The Intuition for Reverse Mortgages
The following is excerpted from chapter 1 of Wade Pfau’s newly revised book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement. It is available at Amazon and other leading retailers.
Understanding how reverse mortgages can add value in retirement planning requires an understanding about the peculiarities of sequence-of-return risk that the reverse mortgage can help to manage. When combined with a long retirement, sequence-of-return risk can lead to some potentially unanticipated outcomes regarding what types of strategies may work to support retirement sustainability. Sequence-of-return risk is a fascinating concept in that minor spending tweaks can have major implications for portfolio sustainability by impacting the amount of investment wealth that remains at the end of the planning horizon. This is the intuition I hope to help you develop in this section, as this will be key to recognizing why the later analysis of reverse mortgages in Chapters 5 to 8 works and is not “too good to be true.”
We proceed by examining these peculiarities using an example from the historical data that will serve as a baseline for comparing different reverse mortgage strategies later in the book. In the case study detailed further in Chapter 5, a 62-year-old recently retired couple is working to create a retirement plan that will support their budget for 34 years through age 95. We will consider a simplified version of that case study in which the couple has $1 million of investment assets in a Roth IRA and is seeking to spend $39,485 per year plus inflation throughout their retirement with a balanced investment portfolio of 60 percent stocks and 40 percent bonds. This spending goal is chosen because it will cause their investment assets to deplete fully after covering their spending at age 95, using the market returns from 1962 to 1995.
Because the risk that a market downturn pushes the current withdrawal rate from remaining investments to an unsustainable level, the first sequence-risk synergy to note is that small changes to the initial withdrawal rate can have a large impact on portfolio sustainability. This situation is illustrated in Exhibit 1.3. With an initial withdrawal rate of 3.95 percent, the portfolio is depleted in 1995. The exhibit also shows portfolio sustainability for small withdrawal rate changes: 3.55 percent (-0.4 percent less), 3.75 percent (-0.2 percent less), 4.15 percent (0.2 percent more), and 4.35 percent (0.4 percent more).