Meeting the Needs of Non-Affluent Retirees
August 31, 2022
An integrated retirement plan is one in
which the components fit together in ways that generate the best
possible plan for the retiree. The components are the retiree’s
financial assets, annuities, and (if the retiree is a homeowner)
a reverse mortgage or partial equity sale. Integration done
correctly generates synergies that are not available when the
components are combined haphazardly. It also reduces the prices
of the components. The synergies and competitive prices increase
spendable funds and/or estate values available to the retiree
over the remaining years of life.
The Retirement
Transition: From the Simple and Orderly to the Complex and
Chaotic
Pre-retirement, the goal is to accumulate
as much wealth as possible. An industry of financial asset
managers is available to help guide the process.
Post-retirement, the objectives become more diffuse. Because the
retiree doesn’t know how long she will live, potential conflicts
arise between spending in early years versus the danger of
running out. Those who want to leave an estate face a similar
conflict of objectives.
But the biggest challenge facing new
retirees with limited wealth is the multiple tools available for
drawing funds, each of which has options connected to it. This
poses questions for the retiree such as the following:
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Should I use some of my financial assets to insure against running out of funds by purchasing an annuity?
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If I purchase an annuity, how long should I wait before the annuity payments start? And should I purchase protection against early death?
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Should I use the equity in my home to increase my spendable funds during retirement?
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If I elect to use my home equity, should I borrow on it with a reverse mortgage or sell a part of the future appreciation?
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If I elect to take a reverse mortgage, which of the several options for drawing funds should I select?
The financial system as constituted today
provides little to no assistance because all the components of
retirement plans are delivered by specialized providers:
financial asset managers manage assets, insurance companies
offer annuities, reverse mortgage lenders offer reverse
mortgages, and home equity purchase firms purchase home equity.
None of them guide the retiree on how the different components
can fit together into a coherent retirement plan.
Who Needs a Coherent
Retirement Plan?
It is most needed for retirees whose
wealth is largely in their homes. As shown in Table 1, the
median net worth of retirees aged 65-74 was only $266,000 in
2019, of which $240,000 was in their homes. That means that at
least half of them live in fear of running out of spendable
funds.
The average net worth was 4.6 times as large as the
median, reflecting the markedly unequal distribution of wealth
that characterizes retirees. Furthermore, wealth inequality
among retirees has been rising. Between the third quarter of
1989 – the earliest date for which wealth data are available
from the Survey of Consumer Finances -- and the second quarter
of 2021, the wealth of the lower half of wealth holders rose by
304% whereas the wealth of the top 1% rose by 800%. In addition,
the share of wealth accounted for by residences increased over
time for the lowest wealth group, whereas for higher-wealth
consumers it declined.
Source: Federal Reserve Survey of Consumer
Finances
What Is a Retirement
Plan?
For the well-heeled retiree, a retirement
plan consists mainly of financial asset management, a service
provided by an industry of financial advisors. Forbes in its
2022 Annual Billionaires Issue for 2022 lists about 400 of the
most successful, selected from a total that “exceeds 6500”. This
industry does not meet the needs of the larger group of retirees
whose wealth is largely in their homes. For this group, a
retirement plan, in addition to financial asset management,
requires the following:
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An annuity, because it provides spendable funds for life, but payments might not begin for some years, termed the deferment period.
-
A home equity conversion program that converts home equity into spendable funds. The program may be loan-based, where the retiree borrows against the house, termed a reverse mortgage. Or it may be equity-based, where the retiree sells part of the equity and/or appreciation in the equity.
-
Integration of the separate components into a single coherent plan.
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An educational program designed to allow retirees to understand how this multi-pronged process would work for them. The sections that follow can be viewed as components of such a program.
A Core Feature: Making
the Plan Visible to the Retiree
A critical part of a coherent retirement
plan is a time series chart that displays the multiple
integrated parts: the spendable funds available to the retiree,
preset to rise every year to at least partially address
inflation; and the value of his estate, every month through age
104. The chart allows the retiree to see exactly how different
assumptions would affect the plan.
The illustrative charts shown below apply
to John, a single male retiree of 64 who has a house worth
$500,000 and $250,000 of financial assets.
On Charts 1A and 1B, the rate of return on
financial assets is 3%, the annuity deferment period is 15
years, the preset rise in spendable funds is 2%, and a credit
line drawn from a HECM reverse mortgage is used in part to pay
for the annuity and in part to provide spendable funds during
the annuity deferment period. The dotted portion of the
spendable funds line in Chart 1A shows draws from financial
assets while the solid portion of the line shows annuity
payments. The dotted line in Chart 1B shows the retiree’s estate
value.
A more detailed chart that allows retirees
to develop their own retirement plan is available on our web
sites,
https://rfiretirementplan.com/retirementchart and
https://www.mtgprofessor.com/retirementchart.
Adjusting to Market
Changes: Higher Than Expected Returns
No retirement plan will materialize exactly
as planned because the world changes in ways that are often
unpredictable; interest rate volatility is a critical case in
point. A workable retirement plan is one that anticipates
changes in portfolio returns in both directions and incorporates
effective ways to deal with them.
If rates of return on financial assets rise
during the deferment period, the simplest adjustment is the
purchase of an immediate annuity at the end of the period. Chart
2 provides an illustration. It assumes that John who is
currently earning 3% on his assets at the outset, finds that the
yield rises to 6% over the first year, generating excess assets
that are used to purchase an immediate annuity. This results in
a jump in spendable funds after 15 years.
John doesn’t have to wait for 15 years, he
could use the excess assets available after, say,10 years or 5
years and buy the second annuity then. His spendable funds would
rise at the earlier point but by less than if he had waited
until the end of the deferment period. This
is illustrated in Chart 2, in which John responds to a rise in
rates from 3% to 6% by purchasing an immediate annuity after 5,
10 and 15 years.
However, converting excess assets before
the end of the deferment period runs the risk that the rate of
return on assets declines after the conversion which, if not
provided for, will cause a drop in spendable funds. One way to
avoid this is to assume an initial rate so low that the
probability of further declines is extremely low. In mid-2022,
the 3% rate in the example would meet this condition. Another
way of dealing with lower-than-expected returns, which is
consistent with a higher assumed asset return, is described
below.
Adjusting
to Market Changes: Lower Than Expected Returns
This approach denotes some of the financial
assets as a set-aside, which is not used in calculating
spendable funds, making it available as a reserve in the event
that rates of return are below expectations. This is illustrated
by Chart 3. The top line of spendable funds assumes an expected
rate of 6% while the declining line is based on the assumption
that a 3% rate materializes. The lower stable
line is based on the set-aside of $17,450 required to offset the
lower rate.
If John elected to do a set-aside that
would cover a return rate decline to 3% (in this case the
required set-aside would be $17.450) but the rate that
materialized was 6%, he has a choice regarding the disposition
of the “unused” set-aside. It could be used to purchase an
immediate annuity, thereby enhancing his spendable funds, or he
could retain it to enhance his estate value. These options are
illustrated by Charts 4A and 4B, which assume that John elects
to purchase another annuity at the end of the deferment period.
It could be purchased at any time but deferring it eliminates
the risk of a decline in rate of return after the purchase.
The Need for Competitive
Pricing
In both the annuity market and the HECM
reverse mortgage market, the prices charged vary widely on
transactions that are otherwise identical. This reflects their
complexity and their novelty – very few retirees transact more
than once, so there is little opportunity for retirees to learn
how to shop these markets. Because of this, an effective
retirement plan requires a technique for finding the best
competitive prices.
In Chart 5 below, prices quoted to John are
drawn from networks of annuity providers and reverse mortgage
lenders. This approach discloses not only the best prices from
those included, but also the worst. At the best terms (for
annuities this includes providers with an AM Best rating of A+
or higher), and assuming a HECM term payment of 15 years, John’s
monthly spendable funds in the first month are $2978 while at
the worst terms they are $2651. This spread is a conservative
estimate because it covers only those willing to post their
prices. The very worst don’t participate in price networks.
Note that the price spread is smaller at
deferment periods shorter than the 15-years assumed in the
chart, and larger at rates of return on assets above 3%.
Selecting the Best
Annuity Deferment Period
The deferment period that generates the
highest schedule of spendable funds depends on the rate of
return on financial assets. Higher returns extend the deferment
period over which spendable funds can be provided from the
assets, while longer periods increase annuity amounts because of
greater mortality.
This is illustrated for John in Charts 6A,
which is based on a rate of 6%, and 6B which is based on a 3%
rate. In 6A, the longer deferment period generates significantly
more spendable funds while in 6B the different deferment periods
result in similar levels of spendable funds. (Note that retirees
with financial assets greater than their home equity can benefit
from short annuity deferment terms in some cases.)
Loan-Based Versus
Equity-Based Methods For Accessing Home Equity
To this point, it has been assumed that the
method used to access home equity is debt-based, in that the
retiree’s house serves as collateral to guarantee repayment. An
alternative approach is equity-based where the retiree sells the
right to a portion of the future growth in the value of the
home. Most retirees will probably opt to make that decision
early in the process.
One important difference between debt-based
and equity-based approaches is that debt-based plans generate
more spendable funds while equity-based plans generate larger
estate values. This is illustrated in Charts 7A and 7B.
There are other differences in the two
approaches that could be compelling. One disadvantage of
debt-based plans is that in the current regulatory climate,
annuities can’t be funded with reverse mortgages. This is a
serious drawback for the least affluent retirees. A second
disadvantage is that in the event the retiree must move out of
the house for any reason, the HECM must be repaid and the credit
line on which the retiree has been drawing disappears. This is
not an issue with equity-based plans because it has no effect on
the retiree’s ability to draw spendable funds.
On the other side of the ledger, greater
than expected house price appreciation can be converted into
increased spendable funds by refinancing the loan. There is no
such option on an equity-based plan.
Timing of Spendable Funds
Availability
An integrated retirement plan would allow
retirees to adjust the timing of their spending to their life
style expectations. For example, the retiree who plans to travel
the world for several years before settling down might opt for a
plan that provides increases in spendable funds early on,
followed by smaller draws in later years. Other retirees may
anticipate that their needs will be greater in future years.
These options (of the many that are possible) are illustrated in
Chart 8.
Retirement Plan Delivery
Structure
Implementation of the plan while
maintaining the integrity of the process would involve the
following participants:
Program Coordinator (PC):
The PC is
responsible for the plan. Its major functions are as follows:
- Provides and supports the technology used to deliver plans.
- Selects, trains, and supports advisors, monitors their
compliance with pricing rules, and with the requirement that the
plan meets the needs of retiree clients
- Compensates advisors, lead sources and others
- Manages networks of competing annuity providers and HECM reverse
mortgage lenders. (Management of equity participation investors
may be sub-contracted.)
- Is responsible for meeting legal requirements designed to
protect consumers, and to impose other requirements as needed –
see the section that follows.
Note that the authors will provide
promising PCs with access to the retirement plan technology and
the networks of annuity providers and reverse mortgage lenders
they have developed.
Lead Sources:
These are the entities
that are responsible for establishing contact with retiree
clients. They could be commercial banks, credit unions, advisory
firms, individual advisors, or independent web sites. Reverse
mortgage lenders and annuity providers could also be lead
sources subject to the pricing restrictions described in the
next section.
Advisors:
These are the people who
consult with and offer advice to retiree clients. They could be
employed
by a lead source or operate independently.
Guaranteeing the
Integrity of the Process
The PC is responsible for meeting legal
requirements designed to protect consumers, and to impose other
requirements as needed for that purpose. The protections, which
are fully consistent with FHA Section 255(n)(1), include the
following:
- Advisors are required to provide the best terms offered on the
networks unless the retiree prefers a different provider.
- Lenders and investors would not receive any part of annuity
commissions, and licensed annuity providers would not receive
any revenue from HECM lenders or investors.
- Plan annuities would be fixed annuities; variable annuities
would not be allowed.
- The retirement plans must be demonstrably superior to any
stand-alone combinations of the same basic features.
- HECM reverse mortgage lenders and annuity
providers acting as lead sources providing their own HECM or
annuity would be required to provide the best prices available
on the plan’s networks.
Concluding Comment: What
Are the Barriers?
HECM reverse mortgage lenders are deterred
by fear of violating HUD rules that are antithetical to
annuities. Annuity providers won’t write annuities that have
been financed with reverse mortgages because of fear of
incurring liability to heirs of the retiree, as well as concern
that their insurance regulator will not view such transactions
as being in the best interest of the retiree. These concerns are
all addressed by the type of integrated retirement plan
described in this article.
Well-meaning consumer advocates, such as
CAARMA, have criticized the HECM reverse mortgage program, based
on transactions that were either over-priced or did not meet the
borrower’s needs. The integrated retirement plan would eliminate
such concerns.
The Federal Government has been a drag. In
addition to draconian restrictions on useful combinations of
HECMs and annuities cited above, programs that focus on meeting
economic needs measure need by income. In the case of retirees,
need should be measured by net worth.
Most financial advisory firms denigrate
annuities which reduce the financial assets of clients on which
their fees are based. Some of them, however, would find it
profitable to participate in integrated retirement plans as lead
sources and/or advisors, if such plans were available.
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