One of the most popular misconceptions we run across when we discuss Home Equity Conversion Mortgage (HECM) with prospective clients and financial professionals is the diminished estate. It’s almost like you get your own personal Rick Moranis aiming his shrink ray at a client’s estate the moment a HECM is considered.
Loss of estate or diminished estate is a huge assumption. People, both professionals and retail clients alike, are often shocked to learn that by utilizing HECM’s we can actually facilitate transferring LARGER estate values to beneficiaries.
Here’s a common situation:
Financial Professional: Ok, you’ve convinced me that HECM’s have an application in planning especially for clients with cash flow needs in retirement. It sounds to me like the ideal client is in need of cash today or down the road and doesn’t have kids.
Wellspring: HECM’s can be used for many different clients. Some of these clients may need cash flow today, many will have a need for protection from cash flow shortfalls in the future. An ideal client may have cash flow needs today or tomorrow and very well may have children. Why do you believe they shouldn’t have any beneficiaries?
Financial Professional: **Giving us an impatient look** Because a HECM will destroy the children’s inheritance.
Wade Pfau, a professor at the American College of Financial Services has done a tremendous job reviewing and analyzing the research on this topic and his conclusions can be found in his book Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement.
Wade’s analysis shows distinct advantages to a client’s overall net worth when they utilize HECM early in retirement for planning purposes. Via a statistical analysis (Monte Carlo) of different performing markets and rates, Wade found in many instances that clients would end up with larger nest eggs to leave to their beneficiaries by coordinating a HECM to offset carrying a traditional mortgage balance & payment in retirement or coordinating a HECM to supplement distributions from traditional investment assets.
But how can that be? Aren’t we taking on a significant amount of debt and accruing substantial interest throughout retirement? Let’s focus on the latter – HECM to supplement distributions from traditional investment assets.
The answer is not so clear. What if, for example, we used the access to equity from a HECM only when we experienced certain circumstances or triggers such as down markets. And, accordingly, what if during other periods of time we paid back the majority of our balance on our HECM. This may come as a surprise to many but a HECM offers you the option of making a payment. You do not need to make payments on the loan, however, you are welcome to make payments at any time if you choose to.
The studies provide a startling observation, if used strategically a HECM can leave a larger investment balance (cash, liquid assets, investment portfolios) to beneficiaries even accounting for any balance and/or interest on the loan upon death.
The easiest circumstance to identify for clients is an example of a market correction. One of the, if not the very, greatest risk to our retirement portfolios is Sequence of Returns Risk. This risk is of our overall portfolio value dropping from short term market volatility (think corrections and bear markets) while we take money out and then never recovering. In the case of IRA’s it is a very dangerous risk, as we typically have little control over RMD’s (required minimum distributions) without facing significant penalties.
Let’s look at the math to help you understand the mathematical difference in losses during accumulation vs. distribution. We believe this will help you understand systematic withdrawal risk.
If you have $1,000,000 in your account and lose 10% in a market correction you now hold $900,000 of assets. To get back to even you only need a return of slightly over 11%. $900,000 * 11.2% = $1,000,000. Many people think the return required is larger, usually the number people jump to is 20%. But it’s typically not a large number until we’re dealing with more significant losses like, say, a 50% loss. $1,000,000 * 50% = $500,000. $500,000 * 100% = $1,000,000.
The first takeaway here is straightforward: The greater the loss, the greater a corresponding return must be to get back to even. However, this math is only correct during accumulation. Throughout distribution, the math can change dramatically.
Let’s take the same scenario and assume that for a period of 3 years you’re also drawing 4% from your portfolio. That 10% loss now is being additionally impacted by distributions, so, in year 1 instead of a 10% drop in our portfolio value we have now dropped 14% or from $1,000,000 to $860,000. The math therefore must change in order to determine what we need to get back to even. In this example, instead of around an 11% rate of return to get back to where we started we now need 25%! **Remember we have an additional 2 years of 4% distributions offsetting some of our portfolio growth
The second essential takeaway here is: if we mitigate or minimize distributions we can make it dramatically easier to sustain portfolio values and/or actually continue to grow our money. This is where we circle back to HECM. A HECM would allow us to potentially eliminate the distributions we are taking from our portfolios during market corrections, thus making our portfolio values more sustainable.
What the studies dig into a little further is ok, great, how would it compare if we then paid back the balance we drew during positive market cycles? And voila, the rubber meets the road, long term net worth could very well end up being higher by using the reverse mortgage.
In this example we have created a tremendous cash flow solution that ALSO creates larger net worth to the estate and/or beneficiaries over time.
Not every advisor understands systematic withdrawal risk and many financial advisors do not practice holistic financial planning. However, those that do, especially when introduced to the research and conclusions from these studies, understand that a HECM can act as more than a cash flow vehicle. It can be a successfully implemented tool that creates positive outcomes for cash flow AND for larger estate values. How about: Honey I Shrunk the Kids Anxiety