We need research on how to fit these two products together in overall retirement plans. I'll launch that effort here.
Let's say a new client walks into an advisor's office and says, "I want to build a secure income for retirement and I've heard about both annuities and reverse mortgages. What should I do?" The advisor's answer is likely to be: "Let's focus on whether you should buy an annuity and leave the reverse mortgage for later in retirement. You can tap home equity in the future if you need to."
But that may not be the best answer. It might be better to set up a reverse mortgage line of credit at the time of retirement for use later on, or opt for the tenure option that will make level monthly payments for as long as the borrower occupies their home. Or an even better option might be to purchase a single premium immediate annuity (SPIA) and combine it with either a reverse mortgage line of credit or the tenure option.
Which alternative is best? To reduce the inevitable confusion, I'll look at these alternatives conceptually, and then use an example to model the financial outcomes.
First things first
We need to ask questions before making recommendations: How much savings does the client have? Will systematic withdrawals or purchasing annuities provide adequate retirement funds, or does the client need even more income? How long does the client plan to stay in their current home? Is the home mortgaged? Does the client hope to leave the home as a bequest or is it more important to generate retirement income? Does the client have long-term care insurance, or is the plan to rely on home equity? If a reverse mortgage line of credit is set up, what is the likelihood the client will use it?
Reverse mortgages are offered under the home equity conversion mortgage (HECM) program administered by HUD and insured by the FHA. A new version of the program was introduced in 2013 offering three alternatives – line of credit (LOC), payments for set periods, or a tenure option. Under the HECM program, borrowers need to be age 62 or older, and the amount of home value that can be mortgaged is capped at $625,000. There are non-HECM proprietary reverse mortgages for larger amounts, but they are not government guaranteed and do not have the HECM standard loan provisions.
Reverse mortgages have significant up-front fees, so effective borrowing costs are high if only small amounts are borrowed, or borrowed for a short time. An example from the National Reverse Mortgage Lenders Association (NRLMA) calculator estimates fees of $8,301 for a $250,000 home. Lending limits (referred to as "principal limits") depend on the age of the borrower and interest rates. For a 65-year-old in this $250,000 home, the current principal limit would be $135,500, so the up-front costs would be 3.3% of the home value or 6.1% of the principal limit. The fees cover loan origination, mortgage insurance and other closing costs, and can be financed as part of the loan, but they come out of the funds available for lending.
An ideal client for a reverse mortgage plans to be in their home a long time; any downsizing for retirement should be done first. The product is best for clients whose primary goal is to generate as much retirement income as possible, with less concern about leaving a legacy. Finally, clients should have insurance for long-term care (LTC) or at least a plan for dealing with the LTC contingency.