Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D. program in financial services and retirement planning at The American College in Bryn Mawr, PA. He is also a principal and director at McLean Asset Management and the Chief Planning Scientist for inStream Solutions. He actively blogs at RetirementResearcher.com.

The following piece is an excerpt from his book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement. He will be joining Tim Jackson and John Salter for the “A New Look at Reverse Mortgages” session at the 8^th Annual Inside Retirement conference in Dallas on May 11-12.

Retirees must support a series of expenses—overall lifestyle spending goals, unexpected contingencies, legacy goals—to enjoy a successful retirement. Suppose retirees only have two assets—beyond Social Security and any pensions—to meet their spending obligations: an investment portfolio and home equity. The task is to link these assets to spending obligations efficiently while also mitigating retirement risks like longevity, market volatility and spending surprises that can impact the plan.

The fundamental question is this: How can these two assets work to meet spending goals while simultaneously preserving remaining assets to cover contingencies and support a legacy? Spending from either asset today means less for future spending and legacy. For the portfolio, spending reduces the remaining asset balance and sacrifices subsequent growth on those investments. Likewise, spending a portion of home equity surrenders future legacy through the increase and subsequent growth of the loan balance. Both effects work in the same way, so the question is how to best coordinate the use of these two assets to meet the spending goal and still preserve as much legacy as possible.

When a household has an investment portfolio and home equity, the “default” strategy tends to value spending down investment assets first and preserving home equity as long as possible, with the goal of supporting a legacy through a debt-free home. A reverse mortgage is viewed as an option, but it’s only a last resort once the investment portfolio has been depleted and vital spending needs are threatened.

The research of the last few years has generally found this conventional wisdom constraining and counterproductive. Initiating the reverse mortgage earlier and coordinating spending from home equity throughout retirement can help meet spending goals while also providing a larger legacy. That is the nature of retirement income efficiency: using assets in a way that allows for more spending and/or more legacy.

Legacy wealth is the combined value of any remaining financial assets plus any remaining home equity after repaying the reverse mortgage. Money is fungible and the specific ratio of financial assets and remaining home equity is not important. In the final analysis, only the sum of these two components matters.

For heirs wishing to keep the home, a larger legacy offers an extra bonus of additional financial assets after the loan balance has been repaid. The home is not lost.

While taking money from the reverse mortgage reduces the home equity component, it does not necessarily reduce the overall net worth or legacy value of assets. Wanting to specifically preserve the home may be a psychological constraint, which leads to a less efficient retirement. As Tom Davison of ToolsforRetirementPlanning.com has described the matter to me in our discussions, a reverse mortgage allows a retiree to gift the value of the house rather than the house itself. Should the heir wish to keep the house, the value of the house they have received as an inheritance can be redeployed for this purpose.

Two benefits give opening a reverse mortgage earlier in retirement the potential to improve retirement efficiencies in spite of loan costs. First, coordinating withdrawals from a reverse mortgage reduces strain on portfolio withdrawals, which helps manage sequence of returns risk. Investment volatility is amplified by sequence of returns risk and can be more harmful to retirees who are withdrawing from, rather than contributing to their portfolio. Reverse mortgages sidestep this sequence risk by providing an alternative source of spending after market declines.

The second potential benefit of opening the reverse mortgage early—especially when interest rates are low—is that the principal limit that can be borrowed from will continue to grow throughout retirement. Reverse mortgages are non-recourse loans, meaning that even if the loan balance is greater than the subsequent home value, the borrower does not have to repay more than their home is worth. Sufficiently long retirements carry a reasonable possibility that the available credit may eventually exceed the value of the home. In these cases, mortgage insurance premiums paid to the government are used to make sure the lender does not experience a loss. In addition, the borrower and/or estate will not be on the hook for repaying more than the value of the home when the loan becomes due. This line of credit growth is one of the most important and confusing aspects of reverse mortgages.

As the government continues to strengthen the rules and regulations for reverse mortgages and new research continues to pave the way with an agnostic view of their role, reverse mortgages may become much more common in the coming years. Many Americans rely on home equity and Social Security as the two primary available retirement assets. 

Wade D. Pfau, Ph.D., CFA, is a professor of retirement income in the Ph.D. program in financial services and retirement planning at The American College in Bryn Mawr, Pa. He will speak on reverse mortgages at Financial Advisor's Inside Retirement conference in Dallas on May 11. He is also a principal and director at McLean Asset Management and the chief planning scientist for inStream Solutions. He actively blogs at RetirementResearcher.com.