Reverse Mortgages are the Rodney Dangerfield of financial planning tools. Long thought of as things retirees used in last-ditch efforts to stay in their house, they were seen more as leaky lifeboats than as financial planning tools. They were badges for people soon to be broke.
I should confess that I shared that view. Based on reader mail, reverse mortgages were great examples of too-little-too-late. The vast majority of the people who wrote in asking about reverse mortgages really needed to rethink where they lived, not draw down what was usually their last asset.
But all that may be changing.
If a recent Journal of Financial Planning paper gets traction, the use of reverse mortgages will move from people who are desperate to practical people who have both home equity and some financial assets. This will happen for a totally unexpected reason. Retirees can use a reverse mortgage as a tool for increasing the probability they won’t outlive their assets while increasing their retirement spending. In other words, if reverse mortgages are used early, rather than late, they can be as important in the retirement planning toolbox as life annuities.
Barry H. Sacks, a San Francisco tax attorney and Stephen R. Sacks, a professor emeritus of economics at the University of Connecticut (and the brother of Barry Sacks) made this discovery by thinking differently about financing retirement. Rather than wait until all financial assets were exhausted and then taking out a reverse mortgage, they asked how things would turn out if retirees took out a reverse mortgage first or early. This would allow them to use withdrawals from the reverse mortgage to delay or reduce withdrawals from financial assets.
None of this matters, they found, if the retirement income withdrawal rate was set at an initial 4 percent, with the amount adjusted upward for inflation in each succeeding year. In that case, there was a 90 percent chance that investment money alone would last through 30 years of retirement. Things change, however, when you up the withdrawal rate, as many retirees need to do. When the withdrawal rate is increased they found that using a reverse mortgage increased the odds of remaining solvent throughout life.
Taking a 6 percent withdrawal rate and using a reverse mortgage first or early, for instance, provided an 80 percent probability of “cash flow survival” for 30 years while using a reverse mortgage last provided only a 50 percent probability of cash flow survival. Similarly, taking a 6.5 percent withdrawal rate and using a reverse mortgage first or early provided a 70 percent probability of cash flow survival for 30 years while using a reverse mortgage last provided only a 40 percent probability of cash flow survival.
Surprisingly, this enormous increase in retirement income seldom comes that the expense of net estate value. In a majority of cases they found net worth at the end of 30 years (remaining home equity and remaining retirement assets value) was greater as often as three-fourths of the time. In other words, you can eat cake and still pass some on to your kids or favorite charity, too.
Curious about how this can be? Well, I think there is an explanation. Just as John Ameriks and others found a decade ago that converting a portion of your retirement assets into a life annuity could increase the probability of portfolio survival, using a reverse mortgage early in retirement works to reduce the impact of bad markets in the early years of retirement— what some call “the sequence of returns problem.” Just as the high cash flow from a life annuity can work to reduce portfolio withdrawals early in retirement, a reverse mortgage— taken early— does the same thing.
Sadly, both Wells Fargo and Bank of America decided to withdraw from the reverse mortgage market last year and they accounted for 43 percent of all reverse mortgages written. They withdrew because some reverse mortgage customers liked the lack of mortgage payments so much that they also failed to pay the home insurance and real estate tax bills. This left the banks exposed and vulnerable on one hand, but faced with a nasty PR problem— foreclosing on ancient homeowners— on the other.
If the mortgages had been given early to people with other assets rather than late to people with no other assets, the big banks might never have left the market.