In a recent article, I described how the HECM program allows eligible homeowners to benefit from unusually large house price appreciation without bearing the risks associated with low or no appreciation. See Reverse-Mortgages-Are-An-Excellent-Hedge-Against-Property-Value-Risk-Especially-Now. The bad news is that rate-of-return risk is a much greater threat to retirees than property value risk. The good news is that the HECM program can be used to hedge against that risk as well.

Consider the case of a male retiree of 64 with $500,000 of financial assets and $500,000 of equity in his home. The division of his financial assets is 25% in common stock and 75% in fixed-return assets. He wants to convert as much of the financial assets as possible into spendable funds during his remaining years but without the risk of running out if he lives too long. The model used to meet this challenge was developed by my colleague Allan Redstone.

Step1 is to use part of the retiree’s financial assets to purchase a deferred annuity – one that does not start payments until some period has elapsed, referred to as the “deferment period.” The balance of his assets is drawn monthly for spendable funds during that period. This is illustrated by the line of spendable funds in Chart 1, which assumes a deferment period of 20 years, a rate of return on the assets remaining after purchase of the annuity of 5.9%, and an annual increase of 2% in both draw amounts and annuity payments. The dotted portion of the line represents asset draws while the solid line shows annuity payments.

Why 5.9% return over a 20-year deferment? This is the median rate of return on 25%/75% portfolios over large numbers of 20-year periods. Why 20 years? Because it results in higher spendable funds than 10- and 15-year deferment periods, as shown in Chart 2.

Step 2 of this approach is to factor in the risk that the rate of return will be lower than the median return. For example, assuming the same 25%/75% portfolio, there is a 2% probability that the rate of return over a 20-year period will be 3.60% or lower.

That is not very high, but we purchase insurance to protect against lower probability hazards than that.

If the retiree assumes a 5.9% rate of return but a return of 3.6% materializes, the draw amounts will decline over 20 years, or until the annuity kicks in, as shown at the top of Chart 3. This can be prevented using a HECM credit line as a buffer, providing draw mounts that exactly match the shortfall in the draws from financial assets. This is the lower line on the chart.

The focus of this article on spendable funds available to the retiree says nothing about estate value, which may or may not be of concern to the retiree. That will be the subject of a forthcoming article.

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