Using home equity to enhance retirement income planning is an emerging topic in financial planning.
When I address consumer groups and conferences for financial professionals all around the country, I note that the traditional three-legged stool of retirement security–which traditionally has relied on pensions, personal savings and Social Security–is broken. Many Americans have not accumulated enough savings to support a retirement that could last 30 years or more.
I offer an alternative analogy of a retirement income pyramid that relies on Social Security and retirement savings as a solid base, augmented by additional layers that tap home equity, assume part-time employment and incorporate other sources of income, if necessary, such as inheritances, brokerage accounts and income-producing assets.
New research by Peter Neuwirth, Barry Sacks and Stephen Sacks published in the October issue of the Journal of Financial Planning documents how including home equity in the form of a reverse mortgage, with retirement savings, can maximize retirement income while minimizing the probability of exhausting all assets before the end of retirement.
In the article, "Integrating Home Equity and Retirement Savings through the Rule of 30", the authors suggest that this new approach could serve as an alternative to the 4% rule of thumb that financial advisers have used for decades. The 4% rule, first developed by financial planner William Bengen in 1994, is based on the theory that if a retiree restricts his or her initial withdrawals to 4% of their portfolio in the first year of retirement, and increases annual withdrawals to account for inflation, their savings should last for 30 years or more.
But steep market declines during the financial crisis of 2007- 2009, which coincided with the first few years of retirement for millions of Baby Boomers, threw that theory into question as steep losses early in retirement decimated their portfolios, leaving many retirees with insufficient assets to benefit from subsequent market recoveries.
The new research demonstrates that the appropriate dollar amount of the initial withdrawal for any given total amount of retirement savings plus home value at the outset of retirement turned out to be 1/30 of that combined amount for a broad range of retirees. The research assumes the portfolio is invested 60% in equities and 40% in bonds.
The analysis is based on retirees using a coordinated strategy of establishing a reverse mortgage credit line at the outset of retirement and drawing income from the portfolio in the first year of retirement equal to 1/30 of total retirement income resources (portfolio and home equity). If the portfolio performance is positive, the next year's income would be withdrawn from the portfolio. If the performance is negative, the ensuing year's income would be withdrawn from the reverse mortgage credit line.
"The dollar amount of the initial withdrawal that resulted in an approximately 90% probability of cash flow survival was the same across a broad range of ratios of home value to initial value of retirement saving portfolio," the article found.
The research tested the hypothesis against four profiles of retirees, including mass-affluent retirees with a home value of about $400,000 and a portfolio of retirement savings of $800,000; house rich, mass-affluent retirees with a home value of $800,000 and a retirement savings of $400,000; the almost-affluent retiree with a home value of $150,000 and total retirement savings of $300,000; and the house-rich, almost affluent retirees with a home value of $300,000 and a retirement portfolio of $150,000.
"Home equity has been the forgotten asset of retirement planning for years," said Jamie Hopkins, co-director of the Center for Retirement Income at The American College of Financial Services.
"Most financial advisers don't take a comprehensive look at home equity solutions in a retirement income plan," Mr. Hopkins said. "This can leave the client's largest asset sitting idle until being used as a last resort or as a legacy asset to heirs upon death," he added. "But for many people, using home equity more strategically and throughout retirement can be a more effective solution."
Mr. Hopkins noted that the new research highlights another important concept: "Reverse mortgages are not just for the cash-poor and house-rich client, but that reverse mortgages can help millions of middle wealth Americans in retirement."
The authors noted that despite recent changes to initial and annual mortgage insurance premium rates and lending limits that affect reverse mortgages issued after Oct. 2, none of the changes "would have a material impact on the key findings presented here."