April 2016 update:
The Journal of Financial Planning published Dr. Pfau’s article in April, 2016: Pfau, Wade D. 2016. “Incorporating Home Equity into a Retirement Income Strategy.”Journal of Financial Planning 29 (4): 41–49. Incorporating Home Equity into a Retirement Income Strategy
November 11th, 2015 | by Jason Oliva, in Reverse Mortgage Daily
Following research released earlier this week detailing the various strategies for using a reverse mortgage in retirement income planning, a new paper explores six methods of incorporating home equity into a retirement plan and how they impact spending and wealth.
The paper (click to access it), published earlier this month by Wade Pfau, a professor of retirement income at the American College of Financial Services, is the latest in a series of research that has demonstrated the use and value of reverse mortgages when used as part of a comprehensive retirement planning strategy. Pfau is also a member of the Funding Longevity Task Force, an organization of distinguished academics and financial professionals, several of which have respectively researched how home equity via reverse mortgages can be a valuable asset in financial planning.
But where other papers have made significant contributions in this regard, Pfau’s digs deeper into the underlying analysis about how reverse mortgage retirement strategies impact spending and wealth.
Past studies, Pfau writes, have generally struggled with explaining the combined impacts of home equity use on sustaining a retirement spending goal as well as preserving assets for legacy. Other studies have also struggled with simulating the random future fluctuations for all key variables that will impact response, he added.
“While past studies have employed Monte Carlo simulations for stock and bond returns, none of these studies simulated the future paths of interest rates, nor did they link future bond returns to future interest rates,” Pfau writes. “This misses the ability to see how changing interest rates impact line of credit growth, the amount of credit available when delaying the decision to open a reverse mortgage, and the interplay of growth in the line of credit or loan balance for the reverse mortgage and the return on bonds in the investment portfolio.”
The main objective of Pfau’s research is to analyze the different reverse mortgage possibilities in order to provide financial planners and their clients with a deeper context for considering how to incorporate home equity into a retirement income strategy.
Pfau specifically examines six strategies that involve spending from a Home Equity Conversion Mortgage (HECM). A breakdown of the various strategies can be found on pages 8-9 of the paper.
Of the six methods, the strategy supporting the smallest increase in success is the one that embraces the conventional wisdom of using home equity as a last resort, and only utilizing the reverse mortgage when it is first needed.
Meanwhile, opening a reverse mortgage line of credit at the beginning of retirement, in order to let the credit line grow before being tapped, provides the highest increase in success rates.
“Especially when rates are low, the line of credit will almost always be larger by the time it is needed when it is opened early and allowed to grow, than when it is opened later,” Pfau writes.
The basic understanding, according to Pfau, is that strategies which open the line of credit early, but delay its use for as long as possible, will offer increasing success rates as more of the credit line is available to be drawn from if, and when, it is eventually needed.
“Generally, strategies which spend the home equity more quickly increase the overall risk for the retirement plan,” Pfau writes. “More upside potential is generated by delaying the need to take distributions from investments, but more downside risk is created because the home equity is used quickly without necessarily being compensated by sufficiently high market returns.”
The line of credit growth opportunity specifically, Pfau says, serves a stronger role than the benefits from mitigating sequence risk through the use of coordinated strategies.
“Nonetheless, use of tenure payments or one of the coordinated strategies can also be justified as providing a middle ground which balances the upside potential of using home equity first and the downside protection of using home equity last,” Pfau writes.
View the study.
Written by Jason Oliva
Comment by Tom Davison:
Dr. Wade Pfau has a unique and very advanced approach to doing these studies. When looking at combinations of cash from reverse mortgages and investment portfolios, a key is the growth rate and volatility of the reverse mortgage line of credit compared to the portfolio. Wade’s technique keeps these factors and others in line with each other through the retirement years. Starting with current conditions they evolve towards long-term interest rates and stock market rates. This thoughtful and “high tech” approach is especially valuable comparing the 6 distinct methods of combining reverse mortgages with investments.