Public policy aims to protect retirees with mandatory counseling on reverse mortgages and suitability disclosures on annuities, ignoring the wide price dispersions in both markets. This article shows how to combine both types of protection.

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May 19, 2020

In the microeconomics literature, the focal point is the price paid by consumers, and what matters is the number of sellers to which consumers have access. If there are many, the market is competitive, and the price will be as low as production costs allow. If there is only one seller, the market is in the hands of a monopolist who sets a price that maximizes its revenues, which is always substantially higher than the competitive price. Other market structures, duopoly and oligopoly, fall in-between.

Federal anti-trust policy reflects this same focus on the number of sellers and the probable impact on the prices paid by consumers. When two firms seek permission to merge, the authorities ask whether the number of firms remaining is enough to assure continued competition.

When retirees fashion retirement plans, in contrast, the regulations designed to protect them have nothing to do with prices. The focus is entirely on assuring that the retiree understands the instrument and associated options being offered, and has made a rational decision. This mandatory education is the major thrust of the counseling required on HECM reverse mortgages by HUD, and the suitability disclosures required on annuities by state insurance regulators.

The rationale in both cases is that reverse mortgages and annuities are extremely complicated instruments that many retirees have difficulty understanding, which is certainly true. The problem is that retirees who have been required to educate themselves about the options available on these instruments at best acquire only limited capacity to judge which options best meet their needs. The problems abound when multiple objectives are involved, as is the case with annuities and reverse mortgages.

Furthermore, the mandatory education typically occurs after the mortgage lender or insurer has been selected, which means that the prices they charge are not part of the decision process.  The Implicit assumption is that the goal of preventing a bad selection based on ignorance is more important than assuring competitive prices.

Our position is that both objectives are attainable using the following 5 step procedure for any given retiree:

1. Merge the annuity and the reverse mortgage into a combination instrument.

2. Identify the retiree characteristics that affect the decision process.

3. Define alternative scenarios of reverse mortgage and annuity options from which the retiree will make a selection.

4. Establish criteria for assessing the relative value of the different scenarios.

5. Find the individual lender and insurer providing the best price for the scenarios selected.

 

Step 1: Merging Reverse Mortgage and Annuity

The rationale is that the combination works best as parts of an integrated retirement plan. Within the plan, the reverse mortgage is used both to fund the annuity and as a source of spendable funds during the annuity deferment period. Annuity payments begin at the end of that period. Reverse mortgage/annuity combinations can have different annuity deferment periods, and different ways of funding the retiree during that period. All combinations are seamless in that the last payment to the retiree from the reverse mortgage matches the first annuity payment.

 

Step 2: Relevant Retiree Features

An illustrative retirement plan is geared for one retiree. This is an example of the information required:

• Age: 63

• Sex: Male

• Financial Assets: $1 million

• Percent of Assets in Equities: 0%

• House Value: $700,000

• Mortgage Balance: $0

• Other Income Sources: $0

 

Step 3: Retiree/Advisor Defines Alternative Scenarios For Comparison

Each of the 6 scenarios shown below, as well as many others not shown, is a potential retirement plan for the retiree shown:

Scenario 1	Scenario 2	Scenario 3	Scenario 4	Scenario 5	Scenario 6
9% Expected Return on Assets	9% Expected Return on Assets	9% Expected Return on Assets	5% Expected Return on Assets	5% Expected Return on Assets	5% Expected Return on Assets
Worst Case Return -3%	Worst Case Return 0%	Worst Case Return 3%	Worst Case Return 1%	Worst Case Return 2%	Worst Case Return 3%
Set-Aside $100,000	Set-Aside $100,000	Set-Aside $100,000	Set-Aside $0	Set-Aside $0	Set-Aside $0
Payment Draws Fixed	Draws Rise 2%/year	Draws Inverse-U	Payment Draws Fixed	Draws Rise 2%/year	Draws Inverse-U
Annuity Deferred 5 Years	Annuity Deferred 10 Years	Annuity Deferred 15 Years	Annuity Deferred 5 Years	Annuity Deferred 10 Years	Annuity Deferred 15 Years
No Annuity Rider	Cash Refund Rider	Return of Premium Rider	No Annuity Rider	Cash Refund Rider	Return of Premium Rider
No HECM Option	HECM Credit Line	HECM Term Payment	No HECM Option	HECM Credit Line	HECM Term Payment

  

Step 4: Criteria For Assessing Scenarios

The retiree will select from among the scenarios based on two criteria: projected future spendable funds, and projected future estate values, over the retiree’s remaining life in both cases. These criteria are deployed in Step 5 below.

Step 5: Select the Annuity Provider and the Reverse Mortgage Lender Whose Price Quotes Are the Best For the Scenario Selected

If scenario 5 is selected by the retiree, the next step is to find the annuity provider and lender offering the best terms. The information system on which this article is based, which we call the Retirement Funds Integrator (RFI), includes networks of 9 reverse mortgage lenders and 11 insurers who price any of the scenarios we deploy. The networks allow us to select not only the best prices for a particular scenario, but also the worst prices, which the unwary retiree may find herself paying.

This is illustrated by the chart, which shows an enormous difference in spendable funds between the best and the worst prices but very little difference in estate values. If anything, the chart understates the difference in spendable funds because the firms in the networks know they are being shopped.

Concluding Comment

The 5-step process described above was designed for expository convenience but it can be conveniently collapsed into 4 steps. RFI merges steps 3 and 5 so that the outputs of each scenario are calculated with the best prices available for the scenario. The upshot is that finding the most advantageous scenario for the retiree, and finding the most advantageous pricing for that scenario, are combined into a single process.