Originally published at Forbes
In a sign that the time had finally come for the idea of coordinated spending from a reverse mortgage, Harold Evensky, Shaun Pfeiffer, and John Salter of Texas Tech University published two articles—beginning with the August 2012 issue of the Journal of Financial Planning—investigating the role of a standby line of credit. They developed conclusions quite similar to the Sacks brothers without knowing of their work.
Harold Evensky said the motivation for their research came about when the home equity line of credit (HELOC) he had established as a source of liquidity for his clients kept getting cancelled during the financial crisis in 2008. The reverse mortgage line of credit was guaranteed to be there even in times of market stress. They write, “Although reverse mortgages aren’t for everyone, the reluctance to consider use of reverse mortgages in the distribution phase limits the flexibility of distribution strategies.”
Their first article in 2012 investigated the use of an HECM Saver line of credit (which, you may recall, had lower costs but was later merged with the HECM Standard in September 2013) as a ready source of cash to be used as a risk management tool for retirement distributions. The purpose of their research was in line with that of Sacks and Sacks: using Monte Carlo simulations to test portfolio sustainability when portfolio distributions are coordinated with a reverse mortgage.
With a similar objective in mind, they developed a coordinated strategy to better approximate using the reverse mortgage when the portfolio was in jeopardy. Rather than drawing from the reverse mortgage standby line of credit after years of market downturns, they instead drew from the line of credit whenever the remaining portfolio balance fell below the value indicated by a separate wealth glide path calculation.
They determined the amount of remaining wealth required for each year of retirement to keep the spending plan on a sustainable path through the desired planning horizon. After experimenting with this critical path for remaining wealth, they determined that drawing from the reverse mortgage worked best when remaining wealth fell to less than 80% of the wealth glide path. This helped avoid overuse of the line of credit while still providing a mechanism to avoid selling financial assets at overly depreciated prices, thereby helping mitigate the sequence of returns risk.
Another difference between this research and that of the Sacks brothers is that whenever remaining wealth grew enough to be back above the 80% barrier for their critical path trajectory, Evensky & co. worked to preserve a larger line of credit for future use by paying back any outstanding balance on the line of credit throughout retirement. For Sacks and Sacks, no voluntary repayment was made during retirement.
Evensky has heralded the value of using cash reserves to mitigate sequence risk since the 1980s. Cash provides a drag on potential portfolio returns, but its presence serves as an alternative choice to finance spending and avoid selling other assets at a loss. He suggested having two years of spending in a separate bucket and investing remaining funds with a total returns investment perspective. He viewed this as a compromise between the offsetting factors of the drag on returns created by holding more cash and not completely protecting the remaining portfolio if market declines lasted longer than two years.
Their reverse mortgage research follows along the same path with the line of credit used in place of a larger cash reserve. In the 2012 article, they replace the two-year cash reserve with a six-month cash reserve, and they use the line of credit to refill the reserve when necessary. This reduces the cash drag and provides a source of funds not impacted by declining market returns, which allows funding to last substantially longer than two years.
Their glide path approach to choosing when to tap the line of credit establishes decision rules that keep better track of cumulative outcomes, so it makes intuitive sense. This same philosophy guides the Asset Dedication work of Stephen Huxley and Brent Burns on when to extend a dedicated income ladder and informs David Zolt’s variable spending strategy regarding when it is acceptable to take inflation adjustments for spending.
Their 2012 research uses the line of credit as a source of funds only when the portfolio is below the mark set by the glide path and the cash reserve bucket has been depleted. They also determined through trial and error that the best threshold for minimizing use of the line of credit and achieving better overall results is when remaining wealth is less than 80% of its glide path level.
As with Sacks and Sacks, they found that using the standby line of credit improved portfolio survival without creating an adverse impact on median remaining wealth (including remaining home equity). This provided independent confirmation that the reverse mortgage line of credit can help mitigate sequence of returns risk without impacting legacy goals.
They also confirm that having a larger line of credit (either through a higher PLF with lower interest rates or greater home value) relative to the portfolio size heightens the likelihood of sustaining a positive portfolio balance. As a result, these strategies were shown to be more attractive in low interest rate environments. Evensky & co. conclude that a standby line of credit deserves a role in mainstream retirement income planning for four reasons:
- it diminishes the need to maintain a larger cash buffer,
- it provides flexibility to hold onto investments during bear markets,
- it allows flexibility to use home equity as a source of income, and
- it improves portfolio survivorship rates without an adverse impact on remaining legacy wealth.
In December 2013, the same authors returned with a second study on using a standby line of credit for retirement income planning. This time, they shifted the focus to how much the sustainable withdrawal rate could be increased with a line of credit while maintaining a 90% success rate over a 30-year retirement. They confirm that the standby line of credit helps sustain higher withdrawal rates when retirement starts in a low interest rate environment and when the home is worth more than the investment portfolio.
Consistent with other withdrawal rate research using lower capital market expectations than the historical average, they calculate that the sustainable spending rate without a reverse mortgage is 3.25%. With a reverse mortgage, the withdrawal rate can reach 6.5%. This highest number happens when the home value matches the portfolio size and interest rates are low at the start of retirement.
Since the HECM Saver no longer existed on its own, this article considered the new form, which still exists today. Otherwise, assumptions are the same as their previous article. They note that these higher withdrawal rates are on par with those obtained through dynamic spending strategies that can involve substantial spending reductions over time, but that the HECM strategy can sustain the higher spending rate without such reductions.
They again emphasize that sustainable spending rates are higher with the coordinated strategy when interest rates are low because a larger principal limit is available. In the current low interest rate environment, it would be less prudent to hold off on the reverse mortgage decision.