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You’ve probably heard of the “annuity puzzle,” which refers to the public’s unexplained neglect of life annuities. But there’s another financial conundrum in the retirement world, which one might call “the reverse mortgage puzzle.”

In theory, demand for reverse mortgages should be high. Retiring babyboomers are, on average, cash poor, with tax-deferred savings of only about $100,000. But collectively, they’re house-rich, with combined home equity of about $5.76 trillion. Reverse mortgages, which let borrowers tap equity without selling their homes, could help millions of people. And today’s low interest rates allow maximum loan balances.   

But the 18-year-old federal Home Equity Conversion Mortgage (HECM) program, whose loans are provided by private lenders and insured by the Department of Housing and Urban Development, is shrinking, not growing. After writing 114,400 reverse mortgages in 2009, HCEM lenders wrote only 58,000 in 2015, or just 3% of all mortgages that year.

So, what’s stopping reverse mortgages from being a major retirement income source for Boomers? Quite a lot. As RIJ discovered after talking to participants in the HECM industry, problems include:

• Regulatory changes since 2009, in response to early abuses and unanticipated failings of the program, that have made the HECM product less generous.
• High costs, especially for borderline borrowers.
• A vacuum left by the disappearance of the program’s former intended market.
• The decisions by major distributors like Bank of America, Wells Fargo, and MetLife to discontinue their HECM operations in 2011 and 2012.
• A requirement that borrowers get pre-loan counseling from a licensed Department of Housing and Urban Development counselor.  
• A history of bad publicity, including media images of evictions of elderly HECM borrowers from their homes for failure to pay their taxes or homeowner’s insurance premiums.

“The basic idea behind a reverse mortgage is good, but they have to be completely revamped,” says Nobel Prize-winning economist Robert C. Merton of MIT’s Sloan School of Management, who has published papers on combining reverse mortgages with Treasury Inflation-Protected Securities in retirement, and has seen them work well overseas.

In this first of a series, RIJ will begin to examine the hurdles, kinks, and broken links that prevent the reverse mortgage market from realizing its potential and contributing efficiently to retirement security in the U.S. 

An incredible shrinking product 

Today’s reverse mortgages are a lot less rich than they were before 2008. That alone explains a lot of the shrinkage in the program. HECMs are no longer a panacea for the financially desperate who at one time constituted much of the program’s market.

“Until September of 2009, homeowners could access a ton up front,” said Dan Hultquist (below right), branch manager at Open Mortgage in Atlanta and author of the book, Understanding Reverse. “At the time, why wouldn’t you get a reverse mortgage and invest the money? It was insured up to 90% of the property value. It was almost too good to be true.”

In fact, it was too good to last. The recession that followed the 2008 financial crisis exposed a lot of weak borrowers. People consumed lump sum loans quickly and couldn’t, or didn’t, pay their property taxes and insurance bills. That led to foreclosures, losses at FHA, and a tightening of limits, fees and standards. [See box below.]

Between 2009 and today, FHA and HUD has reduced the loan amount, restricted the amount that could be taken out in an upfront lump sum, raised insurance fees and toughened financial assessments. “The changes in 2013 were massive. I remember when the September 3, 2013 letter came. It was devastating in the way in the shook up the industry. Now most borrowers could only access 60% on Day One without paying a large initial mortgage insurance fee. People couldn’t get a quick fix for cash. And that was what had been driving the volume,” Hultquist told RIJ. 

“The changes that HUD made strengthened the program,” he added, “but they reduced the number of people wanting the program. A lot has to do with delayed gratification.” The original terms of the program offered immediate gratification, the new terms don’t.

“The ironic part is that the new safeguards to make the HECM safer and more desirable, especially the financial assessment, have screened out the borrowers of last resort,” agreed Mike Gruley, director of reverse mortgage operations for First Financial Reverse Mortgage, in Northville, Michigan.

“HUD said, ‘We don’t want borrowers of last resort,’ so they cut off those borrowers,” he told RIJ. “They were gone in a month. Now we’re in a transition to a new borrower, the kind of borrower who uses it as a tool for retirement planning. They aren’t direly in need of [a HECM], and they still harbor some of the old negative misinformation about reverse mortgages. In my view, the transition will take some time.”

‘Complexity and opacity’

Like many insured products, reverse mortgages are difficult for the uninitiated to quickly or easily understand. Concepts like compound interest, which are essential to gauging the money’s worth of a HECM, are, for example, mysteries to many Americans.

“A major problem holding back reverse mortgages is their complexity and opacity,” Deborah Lucas, director MIT’s Sloan School Center for Finance and Policy, told RIJ. “The product needs to be simplified, and the options made more standard so that people can comparison-shop.”

Partly because of that complexity, the government requires anyone who wants to take out a reverse mortgage to undergo a few hours of counseling from a HUD-approved housing counselor. This process costs about $125 and involves an assessment of the borrowers’ ability to pay taxes and insurance and to maintain the house so that it keeps its value for the life of the loan. Amy Ford, director of home equity initiatives at the National Council on Aging (NCOA), one of several groups licensed by HUD to counsel those seeking a HECM, agrees that the product is too complicated. “It can be daunting to dive into,” she said.

HUD’s counseling requirement itself has added an extra step to HECM sales. On HUD’s website, RIJ found, the search engine for locating counselors by Zipcode was not functioning. A few years ago, the brokers arranged the counseling and even attended the counseling sessions. New rules forbid such coziness. Today, counselors walk a fine-line. They aren’t supposed to interfere in the commercial process, but their job is clearly to prevent inappropriate loans. 

One broker told RIJ that she has a sense that HUD hires counselors with a “watchdog” frame of mind. Another said that, because counselors often have a history of working for nonprofit firms or social service agencies, they often look at brokers with suspicion. They may for instance urge borrowers to negotiate harder with a broker or shop around for additional quotes. HUD rules prevent them from recommending one type of HECM loan or loan originator over another. “We’re prohibited as counselors from steering people to certain lenders,” Ford told RIJ.

Costlier than a forward mortgage

Another significant obstacle to popularizing HECMs is the cost of setting them up, financing them, and insuring them. “Right now HECMs are pretty expensive,” said Merton. “The costs need to come down.”

A HECM mortgage, like a forward mortgage, can involve inspections, title searches and assessments. At best, a homeowner can borrow an amount equal to about half of the equity in the home; the other half will gradually be consumed by compounding interest—that is, the cost of financing the loan over the borrower’s remaining ten, twenty or 30 remaining years of life.    

Greater transparency and competition should reduce HECM costs, said Lucas, who has undertaken a formal study of HECMs. She believes that interest rates on borrowed funds from a HECM should be much lower than they are. “With HECMs, the government takes 100% of the credit risk and the lenders are really just middlemen,” she told RIJ, “Yet they have high fees and high interest rates. That makes no sense.”

There are several layers in the HECM food chain. There are independent brokers who work directly with clients, there are originators or lenders (such as banks and mortgage lending companies, that underwrite the loans and may also act as brokers and wholesalers), then there are wholesalers (often called issuers) who buy the loans, bundle them into securities and sell them to institutional investors. In addition, lenders hire servicing companies to monitor the loans and maintain the client relationships.  

The costs of a HECM include all of the usual closing costs associated with a forward mortgage, including fees for appraisals and title searches. The lender’s origination fee is capped at $6,000. Current fixed interest rates on HECM loans are between 4.75% and 5.06%, or about one percent above the current 30-year fixed FHA rate. The adjustable rate, which is the rate used for HECM lines of credit, is between 3% and 4%.

The insurance costs can make the terms onerous. If borrowers want to take more than 60% of the loan in the first year as a lump sum, they must pay 2.5% of the property value as an initial mortgage insurance premium instead of the usual 0.5%. (That’s separate from the annual insurance premium of 1.25% of the loan balance.) If the borrower has difficulty qualifying, part of the home equity can be set aside for future taxes and insurance. All of these costs can be financed, but if they are, they can substantially reduce the available capital. Certain borrowers may, in practice, be able to access only about a quarter of their home equity in the first year of the loan. 

To illustrate the costs associated with HECMs, Hultquist described a recent discussion with a borrower. The homeowner has decided to borrow $70,000 to pay for a new kitchen in her home, rather than dip into savings to pay for the improvement. Since $70,000 was less than 60% of her borrowing limit, she paid a half-percent (0.5%) of the $250,000 property value for the initial mortgage insurance premium of $1,275 (rather than 2.5%, or $6,250) and closing costs of $2,788. In this case, Hultquist knew that he would earn premium from an investor, so he did not charge the homeowner an origination fee, which saved her almost $4,500. (Unwary borrowers, Hultquist said, may not know that the origination fee may be waived incertain situations.)

NEXT WEEK: The holes in HECM distribution.

© 2016 RIJ Publishing LLC. All rights reserved.

What are the implications of negative short-term interest rates for insurance companies? What do current market valuations tell us about tomorrow’s asset prices? How can near-retirees protect their savings from a bear market?  

Every spring, the Society of Actuaries holds a conference for actuaries who help their companies manage assets. At this year’s meeting, held in New York last week, there was a lot of discussion around questions like the ones above, along with cautious predictions about the future and reminders about a few inconvenient tradeoffs that, collectively, we probably can’t avoid.

Last week’s meeting featured descriptions of several new product ideas from entrepreneurial actuaries, including a structured equity product for qualified plan participants, a psychological assessment tool that tells advisors how to communicate better with each client, and a mobile app that encourages 401(k) participants to rebalance their accounts every day just before the market closes.

De-risking 401(k)s with options

A risk protection product for the 401(k) market was suggested by Dan Cassidy, an actuary and financial analyst at P-Solve, a unit of River and Mercantile Group. P-Solve provides hedging advice and services, and Cassidy was promoting a structured equity product that near-retirement participants could use to de-risk their portfolios in the year or two before their retirement date.

The product establishes an options collar around the returns of an appreciated retirement account. It appears to provide protection similar to that provided by the structured variable annuities that MetLife, AXA, Allianz Life and Thrivent have created for individual investors since the financial crisis. Cassidy told RIJ that he was not familiar with those products.

For participants of jumbo plans whose money is in designated target-risk separate accounts and who are near retirement, P-Solve can provide the managers of those separate account with an options overlay that can establishes a floor under losses and a cap on the gains, Cassidy said.

The options portfolio is actively managed, with P-Solve trading puts and calls behind the scenes with counterparties that have less downside tolerance or more upside appetite than the separate account manager. (In a sense, it operates like an all-season heat pump.) The downside and upside limits, and the triggers for trading the options, are customized for each plan sponsor client.

The money that P-Solve makes by trading options is designed to pay for the overlay. This risk protection service is costless for the plan sponsor. The separate account gets billed an asset-based fee of 10 to 20 basis points a year, depending on the size of the account. Large defined contribution plans with long-tenured participants who have large, highly appreciated investment portfolios are P-Solve’s target clients.

Client psychology

Behavioral finance is an increasingly important topic in the investment world, and two of the conference presenters addressed it. Many advisors are required to assess their clients’ risk-tolerance levels prior to designing an investment plan, but Hugh Massie, president of DNABehavior, takes the assessment process much farther.

An accountant and former advisor originally from Australia, Massie has partnered with psychologists since 2001 to create and refine a battery of personality tests that give advisors a multi-dimensional understanding of their clients.

The results can be used to help advisors communicate with clients, understand their reactions to market events, and set goals for their retirement years. He offers the products to individual advisors for as little as $650 a year; enterprise-level licenses can cost much more. “Our sweet spot would be an advisory firm with about $50 million in assets under management” that have mastered the basics of running their business and want to take their game to a more polished level, he told RIJ.

[Massie administered an online 45-question test to RIJ’s editor and provided instant results. The test categorized me as an “Initiator” with is “creative” with a “take charge” but “reserved” nature.

“Initiators like to take bold, aggressive actions and create the rules. They will prefer to lead decision-making, setting the agenda for others to follow and monitoring the timely completion of tasks. They are goal-driven people who like their expectations managed and not to get caught up in unnecessary details. Their decision-making will typically be fast-paced and rational. They will not be afraid to take on challenging assignments or to accept a lot of risks to realize their ambition.”

The dnabehavior test put me in the third highest risk category (“Accumulation,” or medium to high risk). It also suggested the type of advisor that would be most compatible with me (“influencer,” “initiator,” strategist”).]

Daily rebalancing?

Rick Schmitt, an actuary who teaches retirement planning at Golden Gate University, gave a presentation plugging his “Rebalance app.” It’s designed to allow 401(k) participants to boost their long-term returns by rebalancing their retirement accounts every day, in response to a signal on their smartphones shortly before the closing of the equity markets and the daily valuation of mutual funds.

The system requires at least two 401(k)s, one containing a money market mutual fund and the other an S&P500 Index mutual fund. Each day, the participant rebalances by buying or selling an amount of the Index equal to one one-thousandth of his aggregate balance times the point change in the S&P500. Someone with $50,000 in stocks and $50,000 in cash would move $500 if the S&P500 moved by five points. 

Schmitt calls this “modified daily rebalancing.” It works best in choppy markets and worst in steadily rising markets, Schmitt said. According to his calculations, a 50/50 S&P500/cash fund with modified daily rebalancing would have beaten the pure S&P500 Index by 15 percentage points (about one percentage point per year) between January 1, 2000 and December 31, 2015.  

An audience member pointed out that such an inherently contrarian strategy could not be practiced by everyone and still maintain its effect. Another observed that Schmitt’s hypothetical participant seemed to be trying to profit by acting as a market maker, supplying liquidity or inventory as the market demanded. “I’m just trying to start a conversation,” Schmitt said. 

The macro view

Regarding the overall economy, the outlook from big-picture authors and consultants at the meeting was decidedly sober. Although the SOA held its meeting in a Marriott only two subway stops from the tourist-magnet of the big brass Wall Street bull, none of the sell-side’s irrepressible optimism was evident here.

If anything, investors are on the horns of a dilemma, consultants said.  “We need to accept low interest rates or accept defaults,” said David Ryan O’Meare of Willis Tower in describing the bond market. An increase in rates would make it harder for debtors to service the debt they roll over as well as reducing the value of existing bonds. “We can either write down assets today or write down future returns.”

The outlook for equities was equally gloomy. O’Meare and colleague William Rearden said that, historically, when the cyclically-adjusted price-to-earnings ratio—Robert Shiller’s CAPE ratio—is over 20, the S&P 500 is overvalued. Last June, the CAPE ratio was 27. (In 2000, it was 44.2.)

Investors can expect a real growth for equities of only 1.5% a year over the next decade, the consultants said. They projected the average PE ratio at 8.23 in 2025 and at 9.14 in 2030. Pensions fund managers who assume a 7% asset growth rate will be disappointed. They don’t have enough time to wait for a recovery, because a big chunk of their liabilities come due in the next 10 years.

Demographically, we appear to be victims of our own success. As common sense suggests, middle-aged people tend to buy stocks as they accumulate for retirement and older people tend to decumulate in retirement. Between 1954 and 2010, there was a strong correlation between the middle-to-older-age ratio and the PE ratio. But the ratio of middle-aged to older people peaked in the mid-2000s in the so-called G-7 wealthy countries.

© 2016 RIJ Publishing LLC. All rights reserved.