Trump, Monte Carlo and Insectivores

Some brilliant minds recently assured us that Donald Trump would lose the presidential election and probably lose it bigly. Nate Silver, the High Priest of Election Models and founder of the FiveThirtyEight blog, won the distinction of being the least wrong in predicting the outcome. Although he continually warned us that he might be wrong, his clear implication was that Hillary would win (see Donald Trump's Six Stages of Doom linked below if you question that). Others seemed to feel nearly certain.

In theory, no outcome was completely missing from the predictions, but many were given extremely low probabilities. There was even a possibility that Evan McMullin would win, just not a very big one. (See How Evan McMullin Could Win Utah And The Presidency, linked below.)

Wired magazine ran a story, obviously before the election, entitled, “2016’s Election Data Hero Isn’t Nate Silver. It’s Sam Wang.” To quote Wang, a professor of neuroscience at Princeton and now-famous insectivore who writes the Princeton Election Consortium blog, “It is totally over. If Trump wins more than 240 electoral votes, I will eat a bug.”

Crunch. Crunch.

(The more precise term may be entomophage.)

Nate Cohn at The Upshot needs to eat a bug or two himself, as do the election markets. They all predicted much higher probabilities of a Clinton win than did Silver. I'm not sure there are enough bugs to go around.

These are a lot of high-powered minds with deep understandings of statistics and modeling but they were all – to quote The Donald – Wrong!

How could that happen and what does it have to do with retirement planning?

Predicting election results is social science. Models using Monte Carlo simulation are good at predicting outcomes for physical science in which objects tend to behave in predictable ways under the same conditions. People are not so predictable.

There is an entire social science discipline, called behavioral economics, whose sole purpose is to explain the unpredictable and irrational economic behavior of humans. This unpredictability is a primary reason why statistical modeling won't be as predictive in social science fields as it is in physical science. (see The Marketplace of Perceptions, linked below.)

Monte Carlo simulation was created by physicists. Enrico Fermi used Monte Carlo techniques in the calculation of neutron diffusion in the 1930s. Atoms tend to behave in the same probabilistic ways under the same conditions regardless of emotions, doubts, fears, and biases. People don't.

Silver, Wang, Cohn and the gang have to build a lot of judgments and assumptions into an election model and in 2016 many of these were obviously erroneous. As the exit polls come in, you will hear each expert explain why he was wrong or that he was actually right but we didn't interpret his results correctly. (Like Cohn's Putting the Polling Miss of the 2016 Election in Perspective, link below.)

In other words, we had a lot of confidence in the models and that was a big mistake on our part.

OK, poll aggregators, I can accept my responsibility here and promise to never put much stock in your predictions from now on – my bad. I actually drew comfort from the fact that so many models suggested the same result (a Clinton win) but apparently there was a strong correlation between models that I overlooked. Apparently “herding”, the tendency of polling firms to produce results that closely match one another, especially toward the end of a campaign, is a problem not only with pollsters but among poll aggregators, as well.

Physics models can be more accurately defined than social system models and can use better-defined input data.

The radioactive decay rate of ₂₃₉Plutonium is pretty consistent. “With a half-life of 24,100 years, about 11.5×10¹² of its atoms decay each second by emitting a 5.157 MeV alpha particle.” Monte Carlo simulation models of decay can predict outcomes pretty accurately.

Compare that with “We have a poll from the L.A. Times, but our judgment is that it is skewed a point and a half toward the conservative candidate most of the time so we give it a rating of B+ and weight its contribution a little lower.” You get both an imprecise measurement and a judgment of its quality.

A few weeks later, the L.A. Times poll will show a different result, but ₂₃₉Plutonium will still be decaying at precisely the same rate. Plugging more accurate and consistent inputs into a statistical model provides more predictive calculations.

Then there is the “one-time event” problem. If Silver was correct and Trump had a one-in-four chance of winning (it was probably much greater than that) then if the election were held one hundred times under identical conditions, Trump would win 25 of them. But the 2016 election was a one-time event. Trump won 100% of the election and Hillary lost 100% of it. Your household's retirement is also a one-time event.

We frequently use Monte Carlo simulations for retirement research. I think that is a far better application than for individual retirement planning precisely because research isn't trying to predict an outcome for a single household. It should be used much more carefully for the practice of retirement planning.

So, predicting the results of a one-time election event in a social system with imprecise and conflicting data sources turns out to be a very difficult thing to do and clearly far more difficult than many of us who believed in the modeling understood. In simplest terms, we are attempting to predict the future, or at least to characterize it fairly precisely, and you know what Yogi said about predictions – they're hard, especially about the future. Statistical models enable us to guess the future of social systems and be wrong with amazing accuracy.

There are so many variables, both known and unknown, so little high-quality clear data, and so much difficulty predicting human behavior that I suspect it's a fool's errand to try to predict a close national election. Someone pointed out that the models would have worked better if the electorate weren't so evenly split. That's probably true, but if the electorate weren't so equally split and the winner was more obvious, then why would we need the models?

A friend from my AOL days, Joe Dzikiewicz, made an interesting observation about the Electoral College (EC) and chaos theory. (So you don't spend the rest of your day wondering, it's pronounced “Ja-kev'-itz”). One attribute of chaotic systems is that a small change in initial conditions can result in dramatically different outcomes. If a small change either way in the popular vote can swing the Electoral College vote and greatly change the future path of world history, then the EC actually creates chaos, or "unpredictability." The outcomes may simply be unpredictable by statistical inference models under the initial condition that the electorate is closely divided. As I suggested in Retirement Income and Chaos Theory, the constant-dollar withdrawal assumption probably makes Monte Carlo retirement models chaotic, as well.

What does this have to do with retirement planning? Retirement planning is economics, a social science, not engineering. William Bernstein warned against using engineering techniques and historical data to develop retirement plans in a 2001 post at Efficient Frontiers entitled "Of Math and History" (link below):

And of course, if you’re a math whiz, then all of life’s problems can be solved by spinning proofs and running the numbers. Not a week goes by that I don’t get a spreadsheet from someone demonstrating how this allocation or that strategy led to great riches over the past five, twenty-five, or seventy years.

The trouble is, markets are not circuits, airfoils, or bridges—they do not react the same way each time to a given input. (To say nothing of the fact that inputs are never even nearly the same.) The market, though, does have a memory, albeit a highly defective kind, as we’ll see shortly. Its response to given circumstances tends to be modified by its most recent behavior. An investment strategy based solely on historical data is a prescription for disaster.

My philosophy of retirement planning is summed up beautifully in that last sentence.

The financial planning industry currently depends very heavily on Monte Carlo simulation for retirement planning. In fact, I have written that we often use Monte Carlo simulations instead of actual planning. Many of us try to show that the probability of failure is so low that we shouldn't worry about it (like Trump's odds of winning) and we give short shrift to actually planning for such a catastrophe as outliving our wealth, should it happen.

Assumptions and judgments can dramatically affect the results of retirement simulations. There may be a 95% probability that you won't outlive your wealth if you get good advice, but if you do you will be 100% up that famous creek. Precious few of the planners who use Monte Carlo simulation have Nate Silver's skills, but they make critical judgments and assumptions just the same.

Some of the retirement model assumptions are ridiculous, like assuming that retirees will keep spending the same amount until they go flat broke and the assumption that our limited availability of historical market returns data is adequate to predict the future with reasonable confidence. The election models struggle with assumptions about human behavior, but the typical retirement model is based on a particular human behavior that we all agree would be irrational.

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Yeah? Well, Hillary had a 95% chance of being elected President.

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Though the polls were clearly flawed in many ways, thousands were available on which to base a prediction of election results in 2016. For retirement planning, we have about 200 years of data representing about seven distinct 30-year periods of market returns. We use rolling periods, a technique that is statistically flawed, to create 170 or so rolling 30-year periods. That still isn't much data to predict the future. Such a limited amount of historical market returns data makes for some very large confidence intervals.

As I noted in The Whoosh! of Exponential Retirement, Moshe Milevsky assures us that we can be 95% certain that a shortfall probability of 15% actually lies somewhere between 5% and 25%. Gordon Irlam showed us an example in which the optimal asset allocation has a huge 95^th-percentile confidence interval of 10% to 82% equities. That's not a lot of confidence.

If predicting the results of a presidential election is difficult, retirement planners try to predict the probability of a one-time social event (a client's retirement) with far less data.

My point is this. If you think an election not turning out as predicted is a poor outcome, imagine that the 95% probability of success your planner promised ends with spending your late retirement living off Social Security benefits alone. (Somebody has to fall into that 5%, who says it won't be you?) The tools that didn't predict the election are basically the same ones that planners use to predict retirement finances and those tools failed in the election with better data, a more rational model and entire teams of more highly-skilled statisticians running them.

I'm not suggesting that retirement simulations are worthless; they can provide valuable insights but they should occupy an appendix of a retirement plan and be viewed as one more interesting data point, not as complete plans.

We had confidence in the election models and that was a big mistake on our part. Let's not be overconfident about retirement forecasts.

The next time an advisor hands you a Monte Carlo simulation and says you have a 95% chance of funding your retirement, tell them, “Yeah? Well, Hillary had a 95% chance of being elected President.”

Then ask him if he's willing to eat a bug.

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REFERENCES

Donald Trump's Six Stages of Doom, Nate Silver, FiveThirtyEight blog.


2016’s Election Data Hero Isn’t Nate Silver. It’s Sam Wang, Wired magazine.


Putting the Polling Miss of the 2016 Election in Perspective, Nate Cohn, The Upshot blog.


Princeton Election Consortium blog.


How Evan McMullin Could Win Utah And The Presidency, FiveThirtyEight blog.


The Marketplace of Perceptions, Harvard Magazine.
 

Of Math and History, William Bernstein, efficientfrontier.com.

Reverse Mortgages: When the Last Resort is the Best Resort

Recent research into reverse mortgages to fund retirement suggests that the conventional wisdom of spending home equity as a “last resort” after other savings are depleted should be rethought. On the contrary, I believe there are many retirement scenarios in which spending home equity as the last resort is the best resort.

The “don't wait” philosophy stems primarily from a paper written by Barry Sacks and Stephen Sacks in 2012 and the current unique circumstances for HECM reverse mortgages.

In a paper entitled, “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income (2012), Barry Sacks and Stephen Sacks write:

“A retiree whose primary source of retirement income is a securities portfolio and who also has substantial home equity must decide early in retirement whether to live within the safemax limit set by his or her portfolio . . . This decision is a fundamental component of overall retirement planning . . . The decision process also must take into account the degree of economic discipline required to live within the safemax limit.

If the retiree does conclude that he or she would, on balance, prefer to live beyond the safemax level and wants to remain in his or her home as long as possible, a reverse mortgage, including its substantial costs, is one tool to consider.”

The term “SAFEMAX” derives from the work of William Bengen and typically refers to a “safe withdrawal rate.” Historically argued to be around 4% to 4.5%, more recent work by Wade Pfau suggests that in the current low-interest rate environment the “safe” rate may be closer to 3%.

Sacks (2012) actually makes a fairly modest claim compared to the explanations subsequently provided in the media that spending as a last resort might be unwise. They state that the strategy isn't for everyone. The authors note that “particularly in the range of initial withdrawal rates between 5 percent and 6.5 percent, we have found substantially greater cash flow survival probabilities when the reverse mortgage credit line is used in either of two active strategies rather than in the conventional, passive, strategy as a last resort.”

In other words, for retirees willing to risk spending more (about 5% to 6.5% instead of 3% to 4%) from a volatile portfolio than planners have conventionally considered safe, using home equity to leverage an investment portfolio might provide better outcomes. That's a far cry from claiming that the conventional wisdom of spending home equity as a last resort is wrong, as subsequent reviews of the paper may have suggested.

Wade Pfau concluded in his 2016 book, Reverse Mortgages, that a simple strategy of opening a HECM reverse mortgage early in retirement and not using the line of credit until late in retirement outperformed both of the currently-proposed “coordinated strategies” and the use of tenure payments.

"Of the six strategies that use home equity," Pfau reports, "the strategy supporting the smallest increase in success is the conventional wisdom of using home equity as a last resort and only initiating the reverse mortgage when it is first needed . . . Meanwhile, the "use home equity last" strategy provides the highest increase in success rates."

(Note that Pfau compares two “Last Resort”strategies. The first spends as a last resort but waits to open the reverse mortgage until it is needed. That strategy performs worst, but opening the reverse mortgage early in retirement and letting the line of credit grow before spending as a last resort after savings are depleted performs best. Pfau refers to the latter as “using equity last.” Pfau further notes that if your goal were to create the greatest legacy and not to maximize the probability of successfully funding retirement, tenure payments provided the best strategy most often.)

The current unique circumstances for the HECM are the increased loan limit of $625,500 and present historically-low interest rates. When combined, these two factors could allow a borrower to create a very large line of credit, perhaps greater than the home's fair market value over a long retirement. As Jim Veale recently explained in a comment, the maximum HECM loan amount was increased from $417,000 to $625,500 as part of the American Recovery and Reinvestment Act of 2009. Many believed the increase would be temporary but it has thus far survived.

Regardless, there are many conceivable retirement scenarios in which spending home equity as a last resort, as the conventional wisdom holds, would be advantageous, given that opening the line of credit early is a clear benefit with any strategy.

Avoiding risk to home ownership when it may never become necessary

Some retirees want to pass their home debt-free to heirs. They probably should not borrow a reverse mortgage. Some don't plan to keep the home in their estate and won't mind risking ownership. Still others would like to leave their homes to heirs but realize they might not be able to pay for retirement without using home equity. By spending home equity as a last resort instead of committing it early in retirement, the latter group might find that they never need to risk their home or that they can at least minimize the amount of equity they do need to spend.

Think of it as matching home equity to contingent late-retirement liabilities.

Not encouraging overspending

Imagine a couple that divorces late in life after spending a lot of their home equity. Neither wants to continue living in the home. Perhaps neither can afford to continue living in the home, given their new financial situations. Their best financial alternative may be to sell the home, in which case their HECM will have to be repaid. Although they had planned to age in the home, they find themselves leaving the home and without much remaining home equity to pay for new housing.

I was recently asked to explain how this couple would have been better off by not borrowing the HECM. The answer is that the HECM may have encouraged them to spend more than was safe early in retirement, leaving them with little financial reserve in a crisis.

Giving the household more time to see how retirement will unfold before committing resources

Committing to an early-spending reverse mortgage strategy (matching home equity to early-retirement liabilities) involves betting that the household will remain in the home and age in place. It is a bet against divorce and the early death of a spouse. It is a bet that you will feel the same about your home in 10 to 15 years that you do at the beginning of retirement. It is a bet that your home will accommodate future infirmities.

As Shelly Giordano's book on reverse mortgage suggests, waiting a decade or so before committing to spending your home equity provides more time to see how your retirement will unfold.

Holding a reserve for spending shocks

As I explained in Why Retirees Go Broke, the reason is usually a positive feedback loop of financial setbacks stemming from spending shocks, not from sequence of returns risk or poor investment results. Health care costs are an obvious risk, but there are many potential spending shocks that could leave a HECM borrower unable to afford their home going forward. In those instances, the HECM will need to be repaid leaving the borrower with little equity to help with housing costs.

Just in the past few weeks, I have heard the following stories of financial crises in which a HECM borrower would sorely miss home equity as a last resort after having used it to increase early-retirement consumption:

• A wealthy corporate executive was driven into bankruptcy by his wife's Alzheimer's disease.
• A woman's home is being taken by the state using eminent domain to build a highway through the property.
• An elderly HECM borrower ran out of money and asked her loan originator to “send more.”
• A couple needed to move his father into their home as his dementia progressed.

These crises might also occur after you spend your savings and begin spending home equity as a last resort, of course. In that event, you simply ran out of money and neither spending strategy was likely to save you. The danger is in finding the opportunity for additional consumption early in retirement too attractive and experiencing a more critical need for the reserves later in retirement.

Controlling balance sheet leverage

Leverage is risk and like any financial risk can be beneficial if appropriately exploited and dangerous if it is not. Any balance sheet that includes debt is leveraged and anyone who simultaneously holds a mortgage, conventional or reverse, and an investment portfolio has leveraged those investments. Understanding this leverage risk is important and maintaining a prudent amount of leverage is critical. (Michael Kitces explained it well here.)

Retirees who spend home equity as a last resort after depleting their portfolio will not simultaneously hold reverse mortgage debt and an investment portfolio – they will hold them sequentially. That doesn't mean they won't have leverage from other debts, or that the amount of leverage created by the reverse mortgage will be imprudent. That depends on the rest of the balance sheet. But, it does provide an opportunity to manage that leverage.

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When spending home equity as a last resort is the best resort.

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There are a number of advantages to spending home equity late in retirement. Retirees who don't live a long time may find that by waiting to use home equity they never need to risk their home to fund retirement. Delaying may enable the retiree to better observe how her retirement financial situation will unfold before committing to spending home equity. Some retirees will find a more critical need later in retirement than additional consumption early in retirement. Borrowing later may help control balance sheet leverage.

On the other hand, the argument that spending home equity early in retirement beats conventional wisdom isn't particularly compelling. Sacks (2012) argues only that it might provide better outcomes for retirees willing to commit home equity early and to spend more than most planners would consider safe. Pfau's analysis showed that the best outcomes were the result of simply opening a HECM line of credit early in retirement and waiting to spend it until after the savings portfolio is depleted.

If you expect to remain in your home throughout retirement, my advice is to consider opening a HECM line of credit today, while interest rates are low and the maximum HECM loan value is high, but to hold off on spending much of it until you see what life has in store. Often when spending home equity, the last resort will prove the best.

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Your retirement planner says you have a 95% chance of funding retirement successfully? Find out what that means in my next post, Trump, Monte Carlo and Insectivores.

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REFERENCES

Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, B. Sacks and S. Sacks, Journal of Financial Planning, 2012.

Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement, Wade Pfau, 2016. Available on Amazon.

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.

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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.

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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.

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REFERENCES

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.

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.

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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.

The HECM for Purchase Program Simplifies Home Buying for Retirees

Jim Dean is a HECM loan originator who contributed a great deal to my first two posts on reverse mortgages. I asked Jim to pen the following guest post to explain the HECM for Purchase Program. In a previous post, I recommended a brief one-page overview of HECM for Purchase at Dr. Jack Guttentag's website (link below). Jim delves much deeper into the program.

"H4P", as Jim sometimes refers to it, is a program that can help retirees solve some of the problems of buying a home by using home equity when we no longer have work income to qualify for a conventional mortgage or refinance.

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Buying a house is an expensive proposition, even when interest rates, both on investments and on mortgages, are at or near to historic lows. Buyers generally have two options. If they have the liquid resources, they can pay cash for the house. But most home buyers do not have or choose not to deploy that much of their liquid resources. Instead, they leverage "other people's money" – they take out a mortgage and make monthly payments. Persons 62 years of age and older have a third option. They can purchase the home using a down payment and a HECM reverse mortgage.

Paying cash means that one foregoes the earnings that the liquid resources might otherwise have generated. Taking out a 30-year mortgage entails paying interest for the privilege of leveraging other people's money. The mandatory monthly mortgage payment also imposes a significant cash flow restraint during the lifetime of the mortgage since it is typically paid from income.

A house is not a liquid asset and its value is determined by market conditions at the time and place of sale. That value is largely out of the homeowner's control.

Determining the earnings the cash buyer might have received had she invested the cash instead of using it as a down payment is difficult, as one can only speculate what the earnings opportunities might be 10, 20 or more years from now. A very rough and conservative approximation would be the interest rate being paid on the 30 year Treasury bonds – 2.27% annually at the moment.

The interest payments on a 30-year mortgage are more easily quantified. A 30-year fixed rate mortgage at 3.5% for $240,000 (80% of the cost of a $300,000 house), if held to maturity, would entail payments totaling $387,973, of which $147,973 would be interest.

As I stated above, persons 62 years of age and older have a third option of purchasing the home using a down payment and a HECM reverse mortgage. The HECM requires a larger down payment than a regular mortgage, but the reverse mortgage does not require any payment of principal and interest while the home is the primary residence of at least one borrower. The larger down payment does result in more foregone earnings than a regular mortgage would, but less than an all-cash purchase would entail.

Interest accrues on borrowed funds but does not have to be paid until the home is no longer the primary residence of either spouse. The only required payment of the reverse mortgage is the equity upon departure from the home; hence, it need not impact cash flow during residence. Whether there is equity in the house at the ultimate sale depends on two factors: market value of the house and the mortgage balance.

If the house has appreciated in value at an average rate greater than the accruing interest and ongoing Mortgage Insurance Premium on the HECM, then the owner's equity is increasing; if not, it is decreasing. Although the market value is largely beyond the control of the homeowner (he or she can influence it somewhat by maintenance and renovations during occupancy), the ultimate debt level depends on how the borrower has managed the HECM. The FHA insurance makes the HECM a non-recourse loan, meaning that if the accrued debt exceeds the market value at the end of the loan, no other assets or persons are obligated to cover the shortfall.

The HECM for Purchase borrower has several decisions to make. The first is whether to select the fixed-rate or the adjustable-rate HECM. Reverse mortgages work differently than forward mortgages. In the forward world, a rising interest rate means a higher monthly payment obligation with an adjustable rate mortgage, but in the reverse mortgage world, higher interest rates mean a debt and unused Line of Credit that is rising more rapidly. Thus, the ending mortgage debt would be higher but the value of residual equity would still be determined by the ultimate market value of the house.

It is important that the prospective borrower understands how both the fixed-rate and the adjustable-rate HECM work.

The fixed-rate HECM is a closed-end loan, requiring disbursement of all available funds at closing. By analogy, it is similar to a home equity loan. The interest rate is fixed for the life of the loan, and will not change. Partial repayment at any time is acceptable, but would be similar to prepayment on a forward mortgage – prepayments reduce the ultimate amount of interest charged, but the funds cannot be re-drawn. Prepayments fall into a liquidity trap. In the home equity borrowing market, consumers have more often "voted with their feet" in favor of the adjustable rate HELOC.

In the present market, the fixed-rate HECM with an interest rate of 5.06% offers the borrower the largest net (after closing costs) amount. In addition, all HECMs are assessed an ongoing Mortgage Insurance Premium of 1.25% annually on the loan balance. So, the fixed-rate loan with no prepayments is negatively amortizing at an annual rate of 6.31%. If the house is located in a market that consistently sees housing appreciation greater than 6.31% per year, the homeowner's equity is increasing; otherwise, equity is decreasing.

The analog to the adjustable-rate HECM is the Home Equity Line of Credit (HELOC). Both are open-ended lines of credit, with the ability to repay the debt and later redraw the funds, thereby avoiding a liquidity trap (the HELOC only during the “Draw Period”, typically about 10 years; the HECM during the lifetime tenancy of at least one borrower).

Both fixed rate and adjustable rate HECMs charge an initial Mortgage Insurance Premium at closing. This premium is either 0.5% or 2.5% of the appraised value of the house and is distinct from the ongoing Mortgage Insurance Premium of 1.25% per year on the loan balance, which applies to all HECM loans.

The lower rate applies to draws of 60% or less of the eligible loan amount in the first year of the mortgage. Draws above 60% fall into the higher risk category and are charged the 2.5% rate. Since the only funds available on the closed-end, fixed rate HECM must be taken at closing, opting for a draw at or below the 60% threshold, while it reduces the premium by 2%, also substantially reduces the funds available to the mortgagor by 40%.

Since the balance of the funds is available on the adjustable rate HECM after a required 12-month delay, the HECM for Purchase mortgagor can reduce closing costs substantially if they so choose, albeit at the cost of increasing their down payment.

For example, a 62-year old buyer using either the fixed or the adjustable rate HECM to purchase a primary residence could borrow a maximum gross amount of $157,200 in today's interest rate environment. After financing the 2.5% premium and the various associated closing costs of the purchase, that borrower would have an approximate net amount to apply towards the $300,000 purchase price of $144,000, requiring a down payment of approximately $156,000.

The adjustable-rate borrower (but not the fixed-rate borrower) would have another option that would reduce the initial Mortgage Insurance Premium by $6000 (2% of the $300,000 value). They could opt to only borrow 60% of their eligible amount at closing, or $94,320. Then their down payment would be proportionally higher and closer to 71% of the purchase price. The remaining 40% borrowing limit of the HECM, $62,880, would go into their Line of Credit, and would be available 12 months after mortgage closing.

Finally, since the adjustable-rate HECM offers benefits from making optional payments, by enhancing liquidity through the increasing Line of Credit and by potential tax deduction of mortgage interest and mortgage insurance premiums, the borrower should consider which lender margin to request. In contrast to the refinance HECM, lender/broker credits for closing costs are not allowed on the HECM for Purchase but the lender's margin will influence how rapidly the debt and unused Line of Credit will rise. If the borrower expects to make optional payments, selecting a higher margin will maximize credit line growth and interest, thereby offering a higher itemized deduction. That deduction can be timed to coincide with periods of higher income when the deduction would be more valuable.

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REFERENCES

Dr. Jack Guttentag, the Mortgage Professor website, an overview of the  HECM for Purchase program.

Ten Strategies for Using a Reverse Mortgage to Help Fund Retirement

In my last post, The Mortgage is Dead; Long Live the (Reverse) Mortgage, I wrote about retirement researchers' renewed interest in an improved reverse mortgage product, the Home Equity Conversion Mortgage, or HECM. The post spawned a great conversation in the comments area that pointed out, among other things, just how complicated these products are. But, that complexity contributes to the HECM's versatility.

There is more than one way to use a HECM in retirement and there is more than one kind of HECM. HECMs can be fixed rate or variable rate and there are several ways the proceeds can be distributed. There is even a HECM program that makes it easier for seniors to buy a new home when they don't have adequate income to qualify for a conventional mortgage.

This post is a summary of strategies – not an exhaustive list, by the way – compiled from the books, research papers and blog posts referenced in the endnotes below, that retirees might use to incorporate a HECM into a retirement plan.

As I suggested in the series of posts beginning with A Model of Retirement Planning, Part 1, approaching a retirement plan from a strategic perspective has several advantages. In effect, strategic planning identifies and answers the larger problems first (What do I want to achieve? What do I want to protect? What do I want to leave to my heirs?) and only then considers the best tactics to achieve those objectives (Should I use a reverse mortgage, equities or an annuity?). Once you have identified your strategic goals, some of these HECM strategies might help you achieve them.

Refinance Strategy

Do you currently make a monthly mortgage payment to the bank and would prefer that they send you a check every month, instead? If this sounds like magic or the late-night rantings of Fred Thompson, it isn't. The difference is that a conventional mortgage is building the equity in your home while the reverse mortgage is essentially spending it. Retirees who want to pass their home without debt to heirs should go the conventional route, while those who are happier depleting some or all of the home's equity to pay bills will favor the reverse mortgage alternative.

Refinancing is probably the most common use of HECMs. A retiree can refinance an existing conventional mortgage with a HECM and exchange her monthly mortgage payments for monthly loan distribution checks to spend as she sees fit. This is a double win for a retiree who currently holds a conventional mortgage – consumption is increased by spending home equity while expenses are reduced by eliminating the conventional mortgage payments.

The downside of the reverse mortgage is that spending the equity will have an impact on heirs, though they will have the opportunity to pay off the HECM and keep the home by arranging their own mortgage if your estate cannot. This is the strategy discussed by reverse mortgage originator, Jim Dean, in the comments section following my previous post. It is also thoroughly covered in Shelley Giordano's book, What' the Deal with Reverse Mortgages? (available at Amazon, see link below).

Credit Line Growth Strategy

A unique feature of HECMs is that the line of credit automatically grows over time by roughly the loan's interest rate and it increases with the age of the younger borrower. The longer you wait to spend the proceeds after taking out the mortgage, the larger your line of credit will be when you do spend it. This feature can be used to increase borrowing by taking out the loan early in retirement and spending the money years later.

As retirement researcher, Wade Pfau points out in Incorporating Home Equity into a Retirement Income Strategy, “. . . opening the line of credit at the start of retirement and then delaying its use until the portfolio is depleted creates the most downside protection for the retirement income plan. This strategy allows the line of credit to grow longer, perhaps surpassing the home’s value before it is used, providing a bigger base to continue retirement spending after the portfolio is depleted.” This strategy can be combined with others to increase the amount that could be borrowed later in retirement, for example, to pay for long-term care.

Income Strategy of Last Resort

The most common use of home equity by retirees today is probably to support spending when resources run low at the end of retirement. This was the common wisdom prior to recent research. The new research, however, suggests that spending from the HECM early in retirement rather than as a last resort tends to lead to better outcomes. When the spending will occur later in retirement, the research suggests it’s better to lock in the HECM early and let the line of credit grow. This is especially true in today’s low-interest rate environment that will contribute to growth of the line of credit as rates rise. According to Pfau, “the strategy for using home equity as a last resort supports the smallest increase in success.”

Term and Tenure Strategy

Tenure payments are one of the options for HECMs. These are monthly payments issued to the borrower for as long as he or she lives in the home. They are similar to an annuity, except that annuities pay as long as the annuitants are still living.

Another major difference between tenure payments and an annuity is that the retiree may “leave money on the table” if she dies soon after purchasing an annuity. If that happens with a HECM, there will be no such loss because the borrower will simply have borrowed less of her home equity. With tenure payments, the borrowed amount may eventually exceed the value of the home, but the borrower will never need to repay more than the home's then-current value.

A paper by Gerald Wagner entitled, “The 6.0 Percent Rule”, explains the value of the term and tenure options of HECM loan disbursements in greater detail.

HECM for Home Purchase Strategy

After you retire, you may find it difficult to qualify for a loan no matter how high your credit score because you won't have adequate income. (Former Federal Reserve Chairman, Ben Bernanke, says he was once turned down when trying to refinance.) A HECM has less rigorous credit qualification because it is backed by the home that you already own and it might be the answer to your problem.

HECM for Home Purchase is an FHA program that allows seniors, age 62 or older, to purchase a new principal residence using loan proceeds from the reverse mortgage. The program was designed to allow seniors to purchase a new principal residence and obtain a reverse mortgage within a single transaction and avoid double closing costs. The program was also designed “to enable senior homeowners to relocate to other geographical areas to be closer to family members or downsize to homes that meet their physical needs.”

According to Jack Guttentag, author of the Mortgage Professor's website, “Prior to the HECM for Purchase program, the senior who wanted to purchase a house but could not afford to pay all-cash had to take out a forward mortgage to buy the house, then repay it by drawing on a reverse mortgage. Because the senior had to qualify for the forward mortgage in the same way as any other home purchaser, insufficient income or poor credit could bar the way. Furthermore, the senior who did qualify had to pay settlement costs on both the forward mortgage and the HECM. The new HECM for purchase program eliminates these problems.”

The Mortgage Professor website provides a nice overview of the HECM for Purchase program (link below) and the alternatives a retiree should consider.

Emergency Backup Strategy

A HECM can be established to act as an emergency fund. As described above in the Credit Line Growth Strategy, it might be wise to secure the mortgage early in retirement to allow the credit limit to grow over time.

Long-Term Care Strategy

Some retirees who find long-term care insurance unaffordable or flawed plan to tap home equity to pay for those potential expenses. A HECM line of credit is a good way to achieve this. Again, securing the mortgage in early retirement will maximize the amount of credit available when needed.

Divorce Settlement Strategy

Divorce can have a huge impact on retirement security and the incidence of elder divorce is growing. To show the broad range of retirement strategies afforded by reverse mortgages, consider this possible strategy for providing equal housing after divorce suggested by Giordano.

“For clients who qualify, a reverse mortgage can provide two options that may restore desirable housing to both spouses. By providing financing without a monthly debt obligation, each former spouse can enjoy equal housing without necessarily requiring portfolio distributions. Retirement security is enhanced for both without downgrading the living situation for either”, says Giordano.

A HECM might allow the couple to split the equity of the existing home, which one former spouse can then own, while providing funding for the second spouse to make a down payment on another home. The second spouse might also then combine that down payment with a HECM for Purchase mortgage, enabling both former spouses to own their homes without making mortgage payments. This may be a much better solution than liquidating the original home so the assets can be evenly split.

Social Security Bridge Strategy

Retirees are repeatedly told that they can mitigate longevity risk by delaying their Social Security benefits claiming age. Most households, though, claim Social Security benefits at earlier ages, probably because they need the benefits right away. (The most popular age to claim benefits is the earliest, 62.)

HECMs should be considered as a possible source of funding to help bridge the gap while you delay those benefits. Tom Davison provides a case study of this strategy at his Tools for Retirement Planning blog (link below).

Davison's case study assumes that the retiree plans to live in the home throughout retirement, so it is worth a note of caution here. For strategies that spend from a HECM early in retirement, like this one, the borrower will need to repay the loan if she decides to change housing later in retirement. Retirees who believe they might not stay in the current home throughout retirement need to perform further analysis before deciding on the strategy.

HECM Stock Purchase Strategy

One dangerous strategy, used so often that FINRA felt the need to warn against it (see Betting the Ranch, below), involves obtaining a line of credit secured by the investor's home to buy stocks. If you must buy stocks on margin – and I generally recommend that you don't – pledge the equities as security, not your home. If the market crashes you will go broke faster, but you will lose your stocks and not your home.

(Update: I asked FINRA if their Betting the Ranch warning applied equally to HECMs and conventional mortgages and they referred me to a newer warning entitled Avoiding a Reversal of Fortune (link below) that addresses the issues specific to HECMs. Short answer: it does.)

What To Do

Given the wealth of strategies, how should you integrate a HECM into your retirement plan? Very carefully.

Most every reverse mortgage expert with whom I spoke mentioned that careful planning is needed to integrate a reverse mortgage into a retirement plan. Giordano pointed out that spending proceeds early in retirement cuts off some later options. Davison noted that just because the Social Security Bridge strategy can improve benefits doesn't mean that using the Credit Line Growth strategy and spending later in retirement won't be even better for some households, so multiple strategies should be compared.

I have a couple of concerns. First, this product is very complex. After two months of research, I have not mastered the subject. Second, as Giordano explains in her book's Chapter 13, How Do I Discuss This With My Financial Adviser?, advisers may not recommend them for various reasons even if they are in your best interests. Many advisers don’t understand them. Other advisers are not allowed by their compliance officers to offer them.

Your options are to find an adviser who does understand them and is willing to recommend them if they are the best solution for you, or to invest a lot of time understanding them yourself. Given the potential benefits, I think either path is worth the effort.

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Ten strategies for using a reverse mortgage in retirement.

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The Federal Government offers two major programs to assist with funding retirement: Social Security and the Home Equity Conversion Mortgage. These are especially helpful for retirees who weren't able to accumulate large retirement accounts.

There are many ways to employ a reverse mortgage in a retirement plan. Given that so many households have most of their wealth tied up in home equity, it is becoming urgent that we find ways to spend that equity. The new and improved HECM offers several opportunities.

There are some risks, however. I'll cover those in my next post, The Risks of Reverse Mortgages.

Special thanks to Shelley Giordano, Jim Dean and Tom Davison for their help with this post!

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REFERENCES

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


Tom Davison's Tools for Retirement Planning website extensively covers reverse mortgages.


The Home Equity Conversion Mortgages for Seniors portal at the HUD website


The Mortgage Professor website post on the HECM for Purchase program


HECM for Purchase program at the HUD website


A Model of Retirement Planning, Part 1 describes a strategic approach to retirement planning


The Mortgage is Dead; Long Live the (Reverse) Mortgage, the first post of this series on reverse mortgages


Incorporating Home Equity into a Retirement Income Strategy, research by Wade Pfau.


“The 6.0 Percent Rule.” (downloads PDF) demonstrates the value of term and tenure payments.


Betting the Ranch: Risking Your Home to Buy Securities, FINRA warning regarding investors obtaining lines of credit secured by their homes for the specific purpose of investing in securities. Replaced by HECM-specific Avoiding a Reversal of Fortune.


Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, Sacks and Sacks (2012)


Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions, Salter, Pfeiffer, and Evensky (2012)


HECM Reverse Mortgages: Now or Last Resort?, Pfeiffer, Salter, and Evensky (2013)


AARP Reverse Mortgage Pamphlet (downloads PDF)


Why Ben Bernanke Can’t Refinance His Mortgage.


Gray divorce on the rise with longevity trend from InvestmentNews.com.


Reverse Mortgage Funds Social Security Delay, a case study by Tom Davison at the ToolsForRetirementPlanning.com blog.

The Mortgage is Dead; Long Live the (Reverse) Mortgage

The word "mortgage" comes from the Latin mort, meaning death, and "gage", roughly meaning a pledge to repay.

(I use these little tidbits to rationalize my choice to take four years of Latin in high school instead of learning a language I might actually use.)

So, a mortgage is the eventual "killing" of an obligation to repay something, usually referring to a home loan. Some families work hard to pay off their mortgage before retiring. Some of them should now consider applying for a different kind, a "reverse" mortgage.

The typical American family's home equity constitutes the bulk of its retirement wealth. (Home equity is the amount of money you would have left if you sold your home and paid off all mortgages.)

The Motley Fool reported in 2015 that the median net worth for Americans aged 65-69 was about $194,226 and that roughly 77% of that wealth was tied up in home equity. Most families can't afford to ignore more than three-quarters of their wealth as a potential source of retirement funding.

Fortunately, there are ways to turn that illiquid equity into a spendable asset.

One way is to sell your home and pay off the mortgage and then reduce housing costs. This only works, of course, if you can find a significantly cheaper place to live. Reducing housing costs could be accomplished by downsizing (buying a less expensive home), renting a less expensive property, moving in with relatives, or relocating to a less expensive area. The remaining capital from the sale, minus the substantial transaction costs, can then be invested or used to purchase an annuity to generate retirement income.

Finance writers love to say that "you can’t spend pieces of your home to pay bills.” But, a second way to increase retirement cash flow and consumption from home equity, the oft-maligned reverse mortgage, enables you to spend little pieces of your home indirectly.

Borrowing a reverse mortgage isn't exactly like spending home equity directly because you will have to pay closing costs to obtain the loan and you will have to pay interest on the loan. And, of course, you or your estate will have to repay that loan.

Your choice among selling and downsizing, taking out a reverse mortgage, and leaving your home equity untouched will depend primarily on whether you:

• Intend to sell your home at some point and live somewhere else (it may be better to sell and downsize when you're ready),
• Want to keep your present home for the rest of your life but are not concerned about leaving an unencumbered home to your heirs (consider a reverse mortgage), or
• Want to live in your present home for the rest of your life and then leave it unencumbered by debt to your heirs (just leave the equity untouched).

Note that you can leave the home to your heirs with the reverse mortgage option, but the loan will have to be paid from other estate resources or your heirs can arrange for a new mortgage – they can keep the home, but the reverse mortgage will have to be repaid.

Most reverse mortgages are offered through the Home Equity Conversion Mortgages (HECM) program administered by the Housing and Urban Development Department (HUD) and the Federal Housing Authority (FHA). A HECM reverse mortgage can be paid out in five different ways, according to HUD:

• Tenure- equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence. (Like a life annuity, but ends when the home is no longer occupied as opposed to annuitants no longer living.)
• Term- equal monthly payments for a fixed period of months.
• Line of Credit- unscheduled payments or in installments, at times and in an amount of your choosing until the line of credit is exhausted. (Useful as an emergency fund.)
• Modified Tenure- a combination of line of credit and Tenure.
• Modified Term- a combination of line of credit and Term.

There are several unique advantages to a HECM reverse mortgage.

The main benefit of a HECM reverse mortgage is that it enables the retiree to spend home equity without selling or otherwise giving up title to their home.

There are no prepayment penalties. The lender charges interest but it doesn’t have to be paid until the mortgage is due. Fees, interest payments and the balance on your old mortgage can all be financed with the new loan if you are granted a large enough loan. In fact, one of the benefits of a reverse mortgage for borrowers with a relatively small balance on their original mortgage is that they will no longer have to make mortgage payments. They can begin to receive a monthly check, instead.

HECM reverse mortgages are non-recourse loans. That means the borrower will not owe more than the property's value when sold or at death. Technically, it means that the lender's only recourse for settling the loan is the home itself. A lender cannot demand repayment from your other assets.

There are downsides.

The reverse mortgage must be repaid when both spouses die or sell the home, or when both spouses move out of the home for a year or more. If you decide to sell your home or are forced by a financial setback to downsize, your mortgage will become due and payable. The non-recourse feature means the outstanding debt can’t exceed the sale proceeds from the house, but if you set up the HECM to make tenure payments, those payments will stop and you may find them difficult to replace.

Retirement researcher, Wade Pfau, notes in Incorporating Home Equity Into a Retirement Income Strategy, that high costs can be an issue. It’s worthwhile for potential borrowers to shop around. Typical closing costs, according to a number of sources including AARP, run from $2,000 to $4,000, but most costs can be financed by the loan, in other words these costs, like interest payments, can be added to the loan balance and will not be due until the loan itself is due.

The borrower is responsible for paying property taxes, insuring the home and maintaining it. Failure (or inability in a financial crisis) to do so is grounds for the lender to call the loan. Of course, that's also true of a conventional mortgage.

Some misunderstand that the borrower loses title to the home when she takes a reverse mortgage. The lender does place a lien against the property ensuring the reverse mortgage will be repaid when the home is sold, but home ownership does not change.

I have read of family issues raised by children who expected to inherit a home only to find that their parents had spent the equity and the home needed to be sold to repay the reverse mortgage, or the heirs needed to take out a new mortgage. This is more a family issue than a financial one. Having this family discussion early on should set proper expectations.

Lastly, a potential downside of HECM reverse mortgages is the maximum loan amount, currently $625,500. Retirees with more home equity than that might free up more by selling and downsizing.

Recent research has changed some opinions on reverse mortgages.

Although reverse mortgage have gotten bad press over the years, Pfau and others have a better opinion of HECMs as a result of research beginning in 2012 and program changes in 2013.  “I think it’s really important for advisors who may have done their due diligence about reverse mortgages 10 or 15 years ago to look at what all has changed starting in 2012 and to do their due diligence over,” Pfau recently stated at ThinkAdvisor.com.

Harold Evensky has said that the motivation for the reverse mortgage research at Texas Tech came about when home equity lines of credit (HELOC) kept getting canceled during the financial crisis in 2008. A HECM reverse mortgage, unlike a HELOC, is guaranteed to be available when you need it.

Bankrate.com provides a nice overview of how reverse mortgages work but a more detailed explanation can be found at Tom Davidson's Tools for Retirement Planning blog. Here's a simple example.

Let's say your home is valued at $700,000 and you owe $100,000 on your home's mortgage leaving you with $600,000 equity. You could borrow a $200,000 reverse mortgage and the lender would immediately pay off your $100,000 existing mortgage, leaving you $100,000 (less fees) to borrow. Your old mortgage payments go away.

You could annuitize the $100,000 with tenure payments, effectively replacing your monthly mortgage payments with a monthly check to spend for as long as you live in the home. You still own your home, though the lender will place a lien on the title. Your estate must repay the mortgage, but only the part that doesn’t exceed the home’s then-current market value. If the estate cannot cover the outstanding balance, your heirs may be able to arrange for a new mortgage if they want to keep the home.

Pfau also points out the advantages of applying for a reverse mortgage early in retirement and not spending the money right away. The HECM credit line grows over time. To quote Pfau from Forbes magazine, “Should the borrower live in the home long enough, the loan balance will likely grow to exceed the value of the home.”

Who might use a reverse mortgage? 

The latest research is usually adamant that reverse mortgages aren't for everyone. Every article you read about these products states that, but very few tell you who they are for:

• You must be at least 62 years of age.
• You will need to have paid off your mortgage, or nearly so, or have adequate additional liquid assets available to pay off existing liens since the first thing you must do with a reverse mortgage is to pay off your existing mortgage.
• You must be willing to hold a mortgage on your home – perhaps not attractive to people who once worked hard to become mortgage-free.
• You must be able to pay property taxes, keep up with homeowners insurance, and pay for regular maintenance on the home.
• You should want to age in-place in your current home. You can change your mind later, but when you sell your home you will need to repay the reverse mortgage.
• You must accept the risk that your estate won't have adequate resources to pay off the reverse mortgage without selling your home.
• The home must be at least one spouse's principal residence.

Reverse mortgages are extremely complicated and the expenses can be substantial. If you think this might be an attractive alternative to consider, I recommend you find a good, unbiased financial planner to guide you and that you shop around for rates.

Furthermore, you need to fully understand what could happen to borrowers in the worst-case financial outcomes. A retired borrower with other financial pressures might need to sell the home earlier than planned. In that event, the HECM will become due and payable when they move out and they could see the reverse mortgage called at the worst possible time. Those lenient repayment terms might disappear when they're needed most. I'll post about that one day soon.

Lastly, some researchers have recently recommended using reverse mortgages to reduce sequence of returns risk and permit higher withdrawal rates. As I have previously hinted, I'm not on board with that concept, at least not yet. I'll post about that soon, too.

Reverse mortgages have gotten a bad rap, but recent research suggests that they are worth a second look. They're complicated, some uses are risky, and they’re not appropriate for every household. But bottom line, if a lot of your wealth is tied up in home equity, a reverse mortgage can help you increase retirement cash flow and consumption without selling your home.

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You worked really hard to pay off your mortgage before you retired. Want another one?

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Wade Pfau referenced several recent papers on this topic. If you're interested in the research, check out the following:

Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, Sacks and Sacks (2012)

Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions, Salter, Pfeiffer, and Evensky (2012)

HECM Reverse Mortgages: Now or Last Resort?, Pfeiffer, Salter, and Evensky (2013)

The 6% Rule, Wagner (2013)

AARP Reverse Mortgage Pamphlet (downloads PDF)