A pproximately 80 percent of Americans age 65 and older own homes,1 and of those who own homes, approximately 70 percent own them without mortgage debt.2 Thus, many retirees have housing wealth available to draw upon. Advisors know that drawing upon that wealth can greatly improve financial outcomes, but we need to help our clients do it in the most effective way. Typically, it will make sense to consider a home equity conversion mortgage (HECM), also known as a reverse mortgage. We provide four illustrations of its use below. HECM background Most advisors are familiar with HECMs, but five key points should be emphasized: 1. A reverse mortgage is a loan secured by the borrower's principal residence, with required repayment deferred until the borrower permanently leaves the residence. 2. The loan proceeds can be taken as a lump sum, a line of credit, an annuity, a lifetime or term or monthly payments, or any combination of these forms. 3. The loan is available only to borrowers age 62 or greater. 4. The loan can be taken on a home currently owned by the borrower or for purchasing a new home. 5. The maximum home value that can be taken into account for a HECM is $636,150, and the maximum loan to value ratio is about 14 NAPFAADVISORNOVEMBER2017 50 percent to 60 percent, depending on the borrower's age. Although reverse mortgages had a questionable reputation in their early years, since then changes in the structuring of HECMs and recent research leading to better uses of the product have resulted in its current acceptance by many advisors and planners as a flexible financial tool for retirees. 4 illustrations Here are four situations in which a HECM can improve retirees' financial outcomes: 1. Drawing on a securities portfolio-such as a 40l(k) account or a rollover IRA-for retirement income 2. Replacing a conventional mortgage, to end monthly payments 3. Downsizing to eliminate monthly payments and increase incomeproducing investments 4. "Silver divorce", when housing wealth can provide liquidity for the division of assets Situation 1: securities portfolios used for retirement income Today, most retirement plans covering retirees and soon-to-be retirees are defined contribution plans. In a defined contribution plan, the retiree has an account, usually invested in a portfolio of securities. The retiree's challenge is to draw income from the portfolio at the maximum rate that will not exhaust the portfolio before the end of the retiree's life. The well-known "4 Percent Rule" was developed to optimize the draw rate from a portfolio of securities.3 Although originally developed using historical investment return data, it is still in place, now using projected investment returns. Monte Carlo simulation using such returns shows that a 4 percent initial draw rate results in a 90 percent probability of 30- year inflation-adjusted cash flow survival. But the probability of cash flow survival is quite sensitive to the initial draw rate; for example, increasing the initial draw rate from 4 percent of the portfolio's value to 5 percent decreases the probability from 90 percent to 70 percent. In other words, that increased initial draw rate triples the risk of premature exhaustion from 10 percent to 30 percent. Because of that increased risk, retirees planning to draw retirement income at a rate greater than the amount determined by the 4 Percent Rule would be well-advised to consider a new strategy to reduce the exhaustion risk, which we discuss below. Quantitative analysis shows that a very significant factor that increases the risk of premature exhaustion of a portfolio is an "adverse sequence of returns" 4-that is, negative or weak returns during the early years of retirement. Among the most effective ways to offset an adverse sequence of returns is to not draw on the portfolio in periods following periods of negative or weak returns. But the retiree has to have some income. For many retirees, replacement income from housing wealth might be the solution. Research using Monte Carlo simulation has shown that the strategic use of housing wealth to offset adverse sequences of returns results in very substantial improvements in the sustainability of Courtesy of Don Graves, RICP®, CLTC®, CSA 800-762-6315 | www.HousingWealth.net RETIREMENT Figure 1: Probability of Cash Flow Survival line.6 This is a coordinated strategy in which home equity is used only in years following down years, as compared to a "last resort" strategy, in which the home equity line is established, but it's used only if the portfolio is exhausted. 100% 95% 90% 85% 80% 75% 70% 65% 60% 5 Yrs 20V s 25Yrs 30 Yrs Coard s rat\1 last. Resort Strat'y P' kJ O Onlv Figure 1: Probability of cash flow survival using three different strategies, each with a 5 percent initial distribution rate, with 1:2 ratio of home value to initial portfolio value The original work on the use of home equity to offset an adverse sequence of returns was done with calculations assuming that the retiree was in a category called "mass affluent?' Although there is no precise definition, we characterize the mass affluent retiree as a person who has, at retirement, a savings portfolio in the range of$500,000 to $1.2 million and a home with a value of about $250,000 to about $600,000. Consistent with these figures, the typical mass affluent retiree in the literature has a ratio of home value to portfolio value of 1 :2. inflation-adjusted (i.e., constant purchasing power) cash flow throughout 30-year retirement periods. 5 Although several strategies are possible, let's focus on a very simple one. Labeled the "coordinated strategy;' it is based on the following algorithm: Have You Reserved Your LTC Planning Webinar Vet? e CFP® approved for 2017 CE credit At the end of each year, the investment performance of the portfolio is determined. If the performance was positive, the ensuing year's income is drawn from the portfolio. If the performance was negative, the ensuing year's income is drawn from the reverse mortgage credit Figure 1 shows cash flow survival probability for the typical mass affluent retiree with a 5 percent initial draw rate, using three different strategies. For more than 42 years, we've been crafting just one thing: quality, precision LTCI plans, thoughtfully designed to fit each client's situation and financial/retirement plan. Sure, one stop shops sound convenient. But when you're making recommendations to your clients, wouldn't you rather choose expertise? 800-533-6242 Continued on page 16 • Asset-Based and Traditional LTCI Products • Carefully-Selected, Reputable Carriers • Unparalleled Service and Claim Support • Our Clients Have Collected Millions in LTCI Benefits! Long Tenn Care Planning Brian I. Gordon, CLTC email@example.com -12+?- We Work Hard to Make Long Term Care Planning Easy Peter R. Florek, CLTC firstname.lastname@example.org magaltc.com NAPFAADVISORNOVEMBER2017 15 RETIREMENT Continued from page 17 Situation 3: downsizing A person reaching retirement will often find the home that he/she occupied during his/her working years is no longer suitable. The reasons may be personal or financial. Consider a retiree who is 70 years old. His wife passed away a few years after they refinanced their home. Upon her passing, household income diminished by $1,200 per month, making the monthly payment difficult. Suppose that the home, worth $950,000, had a mortgage with remaining balance of $400,000 and 21 years of payments remaining. Thus, the monthly mortgage payments are $2,350. Selling the home will net $893,000 after a 6 percent broker's commission. Paying off the mortgage leaves net cash of $493,000. If this retiree then purchases a new home at a price of $625,000, he can make a down-payment of $265,000 and obtain a reverse mortgage for the balance of $360,000. This will leave him $228,000 to invest and no monthly mortgage payments. At a 5 percent return, he will receive $950 per month. Coupled with no longer having to make a $2,350 monthly mortgage payment, monthly cash flow increases by a net $3,300. We recognize that this near-retiree could opt to sell his home, live in rental property instead, and invest a larger amount. But there are non-economic benefits as well as economic benefits to home ownership, especially for a retiree who is expecting to "age in place" for a relatively long period of time. The decision will come down to weighing many factors, including personal preferences, relative attractiveness of available homes and rental units, and economics. Situation 4: dividing assets in silver divorce There are many situations in which a reverse mortgage can facilitate asset division in a "silver divorce;' generally by providing liquidity where liquidity is otherwise insufficient. This illustration is the simplest case. 18 NAPFA ADVISOR NOVEMBER 2017 Assume that a divorcing couple's only illiquid asset is their home. (For simplicity, assume that the liquid asset, e.g., a 40l(k) account, is to be divided equally, and that neither party would be able to go forward economically with less than onehalf of the liquid asset.) Also assume that the home value is $700,000, it is owned free and clear, and the parties agree that the wife will keep the home. In the first step, the wife will obtain a HECM refinance and receive a lump sum of $372,000. She will receive that amount in cash and use $350,000 of it to purchase the husband's interest in the home. The wife will not have any mortgage payments as long as she continues to permanently occupy the home. She will retain the remaining $22,000 as a cash reserve. In the second step, the husband can proceed in either of two ways to purchase his new home for $635,000. The first would be to use the entire cash amount of $350,000 as a downpayment, obtain a HECM of $340,000, use $285,000 from the HECM to complete the purchase, and keep the remaining $55,000 as a credit line. The second would be to use $295,000 of the cash as a down-payment, invest the remaining $55,000, and obtain a HECM of $340,000 to complete the purchase. The financial outcome includes the following results: 1. Both parties remain homeowners, not renters. 2. Neither party incurs a monthly mortgage payment obligation. 3. Neither party has had to draw upon income-producing assets (such as their securities portfolios). 4. No capital gain tax or sales fees were incurred. 5. One party increased the value of his investment portfolio or credit line while the other added to her cash reserve. These four illustrations suggest only a limited number of the ways that advisors and planners could help clients use reverse mortgages to improve financial outcomes. 0 Barry H. Sacks, PhD, JD, is a practicing tax attorney specializing in pensions. Email: email@example.com. Mary Jo LaFaye is a reverse mortgage loan officer with more than 14 years of experience. Email: info@ MaryJoLafaye.com. Stephen R. Sacks, PhD, is professor emeritus of economics, University of Connecticut. Email: sacks44@ earth/ink. net. Footnotes 1. Merrill Lynch in partnership with Age Wave. 2014. Study entitled "Home in Retirement: More Freedom, New Choices:' Page 7, Figure 7, citing Bureau of Labor Statistics, 2013 noninstitutionalized population. 2. Ibid. 3. Bengen, William P. 1994. "Determining Withdrawal Rates Using Historical Data." Journal of Financial Planning 7 (4):171-180. Guyton (2014) and Wade Pfau (2014). 4.. Kitces, Michael. 2017. "Strategies for Managing Sequence of Return Risk in Retirement:' Talk presented at NAPFA National Conference, May 18, 2017, in Seattle, WA. 5. Sacks, Barry H. and Stephen R. Sacks. 2012. "Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income:' Journal of Financial Planning 25 (2): 43-52. See, also, Salter, John R., Shaun A. Ffeiffer and Harold R. Evensky. 2012. "Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions:' Journal of Financial Planning 25 (8): 40-48 and Pfau, Wade D. 2016. "Incorporating Home Equity into a Retirement Income Strategy:' Journal of Financial Planning 29 (4): 41-49. 6. A minor modification in certain cases when the investment performance was positive: If the dollar amount of the portfolio's positive return was less than the withdrawal amount scheduled for the ensuing year, only the amount of the positive performance is drawn from the portfolio, and the remaining portion of the scheduled withdrawal amount is taken from the credit line. Also, of course, if the investment performance was negative but the reverse mortgage credit line has already been exhausted, the entire withdrawal will come from the portfolio. 7. Neuwirth, Peter, Barry H. Sacks and Stephen R. Sacks. 2017. "Integrating Home Equity and Retirement Savings Through the "Rule of 30;" Journal of Financial Planning, 30 (10):52-62. 8.The interest portion of the payments are generally deductible, but not the principal portion.
Courtesy of Don Graves, RICP®, CLTC®, CSA
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