When financially planning for retirement, the main objective is to keep from running out of money in the later years. There is a significant portion of the retirement community that relies on portfolio securities as their primary source of income. These are often pre-tax accounts such as 401(k) plans or roll-over individual retirement accounts (IRA).
The long-held belief for maintaining portfolio value throughout retirement has been that the maximum safe annual withdrawal amount should equal 4% of your client’s initial portfolio value. The notion continues that the same dollar amount, adjusted for inflation, would then be withdrawn every subsequent year to maintain the portfolio. This withdrawal period/frequency delivers a 90% or higher probability that the account will have sufficient funds to make these annual payments for at least 30 years1. Unfortunately, a majority of new retirees find that this withdrawal amount uncomfortably limits their lifestyles, so they tend to draw more than that amount. Withdrawing more than the safe amount, coupled with economic risk, dramatically increases the risk of running out of retirement funds. Using home equity is a reliable strategy for coping with these risks, but the point in your client’s retirement at which they get a reverse mortgage can make a big difference in their long-term wealth. The reverse mortgage credit line is the feature described in this article as a strategy for protecting an investment portfolio.
Letting Your Client’s Largest Asset Work for Them
The conventional way of thinking proposed that home equity should only be in retirement funding plans as a last result when your portfolio is exhausted. However, this passive approach does not adequately account for economic downturns when portfolio valuation is down. Alternatively, borrowers could implement active strategies for using home equity in conjunction with your portfolio account earlier in retirement to significantly increase your probability of cash flow survival.
Active Retirement Funding Strategies
Instead of using the traditional passive approach of using a reverse mortgage as a last resort, financial experts have proposed alternate financial strategies that incorporate a reverse mortgage as part of retirement funding plans early in retirement to protect your portfolio accounts.
One strategy outlined is the opposite of the conventional method of using home equity as a last resort. Instead, this approach proposes to establish a reverse mortgage line of credit at the very beginning of retirement and withdraw from this line of credit until it’s completely exhausted before tapping into portfolio accounts.
As a third strategy, a borrower may elect to take out a reverse mortgage credit line at the start of retirement, but withdrawals are not taken from the line of credit every year. Instead, this coordinated strategy considers the performance of investment accounts. The overall performance of your client’s portfolio is determined at the end of the year. If the return was positive, then the next year’s income withdrawal will come from the portfolio account; if the performance was negative, then the following year’s income will be withdrawn from the reverse mortgage credit line.
By implementing this active strategy, the borrower’s portfolio account is spared from drain downs from income withdrawal when the market is down. Leaving more assets in the portfolio allows it time to recover in subsequent years when the market is back up.
Cash Flow Survivability Results
At first glance, it can be difficult to tell which of these strategies would yield the highest cash flow survivability. To make matters clear, Barry Sacks ran a financial model comparing the cash flow results in an article titled, Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income2. Using the same home and portfolio valuations across all three strategies, Mr. Sacks ran a model using performance calculations against actual economic investment return data over a 37-year period. In the model, if the borrower exceeded the 4.25% withdrawal rate, all three reverse mortgage strategies outperformed the cash flow survivability compared against strictly leveraging portfolio assets.
Both active strategies significantly outperformed the conventional, passive approach of using a reverse mortgage as a last resort. The scenario’s highest cash flow survivability came from the coordinated plan of using reverse mortgage funds after years of negative portfolio performance. Using this coordinated reverse mortgage withdrawal strategy, the cashflow survivability calculated at 85% after 25 years, even with a 6.5% withdrawal rate. It’s clear from these scenarios that accessing home-equity can a good option if the retiree wishes to live beyond the safe withdrawal levels and wants to remain in his or her home as long as possible.
1Bengen, William. 2006.
“Sustainable Withdrawals.” In Retirement Income Redesigned, edited by Harold Evensky and Deena B. Katz. New York: Bloomberg Press.
2Sacks, Barry.
“Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income.” Journal of Financial Planning, February 2012
Oregon Only:·When the loan is due and payable, some or all of the equity in the property that is the subject of the reverse mortgage no longer belongs to borrowers, who may need to sell the home or otherwise repay the loan with interest from other proceeds. FAR may charge an origination fee, mortgage insurance premium, closing costs and servicing fees (added to the balance of the loan).·The balance of the loan grows over time and FAR charges interest on the balance.· Borrowers are responsible for paying property taxes, homeowner’s insurance, maintenance, and related taxes (which may be substantial). We do not establish an escrow account for disbursements of these payments. A set-aside account can be set up to pay taxes and insurance and may be required in some cases. Borrowers must occupy home as their primary residence and pay for ongoing maintenance; otherwise the loan becomes due and payable. The loan also becomes due and payable (and the property may be subject to a tax lien, other encumbrance, or foreclosure) when the last borrower, or eligible non-borrowing surviving spouse, dies, sells the home, permanently moves out, defaults on taxes, insurance payments, or maintenance, or does not otherwise comply with the loan terms. Interest is not tax-deductible until the loan is partially or fully repaid.
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