Equity release for risk reduction

jamesd

In The Case for Reverse Mortgages Wade Pfau points out that equity release can be used to reduce drawdown risk by removing the need to draw from investments during times when markets are down.

kidmugsy

Does this refer to a subsidy from the taxpayer?
"The process involves opening a standby line-of-credit through the Federal Housing Administration’s Home Equity Conversion Mortgage (HECM) program."

"These reverse mortgages are also non-recourse"" might that imply a subsidy from someone, again presumably the taxpayer? Or is it funded by charging a higher rate on the mortgage than would otherwise be necessary? I'd think if I were a customer I'd be prepared to pay more to avoid the risk of ruin. Perhaps that's what he means by "Mortgage insurance paid on any outstanding balance is what will be used to make the lender whole in such cases", a sentence which unfortunately uses the passive mood so he doesn't tell us who is doing the paying, but I assume it's the customer, unless it's the taxpayer via HECM.


Anyway his general point is interesting. But why is it better to (effectively) sell off a bit of your house when equities are doing badly, than to sell some of the equities and sell off a bit of your house later when funds have run low? I mean, what if house values have sunk along with the value of equities? Why is it better to fund your expenses with one rather than the other? Or more precisely, how can you tell which is the better one to use at any particular point?

Another possibility is to have a fair chunk of your portfolio in cash or bonds, and draw on that while equities are low. I suppose that's unattractive while interest rates are so low.

jamesd

What's being discussed are standard UK-type equity release mortgages with variable drawdown facility.

No subsidy. In the US a high proportion of all mortgages are sold to state-governed buyers and this is just another one of those. They aren't supposed to be subsidising, just helping to make mortgage money available, though they do help to produce lower overall mortgage rates. The UK the equivalent wording for non-recourse is a no negative equity guarantee and that's now standard in the UK market. That protection is just built into the charging, as with the mortgage insurance he mentioned, though it's also done by limiting how much can be borrowed so there's a low chance of living to what could become negative equity, he mentions this with his "line-of-credit will grow throughout retirement" wording.

The equity release drawing down doesn't sell an asset so it doesn't matter whether prices are temporarily down or not. While if you draw on investment capital you are selling assets at a time when prices are down. If you want a rule you'd perhaps look at the cyclical P/E ratio. At the high use level you might consider using it for all drawings above natural yield whenever the P/E is below long term average by more than a fewe percent, to represent the cost of the interest.

Having a large chunk in cash is unattractive because of the lower investment returns. Bonds can also be unattractive when rates are low, except that in the case of bonds that would be a good time to sell and repay some of the equity release.

redux

When the stock market is down, could someone release more from their dwelling than they need to live on, and pay some back into the pension scheme, on an assumption of market recovery ahead?

Linton

Looking at the house as simply another asset held along side pension pots and savings the idea seems misconceived to me if one doesnt need the cash in the near term. All equity release does is to transfer value from one asset (a house) to another (savings).

The trouble with equity release is that interest rates are high (around 6% from a quick Google) and so one is paying 6% every year until death for the lump sum converted.

Wouldnt this make taking an over-large equity release and investing the proceeds a doubtful proposition? Much better surely to leave the equity in the house and take more later if and when it is needed.

jamesd

redux, yes, that's the idea. Just sufficient to top up the natural income from the investments so no capital sales are needed. Or alternatively the more risk-inclined could borrow to buy during the deeper downturns.

Linton, yes, 6% is still better than selling during a market downturn when the capital cost would be 20-45% or so but with a recovery time unlikely to exceed a year or three..

Linton

jamesd wrote: »

redux, yes, that's the idea. Just sufficient to top up the natural income from the investments so no capital sales are needed. Or alternatively the more risk-inclined could borrow to buy during the deeper downturns.

Linton, yes, 6% is still better than selling during a market downturn when the capital cost would be 20-45% or so but with a recovery time unlikely to exceed a year or three..

James - thats 6% per year for the rest of ones life given up for a one-off return. Do you really want to be trading with the proceeds of your house well into retirement????

jamesd

Linton, the type of equity release mortgage being discussed allows drawing down and repaying at any time. So it's not for life, just until market recovery makes it sensible to repay. Think of it as a big, cheap overdraft or flexible standard mortgage.

Linton

jamesd wrote: »

Linton, the type of equity release mortgage being discussed allows drawing down and repaying at any time. So it's not for life, just until market recovery makes it sensible to repay. Think of it as a big, cheap overdraft or flexible standard mortgage.

So you would advocate borrowing money at 6% in order to invest on the stock market?

wotsthat

jamesd wrote: »

In The Case for Reverse Mortgages Wade Pfau points out that equity release can be used to reduce drawdown risk by removing the need to draw from investments during times when markets are down.

Sounds more suitable for people who are able to determine with accuracy that markets are low and about to recover. Such a person ironically wouldn't need a reverse mortgage in the first place.

jamesd

Linton wrote: »

So you would advocate borrowing money at 6% in order to invest on the stock market?

That's not what Wade Pfau's article or the studies he references are about. It's about borrowing money at a suitable rate to avoid selling during a market low period. As the paper Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income explained "the 30-year cash flow survival probability for an initial withdrawal rate of 6 percent is only 55 percent when the conventional strategy is used, but is close to 90 percent when the coordinated strategy is used" compared to just 4.5% being possible to have the same 90%+ success rate over 30 years without the use of the equity release mortgage.

That paper also mentions the Guyton or Guyton and Klinger safeguards that would allow a 6.5% withdrawing rate with nearly 90% success rate when used in combination with their work. The two additional safety rules are:

1. "there is no increase in withdrawals following a year in which the portfolio’s total investment return is negative, and there is no make-up for a missed increase in any subsequent year"
2. "the maximum inflationary increase in any given year is 6 percent, and there is no make-up for a capped inflation adjustment in any subsequent year"

Both of those rules implement income cuts in adverse investment return circumstances.

Personally I think that an increase in income without a substantial increase in failure probability from 4.5% to 6.5% is worth knowing about: that's a 44% increase in income. Or if you prefer the over 90% success cases only, it's an increase from 4.5% to 6%. Alternatively you could keep the income the same and have lower failure rate.

wotsthat wrote: »

Sounds more suitable for people who are able to determine with accuracy that markets are low and about to recover. Such a person ironically wouldn't need a reverse mortgage in the first place.

Knowing that markets have fallen is easy. No need to know when they are about to recover, just that mean reversion happens eventually. the studies don't include a predicting the future component.