Two major retirement challenges could be addressed through a simple innovation. First, long-term investors are struggling to meet their (lowered) target rates of return. Attempts to raise returns by investing in riskier assets only raises the risk of future underperformance. Second, individuals have insufficient retirement savings, and are facing the prospect of a meager retirement pay check. A new real estate sub-asset class, iHomes (Income from Homes), created by innovative funds and real estate managers, could address these twin challenges with attractive results for all parties. The solution rests in allowing retirees to tap into home equity to generate income, and for innovative investors to get rewarded for supplying capital for these transactions.
A global retirement crisis looms because traditional pillars of retirement (e.g., Social Security and employer-provided defined benefit plans) are under pressure. Under-funded pension funds are facing enormous pressure to raise realized returns while controlling pension fund risk. Simultaneously, financially unsophisticated individuals are being asked to bear the risk of retirement, and the National Conference on Public Employee Retirement Systems study notes an average American retirement savings deficit of approximately $50,000 per person, with an aggregate national retirement savings shortfall of almost $5 trillion. However, globally, more individuals are likely to own a home than own stocks and bonds, or even a bank account. In the US, the National Association for Home Builders study notes that, “[A]t $20.7 trillion, the primary residence accounted for almost one-third, 30%, of all assets held by households in 2010…The primary residence represented 62% of the median homeowner’s total assets and 42% of the median homeowner’s wealth…The primary residence is also a widely held asset. A greater share of households (67%) owned a primary residence than held a retirement account (50%) or stocks and bonds (16%).”
Home equity can cover all or some of the savings shortfall, and innovative funds can tap into an “equity-like” opportunity to benefit themselves (and by addressing a national challenge, potentially qualify as “Socially Responsible Investing”). The existing approach to convert home equity into cash flow in retirement, a reverse mortgage (RM), has not seen much favor globally. There are some key innovations needed to enhance this market, and long-term investors may have a key role to play that could benefit them enormously—driven by the attractive risk-adjusted return and diversification benefits that iHomes provides.
The Challenge Posed by Reverse Mortgages
The typical RM is a home equity conversion mortgage (HECM) and is subject to many limitations. The borrower must be 62-years-old, retain the home’s title, and can borrow based on a line of credit, approximately, 50% to 75% of the home value based on age. The Federal Housing Agency (FHA) in the US and similar institutions elsewhere is a party to the transaction and maintains an approved RM-lender list. FHA offers two guarantees for an insurance premium paid by the borrower: (a) if the lender goes bankrupt, the homeowner is protected by FHA; and (b) if on the death of the owner, the house value is below the loan value, the FHA protects the lender.
Essentially, the borrower draws from the line of credit to finance consumption and the loan value increases until the surviving spouse dies (i.e., there is no need for periodic repayment of the loan). The homeowner is expected to make all the payments related to taxes, insurance, etc., and maintain the house. At death, heirs can either repay the non-recourse loan and keep the house or turn over the keys to the RM lender.
While sadly the reputation of RMs/HECMs has been tainted by unscrupulous lenders who took advantage of financially unsophisticated individuals, there are other challenges to this transaction even if it was entirely on the up-and-up:
- RMs have non-trivial default risks, and banks, as sole intermediaries, limit the amount of capital that can be applied to solving this national/international challenge.
- FHA, as a party to the transaction, raises the cost and limits the widespread use of RMs. (Ignoring the issue of whether they are sufficiently funded and best capable of managing housing price risk at a national scale.)
- RMs are complicated and FHA requires a counselor to validate that the individual understands the transaction.
- The borrower is limited to a line of credit that is approximately 50% of the current home value and must pay back the loan with interest.
- The biggest risk that retirees face is the ability to receive a guaranteed real income stream that protects them from standard-of-living risks.
- Older individuals become less competent at managing their own homes and often miss payments for taxes, insurance and other costs.
In short, RMs, in their current form, do not lend themselves to solving one or both of the national/global crises.
Finance Science and Financial Innovations
This is a challenge easily addressed by finance science and financial innovation. First, as Nobel Laureate Prof. Robert C. Merton has noted, the source of finance for these transactions should be pensions and endowments that are focused on long-term diversification and accept market returns. As the last column in Table 1 suggests home price returns may not be highly correlated with other asset returns, and offer the attractive potential for a new diversifying asset. (Some of the low correlation may be a quirk of typical illiquid assets which are not marked-to-market frequently, but for many institutional investors, infrequent marking-to-market is an attractive feature as it minimizes funded status volatility).
Moreover, Table 2 shows that home prices have offered an attractive risk-adjusted return superior to that of stocks and commodities over this nearly 30-year time window. While some may argue that the absolute return is low (say, for a pension fund targeting an expected return 7.5% p.a.), higher returns can be achieved by levering up returns to have the desired level of volatility than a client might seek. (Over the slightly shorter 2000-2018 period, home price indices retain their attractive return-risk ratios, but now provide a higher absolute return than the S&P 500 Equity Index, while retaining their attractive diversification properties of being essentially uncorrelated to typical assets.) Hence, long-term investors may want to provide capital to this opportunity as a way of improving their own risk-adjusted returns. However, this new sub–asset class will need to meet certain criteria to be palatable to end investors—transparency of prices/valuation, sufficient size to make a meaningful allocation, and managers willing to intermediate the transactions—all of which are easily achieved by iHomes.
With this new source of sizable long-term capital, willing to bear the equity risk of homes, the transaction could be simplified to eliminate FHA and its inherent costs/inefficiencies, through a more appropriate intermediary.
Two approaches lend themselves for consideration. One—call it the “Financial Engineering Approach”—is to exploit the “no-recourse” feature (whereby heirs are protected if the value of the house declines below the value of the outstanding loan), which makes RMs a pure asset-backed financing. As Prof. Merton has noted, innovative intermediaries could repackage a pool of RMs to have an equity tranche (tied to home prices and attractive to all investors), a long-duration senior debt tranche (attractive for liability hedging for pensions and insurance companies), and a subordinated debt tranche (for those seeking a credit play and willing to bear tail-risk). An alternative approach—call it “Retire In-Home”—would be to use long-term investor capital to purchase these houses outright (i.e., an equity play on home prices as in Tables 1 and 2), and simultaneously enter into a long-term rental agreement until the owners die (which provides income to the investor) so that retirees can retire in-home and not be displaced.
Recall, that in RMs, since there is great uncertainty about the future value of the house, the FHA is required to intervene, and the line of credit is typically limited to 50% of the house value. This uncertainty caused by postponing resolution of the transaction till one’s death leads to many inefficiencies. In the “Retire In-Home” approach, the proceeds of the house sale are converted into a net retirement income stream (i.e., the value of the house converted to income minus the rent) using the proposed new SeLFIES bonds proposed jointly with Prof. Merton (that pays a real dollar coupon indexed to standard-of-living for say 20 years). As a result, the owners and real estate managers are hedged against rising inflation/standard-of-living. In addition, bequests are easily handled in this arrangement. When the owner dies, the heirs can either take the bonds that their house was converted into and walk away if they do not want the house, or use those proceeds to buy the house (along with a conventional mortgage for the balance). The pension funds make money because if the house has appreciated in value (i.e., the heirs are buying it at the market price—just that they their offer is picked as long as it matches the next best), they earn the price appreciation, plus in the interim, they get income from the rents (which is what pension funds really need).
Pension funds benefit from a real diversifying asset (as opposed to allocating more to potentially rich asset classes), with an attractive risk-return payoff and which generates income in the interim. Real estate managers have relevant expertise in this area and are ideally positioned to intermediate between these parties, thereby improving alignment of interests among all parties. While both approaches have pros and cons, real estate managers are unlikely to explore this new sub-asset class themselves without interest being expressed by pension funds and endowments who are willing to commit sufficient capital to this opportunity.
Twin retirement crises, insufficient savings by individuals, and low expected returns for institutional investors, could be addressed by finance science and innovation. iHomes as a real estate sub-asset class could allow retirees to convert home equity into income and address the challenges facing the RM market (more capital, better risk-bearing interest alignment) and long-term investors (attractive risk-adjusted returns while potentially not raising the risk of their fund). Confucius may have had it right when he stated that, “The strength of a nation derives from the integrity of the home.”
Arun Muralidhar, Ph.D., is founder of Mcube Investment Technologies and AlphaEngine Global Investment Solutions. He is the author of “Fifty States of Grey: An Innovative Solution to the DC Retirement Crisis.” These are the personal views of the author and do not reflect the views of any of the organizations or universities with which he is associated.