The Wall Street Journal recently pronounced that “A generation of Americans is entering old age the least prepared in decades.” The article authored by Heather Gillers, Anne Tergesen and Leslie Scism documents how a “combination of economic and demographic forces has left older Americans with bigger bills and less money to pay them… more than 40% of households headed by people aged 55 through 70 lack sufficient resources to maintain their living standard in retirement.”
This is a counsel of despair that ignores the potential for increasing the spendable funds available to existing and soon-to-be retirees by integrating existing retirement fund sources. Also ignored is the potential for incenting younger consumers to save more for retirement. The two objectives are closely related, and this article covers both.
Increasing Spendable Funds by Integrating Retirement Fund Sources
The three existing sources of retirement funds – financial asset liquidation, annuities and HECM reverse mortgages – are stand-alone products offered by different industry groups that have nothing to do with each other. As a result, the substantial synergies from combining them are unrealized.
Financial assets are managed by investment advisors who are generally hostile to annuities and uninterested in HECM reverse mortgages. Insurers offering annuities seek to package them with insurance policies but not with reverse mortgages. In fact, most insurers won’t write an annuity contract if they know that a HECM reverse mortgage would be used to finance it. HECM reverse mortgage lenders are completely specialized except for a few small commercial banks that offer them.
This segmentation prevents retirees from selecting the combination of expected longevity and rate of return on financial assets that maximizes their spendable funds during retirement. This is illustrated in Table 1 which applies to a 65-year-old with financial assets of $300,000, and Table 2 which covers the same retiree except that he also has a house worth $500,000 — typical values for a new or soon-to-be retiree.
Combining Financial Asset Liquidation With a Deferred Annuity
Table 1 shows monthly spendable funds, with and without the purchase of a deferred annuity, for different life spans and asset yields.
The retiree’s spendable funds based solely on financial asset liquidation depends on the rate of return on the assets and on how long he expects to live. For example, if he assumes a rate of return of 6.1%, which is the median over 10 years on a portfolio that is 25% in common stock and 75% in fixed-income securities, he could draw $3,325 for 10 years but his financial assets would then be depleted. He could reduce the draw to $2,132, in which case his assets would last for 20 years.
In contrast to liquidating assets as the sole source of funds, with its risk of running out, combining asset liquidation with a deferred annuity results in payments that continue for life. Retirees with the finances shown should avoid the annuity only if they are confident that they will earn a very high rate of return on their assets, or are convinced they will have a very short life span. These are bad gambles.
[Parenthetical note: To ameliorate the anxieties associated with outliving their money, financial advisors have come up with the so-called 4% rule in which the retiree draws 4% of his assets every year and increases the draw amount by an inflation adjustment every year. This reduces but does not eliminate the risk of running out while sharping reducing the monthly draws. In the example shown, the 4% rule would provide an initial draw of $1,000, or significantly less than the combination option].
Adding a HECM Reverse Mortgage to the Plan
More than half of retirees-to-be are homeowners who can convert their home equity into spendable funds using a HECM reverse mortgage. The optimal way to do that is to use some of the funds drawn on the HECM to “free up” financial assets which can then be used to increase the size of the deferred annuity, and part to increase asset draws during the annuity deferment period. Table 2 is based on the optimum allocation between these uses using a program developed with my colleague Allan Redstone called Retirement Funds Integrator (RFI). Adding the HECM in this way increases spendable funds significantly.
Note that spendable funds are immune from downside risk after the deferment period, whether a reverse mortgage is included as a retirement plan option or not.
HECM reverse mortgages have never been used as a component of retirement plans, although that was their original purpose. They have been marketed as a stand-alone option for people in financial distress, and their public perception has been correspondingly abysmal – to the extent that advocates for the elderly such as AARP warn against them. Integrating HECMs into retirement plans should cause a major shift in attitudes.
Incenting Younger Consumers to Save More For Retirement
The prospect of a known retirement plan in the future is a powerful inducement to adopt a savings program that would actualize the plan. I discussed this in Targeted Saving for Retirement (We Haven’t Had It – Until Now) and will limit further comment here to a few concrete examples, which are shown in Table 3.
Disclosure of My Involvement
The Retirement Funds Integrator (RFI) is owned by Mortgage Professor LLC, of which I am chairman. It has licensed Retirement Saver, which is based on RFI, to the non-profit Retirement Saver Funds which has made it freely available at no charge. In due course, I expect RFI itself will be licensed at a fee.