A Reverse-Mortgage Strategy to Complement Your Buckets

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Some new research suggests that retirees can be even more successful if they add a new type of reverse mortgage to their toolkits. Joining me to discuss this research is John Salter. He's assistant professor of financial planning at Texas Tech University.

John, thank you so much for being here.

John Salter: Thank you for having me.

Benz: John, your approach here, the one that you outlined with your co-authors, it begins with discussion of the bucketing strategy, and I know a lot of our Morningstar.com users have embraced bucketing when managing their retirement portfolios. And in its most simple form bucketing simply means that you set aside some cash to cover your near-term income needs, maybe two years or so. Then you have a separate long-term bucket for your more volatile asset classes your stocks and bonds. Your research, what you outlined in this paper, argues that maybe retirees should think about adding a third bucket that consists of this reverse mortgage product. Let's talk about how this whole thing works.

Salter: Sure. So, the idea came from sitting back thinking that the amount of cash that we hold also holds an opportunity cost, meaning if you take a two-year strategy--I'm going to hold two years' worth of my living needs in cash--that’s a fairly sizeable chunk of a portfolio that's not invested. So, we thought to ourselves is there a way that we can decrease that opportunity cost and allow more money to be invested to meet future goals.

On the other side, we know we keep the cash in order to not have to sell the portfolio during bear markets. They kind of work with each other, but is there a way to decrease the cash that we hold and get that same benefit from the bucket strategy. So we introduced the reverse mortgage in order to limit the amount of cash that we hold, and should we need to refill the cash when it runs out, we can borrow from the reverse mortgage.

Benz: So, are you taking cash lower than that two years' worth that you had run with as a baseline in the past?

Salter: We did. So we started, Harold Evensky, my co-author, kind of started this two-bucket strategy actually a while back, and at the time with the analysis two years made the most sense. We actually went down in our current analysis to six months; so it was a substantial decrease in the amount of cash being held.

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Benz: So you've got this six months' worth of cash reserves, you've got your longer-term portfolio, and then you're also adding in this reverse mortgage. And it's not just any old reverse mortgage, it's a specific type called the HECM Saver. Let's talk about why you think that reverse mortgage product is relatively appealing? Let's start with the costs of setting something like that up.

Salter: Absolutely, and the cost is really the attractive part of the Saver, and one other part to note is we do talk about the Federal Housing Authority-insured reverse mortgage. And what that insurance allows is for that loan to be nonrecourse meaning the house will never be underwater. The loan value will never exceed the home value to the homeowner. So there is insurance that's paid to cover, should that home become underwater with the mortgage.

So the upfront cost really is what changed with the Saver product. The big change is actually from the FHA upfront insurance. So what we've known in the past is a very expensive reverse mortgage option--it is now known as a standard reverse mortgage--and there was around a 2% fee that also went to FHA to help insure that possibility of being underwater. They have decreased that to I believe 0.2%; that’s very low now, but on the other side they've limited how much you can access. So, you can't borrow as much in terms of say line of credit or cashing out or you can also basically annuitize your home value. With the Saver product you don't get as much out of it, but you pay a less upfront.

Again, for our strategy, and we'll talk about it a little bit, we hope to never use it. So we don't want to pay a lot upfront. We're thinking risk management. In terms of what's called tenure payments and annuitizing the equity, you might not care as much upfront how much it costs because you can get more money over the long term. And you can also roll these costs into the product moving forward.

Benz: John, let's talk about the costs associated with this HECM Saver product in terms of the origination fees, and then in terms of ongoing borrowing costs, if in fact you end up tapping one of these reverse mortgages. What are they?

Salter: Sure. The origination charge, or the upfront costs, they do vary by region, so check that your local areas have a lot of the same costs as a forward mortgage in terms of getting a house appraised, title insurance, all that good stuff. Much like forward mortgages, too, there might be an origination charge that goes to the lender for servicing the product, and at least in the past there have been options where you pay a low or no origination charge, pay a little bit more on an ongoing basis. So, it's cheaper upfront, more expensive if you borrow; and you can do the opposite, pay more upfront, pay less when you borrow.

In terms of our analysis, we use 1.75% of the home value as the setup cost. We arrived at that number by just talking with our contacts in the reverse mortgage industry and coming to a consensus that, that was about the right, say, average across the U.S.

Benz: So, the interest rates are variable, correct?

Salter: Yes, very import to note. The ongoing interest rate for a line of credit is variable. There are fixed rates that you have to basically take the cash out and you can have a fixed rate ongoing. The ongoing cost for what we use, as the line of credit in the reverse mortgage consists of an insurance premium that goes to FHA; that is 1.25% of the ongoing balance. There is what's called the lender margin, which is similar to the origination charge; that goes to the lender. And add those two things plus the one-month LIBOR rate and that arrives at the total borrowing cost. And it's variable because of the one-month LIBOR rate. The other two were fixed.

Benz: So, John, you and your coauthors ran a number of different scenarios looking at the success rate of this strategy, and what you found is that actually investors who employed this reverse mortgage had a better probability of having their retirement assets last throughout their 30-year time horizon. What was the general finding in terms of the success rate of this strategy?

Salter: So, it was actually quite successful, honestly to my surprise going into it. I would say that for one of the scenarios, say a retiree who is 62 years old with $500,000 house that had a $250,000 home value, the success rate say at year 30--a typical planning horizon--was about 25% to 30% higher than just the cash flow reserve strategy. And, how do I explain that, there are two pieces to it. Number one, we didn't sell assets at depreciated values. We allowed them to recover. And not in all simulations; they may not have recovered. But there definitely was an average benefit across the 1,000 simulations. The second is this idea of lower return in terms of moving forward, but a high volatility. It really hurts.

So, we assume that stocks and bonds will be just as volatile as they were in the past, but not have as high of a return, so when they hit a bump, it takes a lot longer to recover. But I think those two things really contribute to that 30%, whereas if we ran this using historical returns, not projected, we wouldn't see that 30% benefit. We do see a benefit, say around 10%, I believe, when we did run the simulation using historical returns, as well.

Benz: So, John, would you say this is kind of a one-size-fits-all strategy, or are there retirees for whom a strategy like this would tend to be the most appropriate? Is there sort of a profile you can create that would line up in favor of employing one of these HECM saver mortgages on the side of your retirement portfolio?

Salter: Yes, there are. There are some considerations for sure like anything else. So, definitely as I mentioned, it's tool in the toolbox. This is a tool, and you have to fit it to where the right situation exists. So, first there is age restriction of 62, and the youngest borrower on the title has to be 62. So, say Spouse 1 in a couple is 62 and Spouse 2 is 55. They're not eligible if they both want to be on the title and leaving one off the title opens up some problems that probably, you don't want to get into.

We say it's better to have little or no mortgage going into it, and the reason being you have to pay that off. You cannot have a traditional forward mortgage as recalled and a reverse mortgage at the same time. So if someone had mortgage worth half their property value, probably it'd be a situation I'm not sure how much sense it makes. Our research assumed a home owned free and clear. So, I can't speculate with any certainty that it'd be worthwhile taking from a portfolio to pay off a loan in order to get the reverse mortgage to do the strategy. So, I think for that matter, someone with the little to no existing mortgage would fit.

The other thing--and I kind of just added a new term in my list of risks during retirement--in the reverse mortgage industry it’s known as mobility risk, meaning that even in this strategy, we don't expect to use it. But there'll be times, the recession would be a good example of that, when probably I would have used the strategy during the recession. And there'll be times when you could carry a balance for long periods of time, a year or maybe two; it just depends what the market does. What happens in the middle of that is if you need to move into say an assisted living nursing home upon the sale of the house or moving from more than one year that loan becomes due? And so that's just another thing to keep in mind.

Benz: So, if you might have to move, you probably wouldn't want to engage in such a product or such a strategy?

Salter: Well, that's a good point, too. Even if you're planning to move in five years, I'm not sure that it's worth spending 1.75% of your home value to do this over five years. This is a risk management idea, my co-author, Harold Evensky would say, we pay for home insurance in case our homes burns down not hoping it will, and we're not mad that we paid the money and it didn't burn. So, the shorter time, five to 10 years, that’s kind of maybe a personal preference. You might feel some security for it, and you're not worried about paying a couple of thousand dollars to have that security.

Benz: Well, John, thank you so much for sharing this strategy. It's a complicated one. There are lots of different facets to consider, but we appreciate you sharing it with us.

Salter: Absolutely, thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.