Here’s Why Retirement Planning Tools Make a Difference

Interview with Wade Pfau

Professor Wade Pfau, a professor of retirement income at the American College, shares his thoughts on reverse mortgages. A lot has changed in terms of the rules for this kind of mortgage, as he explains this at length.

Douglas Goldstein: I'm very excited to have on, The Goldstein on Gelt Show, Professor Wade Pfau who is a Professor of Retirement Income at the American College.

Professor Wade, it sounds like you deal with the subject of retirement income on a much more theoretical level.

I'd like to dive into a real practical question that comes up all the time, which is, a lot of times, people get older and they own their home and they're asked to take a reverse mortgage on it to pay their expenses for the rest of their lives

Are they getting good advice?

Should You Take a Reverse Mortgage on Your Home When You Retire?

Wade Pfau: I think reverse mortgages is something that has a negative perception, but a lot has changed in terms of the rules found in the program to correct some of those issues.

It's evolved with financial planning research, to become part of the toolbox for a responsible retiree. The old perception about reverse mortgages was that you use them as a last resort when all else has failed, but now the idea is to open a line of credit on a reverse mortgage early in retirement, allow that line of credit to grow over time, and then use it strategically throughout retirement as part of an overall plan.

And yes, absolutely. They can improve retirement outcomes.

Douglas Goldstein: Explain that once more. When you say, “open a line of credit,” that sounds to me like you're putting up your house as collateral, and they're just going to give you a checkbook against it.

What Does It Mean to Open a Line of Credit on Your Home?

Wade Pfau: It's like a traditional home equity line of credit, although there are a number of important differences that are within the context of a reverse mortgage line of credit. There are several important things, one being that it will grow throughout retirement.

It provides a way to create liquidity for the home so that you can tap into the reverse mortgage as you need to throughout retirement. You don't necessarily have to take everything out right away and in fact the rules of the program now discourage you from taking everything out right away.

Douglas Goldstein: I just want to clarify. It used to be, let's say a person owned a $5,000 home. He would take a reverse mortgage and then they might give him on day number one, $200,000 and from that moment on, he's paying interest on that loan forever.

You're saying that it works differently now. You might take out $3,000 on day number one to pay some bills but that's the extent of your reverse mortgage?

Wade Pfau: There's been a big change. There are still these fixed-rate reverse mortgages where you take everything out at the beginning but they're hardly ever used anymore.

It's now the variable-rate reverse mortgages, where you can take out some at the beginning, but it's mostly in terms of setting up this line of credit that you can draw from throughout retirement, not taking everything all at once.

Douglas Goldstein: When you say variable rates, what would happen if interest rates were to move up?

Wade Pfau: Then the rate would increase. This is interesting because it's pretty much the only retirement income tool that benefits from low interest rates, if your goal is to use the line of credit slowly rather than quickly.

You get to borrow more initially when interest rates are low. Then if interest rates go up over time, if you're keeping it mostly as a line of credit, it's going to be the line of credit that grows more quickly over time.

Douglas Goldstein: Can you lock in the low rate once you borrow the money or is it going to go up? Is the interest on the amount that you owe going to increase if interest rates rise?

Wade Pfau: Yes. For the loan balance part it would. The interest rate would increase as interest rates rise. For these variable rate versions that you use to create a line of credit, you want the interest rate to increase potentially. But if you are thinking to perhaps pay off an existing mortgage, you may want a fixed rate and you may take everything out at the beginning.

There are still the fixed rate options out there. They're just not commonly discussed versions anymore because they don't have a line of credit associated with them.

Douglas Goldstein: When you borrow money against your house like a reverse mortgage, isn't that making the concept of compound interest work against you rather than for you?

Will Compound Interest Work for You or Against You When You Take a Reverse Mortgage?

Wade Pfau: There are several things to think about. Yes, if there is a loan balance in there, that loan balance is growing at a variable rate and as rates go up that rate is increasing.

The research about reverse mortgages has mostly focused on using them in a coordinated fashion, to help manage the sequence of returns risk in retirement.

This is one of the new risks in retirement where, if your portfolio is down in value and you're trying to fund your spending from a portfolio that's down, you have to sell a higher percentage of what's left to meet your spending goal and that creates a tough hurdle for your portfolio to overcome.

In terms of the research about the reverse mortgage, it's important to include realistic costs both for setting them up and for that growth of the loan balance over time.

But when you look at the end of retirement, how much is left in the investment portfolio plus how much the house is worth minus the loan balance, if that overall number is bigger then you're in a better position than otherwise.

The research I've done, as well as a lot of others, points to the idea that you do have a loan balance, and it does have a variable interest rate, but you're still going to be better off overall when you use the reverse mortgage in a strategic way throughout retirement.

Douglas Goldstein: And it's also a way to give cash flow at a time when you don't necessarily have other means of cash flow.

I want to go to other strategies, Wade, that you talk about. You've mentioned the sequence of returns risk. There's another idea that people talk about, which is a time segmentation strategy. Can you explain how that can be used to benefit retirees?

How Can Time Segmentation Benefit Retirees?

Wade Pfau: The prime segmentation strategies are also sometimes called “bucket strategies”. The basic underlying idea is that you invest differently for different time horizons.

In particular, you tend to hold bonds to cover the near-term expenses because they're less vulnerable to market downturns.

Managing the sequence of returns risk is really about trying to find ways to avoid selling assets at a loss.

So, if you have bonds covering your first 5-10 years of retirement expenses, if there is a downturn in the stock market, you still have time to overcome that.

Because you just leave your stocks alone and hope that they recover before your bonds have run out, and before it's absolutely essential that you start tapping into the stocks again.

Douglas Goldstein: In my day job, I'm a financial advisor so I work with retirees. We've got our eyes always peeled to find some way to make more income, and you're mentioning bonds as part of the bucket, which is something we talk about all the time.

But it inevitably comes back to the fact that interest rates today are anemic. They are just so low. People who would remember days when rates were, let's say, 5%, let alone 10% or 15%, and you’re telling them, “Listen, you could buy a bond and make 2% or 3%”

It drives them crazy, and I understand that. What should retirees do with their safe money given such a low interest rate environment?

Wade Pfau: That's where it's important to think holistically about all the available assets. Bond yields are low and that's going to depress returns on bonds and stocks. For something like an income annuity that pays an income for life, that's going to lead to lower payout rates.

But contrary to popular wisdom, an income annuity becomes more attractive, relatively speaking, when interest rates are low because they also include mortality credits.

It's the idea that since you're receiving a guaranteed income for life and that risk is pooled to a large number of people, those who don't live as long subsidize those who live longer and that component's not impacted by interest rates.

The cost of building a retirement income with bonds and stocks increases at a faster rate when interest rates are low, relative to something like an income annuity.

Or, that's another case where a reverse mortgage can fit in because when interest rates are low, you get a higher initial borrowing amount and you can use that in a coordinated fashion.

Low interest rates also increase that exposure to the sequence of returns risk because your portfolio's not generating enough interest and dividends to fund your lifestyle.

So you are in a position where you're tapping into that principal. That makes you more vulnerable to selling assets at a loss. It's thinking beyond just the investment portfolio as a starting point.

Douglas Goldstein: I like your model of thinking holistically. That is important. I also think that one of the fears that people have that is not always warranted is, “Oh my gosh! I can't touch my principal,” depending on which principal you have.

If you do it in a scheduled way, for example if you buy bonds, premium bonds, over time some of your principal will get eaten up because you're going to spend it.

But as long as you, depending on how old you are, understand how and when, that's a way of increasing cash flow without selling off your stock portfolio and taking money today. It's done in a way that you can get consistent income, which I think is important for people, rather than getting chunks of income at a time when they may not know what to do with the money.

Investing Solely For Income As a Retiree Can Be Risky

Wade Pfau: Yes that's right. Most of the research shows that you want to invest for a total return where you're willing to also spend some of your principal as well, versus trying to invest to generate income.

Just investing for income can be a risk to your overall strategy, and though you may get a higher percentage from the income portion your capital gains may be less, and so you're not really in a better overall position with that sort of strategy.

Douglas Goldstein: Yes. Great point. Hey, Wade, this has been really great. You've covered a lot of interesting information and I think that these are ideas that people don't always think about. It's certainly opened up ideas that they should think about more.

I know that there's a lot of ways that people can follow you and follow your work. Tell us, what's the best way to keep tabs on what's going on in your world?

Wade Pfau: Thanks, Doug. You mentioned earlier my website, which is retirementresearcher.com. You can also Google my name. I'm the only one with this name, which is pretty lucky in our new Internet age.

Douglas Goldstein: Alright. Professor Wade Pfau, thanks so much for your time.

Wade Pfau: Thank you. It's been a pleasure.