The integration of the three components of retirement plans – financial asset management, annuities and reverse mortgages – would widen the use of annuities and generate significant externalities. The greatest benefits would accrue to the most disadvantaged retirees.

Why Annuities Are Underutilized
(And What Could Be Done About It)

August 21, 2020

As the only way in which retirees can profit by sharing mortality risk with others in the same age bracket, annuities should be in the retirement plans of almost all retirees. That they are not speaks to the chaotic nature of our private retirement system.

Retirees who could profit from an annuity but don’t, for reasons discussed below, suffer lower spendable funds over their life spans. The loss is particularly large among homeowners with limited or no financial assets. These are the “cash-poor-house-rich retirees, who comprise a large proportion of all retirees,

The Available Options

Consider a retiree of 63 who has no financial assets and a house worth $700,000. To convert that into spendable funds without selling the house, this retiree has two options under the HECM reverse mortgage program. One option is a tenure payment which provides a constant monthly payment for as long as the retiree resides in the home. The alternative, which is substantially better but little used, is to draw a credit line, part of which is used to purchase a deferred annuity while the remainder is used to provide spendable funds during the deferment period.

Comparing Spendable Funds Provided by the Options

Comparing the options is complicated by the fact that the market structures for both HECM reverse mortgages and annuities are highly imperfect. In both markets, prices can vary widely on the same transaction. To take account of that, I shopped 11 reverse mortgage lenders and 10 insurers, identifying the best and the worst of their quotes. The results are shown in the table below.

 HECM Tenure Payment Compared to HECM Annuity COmbo  

In sum, the payment to the retiree using the credit line/annuity combination is significantly better than the tenure payment. The spread between the best and worst quotes is horrendously large in both cases, a problem discussed further below.

Other Advantages of the Credit Line/Annuity Combo

The credit line/annuity combination has other significant advantages over the tenure payment. The major one is that it can incorporate an inflation adjustment, illustrated in the chart below. The payment on the combination increases by 2% a year while the tenure payment is fixed. The chart uses use the best market quote in both cases.


Chart of HECM Tenure Payment vs HECM Annuity Combo

 

In addition, payments on the credit line/annuity combo continue until death whereas tenure payments end if the retiree moves to a nursing home.

Why the Credit Line/Annuity Combo Is Stunted: The Role of Insurers

Many if not all annuity providers have a policy of rejecting annuities that would be financed with a reverse mortgage. The reason seems to be a concern that such transactions expose them to litigation from disgruntled heirs who claim they were cheated out of the house they expected to inherit.

This is a well-founded concern, since such cases have arisen, The need to fix it is compelling, since the policy affects the homeowners who are most in need of annuities – those without significant financial assets. The homeowner with sufficient assets to pay the annuity premium has no problem combining a credit line with an annuity.

A way to eliminate the litigation risk is discussed below.

Why the Credit Line/Annuity Combo Is Stunted: The Role of HUD

HUD is hostile to the practice of combining reverse mortgages with annuities. While HUD cannot tell a borrower what it can and cannot do with HECM proceeds, it instructs the counselors who must sign off on the readiness of the client, as follows:

  • Determine if client is considering using loan proceeds to purchase an annuity
  • Inform client that there are ways to obtain an annuity without using HECM proceeds
  • Discuss costs and implications of purchasing an annuity with the proceeds from a reverse mortgage
  • Explain that in some cases fixed monthly annuity advances that continue for life may be smaller than fixed monthly loan advances from a reverse mortgage for as long as the client lives in his/her home. (HECM Protocol, Chapter 5, Section B)

The last bullet point is flat-out wrong. A corrected statement, based on the evidence provided earlier, would be that fixed monthly annuity advances funded by HECM credit lines will almost always be larger than fixed monthly loan advances from a stand-alone reverse mortgage. The reason is that the first option involves mortality risk-sharing while the second does not.

HUD’s stance is inconsistent with its responsibility for prudent management of the mortgage insurance reserve fund. The GNMA segment of the fund has been suffering losses for several years because too many borrowers have been failing to pay their property taxes and home insurance premiums.

While I have not been able to find any data on this, a plausible inference would be that the failures have been heavily concentrated among borrowers who used up their HECM borrowing power early on. The program allows borrowers to cash out 60% of their borrowing power upfront, and the balance a year later. In contrast, the credit line/annuity combo guarantees that they will have money for the rest of their lives. HUD should promote it, not pan it.

HUD’s antipathy to combining reverse mortgages with annuities reflects its concern that the client will be taken advantage of. They will be confronted with two very complicated transactions instead of one, and while clients are counseled about reverse mortgages, the counseling does not cover annuities — except for a warning.

An effective remedy should deal with the concerns of HUD about the need to protect borrowers from being exploited, as well as the concerns of insurers about legal exposure.

Proposal For an Independent HECM/Annuity Integrator   

The proposed entity would provide the following functions.

Comparative Option Analysis: A retirement plan that integrates annuities with HECM reverse mortgages and financial assets can take many different forms. For example, annuity deferment periods can vary from 1 to 25 years, annuities can be priced with and without early death protection, and the yield on financial assets can take many values. The integrator should be able to counsel retirees on which combination of features best meets their needs by comparing their implications for monthly spendable funds and estate values.

Legal Protections: The integrator would protect annuity providers by assessing the overall financial condition of the client to verify that the transaction is suitable. In addition, it would require clients to acknowledge that they have been offered annuity riders for Cash Refund and Return of Premium on Early Death.

Competitive Pricing: The integrator would meet HUD’s concern that seniors need to be protected from predatory pricing by selecting the best prices from networks of both insurers and reverse mortgage lenders. The selection of the provider offering the best price can be over-ridden only by the retiree who has some special reason to choose a particular provider.  

Certification

In the best of all worlds, integrators would be certified by an authoritative source. HUD is a logical choice but has an unfortunate history of taking forever to get anything done.

In the absence of a plausible certifier, integrators will have to sell themselves. Since their option analysis, legal protections and competitive pricing are readily documentable, self-certification should be workable.  

The Retirement Funds Integrator

Since there are no integrators at this time, my colleagues at Mortgage Professor LLC and I decided to develop our own. Not surprisingly, our patent-pending Retirement Funds Integrator (RFI)tm has all the features discussed in this article. Insurers and reverse mortgage lenders who might wish to participate can email me at jguttentag@mtgprofessor.com.


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