On Dec. 12, 2007, the Senate’s Special Committee on Aging heard testimony on reverse mortgages. The information highlighted the importance of reverse mortgages, which convert illiquid home equity into liquid savings. These savings can then be used for retirement expenses. They can also be used to mitigate the risks of retirement. The senior population, which possesses $4 trillion in home equity, faces the risks of living much longer than they expected and of needing assistance in daily living.
Reverse mortgages can help provide necessary funds to purchase insurance that can then help mitigate the cost posed by these risks. It is not surprising, then, that the Senate committee members were told that the number of originated reverse mortgages is rapidly on the rise.
The senators heard other witnesses, however, who believe that reverse mortgages may pose a threat to seniors. These witnesses indicated that they believe reverse mortgages are to blame for any losses that are incurred on financial products purchased with the transaction’s proceeds, such as variable annuities. A common story emerged from this testimony, a story that is periodically repeated in the media. In this negative scenario, a reverse mortgage customer obtains a home equity loan that they neither want nor need, and the advisor uses the proceeds from the transaction to purchase unsuitable products.
Some agents may describe this transfer of proceeds as playing a large part in the reverse mortgage transaction which, of course, it is not. Variable annuities, which are the biggest culprits named by those who are cautious about reverse mortgages, carry high surrender charges and earn rates of return below the loan cost, which can make them unsuitable for seniors who may not outlive the length of the term.
Disclosure and suitability
There are two essential concepts that insurance agents must grasp in order to protect themselves and their clients: disclosure and suitability. Since third-party counseling is, by law, required for 90 percent of reverse mortgage loans (and is nearly universal for the other 10 percent), borrowers should receive full and fair disclosure without exception. Suitability relates to the customer themselves and whether the proposed financial product or transaction reasonably meets their objectives given the client’s age, wealth, marital status, risk tolerance, health, bequest motives, and other factors.
The source of funds used to purchase another financial product, however, is not material to that product’s suitability. It is irrelevant whether a senior used Social Security benefits, lottery winnings, or a reverse mortgage to purchase a high-cost, high-risk annuity with their savings. Rather, the purchase can be unsuitable because the wealth accumulation products some agents sell to seniors are not appropriate and are far more suitable for younger workers saving for retirement. In other words, suitability has nothing to do with the source of funds — has everything to do with the personal profile of the customer.
By its very nature, the insurance industry offers products that may not be suitable for each and every consumer. There are suitable annuities, life insurance products, and other investments for seniors, as there are different products that better suit their younger counterparts.
Obviously, not all annuities are bad. Some regulators, as well as advocacy groups, see annuities as monolithic, but they are not — there are indeed suitable annuities for seniors. In particular, annuities that manage risk may work well for seniors. Immediate annuities, which guarantee an income that cannot be outlived, are more in line with the types of products that seniors should be buying, even if they’re purchased with a portion of their reverse mortgage proceeds.
From this, a theme emerges. Risk management should be regarded as a primary goal, and products that help achieve this goal are more likely to be suitable. A small portion of reverse mortgage proceeds can go a long way in mitigating the risks that seniors face for the duration of their retirement. Longevity insurance provided by immediate annuities is generally fairly priced. The risk-adjusted cost of LTCI can also be favorable. By contrast, wealth accumulation using retirement products is generally not a suitable transaction for seniors who are eligible for reverse mortgages because the risk profile of the investment and the near-term liquidity costs are too high.
Seniors who are eligible for reverse mortgages must be advised of the risks such a transaction can pose in their retirement years. It is not uncommon for seniors to demur at the thought of insuring longevity risk through immediate annuities by believing they will die prematurely. The very same senior may also be reluctant to purchase LTCI because they believe they will live in perfect health until their death. The more likely scenario is that many of us will be around longer than we expect to be.
Many of us will also face risks to our health and retirement income that could have been mitigated most effectively in advance through financial planning. Seniors and their advisors should not shy away from suitable products to help them manage these risks.
Jeff Lange is a cofounder of the reverse mortgage lender Generation Mortgage. He can be reached at 212-381-7530. Jeff Lewis is chairman and cofounder of Generation Mortgage. He can be reached at 212-651-0822.