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Today we have two guests on the podcast, Don Graves and Wade Pfau. Don Graves is the president and founder of the Housing Wealth Institute and an instructor of Retirement Income at The American College of Financial Services. He is considered one of the nation’s leading educators on incorporating housing wealth into retirement income planning. He is also the author of three books, Housing Wealth: An Advisor’s Guide to Reverse Mortgages, Housing Wealth Conversations, and The Retiree’s Guide to Housing Wealth. He graduated from the Fox School of Business at Temple University.
Wade Pfau is professor of retirement income in the Financial and Retirement Planning Program at the American College of Financial Services. He is also co-director of the American College Center for Retirement Income and Retirement Income Certified Professional program director at the American College. Pfau has written several books, including his most recent Retirement Planning Guidebook. He is a co-editor of the Journal of Personal Finance, and he publishes frequently in a wide variety of academic and practitioner research journals. Pfau holds a doctorate in economics and a master’s degree from Princeton University and Bachelor of Arts and Bachelor of Science degrees from the University of Iowa. He is also a chartered financial analyst.
Background
Don Graves: Bio
The American College of Financial Services
Books: Housing Wealth: 3 Ways the New Reverse Mortgage Is Changing Retirement Income Conversations
The Retiree’s Guide to Housing Wealth
Wade Pfau: Bio
Books: Retirement Planning Guidebook
Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement
Reverse Mortgages
Home Equity Conversion Mortgage (HECM): Definition, Eligibility
“Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income,” by Barry H. Sacks and Stephen R. Sacks, financialplanningorganization.org, February 2012.
“Using Reverse Mortgages in a Responsible Retirement Income Plan,” by Wade Pfau, retirementresearcher.com.
“The Decumulation Drawdown: How Spending Became the Big Dilemma in Retirement,” by Alessandra Malito, marketwatch.com, June 4, 2022.
“Jamie Hopkins: A Framework for Financial Freedom,” The Long View podcast, Morningstar.com, Dec. 2, 2022.
“Reverse Mortgage Net Principal Limit: Meaning, Pros and Cons,” by Julia Kagan, Investopedia.com, April 7, 2022.
“Understanding Why and How the HECM Line of Credit Grows,” by Wade Pfau, forbes.com, Jan. 7, 2021.
“Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions,” by John Salter, Shaun Pfeiffer, and Harold Evensky, financialplanningassociation.org, August 2012.
“Integrating Home Equity and Retirement Savings Through the “Rule of 30,’” by Peter Neuwirth, Barry Sacks, and Stephen Sacks, Journal of Financial Planning, October 2017.
“Wade Pfau: The Risk of Retirement Today,” The Long View podcast, Morningstar.com, Aug. 2, 2022.
“Unbundling Investments From Insurance to Solve for Lifetime Sequence-of-Return Risk,” by Wade Pfau, retireone.com, Jan. 12, 2022.
Transcript
Amy Arnott: Hi, and welcome to The Long View. I’m Amy Arnott, portfolio strategist for Morningstar.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Arnott: Don and Wade, welcome to The Long View.
Wade Pfau: Thank you.
Don Graves: Thank you so much.
Arnott: So, the first question is for Don. Before we get started, can you tell us a little bit about your career and how you first started learning about reverse mortgages?
Graves: About 25 years ago, I was the CEO of a nonprofit in Philadelphia called Habitat for Humanity. And my sister called me, my older sister, and she said, “Little brother, I’ve got something you should look at.” And she described it, and I told her, “Oh, no, you’re going to prison this time. You’re taking old people’s houses. I didn’t want anything to do with it.” And I asked her, “Why would you think I’d want to do something like that?” I didn’t know anything; I was like most people. And she said, “You love serving people. That’s part of your DNA. And this is a good way for you to support your three children who are of school age.” So that was kind of my entree. It took me a year after my sister talked about it. And I visited HUD’s Home Ownership Center in Philadelphia, spoke to Fannie Mae, spoke to three or five housing counselors, because I wanted to make sure that this is what it said. I wanted to see the fine print, the aha, the gotcha. And only after I did all of that could I look someone in the eye and say, this is an appropriate resource for the right person. So that was my entree into the world of reverse mortgages.
Benz: We want to delve into the products and the utility in the role of retirement planning. But Wade, maybe we need to cover some ground first just on the basics of reverse mortgages. And I’m hoping you can talk about the type of reverse mortgage called a home equity conversion mortgage, sometimes shorthanded as a HECM. Maybe you can give us some basic background about what a HECM is and how it works?
Pfau: So, the vast majority of reverse mortgages are HECMs. There are some proprietary reverse mortgages out there and generally they’re for homes that are more highly valued well beyond a million dollars. But the HECM program is usually what people have in mind with the reverse mortgage. It was created during the Reagan administration. It’s a federally administered program through Housing and Urban Development and the FHA, Federal Housing Authority. It’s a framework and system and set of standardized rules for how to allow individuals to tap into their home equity through the reverse mortgage so that there’s the borrowing capacity. They’re able to borrow, spend—it creates liquidity for the home effectively to be able to incorporate that into their retirement strategies. And it’s really the foundation for what people have in mind when we hear the term “reverse mortgage.”
Arnott: So, Don, we both have a copy of your book. It’s called Housing Wealth and it’s geared toward advisors. And you write that HECM mortgages have been controversial in the past. It sounds like it was an issue where there were a few unscrupulous advisors that were encouraging people to get these reverse mortgages and basically using that to have clients buy products that would earn them commissions. So, the NASD actually issued a decree that none of their advisors could even talk about reverse mortgages, but eventually FINRA ended up changing that position in October 2013. Can you talk about the reasons behind FINRA changing that position?
Graves: The history—when I started 25 years ago, the American Home Ownership Economic Opportunity Act of 2000 had a provision that if you use your proceeds from a reverse mortgage to purchase a qualified long-term-care plan, they would waive the initial mortgage insurance premium. Also at that time, if you went to the AARP website and you plugged in some information, they would give you some quotes, a reverse-mortgage lump sum, line of credit, monthly payment, and a fourth category, which happened to be a chassis based on John Hancock single-premium immediate annuity. So, at one point in time, reverse mortgages, the Congress was thinking, how do we strengthen retirement? Now the long-term care didn’t take too many glitches with that, but what happened was some advisors at that time would take the money and then purchase some sort of lump-sum product, and in the industry, we would say to them, be careful with that. As a matter of fact, don’t do that. Make sure there’s enough liquidity, don’t be greedy.
And what happened in Portland, Maine, and Seattle, Washington, two advisors independently took Mr. and Mrs. Flintstone’s lump sum, purchased a whole bunch of annuity products, which are not bad in and of themselves, but they had pretty old surrender terms. Well, after that, Barney, Frank, Claire, McCaskill, what was the NASD got involved and said, hey, this is inappropriate, and they shut it down. As NASD morphed into FINRA, I think, Wade, around 2011 MetLife Mature Market Institute, Dr. Sandra Timmermann, began to say, we need to look at this again. Housing wealth, reverse mortgages have an appropriate use, and that started the conversation again. And so, in 2013, FINRA’s official position, their written position where reverse mortgages should only be used as a last resort until Dr. Barry Sacks’ brother, Stephen Sacks, really challenged that, and they relented on some of that language. They removed the last resort language. Wade, you can add some to that if I missed something.
Pfau: No, I think you got it right. Unfortunately, FINRA still has a negative-sounding title for their report. They didn’t change the title. It’s still like reversal of fortune or something like that. But if you actually read the contents, they give warnings and things about make sure you understand how reverse mortgages work and so forth. But they took out some of that really restrictive language about this should only be used as a last resort. And Don, I agree—my understanding is effectively the research that Barry Sacks and Stephen Sacks had published in 2012, they took that to FINRA and were able to convince them that that sort of last-resort scenario really is the worst way to think about incorporating a reverse mortgage into a financial plan.
Benz: There have also been some regulatory changes. There was a series of regulatory changes in the mid-2010s. Can you talk about some of the key changes that were made from a regulatory standpoint?
Pfau: So, it seems like every few years the government decides to adjust some of the parameters of the program, always working to strengthen it for the long term. And so, in 2013, 2015, 2017, we saw a lot of changes. One was to create protections for eligible nonborrowing spouses. One of the rules of the HECM is you have to be at least 62 years old to be a borrower, and that created a potential conflict for couples where one person was over 62, the other was under 62. Before creating these nonborrowing spouse protections, that spouse was in jeopardy to have to settle the loan when the borrower left the home. But after these protections were established, eligible nonborrowing spouses—they’re not borrowers, so they can’t continue to draw funds from the line of credit, but they are protected to stay in the home as long as they meet the basic homeowner obligations for as long as they wish to stay in the home. So that was an important change.
Another big change was creating financial assessments and life expectancy set-asides. So, another concern with reverse mortgage—it’s always been this last resort idea where when people run out of options, the only thing left is maybe they can tap into their home equity through a reverse mortgage. That’s not how we really talk about that in the financial-planning context of building a responsible retirement income plan. But if you were using a reverse mortgage as a last resort, you might ultimately just be kicking the can down the road. And if you don’t have the resources to pay homeowners insurance, to pay property taxes, to do basic home maintenance, there was risk that eventually the home could be foreclosed upon. And so the financial assessments came into play to either say this individual looks like it’s not going to be sustainable or to create LESA, or life expectancy set-asides, where at the extreme, maybe the reverse mortgage is simply used as a way to continue to stay in that home because you’ll be able to use the resources of the reverse mortgage to pay those property taxes or to pay for the homeowners insurance, to do the basic home upkeep. And so that was an important change to help ensure people are able to stay in their homes. And then they’re always modifying the parameters to help protect the mortgage insurance fund and so forth to make sure that the reverse mortgages do stay sustainable over the long term.
Arnott: And as I understand, one of the regulatory changes that was made is there’s actually a requirement that people have to go through financial counseling before they take out a mortgage like this. Do you think that that kind of consumer education has been helpful?
Pfau: Absolutely. That’s been a rule for a long time. Don, I think that goes back even further, but I don’t actually know what year did financial counseling come into play?
Graves: It’s been around for pretty much as long as I’ve been around, 25 years.
Arnott: OK.
Graves: And so, it is very helpful because it takes the onus away from the lender or the financial advisor. And the purpose of it is to make sure that the client understands what’s going on. There’s no cognitive impairment. And they get a certificate from the United States Department of Housing and Urban Development saying they’ve completed HECM counseling and that they’ve met the requirements of understanding and things of that nature. So, it’s a wonderful safety feature.
Arnott: One criticism of using a HECM is that it can give retirees a lot more flexibility, but potentially at the cost of leaving their children or other heirs with less home equity to inherit. Would it be fair to say that reverse mortgages are less appropriate for people who really have a strong bequest motive who want to leave something behind for their children?
Graves: I would say not necessarily. And I’m going to ask Wade to chime in on this because a lot of his research says that if you use the reverse mortgage in a certain way, you have the opportunity to leave a greater bequest, a greater legacy, than if you hadn’t done it at all. And that’s what the research is bearing out. So I wouldn’t say if you’ve got a strong bequest motive, you should ignore this. You may want to lean into it. And my mom once said—my Kentucky sensibilities, Mama asked me, “When we go, would you rather have the apple tree or the orchard?” I said that, well, I’d rather have the orchard. And that’s what, again, Wade’s research says that if we leverage the house to offset portfolio draws during down markets and things of that nature, that there’s a distinct possibility and probability that we’ll leave more as a bequest motive than if we don’t. Wade, you can chime in on that.
Pfau: Let me chime in a little bit too, because there’s two scenarios to talk about with this. The media stories that say, oh, the reverse mortgage took away the child’s inheritance. That’s generally more the last-resort scenario where maybe the home was the only thing left. And in this case, the homeowners decided to use that home to help fund their own retirement, rather than to leave it for an inheritance. But at the end of the day, it’s their asset. And sometimes those media stories are written from the perspective of beneficiaries, rather than from the perspective of retirees.
But if we step away from the last-resort scenario that generally probably doesn’t apply to listeners and talk about the broader financial planning scenario, which is you’re going to coordinate your assets to most effectively meet your retirement goals. You need to meet retirement expenses. You may have an investment portfolio, Social Security, home equity. How do you coordinate that all together? Then at the end of the day, money is fungible, and you can potentially bequest more by strategically using a reverse mortgage. You think of legacy as what’s left in my investment portfolio plus the value of the home minus the loan balance due on the reverse mortgage. And with the sequence-of-returns risk in retirement and all the retirement income planning—what we talk about with retirement risks, longevity, sequence of returns, and so forth—strategically, drawing from the reverse mortgage to help reduce the risk for the investment portfolio can lay the foundation so that you get these synergies that the portfolio growth is greater than the cost of the reverse mortgage. And like Don was saying, then you’re able to leave a larger legacy at the end by strategically using the reverse mortgage. And we should add the reverse mortgage is nonrecourse. So, there’s never going to be a scenario where the loan balance due exceeds the value of the home. So, it creates a lot of opportunities to just be more strategic with home equity. It’s not necessarily and generally it’s not going to lower for a responsible retirement plan. It’s not going to lower the net legacy value of assets at the end.
Benz: Wade, I’m hoping you can follow up on the nonrecourse piece of it. That term is probably not familiar to a lot of people. Can you walk us through what that means from a practical standpoint? I think you just said it, but I’m wondering if you can amplify a little bit.
Pfau: Individuals with HECMs pay insurance premiums to the federal government and mortgage insurance fund for a number of different protections. And one of those is this idea of nonrecourse that if at the end the loan balance is greater than the value of the home, the homeowner is not on the hook, or the beneficiaries are not on the hook, to pay back more than 95% of the appraised value of the home at that time. And then the lender is made whole through the mortgage insurance fund, but it’s just a way so that if your home value stagnates and just for numbers, you have a $200,000 home and it just stagnated, but you borrowed from the reverse mortgage, you held it for a long time. The loan balance ends up being $250,000. Then you’re not on the hook for paying back more than the value of the home. And that’s the idea of nonrecourse. And that applies to home-equity conversion mortgages or HECMs, the main type of reverse mortgage in the United States.
Arnott: We wanted to get into some of the nuts and bolts of how these mortgages work. But maybe before we do that, can you talk about how much home equity the average person has and how does that compare with other retirement assets like IRAs and pensions, and so on?
Graves: A few years ago, the census—and Jamie Hopkins and Wade talked about this—and their research said that the average retiring couple has less than $100,000 saved, but they have a home that was in excess of $200,000. So, 68% of their total wealth was in their housing wealth. Earlier this year, that unmonetized senior home equity had surpassed $13 trillion. So, it’s a large part of the average baby boomers’ total wealth is their housing wealth.
Benz: In recent years, Wade, we’ve seen significant home appreciation in most areas around the country, but at the same time, interest rates are also significantly higher. So maybe you can talk about how rising rates affect reverse mortgages and how that interacts with home price appreciation. So, it seems like you’ve got a plus on one side, but a negative in the form of rising rates.
Pfau: Reverse mortgages are the one retirement income tool I’m aware of that actually benefit from a low interest-rate environment. And that’s just because you have a higher borrowing capacity when interest rates are lower. So as interest rates rise, it’s going to lower the borrowing capacity through the reverse mortgage. But that being said, we’re still not really in a scenario where interest rates are very high. And when I do now historical simulations using historical data with reverse mortgages, we’re nowhere near that point where interest rates are so high that there’s not value from a reverse mortgage. It’s really 1982 when well, reverse mortgages, HECMs didn’t exist in 1982. But when I look at the historical data and apply historical stock/bond returns, interest rates to today’s HECM rules, 1982, when we were talking about 15%, 16% interest rates, that was really the only time that you really see that, OK interest rates are too high at this point. But yeah, it is the case that when interest rates increase, you do reduce the initial borrowing capacity through the reverse mortgage.
Graves: And Wade, let me jump in with that. That’s one thing that happens. But also, because the line of credit, the growth rate on the reverse mortgage is based off of the prevailing interest rate. Whereas at the beginning of covid, maybe the line of credit interest on the reverse mortgages growing at 3%, 4%. Now it’s 6, 7, 8% in some cases. And so, depending on what the borrower and the investor is seeking to do, reactive or proactive, actually having a higher interest rate, lower starting benefit, but it grows significantly faster because of today’s prevailing interest rate. And that can be used to their advantage.
Arnott: So maybe we can talk a little bit more about the effective interest rate and how that’s calculated. So, from what I understand, there’s three different components. There’s the loan index amount, which is now based on Treasury bond yields, the lender’s margin, and then the HUD mortgage insurance premium charge, which you mentioned before. So, what’s a typical lender’s margin and how does that end up impacting the overall effective interest rate?
Pfau: The lender’s margins do vary. And I last checked—you can get all this data. It’s available through the government websites, HUD websites. I looked, it’s lagged a few months, but in October of 2023—that’s the most recent data I had—I’m thinking that the average lender’s margin was right around 2.25%, and then it generally fell within a range a little bit under 2% to potentially a little over 3%, somewhere in that ballpark. And that’s something that’s fixed in the loan at its initial—when you’re signing the contract, these are the terms of the loan. So that will feed into the growth of the loan balance or the growth of the line of credit, whatever composition you have there throughout the lifetime of the loan.
Benz: So, Don, there are numerous ways that people can use proceeds from a HECM. Can you walk us through the main payment options?
Graves: A reverse mortgage is going to make money available based on three primary factors: the age of the youngest borrower—someone has to be age 62. In most states a person has to be age 18, except for Texas; they have to be both 62. Value of the home, and the future projected interest rate, which HUD calls the expected interest rate. So based off of those three things, a certain amount of money is made available. A reverse mortgage must be a first mortgage. So, any existing mortgages or home equity loans, lines of credit have to be paid off. And then we have some money remaining. The question is the remaining money, how can that be taken? They can be taken as a lump sum. There are some restrictions depending on which program you use: a line of credit, a term payment—which is, Don, I just want this for five years, or 10 years, or 12 years; a 10-year payment, which means money will be sent to you monthly for as long as you have the loan or a hybrid where you take a lump sum and maybe a line of credit and monthly payments. So those are the five ways.
Pfau: And just to add to that, to be clear, that’s for a variable-rate HECM, which in fiscal-year 2023 was more than 99% of all HECMs. But to avoid confusion, there’s also a fixed-rate HECM where you don’t have that ongoing ability to borrow from a line of credit. You just take out a lump sum at the beginning. But again, more than 99% of HECMs are what Don was just describing.
Graves: Thank you, Wade.
Arnott: Don, you mentioned earlier the amount that a person can borrow. And there’s actually something called a principal limit factor, which determines the percentage of the home value that you can tap into. Can you talk a little bit more about how that works?
Graves: And Wade can jump in. HUD, this was one of the changes I believe in 2017, the PLF tables are produced by HUD. And it says based off of the lender’s margin and the expected rate, a certain amount of money is going to be made available based on age. And that could be 37.5 or 32.6 or whatever the number is. So that number is what we call the principal limit. So, the PLF, the principal limit factor, is a percentage that HUD produces that could be found online as well. And so, the principal limit is the amount of money, the growth-borrowing capacity before any closing costs or any mandatory obligations are paid off.
Benz: I’d like to discuss the repayment options. It seems like the key advantage of a reverse mortgage relative to a traditional line of credit on a home is that the loan doesn’t need to be repaid during someone’s lifetime. But can you walk us through how repayment works and what types of options the family has for repayment when the borrower dies?
Graves: I can take that, Wade, and you can chime in. But the HECM, the loan becomes due and payable when the last surviving borrower permanently departs the home—moves, dies, or has gone into a facility for 365 consecutive days for physical or mental incapacity. At that time, whatever proceeds were advanced to the client, plus any accrued interest has to be repaid. There are primarily three ways that can be repaid. Number one, the heirs sell the property. They pay off what’s owed on the reverse mortgage, and they pocket 100% of the difference. Number two, they can refinance the reverse mortgage and just take out a traditional mortgage and make payments if they want to keep the house. And number three, they could use other assets to pay it off. Maybe there was life insurance or something else that way. So those are your three primary ways to repay the reverse mortgage balance.
Pfau: And that applies at death as you were noting with the question, but also you can make voluntary repayments over time as well. And that’s getting into, you can adjust the composition between the loan balance and the line of credit. And if you make a voluntary repayment while you’re still a borrower, that just moves funds back into the line of credit. So that subsequently you’ll get more growth in the line of credit rather than having that growth be in the loan balance. And then you can tap into those funds again later as you go through retirement.
Arnott: You’ve noted that the line of credit actually grows over time in line with the effective interest rate. And I know, Wade, you’ve done some research about this and looked at a strategy where a person might set up a HECM at the beginning of retirement, but then wait to tap into it until closer toward the end. Can you talk a little bit more about how that strategy can work and why it seems to be beneficial?
Pfau: So, the idea that a growing line of credit can sound too good to be true. And I think it was an unintentional consequence, but it has really powerful implications. I think when the rules of the program were designed, the assumption was people would pretty much want to borrow whatever they could. And so that principal limit, the initial borrowing capacity, that would reflect loan balance. And we can understand why the loan balance would grow over time. But the planning implication was you didn’t have to take out the full amount as a loan balance. You could leave line of credit. You do need a minimal balance to keep it open. But I can have this line of credit that’s growing at the same rate the loan balance would be growing. And it’s really powerful so that when we look at, well, if I think I might want to use the reverse mortgage at some point, should I open it as soon as I can at 62 or should I wait until the age that I first need it? The odds are really in favor of going ahead and opening it at age 62 and letting that line of credit grow.
If you wait until later, you may be able to borrow more because you’re older, so you get a higher percentage of the home value. And hopefully, your home has been growing as well in value so that you get a higher amount. But it’s really hard for that to beat the growth you get by opening it at 62 and letting it grow. Sixty percent to 70% of the time with historical data, you’d have faster growth by opening it at 62 and letting that grow over time. But plus, even if you open it at 62, you can always refinance. And that’s something we saw happening quite a bit after the pandemic. Home prices were appreciating very rapidly. Interest rates were getting very low. And so, we were getting into scenarios where people who did open it at 62, they could have gotten more by waiting. Well, then they can go ahead and refinance and tap into that larger equity at that time. So, really, either direction, you have this opportunity that if you think you might use the reverse mortgage, opening it sooner rather than later, and letting that line of credit grow is probably going to lead to having a bigger borrowing capacity when you do want to tap into those funds at any point later in retirement.
Benz: Wade, in a related vein, you have discussed a strategy of setting up a reverse mortgage early in retirement and then using it as a buffer asset, looking at the portfolio’s results and if the portfolio has had a loss, you’d take money from the HECM rather than touch the portfolio in that downdraft. Can you talk about that strategy and how much—based on your testing and so forth—how that helps improve the odds of success during retirement?
Pfau: In the Journal of Financial Planning, which is one of the main outlets for financial planning research, there were two articles published in 2012 that really made that same point. They didn’t know about each other’s work, so they pushed it in different manners, but you had Barry and Stephen Sacks in February 2012. And then you had, I called the Texas Tech University team—Harold Evensky, John Salter, Shaun Pfeiffer—published an article in August 2012. And they both made the same point that opening a line of credit on the reverse mortgage and letting it grow provides a resource to help manage sequence-of-returns risk in retirement, that if your investment portfolio looks to be in trouble—and you can define that in any number of ways. But market downturns or you’re lagging behind where you need to be, the portfolio is not performing at the level it needs to, to make that retirement plan be successful, then you temporarily draw your spending need from the reverse mortgage, leaving the portfolio alone, giving it a better opportunity to recover before you then tap into the investment portfolio again.
Because you have that growing line of credit and because it’s not correlated with the market, meaning if the stock market is down, your line of credit doesn’t decrease in value, it’s a classic buffer asset. There are really only three buffer assets out there: just cash, but then you’re giving up the yield on having assets in cash; the HECM growing line of credit; and then also whole life insurance cash value has been described in this way. Three different resources that can provide a temporary bridge to tap into to avoid selling from the portfolio when it’s in trouble. And that creates these synergies about if I don’t have to sell from a declining portfolio, if I let that portfolio recover, the long-term growth and benefit to that portfolio can more than offset the cost of the reverse mortgage to create that better overall financial planning outcome to meet the spending goals in retirement and to preserve more assets for legacy at the end as well. Both of those research articles illustrated that point.
And then I’ve also replicated their work, looked at it and just created an even simpler rule where it’s just you record what was the portfolio balance at retirement. Whenever the portfolio balance is higher than that, spend from the portfolio. Whenever the portfolio balance has dropped below where it was at the start of retirement, spend from the reverse mortgage. So, lots of different options, but they all point to this idea that synergistic, coordinated use of a growing reverse mortgage line of credit can lay the foundation for better outcomes in retirement.
Arnott: Don, another study you mentioned in the book was a Journal of Financial Planning paper written by Barry Sacks in 2017 called “Integrating Home Equity and Retirement Savings Through the Rule of 30.” Can you walk us through some of the key findings there?
Graves: I’m going to defer that to Wade because some of some of Barry’s findings there, in 2017, there was a different kind of economic outlook. It’s very powerful what he was presenting. But Wade, would you unpack a little bit of Barry’s rule of 30?
Pfau: So that article, one of the highlights I remember from it was he was looking at different compositions of what’s the ratio of your home equity/your portfolio balance. So, if my home is worth $400,000, what’s my investment portfolio? Is it $200,000 $400,000, $800,000? And he was just looking at different ratios of home equity/portfolio balance and demonstrating that the bigger the home relative to the portfolio, the more benefit you could get from the reverse mortgage. And I think there was also some aspects of that article that talked about using a withdrawal rate based not just on the investment portfolio, but on the combined value of the investment portfolio and the home equity. But I must admit it has been a while since I’ve read that article. So, I don’t know if I’m getting all the key highlights or not. You had some other ideas about it, Don.
Graves: And I think he’s refreshed some of that as well that if you had a home of $400,000 and a portfolio of $500,000, how do we determine the safe withdrawal rate, the initial safe withdrawal rate? And that’s what his thinking was. But I saw that the Amy and Christine had incorporated that, and I was going to call Barry and see if he had updated it because there were some changes. But I didn’t get a hold of him.
Arnott: So, I think the basic idea was, as you said, instead of just looking at the portfolio value to determine a safe withdrawal rate, you would combine the portfolio value and housing wealth and then divide by 30 to come up with a safe withdrawal rate.
Graves: Yes, that was the premise. And again, he has done some additional work since then. And I can’t speak on that right now.
Arnott: OK.
Benz: I wanted to follow up on that standby reverse mortgage idea that you were discussing, Wade. I’ve talked to some financial advisors about this. And one, I made a comment that he felt that it makes total sense on paper, but just that it’s perhaps an overly complicated way to address sequence-of-return risk that he said he would rather do it with asset allocation and adjusting withdrawal rates. What’s your response to that reaction, which I would guess is pretty common among financial advisors?
Pfau: I guess I would push back on that. At the end of the day, there’s really only four ways to manage sequence risk in retirement. One, you can just spend less. That’s the logic of the 4% rule idea. Well, how low does my spending need to go so that I don’t have to worry about outliving my money? Another is you can be flexible with your spending. If I can cut my distributions after a market downturn, that helps manage sequence risk. So, it sounds like that advisor may have a preference for that approach.
The third is to manage volatility in some manner in retirement. That can get us down a big rabbit hole of what actually works as a way to manage volatility in a manner that doesn’t sacrifice too much yield. It doesn’t simply mean using a bond portfolio to fund retirement because as soon as you want to spend more than the bond yield curve can support, you’re going to ensure that you deplete that asset base. But there’s different ideas there with bucketing approaches, or annuities can even fit into that.
But then the fourth approach is this idea of a buffer asset. And I don’t think it has to be that complicated. Like I said earlier, there’s a very simple decision rule. If I have the buffer asset, if I had a million dollars in my portfolio at the start of retirement, I don’t even have to inflate that number for inflation. I just keep track of that number. If my portfolio has fallen below that balance, I’m going to tap into the buffer asset, whether it’s a reverse mortgage or some other buffer asset. I don’t think it has to be all that complicated.
It can get more complicated and the Texas Tech approach did get more complicated because you had to track this is exactly how much I should have in my portfolio every year of retirement and use that as a threshold to decide when you spend from the reverse mortgage. But I think with a simpler rule, it really doesn’t have to be all that complicated and can be done a lot easier than some of the variable spending strategies that also make complicated decisions based on portfolio balance.
Arnott: We also wanted to talk about some of the risks or negatives associated with reverse mortgages. Wade, I’m wondering if you can talk about the risk of foreclosure with these products. The borrower doesn’t need to make payments, but they still have to pay property taxes, home insurance, continuing maintenance on the home. Are there any statistics on the risk of foreclosure who take out these products?
Pfau: I haven’t seen statistics on foreclosure rates. And we do need to emphasize again the difference between the last-resort scenarios and then the financial planning scenarios. If you’re listening to Tom Selleck pitch reverse mortgages on TV and calling the 800 number just because you don’t have other options, that’s really where that risk of foreclosure may be a relevant consideration. But that’s where the government has tried to strengthen the program with the financial assessments to simply have set-asides put into place. I can’t tap into all of the potential borrowing capacity because there’s part that’s been carved out and set aside to pay the future property taxes and homeowners’ insurance and so forth and also to make sure that home repairs are done so that the home meets the requirements at the very beginning just to get you on that right path.
In the broader financial planning context where it’s not necessarily the case that people are going to be running out of money, then this conversation around foreclosure is really going to be much less relevant. And then probably for a lot of listeners of the podcast, they’re more in that ladder bucket where they’re not going to be completely deplete of all assets in retirement. And so, they’re going to have the resources to maintain their homeowner obligations.
Benz: Sticking with some of the reasons that someone might not consider a reverse mortgage, older adults often find themselves in homes that are impractical to age in. They might be too large, or they have stairs, or they need costly repairs. Given that, is relocating to a more practical space often the better call than staying put and tapping home equity via a reverse mortgage?
Graves: It all depends on what the client wants to accomplish and where they live. For example, someone in California, they had a $400,000 home in San Francisco. It’s worth $1.5 million. And if they sell it, the capital gains are going to be pretty extensive. And so, one of the ways to say, well, you don’t have to sell it, you could do a reverse mortgage and stay to manage your capital gains. That’s probably the exception. But for a lot of folks, the home is not the right size anymore.
One of the things I ask—I train advisors for what I do—and I said, ask your client this: If we could increase your cash or reduce your expenses and add new dollars back to your retirement savings, but amid moving to your next, last and best home, would you want to see how it works? Now that’s a financial planning question. So, you’ve got a client that, let’s say they sold their home and they’ve got $500,000 in proceeds left over. And they could go to a $500,000 home and pay cash, or they could use the reverse for purchase program that came about in 2009 that would allow them to buy their next home today at about 60% down payment and have no monthly mortgage payments and then they’d have some excess money left over to add back to their savings.