Home Equity: A Retirement Income Source?

The body of research into the efficacy of reverse mortgages to fund retirement continues to grow.  This research, however, has suffered from limitations, especially with regard to understanding the range of potential outcomes for legacy and retirement income goals.

Building on past research, a recent paper by Wade D. Pfau, Ph.D., CFA, entitled “Incorporating Home Equity into a Retirement Income Strategy”^* adds fresh insight into this issue.

Seven Reverse Mortgage Strategies

The reasons to consider a reverse mortgage to fund retirement are:

1. Insufficient investment assets
2. The expectation that an investment portfolio will outperform a housing asset
3. To mitigate sequence of returns risk

Using a hypothetical scenario of an individual with a $1 million retirement portfolio and an after-tax, inflation-adjusted income objective of $40,000, Pfau analyzed seven strategies.

1. Ignore home equity, a baseline to benchmark success probability when home equity was not used.
2. Home equity as a last resort, representing prevailing wisdom that a reverse mortgage should only be opened if investment assets were exhausted.
3. Use home equity first by opening a line of credit at the start of retirement and fully tapping its limits before withdrawing from investments.
4. A coordinated strategy, which establishes a line of credit at the start of retirement and is tapped following years in which the retirement portfolio experiences negative returns.
5. A modified coordination strategy in which the line of credit is used any time that the remaining portfolio value is less than 80 percent of the required glide path.
6. Use home equity last, but which opens the line of credit at the start of retirement rather than “when needed.”
7. Take tenure payments, which involves taking payments based on annuitization calculations at the start of retirement.

Key Findings

• Of the six reverse mortgage strategies, the strategy with the smallest increase in success probability was “use home equity as a last resort,” while the strategy of opening a reverse mortgage at the start of retirement, which allows the line of credit to grow before being tapped (number two above), enjoyed the highest increase in success probability.
• The median legacy values were roughly comparable over a 20-year period. However, after about 25 years the tenure payments strategy offered the best wealth outcomes.
• For retirees confident of outsized investment returns, the best legacy outcome would be to first exhaust the reverse mortgage credit limits before using investment assets to fund retirement since the portfolio value would grow faster than the loan balance.
• In the worst-case scenarios (i.e., 10th percentile outcomes), spending down home equity first was the riskiest strategy, while spending the home equity last had the best record of success.

* For advisors seeking a more detailed discussion, click here to access the original research.