Jack M. Guttentag (www.mtgprofessor.com) is Professor of Finance Emeritus, formerly Jacob Safra Professor of International Banking, at the Wharton School of the University of Pennsylvania.
There are three major components of a retirement plan, namely financial asset management, annuities, and reverse mortgages. Yet each element is complex, and each financial product tends to be marketed by different firms which, with few exceptions, do not interact with each other. Further, the markets for both annuities and reverse mortgages are extremely inefficient as a result of their complexity, buyers’ lack of sophistication, and the absence of repeated transactions from which buyers can learn.
The inefficiency of the financial marketplace may not matter to retirees who are sufficiently wealthy. Yet it is critically important to the larger and growing number of older Americans whose home equity comprises a large part of their wealth, along with those forced to delay retirement until it is financially feasible.
Simplifying integration
Developing retirement plans that integrate financial asset management, deferred annuities, and reverse mortgages for retirees who may be past their intellectual prime has long posed an educational challenge. To help solve this conundrum, Allan Redstone and I developed the Retirement Funds Integrator (RFI). Our program benefits retirees by providing them access to more spendable funds during their retirement years, as well as protection against running out of money. These advantages stem from the synergies gained by integration, as well as competitive pricing on annuities and reverse mortgages.
The approach breaks the development of a retirement plan into two phases. Phase 1 is designed to allow a retiree to design a preliminary retirement plan using an easy calculator that simplifies the amount and complexity of information required. In this way, the retiree first learns what a retirement plan is, how the various components fit together, and what a first approximation of his or her financial future might look like.
In Phase 2, and in consultation with an RFE-certified financial advisor, the retiree then is helped to convert the preliminary plan into a final plan. At this stage, additional features and options can be incorporated that reflect the retiree’s preferences and specific assets. Additional features and options not in the preliminary plan can include:
- The retiree may want a different future pattern of drawdown amounts, rather than the 2% a year rule built into Phase 1.
- The retiree might want to check how the plan should change if assets earned different returns.
- The retiree could include a death benefit in the annuity (which would reduce the lifetime income stream).
- The retiree may wish to create a “set-aside” for the estate, with or without a provision that would make it available in an emergency.
Pricing matters
To ensure that retirees get the most competitive annuity and reverse mortgage prices, we have developed networks of both annuity providers and reverse mortgage lenders, so that the best deal can be selected from those offered.
For instance, my comparison of potential spending offered by 10 insurers and 11 reverse mortgage lenders in 2020 showed that the best option paid out 15% more per year, for life, compared to the worst option. This would make a substantial difference in retiree consumption.
Our simulations illustrate that this integrated approach provides more spendable funds over the retiree’s life, along with greater protection against running out as a result of living too long, compared to the 4% withdrawal rule often used by financial advisors. This approach is particularly valuable for house-rich/cash-poor retirees who have few financial assets.
Potential policy implications
In view of the benefits of integration, one might ask why this approach isn’t more widespread? One answer is that the federal Housing and Urban Development (HUD) agency restricts reverse mortgage lenders from participating in ventures with other types of financial institutions. Moreover, it instructs HECM counselors to warn borrowers about the hazards of annuities.
Resistance also comes from advisors who manage assets, since when retirees buy annuities, it reduces most advisors’ fees.
And finally, some state insurance regulators may worry that people taking out reverse mortgages might deplete retirees’ assets. Nevertheless, the Home Equity Conversion Mortgage (HECM) program run by the Federal Housing Administration is insured by the federal government, which should mitigate these concerns.
Unfortunately, however, Congress is concerned about the HECM program because many HECM borrowers have drawn maximum cash from their properties in the first year, leaving nothing to cushion rising tax and insurance payments in later years. This has left large deficits in the mortgage insurance funds, and these may threaten termination of the program.
Our integrated approach could rescue the HECM program from termination because everyone will receive a life annuity, which in most cases will rise over time. As a result, fewer borrowers will fail pay their taxes and insurance in their later years.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
