How to Use Reverse Mortgages to Secure Your Retirement
The following is excerpted from Wade Pfau’s new book, Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement (The Retirement Researcher's Guide Series) (Volume 1), available from the link above. This is taken from Chapter 8: The tenure payment as an annuity alternative.
When comparing strategies for coordinating home equity with portfolio distributions to generate retirement income, the tenure option fairs well and is an appealing option. As a way to fund retirement efficiency improvements, using the tenure payment option from the line of credit as an alternative to purchasing an income annuity (such as a single-premium immediate annuity – SPIA – or a deferred-income annuity – DIA) is worth exploring further.
The tenure option annuitizes home equity as an alternative to annuitizing financial assets. If you are considering income annuities as your clients approach retirement, what could be a more effective way to building an income stream: purchasing an income annuity, or using a tenure-payment option on a reverse mortgage? A tenure payment behaves similarly to an income annuity, though they are not the same.
First, to be clear, a tenure payment does not necessarily provide a guaranteed monthly cash flow for life as an income annuity would. Guaranteed cash flow continues only as long as the borrower remains eligible by staying in the home and meeting homeowner obligations. Moving away from the home for more than a year would end the payments. While a non-borrowing spouse may remain in the home if the borrower is no longer eligible, tenure payments would stop once the borrower has become ineligible. Only when both spouses are eligible would the tenure payment behave like a joint-life annuity.
Another difference is that no lump-sum payment (other than any upfront reverse mortgage costs) must be made from the portfolio to initiate the tenure payments. Each tenure payment is taken from the line of credit and moved to the loan balance. In the event that the retiree dies early, the loan balance may be substantially less than an annuity premium would have been. Conceptually, the tenure payment behaves more like an income annuity with a cash-refund provision, in terms of whether any assets would be available at the end of the contracted period. Still, there is no upfront lump sum to initiate these payments with the tenure option. This is an important distinction.
The tenure payment also does not provide mortality credits in a conventional sense. Its pricing is based on an assumption that the borrower or borrowers live to age 100. Despite the lack of traditional mortality credits, tenure payments provide a degree of longevity protection, assuming the borrower remains eligible. Cumulative cash flow received from the line of credit through the tenure payment can exceed the value of the principal limit and can even exceed the value of the home. Once this happens, the non-recourse aspects of the loan provide spending power without a tradeoff to legacy in a way philosophically similar to an income annuity. That non-recourse aspect could be interpreted as a type of “mortality credit.”
A final difference is that the formulas to calculate tenure payout rates and income annuity payout rates are different. The tenure payout rate depends on the 10-year LIBOR swap rate plus a lender’s margin and mortgage insurance premium rate of 1.25%. It also depends on an assumed time horizon or “life expectancy” of age 100. It does not vary by gender or whether payments are for one or two eligible borrowers.
Meanwhile, income annuity payment rates depend on actual mortality data for the age and gender of the individual or couple, as well as on a lower interest rate, which may be a bit higher than a 10-year LIBOR swap rate but doesn’t include a lender’s margin or mortgage insurance premium.
For the tenure payment, the higher interest rate supports higher payments than an income annuity. But the assumption that “life expectancy” is age 100 supports lower payments, relative to the income annuity. However, the higher interest rate assumption should more than counterbalance the age-100 assumption in most cases, so the tenure payments will be greater than from an income annuity.
For example, as I write, the 10-year LIBOR swap rate is about 2.1%. For a 65-year-old with a lender’s margin of 3%, the payout rate for the tenure payment option is 7.1%. We can compare this rate to annuity quotes with cash refunds offered through ImmediateAnnuities.com for 65-year-olds. The payout is 6.15% for a single male, 6.07% for a female and 5.61% for couples. Women and couples especially benefit from the tenure payment, as it does not penalize them for their longer relative life expectancies.
Another interesting aspect to consider for tenure payments is that, surprisingly, the monthly tenure payment amount for a given home value is actually higher when interest rates are low. Naturally, higher interest rates allow for a higher payout rate from the principal limit amount as just discussed. This is documented at the top of Exhibit 1 for expected rates between 5% and 10%, in the case of a 65-year-old borrower with a $300,000 home. The payout rate from the principal limit increases from 7.01% when the expected rate is 5%, to 11.37% when the expected rate is 10%. However, the initial principal limit that the payout rate is applied to decreases as rates rise, creating a much stronger counter-effect. For a 65-year-old borrower, an expected rate of 5% supports a principal limit factor of 54.2%. The principal limit factor falls to 14.8% when the expected rate is 10%.
Exhibit 1 The Relationship between Expected Rates and Tenure Payments, $300,000 home value, sixty-five-year old borrower
The combined impact of the higher payout rate applied to a smaller principal limit is shown in the bottom of the figure. The monthly available tenure payment decreases as interest rates rise. It was $950 per month with a 5% expected rate, falling to just $421 per month with a 10% expected rate. The surprising implication is that tenure payments will represent a higher percentage of the home’s value when interest rates are low. With income annuities, a given lump-sum premium would support a larger monthly payment when interest rates are higher. Of course, the principal limit, not the home value, would provide an equivalent amount to annuitize, but the interesting point is that low interest rates allow for more annuitized spending for a household with a given ratio of home value to portfolio size.
Exhibit 2 illustrates the circumstances that would favor tenure payments or income annuities. First, as noted, couples and single females would experience lower payout rates from income annuities, as their pricing considers their increased longevity relative to single males. Single males can receive the highest relative payout rates from income annuities and would have a stronger reason to consider them, relatively speaking. Second, tenure payments make more sense for those planning to remain in their homes, as they have more opportunity to spread out any upfront costs and potentially receive a windfall from the non-recourse aspect of tenure payments. For those likely to move, or who otherwise do not live in an eligible home, income annuities have an edge.