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Reverse mortgages can be a good last choice, in special circumstances

If annuities are the nerds of the retirement planning world, then reverse mortgages would be the black sheep; sort of like that distant cousin who started smoking at 13 and writing graffiti in the school washroom, the guy your mother warned you to stay away from.

At least in the case of reverse mortgages, the bad reputation is overstated. A reverse mortgage is perceived negatively because it erodes the equity in one's home, an act that is regarded as practically sacrilegious. Sometimes, however, there is no choice.

Consider a couple, both age 65, who have a paid-off house worth $500,000. They also have retirement savings of $450,000 as well as the usual government pensions. Unfortunately they encounter some bad luck in the form of investment returns that are so poor they are better than only 5 per cent of all outcomes. As a result, the couple's savings run out by age 79. The situation is illustrated in the first accompanying chart, below.

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Without a new source of income, this couple will have to reduce their expenditures by a whopping 36 per cent starting at age 80. Most likely, they would be forced to downsize and really, who wants to go through a major move at age 80?

Let's see what happens if they decide instead to take out a reverse mortgage. They choose the monthly income payment option rather than a lump sum and receive income of $16,000 a year starting at age 75. These payments allow them to reduce the rate at which they are drawing down their retirement savings. As a result, they now have enough money to maintain their spending habits until age 90 even though their returns are no better than under the first scenario. This is shown in the second, lower chart.

They incur interest on these income payments at a fairly high rate, currently 5.22 per cent for a five-year term. (The rate comes from HomEquity Bank, the dominant player in the reverse mortgage business in Canada.) This means the debt grows fairly quickly over time but since it is a reverse mortgage, nothing has to be paid back until the last survivor leaves the house. By age 90, the amount of debt has climbed to $360,000 while the equity in their home has grown to $900,000 (assuming annual increases in house prices of 2.5 per cent). That still leaves them with $540,000 in equity that can be used for long-term care if necessary or passed along to their children upon death.

One should always think twice before incurring debt, but sometimes it is necessary. The fact that this retired couple can maintain their lifestyle with a reverse mortgage should be reason enough to proceed, but only once it becomes clear that the need is there. Note that if they achieve average investment returns instead of the dismal fifth-percentile returns used in the charts, their retirement savings would be sufficient to last their entire lives.

Perhaps reverse mortgages are now starting to look a little better than that reprobate cousin. Still, two questions should come to mind. The first is whether there was a better way, an approach that does not involve the creation of debt. A regular mortgage or a home-equity line of credit would have entailed much lower interest payments but they still produce debt and, moreover, that debt that would have to be repaid while they are still alive, which is a non-starter.

Alternatively, they could have downsized or spent less money from the outset but that would have meant a substantial drop in their quality of life. Finally, they could have chosen less risky investments to mitigate the impact of future investment losses but such a strategy merely locks in a lower investment return, which means they would still run short of money eventually.

The other question relates to the downside risks of a reverse mortgage. The benefits are reasonably clear but have we really plumbed the depths of what could go wrong? There are indeed some risks but they should be manageable. In the worst case, house prices fall while interest rates climb. To minimize this risk, it is best not to start a reverse mortgage too early, such as at age 65 because the buildup of debt might make it impossible to move.

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It is true that starting payments at 75 creates the same problem, but to a much lesser degree since the chances of moving are slim and there is less time for the debt to grow too large. The other pitfall with starting a reverse mortgage too soon is that the extra payments might tempt you to indulge in a lifestyle that you may not be able to afford in the long run.

In summary, a reverse mortgage can be a respectable vehicle in the retirement planning process. It doesn't replace the need for retirement savings but it can certainly act as a useful income supplement if it is used wisely.

Frederick Vettese is the chief actuary of Morneau Shepell and author of the book, The Essential Retirement Guide: A Contrarian's Perspective. He does not benefit directly or indirectly from the sale of reverse mortgages.

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