Friday, September 23, 2016

The Risks of Reverse Mortgages

My last couple of posts, beginning with The Mortgage is Dead; Long Live the Reverse Mortgage, have extolled the virtues of the improved FHA HECM reverse mortgage products. Given that the typical American family has far greater home equity than all other assets combined, making more productive use of that home equity to fund retirement should be a big help to many households.

No retirement strategy is perfect for every household, though, and there are some risks with HECMs that you should understand. Here are a few.

A HECM does not guarantee that you can keep your home.

A HECM guarantees that you can keep your home for as long as you, a spouse or a non-borrowing spouse still live in it. It also guarantees that you can't owe more when you repay the loan than could be recovered by you selling the home at fair market value. HECMs provide the opportunity for you, your estate, or even your heirs to pay off the loan with other assets and keep the home. But, they don't guarantee that you will have the financial means to do so.

We are told by late-night TV commercials that a HECM borrower can never have their loan foreclosed except for three reasons: failure to pay property taxes, failure to keep insurance in force, or failure to maintain the property so long as the borrowers or a non-borrowing spouse live in the home. But, that's really four reasons, isn't it?

Tom Selleck (I think he plays an amazing Police commissioner in Bluebloods, by the way) is reported to say the following:
When you get a reverse mortgage, you are getting a loan. The bank is loaning you money in much the same way as it loans you money when you take a home equity loan. And when you die, the home is still yours to pass on to your heirs.
Some of this is correct. Banks are rarely involved, as I will explain below, but that’s a quibble. When you leave the home, and not necessarily because you died, the home is still yours to pass on to your heirs if you have other assets with which to pay off the loan or your heirs can arrange a new mortgage. The home is, in fact, still yours (or more accurately your estate's) after you die, but the home was collateral for the loan. If you or your estate can’t pay back the loan from other resources, you can’t pass on the home to heirs. It must be sold by your estate to pay back the loan.

Should you decide that you no longer want to live in the home, you will also have to repay your HECM. More importantly, if you are no longer able to afford the house and need to sell it, your HECM loan will also become due and payable. A retiree who loses a spouse, gets divorced, or incurs huge medical expenses, for example, may find the home no longer affordable or perhaps just no longer desirable.

Imagine an executive at an oil company whose wife develops Alzheimer's disease and is bankrupted by the cost of her care. Why might a HECM not enable them to stay in the home? Maybe because they can no longer afford a mansion in a high cost of living area even with no mortgage payments or perhaps they need to access home equity in excess of their HECM credit limit.

Every retirement plan should consider the possibility of a spouse's death, a divorce, spending shocks or any of a number of life-changing events. HECM borrowers should also consider the possibility that these changes might leave their home unaffordable or undesirable and necessitate paying off the loan long before they had planned. Retirees with expensive homes in areas with a high cost of living are at greatest risk of deciding to sell because they will see the largest benefit from selling and relocating.

If you can't repay the loan, you won't be able to keep the home.

A reverse mortgage can be a great idea, but understand the risks.
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A forced repayment can happen at the worst possible time.

Repayment of a HECM loan can be forced by foreclosure, by the borrower’s choice to move, or by the borrower’s need to move when she can no longer afford the home.

In Why Retirees Go Broke, I explained that elder bankruptcies are usually the result of expense shocks and not poor investment results. I referred to Dr. Deborah Thorne's study showing that these bankruptcies are usually the result of multiple interconnected causes – loss of a job or huge medical costs, for example, leading to excessive credit card usage that leads to insolvency.

In Retirement Income and Chaos Theory, I showed how insolvency can result from a downward spiral of continually worsening financial problems. If those interconnected problems also result in a HECM borrower needing to move out of an expensive home to stabilize her finances, her HECM will need to be paid back at the worst possible time – during an ongoing financial crisis – and may accelerate the downward spiral.

As Shelley Giordano pointed out to me, it is also possible that a HECM loan might stabilize the downward spiral and save the retiree’s finances. That would be a rational strategy when there is adequate credit to address the crisis. When the credit is not adequate, the forced repayment might accelerate the spiral.

For example, if you have a $100,000 HECM line of credit and incur a $100,000 medical expense, the HECM might well stabilize and save your financial situation. If the spending crisis costs $200,000 it may not stop the spiral and, in fact, may force you to sell the home and trigger repayment. Given that you already have a crisis on your hands, repayment might simply accelerate the downward spiral.

The tax implications of a reverse mortgage aren't all clear and even the clear issues are complex.

Funds borrowed from a HECM are considered loans and not taxable income. That much seems clear. How you will be taxed should you borrow more than the fair market value of your home and take advantage of the non-recourse character of HECM loans is less certain, as are eligible tax deductions. That uncertainty is risk.

Taxes aren't deductible until you leave the home because that’s when they are paid. While the HECM protects you from having to repay more of the loan than the sale of your home will bring, a non-recourse loan doesn’t protect you from taxes. If your line of credit grows beyond your home’s fair market value, you might end up with a sizable capital gains tax.

Dr. Barry Sacks and his co-authors wrote a paper entitled Recovering a Lost Tax Deduction (link below) that explains how to capture the potential interest deduction. (If nothing else, it will convince you that the tax implications are complex.) Tom Davison wrote an excellent overview of the tax implications of reverse mortgages at his Tools for Retirement Planning blog (link below), though I think he would readily admit that it is not a complete treatment of all issues.

Your risk isn’t so much that the tax law is uncertain (it is a bit uncertain) but that the laws are so complex that you will borrow a HECM loan without understanding the potential impact of taxation. Even if you have difficulty understanding the taxation of HECMs, it is important to recognize its uncertainty and complexity when making your decision to borrow. Uncertainty and complexity are risks.

Tax and estate planning on this topic are in order to take advantage of the opportunities and to avoid leaving your heirs a possible nightmarish tax issue. I’ll leave this point with a quote from Wade Pfau’s excellent new book, “How to use Reverse Mortgages to Secure Your Retirement”, available at Amazon.
A more complex area relates to eligible deductions for reverse mortgages. These taxation issues are still relatively untested and not fully addressed in the tax code. Researchers Barry Sacks and Tom Davison have recently been exploring deeper into the tax code to better understand these aspects. Individual cases vary, so a tax professional with reverse mortgage experience should always be consulted.” (Emphasis mine.)
Just because your reverse mortgage can't be foreclosed doesn't mean you can't lose money.

Some argue that a HECM line of credit is essentially risk-free due to its lenient repayment terms. Who cares if you run up a HECM line of credit when you don't really have to repay the loan or the interest and fees until you die?

Borrowing from a HECM is not risk-free. As I pointed out above, that works great if the rest of your finances go well, but when your finances collapse (see Why Retirees Go Broke for a list of reasons this can happen) and you need or want to sell the home, those lenient terms disappear. The loan becomes due and payable.

Even retirees who are able to stay in the home for the rest of their lives spend real wealth. The loans they borrow reduce future potential consumption. Once you spend the money from the line of credit your wealth has decreased in the same way as spending from any other resource. A HECM line of credit won't be foreclosed so long as you meet the four conditions but spending from it does reduce your wealth, just like any other form of credit.

Borrowing to invest is imprudent for most retirees, especially when their home is the collateral.

AARP, FINRA and most economists and financial planners warn that a household should not use home equity to invest in the stock market. Risking your home to invest in volatile assets is a bad bet. After retirement it becomes a worse bet because the borrower no longer has a stream of job income from which to make the loan payments. Retirees should not rely on good investment results to repay loans. With a HECM and an investment portfolio, poor investment results alone may not force you to leave the home but they may leave you unable to eventually pay off the loan and keep the home in your estate.

Borrowing early in retirement may limit your options later in retirement.

Some strategies like borrowing from a HECM to pay taxes on a Roth conversion or to help delay claiming Social Security payments require borrowing early in retirement. Doing so might cut off important options later in retirement that might be even more beneficial.

A large HECM balance might complicate a decision later in retirement to downsize or move to a retirement home, necessitating paying back the loan. A HECM line of credit might be more valuable late in retirement to pay long-term care expenses than borrowing earlier in retirement to avoid taxes or delay claiming Social Security benefits.

Retirees who borrow early run the risk of needing the funds later in retirement even more. In What's the Deal with Reverse Mortgages, Shelley Giordano discusses the value of borrowing later in retirement not only to allow the line of credit from a mortgage taken out earlier to grow but also because many issues like where you will live may become more settled as you age.

Large banks have exited the reverse mortgage business.

This issue is not solely one for reverse mortgages. An article in the August 20, 2016 issue of The Economist describes it as follows:
The trouble is that, in America, the banks are only part of the picture. There is a huge, parallel structure that exists outside the banks and which creates almost as much credit as they do: the mortgage system. In stark contrast to the banks it is very badly capitalised. It is also barely profitable, largely nationalised and subject to administrative control.
After the housing crash, the federal government moved to shore up big banks and increase their capital requirements, but those changes don't apply to the non-bank portion of the mortgage market where most reverse mortgages are held. Mortgages of all types may be riskier than we realize.

Tenure payments last the life of the mortgage, not the life of the retiree.

Tenure payments from a HECM are a lot like a life annuity from an insurance company, but they are quite different in important ways. The HECM tenure payments will go away when the borrowers move out of the home or the mortgage is foreclosed.

Once the mortgage is paid off, it may be difficult to find a replacement source for tenure income. That won't be a problem if it is your estate that is paying off the HECM, but it might be one if you are forced to repay the mortgage earlier than planned and were counting on a lifetime of income from the HECM tenure payments.

An annuity guarantees income for life no matter where you live. HECM tenure payments are not portable. The risk is that you will plan to live in the home for the rest of your life but will not be able to, or that you will change your mind.

Tom Davison points out that HECM tenure payments have a mitigating feature. Unlike life annuities, HECM tenure payments will return any unused equity when the loan is repaid. Pfau’s new book compares tenure payments and annuities in Chapter 8, The Tenure Payment as an Annuity Alternative. There are distinct advantages and disadvantages to each.

The credit line growth feature could be limited in the future.
The growing-line-of-credit feature of HECM adjustable rate mortgages is a unique and powerful feature, so much so that one wonders if it is too good to be true over the long term. AARP's Policy Guide recommends that HUD "should prohibit the use of reverse mortgages as a portfolio hedge for wealthy individuals and should eliminate the credit line growth feature of adjustable-rate HECM loans where borrowers choose a line-of-credit payout.”

The present seems to be a nearly ideal time for HECM adjustable-rate mortgages. The program contains what I consider to be a loophole based on the assumption that borrowers wouldn’t typically take out a HECM reverse mortgage and not borrow from it for decades. Combine that with the current low-interest rate environment and you have the potential for some huge future benefits that the program probably didn’t consider.

For these reasons, most of the HECM experts with whom I spoke suggested that the loophole is likely to be closed at some point in the future. Some of the strategies currently suggested for HECMs in retirement would be far less attractive if that loophole were closed or interest rates rise, as they likely will.

This is perhaps my most important point: these risks are not reasons that retirees should avoid HECM loans; they are reasons that retirees should plan.

They’re reasons to learn about HECMs, prepare for taxes, and understand the reverse mortgage’s role in your retirement plan. I'm suggesting that you shouldn't run out and borrow a HECM reverse mortgage without understanding the complexities and probably not without some professional guidance. That may well be worth the effort for many households.

No retirement product is perfect for every household but if we understand both the risks and benefits then we can incorporate them into a retirement plan that exploits the advantages while mitigating the risks.

In my next post, I'll discuss when spending home equity as a last resort is the best resort.

Once again, I need to thank several people for discussing the issues in this post including Wade Pfau, Shelley Giordano, Ron Heath, Jim Dean, Jim Veal and Mary O'Keeffe. (I should point out that none of us are in full agreement regarding HECMs, yet, but if we were, this wouldn't be fun. The disagreements are enlightening.) 

In particular, I want to thank Tom Davison for a marvelous three-and-a-half hours of discussion at a coffee shop on his way to catch a flight and to Wade for publishing a book this week that felt like it was intended specifically for me.


How to use Reverse Mortgages to Secure Your Retirement” by Wade Pfau, available at Amazon.

AARP Policy Book on HECMs.

What's the Deal with Reverse Mortgages by Shelley Giordano, available at Amazon.

Tax Deductions and Reverse Mortgages: August 2016 Update by Tom Davison.

Recovering a Lost Tax Deduction, Barry Sacks, et. al.

Comradely Capitalism: How America accidentally nationalised its mortgage market, The Economist, August 2016.

Wednesday, September 7, 2016

Why the Retirement Train Wrecked

I was recently contacted by Northwestern University MBA student, Jared Scharen, about writing a guest post for his eRetirements blog. The following post first appeared there. I hope you will visit his blog.

My first job out of college, with a degree in computer science, was with staid General Electric's Information Systems Division in 1975. I was promptly taken under the wing of a few GE lifers whose first advice was this: “Never change employers. Stick with GE for your entire career and they will pay for an excellent pension for your retirement.”

At the ripe old age of 21, retirement wasn't on my radar. I stuck with GE for three whole years. Since the 1980's, defined benefit pension plans have all but evaporated, replaced by defined contribution plans like 401(k)'s. That's retirement planner-speak for the burden of funding retirement being shifted from your employer, like GE, to you and me.

Whereas the 1975-vintage GE retirement plan guaranteed eventual retirement benefits, new plans define how much you can contribute to the plan with tax advantages and your eventual retirement income depends on how well you invest those contributions. Defined benefit "pension" plans like GE's are nearly extinct, as you can see from the following graph published by the Employee Benefit Research Institute (EBRI).

The terms "defined benefit plan" and "defined contribution plan" can be confusing. A defined benefit plan, sometimes referred to as a pension, says, "Work for us for 30 years and we will pay for your retirement. Let us worry about where the money comes from to pay for it." A defined contribution plan, like an IRA or 401(k), says, "You can save for retirement and we will give you a tax break on those savings. You can use this money to help pay for retirement and the amount available to do that when you retire depends on your personal investment results."

401(k) plans were created during the Reagan administration and quickly began to replace defined benefit pensions. While it is tempting to imagine conspiracies at play to transfer the risk of retirement funding from corporations to employees, it appears that defined contribution plans were a random development that just happened to meet the interests of large companies that wanted to shed the burden of their employee pension plans. Pension plans weren't perfect, either – some became “mobbed up” and others simply made promises they couldn't keep. Several failed.

The notion that we are in a retirement-funding crisis is well documented. John Bogle, the storied founder and retired CEO of Vanguard Investments has referred to our retirement system as a “train wreck” waiting to happen. Labor economist, Teresa Ghilarducci, has testified many times before Congress on the nature of what she refers to as “Our Ridiculous Approach to Retirement.”

As Ghilarducci explains, we need to save 20 times our annual income (in some cases more) in financial assets to fund retirement. Retirement researcher, Wade Pfau, finds that in some cases employees will need to save upwards of 20% of their income throughout their career. These are staggering numbers for families trying to pay the mortgage and put a couple of kids through college. The results are seen in EBRI's Retirement Readiness Rating™ that "finds that nearly one-half (47.2 percent) of the oldest cohort (Early Baby Boomers) are simulated to be 'at risk' of not having sufficient retirement resources to pay for 'basic' retirement expenditures and uninsured health care costs."

Families need to earn enough over a 35-year career not only to support themselves for those three and a half decades, but also to help fund perhaps three more decades in retirement. Most Americans will receive Social Security benefits, but they are meant to replace only about 30% of pre-retirement income.

The “train wreck” we face is the result primarily of four trends. First, life expectancy at birth has increased from 47.3 years in 1900 to 68 years in 1950 to 78.2 years in 2009. Because we essentially pay for retirement by the year (a three-year retirement is far cheaper than a 30-year retirement, right?), these extra years of life for the typical retiree dramatically increase the overall cost.

A second contributor has been the stagnation of middle class incomes over the past 30 years. At the same time we shifted the enormous burden of personally saving enough money to fund retirement from corporations to individuals, after-inflation incomes for all but the highest-paid of the middle class flat-lined, as shown in this chart from the Economic Policy Institute.

(Note: Some economists question this income stagnation. I'll let you do your own research and make your own assessment, but I am personally convinced that it is all too real.)

A third contributor to the train wreck is medical cost inflation. Medical services are, as you might expect, disproportionately used by the elderly and represent a substantial risk to retirement finances. As I mentioned above, retirees are living longer and people who live longer consume more medical services than those who don't. The following chart from Business Insider shows both the stagnation of income for many in the middle class alongside the tremendous increase in medical costs since 1980.

A final contributor to the train wreck of retirement finance has been under-saving by Baby Boomers. (Before you complain about Boomers, note that studies like the  EBRI's Retirement Readiness Rating™ referenced above indicate that Gen X'ers and subsequent cohorts are in even worse shape.) In addition to stagnant incomes and a huge savings burden, we Boomers didn't recognize the importance of the sea-change from company-provided pensions to 401(k) plans quickly enough. Those few of us who did save enough didn't do so because we foresaw the retirement funding problem. We saved in 401(k) plans because we had high incomes and the plans offered substantial tax savings.

Most Boomers, in my experience, reached age 60 with very little idea how their retirements would be funded, except for some vague notion that they had earned Social Security benefits.

Corporations stopped pooling retirement risk for us and left us to handle it on our own. This put a tremendous savings burden on the middle class. Costs went up dramatically while incomes remained flat, so there wasn't much left to save. We enjoyed longer lifespans so retirement costs even more. Most of us had no idea this was transpiring.

Train wreck.

This explains the roots of the retirement finance “train wreck”, or “Our Ridiculous Approach to Retirement”, but it doesn't explain the challenge of retirement planning. In essence, we have about thirty or so years of career that must not only pay for those thirty years of supporting a family but also generate enough additional wealth to fund perhaps thirty or more years of retirement.

Fortunately, we don't have to generate that entire retirement income while we are working because we can invest our retirement savings and hopefully watch them grow, taking advantage of the time value of money. A dollar earned today and invested might be worth $7 or $8 in thirty years. (Of course, halfway through our careers we have only 15 years of job earnings remaining, so a dollar saved then is worth only $2.80, and right before we retire a dollar saved is worth about a dollar.) If our investments are successful both while we are contributing to our 401(k) plans and after we retire, we can generate a lot of the income from earnings. We need only save an adequate nest egg.

Unfortunately, that's far easier said than done.