HUD created this ingenious and multi-faceted reverse mortgage program, but its well-intentioned effort to protect it against misuse has been a disaster.
The disaster has stemmed from HUD’s requirement that the HECM be a stand-alone product, as opposed to being part of integrated retirement plans. FHA Mortgagee Letter 2008-24 bars HECM lenders from “involvement with any other financial or insurance product.” This rule stemmed from some abusive transactions early in the history of the program where HECMs were combined with annuities in order to generate 2 commissions.
The stand-alone rule prevents synergies that would benefit retirees, generates excessive loss rates, and is not needed to prevent market abuses.
Synergy Between HECMs and Annuities
The mortality-sharing feature of annuities allows retirees taking a HECM to draw larger amounts over their lifetimes if they combine it properly with an annuity. This would be particularly valuable for house-rich/cash/poor retirees who have negligible financial assets.
Chart 1 applies to a retiree of 63 who owns a $700,000 house but no financial assets. He draws a HECM credit line and uses a portion of it to purchase an annuity on which payments will begin after 10 years and grow at 2% a year. The balance of the line is used for monthly draws during the first 10 years, also growing at 2% a year, [Note: The math underlying the seamless transition from HECM draws to annuity payments was developed by my colleague Allan Redstone.]
The horizontal line in Chart 1 is the highest HECM tenure payment quoted by any of the lenders who report their prices to my web site. Tenure payments are for a fixed amount and cease if the borrower moves out of the house. With a stand-alone HECM, this is the best the retiree could do. The HECM/annuity combination can escalate, it is 2% a year in the example, and it runs for life.
The higher of the two upward-sloping lines is based on the best annuity price quoted by a network of carriers who offer deferred annuities, to which I have access. The lower line is based on the lowest price of the carriers in the network, though there could be others with even lower prices. HUD’s stand-alone rule protects HECM borrowers from the worst annuity providers but prevents them from taking advantage of the good ones.
Synergy Between HECMs, Asset Management and Annuities
Homeowners with significant amounts of financial assets can safely increase the rate of return on assets by integrating asset management with a HECM and an annuity.
The received wisdom among financial advisors is that as retirees age, their asset portfolios should shift from assets with high expected returns and large variance to assets with lower expected returns and low variance. The logic of this shift is that as the investment period shortens, the likelihood rises that a large decline in asset returns won’t be offset.
For example, using data compiled by Ibbotson covering asset returns over 86 years, portfolios composed entirely of common stock had a median rate of return over 10-year periods of 10.9%, but in 2% of the periods, the return was -6.9% or less. Shifting a major part of the asset portfolio to fixed-income securities would reduce both the risk and the expected return.
But the homeowner with financial assets has another option. He can use a HECM credit line in conjunction with a portfolio composed entirely of common stock to hedge against the possibility that the rate of return on the stock will be markedly lower than the expected return.
Consider the retiree of 63 cited above but assume he now has a portfolio of $1 million of common stock in addition to the $700,000 house. He retains the stock portfolio with its 10.9% expected return, and will draw on a HECM credit line as needed to offset returns that are less than 10.9%.
This is illustrated in Chart 2. The spendable funds line is calculated at a rate of 10.9%. If the realized return is 5%, the retiree will draw on the credit line to make up the difference. The unused portion of the line will be retained for possible future use.
In my example, the realized rate of return has to fall to –9.2% for the credit line to be fully used in the 10-year period. The maximum shortfall that can be fully hedged depends on the amount of equity the retiree has in his home relative to the amount of financial assets that will be hedged.
The Stand-Alone Rule Generates Excessive Loss Rates
Current HECM losses are much higher than they would be if HECMs were integrated into retirement plans.
The program has been subjected to a great deal of bad publicity, for reasons I can’t explain, but the effect has been to subject it to adverse selection. The HECM client pool has been heavily weighted by borrowers with low credit scores, many in desperate financial condition, who turn to a HECM as their last resort. Many such borrowers fail to pay their property taxes and maintain their properties in good condition.
HECMs that are integrated with asset management and annuities into comprehensive retirement plans are likely to draw borrowers with better payment habits. Further, a borrower who obtains a rising payment for life is better positioned to meet home ownership charges than those who exhaust their HECM borrowing capacity in the first few years.
The major concern that generated the stand-alone rule is potential abuses connected to annuities. The rule does not prevent HECM borrowers from using credit lines to purchase annuities, but it prevents HECM lenders from helping them in any way.
The better way would be to remove its rule that HECM lenders cannot be involved with annuities but subject to the following conditions:
• The terms of annuities associated with HECMs would be competitively determined in a manner acceptable to HUD.
• The retirement plan that includes an annuity with a HECM is demonstrably better for the retiree than any plan without the annuity.
The writer has been developing a retirement planning program, called the Retirement Funds Integratortm, a segment of which is directed to the house rich/cash poor retirees discussed above. We call it the “Enhanced HECM”tm, and it will become operational shortly. It marries HECMs with deferred annuities in the way described earlier, and it provides competitively determined annuity and HECM prices. However, in conformity with the stand-alone rule, the program shields the lender from any involvement with the annuity. This makes the process somewhat clumsy for no good reason.