Does your financial plan include “retirement insurance”? I’m guessing you’ve never heard of such a thing, right? The term is sometimes used to refer to Social Security or insurance products that target retirees, but that’s not what I’m referring to here.
There is no insurance product called “retirement insurance”, but there is a strategy that can serve as a “retirement insurance” of sorts. When used prudently as part of a broader retirement plan, this strategy can significantly reduce the risk of draining your retirement assets faster than expected.
The financial tool I have in mind is called the home equity conversion mortgage, or HECM. The FHA-insured HECM is the most common reverse mortgage program in the United States today.
Contrary to popular belief, the HECM is not a product for broke and desperate people. I think it has received a bad rap in the past because of this popular perception. The reverse mortgage has changed for the better over the years. Today, it’s best used by seniors who are least reasonably financially stable and want to enhance their financial security.
I also want to make clear that I’m suggesting that a HECM reverse mortgage is insurance. It’s not. I’m using the term “retirement insurance” metaphorically to make the point that a HECM can help protect against financial risk in retirement.
Not a loan of “last resort”
Unfortunately, many people still think of a reverse mortgage as a loan of last resort only for broke and desperate people. In reality, such people often don’t qualify for a reverse mortgage.
A reverse mortgage can sometimes help a broke and desperate person, but it works far better as a safety net – not a lifeboat. Check out the following from an article over at Housing Wire:
“. . . we still have advisors out there who, without a shred of evidence, are telling retirees to use a reverse mortgage only as a last resort, even though academics have demonstrated over and over that’s the worst way to use it,” [Longevity View Associates Principal Shelley Giordano] said.
“When you use the HECM as a last resort, your cash flow and your portfolio have already been depleted,” Giordano said. “This is a pretty huge hole, so retirement income experts suggest the coordination of housing wealth with other assets throughout retirement in order to help protect against catastrophes.” (emphasis mine)
In other words, retirees in dire financial straits may already be beyond the help of a reverse mortgage. The reason why? You have to qualify for a reverse mortgage.
Prior to 2014, just about anybody could get a reverse mortgage. Unfortunately, that led to increased defaults due to nonpayment of property charges. To prevent and mitigate the growing default problem, FHA implemented new financial assessment guidelines that prevent borrowers with limited income and/or shaky credit from qualifying. Seniors at the point of “last resort” probably won’t even be able to get a HECM reverse mortgage.
The reverse mortgage is best used as a safety net
Again, the reverse mortgage is best used not as a last resort, but as a safety net (i.e., “retirement insurance”) to help protect and preserve assets throughout retirement. Wade Pfau, a prominent retirement researcher and thought-leader in the reverse mortgage space, wrote:
[The reverse mortgage] must not be viewed in isolation, but rather as how it contributes to an overall plan. The value of the reverse mortgage can mostly be found in its diversifying benefits for investments in retirement. Taking distributions from investments can dig a hole that is hard to recover from, and wise use of the reverse mortgage protects the investment portfolio in retirement.
Again, a reverse mortgage is best used before the financial situation becomes desperate.
It’s essential to have multiple financial options
Life can throw any number of financial curveballs at you: bad stock market, medical bills, long-term care expenses, home repairs and maintenance, family members needing money, etc.
If you want your money to last at least as long as you do, it’s essential to have as many financial options as possible. The reverse mortgage strengthens your financial position by adding an additional cash source to the picture: home equity.
When you add more financial options, you can more easily protect and preserve the ones you already have. You’re in a better position to handle the unexpected.
Now, before we dig into how a reverse mortgage can strengthen your financial plan, let’s first cover a few basics about how a reverse mortgage works.
Reverse mortgage basics
The most popular reverse mortgage in America today is the home equity conversion mortgage, or HECM. The FHA-insured HECM enables seniors 62 or older to convert a portion of the equity in their homes into cash.
No mortgage payments are required as long as at least one borrower (or non-borrowing spouse) is living in the home and paying the required property charges.
You remain the owner of your home and you’re free to leave it to your heirs. Your heirs will inherit any equity remaining in the home.
The HECM is a non-recourse loan; the most that will ever have to be repaid is the value of the home. If the home isn’t worth enough to pay off the entire balance, the shortage will be paid off by FHA.
The HECM is a mortgage, so it has an interest rate like any other mortgage. Rates are typically comparable to traditional 30-year fixed mortgage rates.
If you choose not to make a mortgage payment (which is the point, right?), accrued interest is simply added to the loan balance over time.
Reverse mortgage borrowers commonly use the proceeds to eliminate mortgage or other debt payments, finance home improvements, or supplement existing retirement income or assets.
The reverse mortgage is very versatile; it can be fine-tuned to achieve your individual goals and needs. Proceeds can be received as term or tenure income, line of credit, lump sum, or some combination of all of these options.
The best option to serve as “retirement insurance” is the line of credit. When used prudently, the reverse mortgage line of credit can be a powerful financial tool that protects and preserves your retirement financial security.
Skeptical? No problem! Hang with me and I’ll prove it! 😉
The HECM as “retirement insurance”
To see how the reverse mortgage can protect and preserve your financial well-being in retirement, let’s check out a case study.
First, let’s assume it’s January 1, 2007 and two 65-year old bachelors named Larry and Harry have just retired.
I am setting this scenario in 2007 because I want to show you how the HECM line of credit can preserve retirement assets through a bad bear market. I will use real-world stock market data (courtesy of Yahoo! Finance) to prove my point.
Let’s also assume Larry and Harry have the exact same financial profile: they each own free and clear homes worth $300,000 and have non-taxable Roth IRAs worth $250,000.
On January 1, 2007, they both move 100% of their IRAs into VSCGX (note that this is not investment advice nor an endorsement of this fund), a conservative balanced fund trading at $16.73. With their $250,000, they are able to purchase 15,000 shares each.
Both men plan to supplement their Social Security income with $1,000/month from their retirement assets.
Before we dig into this further, let’s review our starting assumptions for both retirees:
- Age: 65
- Home value: $300,000
- Mortgage balance: $0
- Roth IRA: $250,000 invested in 15,000 shares of VSCGX
- Planned monthly asset withdrawal: $1000
Larry and Harry happen to both use the same accountant, who’s name is Joe. Joe is concerned that the stock market will go down in the next few years, so he recommends that both men set up a reverse mortgage line of credit to supplement their Social Security and Roth IRAs.
Harry agrees with Joe and immediately gets a reverse mortgage line of credit set up. His available credit starts off at $121,700 and has an annual growth rate of 5.87%.
Harry is also a little worried about the future prospects of the stock market, so he decides to leave his IRA untouched and take $1,000/month from the line of credit starting January 2007. He figures he’ll leave the IRA alone until the market outlook is better. He doesn’t want to be selling shares in a falling market because it means he could be at risk of draining his IRA too rapidly.
Larry, on the other hand, says “Bah! I don’t need no stinkin’ reverse mortgage! I’m not broke and desperate and I’m not going to let the bank steal my house!”.
Of course, Larry’s worries are 100% unfounded, but he can’t be convinced otherwise. He figures he’s got plenty of money, so he’ll live on his Social Security and the $1,000/month from his IRA regardless of what the stock market does.
Fast forward to the present
Let’s fast forward to the present and see how Larry and Harry end up.
Larry chose not to get a reverse mortgage back in 2007. He figured he would ride out the stock market come hell or high water. He has faithfully withdrawn $1000/month from his IRA every month since he retired – even through the terrible bear market years of 2008 and 2009. His IRA is now worth around $126,000. He’s burned through almost half the value of his portfolio in just 12 years! Yikes!
Even more alarming, Larry has only 6,315 shares left of the original 15,000 he had when he retired. He’s burned through almost 2/3 of his shares.
The share price of VSCGX dropped badly in 2008 and 2009, which forced Larry to sell more shares to maintain his $1,000/month income requirements. When he retired, he only needed to sell 60 shares to get $1,000. At the market bottom in 2009, he had to sell 80 shares for the same income.
Larry now has just a little more than 1/3 of his shares left, yet he could potentially live another 10 or 20 years.
Larry is in the very real danger of running out of money.
Harry, on the other hand, left his IRA untouched through the bear market in 2008 and 2009. It was painful to watch the IRA go down in value, but it recovered completely in early 2011. In February 2011, Harry decided to stop his withdrawals from the line of credit in favor of withdrawals from his Roth IRA. His IRA was performing well, so it made sense to live on that instead.
So, how do Larry and Harry stack up today? Which man had the better strategy? Well, I think the graph below provides the answer in stark terms.
As you can see, both men took a hit in 2008 and 2009. However, Harry’s portfolio (the top line) is in much better shape than Larry’s.
Larry’s portfolio took a beating in the recession and never recovered. It continues to dwindle fast despite the strong bull market we’ve enjoyed the last ten years.
Harry took a hit, too, but his total liquid assets have recovered nicely. Because he was able to pick and choose which assets to withdraw from based on market conditions, he was able to more effectively preserve his overall portfolio.
Even though Harry has consistently withdrawn $1,000/month ever since he retired, his total liquid assets are maintaining a constant balance of about $350,000.
Who has the more financially secure retirement?
Folks, who do you think has the more financially secure retirement? Harry or Larry? Which of these men is likely sleeping better at night? Which one is likely worrying about running out of money?
I think the answer is pretty obvious! Harry opted to use the HECM as a form of “retirement insurance” and I think the results speak for themselves.
Using the HECM like “retirement insurance” helps preserve your assets
Retirement can last potentially 20 or 30 years. It is essential that you have as many financial resources at your disposal as possible.
How many more times will you replace the roof on your house? Will you need to replace your car at some point? What if you get hit with medical bills? What if the stock market goes down? What will that do to your portfolio?
Again, the reverse mortgage is best used as part of a broader plan to protect and preserve your assets in retirement. It reduces financial pressure on your other retirement assets because it provides an additional cash source to cover unexpected expenses.
Additional resources
Robert Powell of TheStreet’s Retirement Daily recently sat down with Steve Resch, Vice President – Retirement Strategies at Finance of America, for an interview that covered a few different topics, but emphasized how a reverse mortgage can increase financial security in retirement. The interview is worth your time and can be found here.