Which is worse with respect to sustaining retirement income: sacrificing potential investment portfolio growth early, or exposing mortgage debt to interest rates later? In his November 2015 paper entitled “Incorporating Home Equity into a Retirement Income Strategy”, Wade Pfau simulates different strategies for incorporating home equity into a retirement plan (both income assurance and legacy) via a Home Equity Conversion Mortgage (reverse mortgage). A reverse mortgage is a non-recourse loan that enables many U.S. homeowners to tap (untaxed) up to $625,000 of home value. The different strategies are:
- Ignore Home Equity: A baseline not comparable to the other strategies.
- Home Equity as Last Resort: Delay opening a reverse mortgage line of credit until the investment portfolio is exhausted.
- Use Home Equity First: Open a reverse mortgage line of credit at the start of retirement and draw upon it first, letting the investment portfolio grow.
- Sacks and Sacks Coordination Strategy: Open a reverse mortgage line of credit at the start of retirement. Draw upon it (until exhausted, with no repayments) only after years when the investment portfolio loses money.
- Texas Tech Coordination Strategy: Open a reverse mortgage line of credit at the start of retirement. Draws upon it (until exhausted) when investment portfolio balance falls below an estimated 80% of a required wealth glidepath. Pay it down when investment portfolio balance rises above an estimated 80% of required wealth glidepath.
- Use Home Equity Last: Open a reverse mortgage line of credit at the start of retirement. Use it only after the investment portfolio is exhausted.
- Use Tenure Payment: At the start of retirement, implement a reverse mortgage tenure payment (life annuity) option, with the balance of annual spending drawn from the investment portfolio.
For each strategy, he runs 10,000 Monte Carlo simulations of a 40-year retirement based on historical annual distributions of 10-year bond yield, equity premium, home appreciation, short-term interest rate and inflation rate. Annual withdrawals and investment portfolio rebalancings (to 50% stocks and 50% bonds) occur at the start of each year. Assuming initial home value $500,000, initial tax-deferred investment portfolio value $1 million, annual withdrawal 4% of initial investment portfolio value ($40,000, subsequently adjusted for inflation) and marginal tax rate 25% for investment portfolio withdrawals, he finds that:
- Regarding retirement plan failure probability (see the chart below):
- Strategy 2 is least attractive.
- Strategy 6 is most attractive.
- Regarding median legacy value:
- Strategies 7 and 3 are most attractive.
- Strategies 6 and 2 are least attractive.
- Regarding upside potential (lucky outcome, 90th percentile):
- Strategies 3 and 7 are most attractive.
- Strategies 5, 6 and 2 are least attractive.
- Regarding downside protection (unlucky outcome, 10th percentile):
- Strategy 6 is least attractive.
- There is little discrimination among other strategies.
- Strategies 4, 5 and 7 offer a balance between upside potential and downside projection.
- It is generally preferable to open a reverse mortgage line of credit as early as eligible.
The following chart, taken from the paper, compares probabilities that the seven retirement strategies described above will survive for each year during a 40-year retirement. Strategy 1 (Ignore Home Equity) is included as a benchmark, but it is not directly comparable to the other strategies. Strategies that open a reverse mortgage line of credit early but delay its use are most effective in avoiding failure.
In summary, evidence from simulations suggests that U.S. investors should open reverse mortgage lines of credit as soon as eligible but defer their use.
Cautions regarding findings include:
- One or more of the fairly complicated simulation assumptions may be materially wrong.
- As noted in the paper, there is risk of changes in reverse mortgage rules (for example, eliminating the option to open a line of credit without using it).
