Working with clients who are in or nearing retirement, financial planners will work to mitigate a laundry list of potential retirement risks that threaten their clients’ long-term financial security. The U.S. Society of Actuaries recently published a list of 15 post-retirement risks that can affect retirees. This list addresses risks that can be managed through careful planning and those that are completely out of our control, which emphasizes the importance of backup financial strategies to see clients through potential events such as:
- Financial Risks: Insufficient savings, reduced income, and increasing life expectancies are primary risks threatening financial security.
- Personal and Family Risks: Changes in the retiree’s life or the life of a loved one that could impact their retirement income stream
- Healthcare and Housing Risks: The risk that failing health could require moving to facility with professional caregivers.
- Public Policy Risks: Changes in government policies and decisions that could impact retirees.
The single most important factor that people can control is our finances. Maintaining a disciplined savings plan during our working years is the smart thing to do, but relatively few are successful at saving enough.
The basic challenges that financial advisors and retirement professionals are confronted with are:
- Managing each client’s resources to provide lifetime income sufficient to support a chosen standard of living
- Providing enough reserves to fund anticipated, and unanticipated, future needs.
Depending on the value and nature of assets available, these objectives may or may not be achievable for the time period needed. If not, adjustments will be needed to make the plan viable. It is better to know this up front rather than later when it may be too late.
The Two-Bucket Investment Strategy to Managing Financial Wealth
Traditional financial planning practices use a two-bucket investment strategy to reduce portfolio volatility risks, especially those experienced in down market cycles. This strategy includes maintaining a liquid reserve (bucket #1) to provide disbursements for near-term cash needs. Longer term income and growth objectives are achieved using an investment portfolio (bucket #2). bucket #1 provides needed cash flow and avoids the necessity of selling investment assets too soon, thus avoiding tax consequences and protecting investments from premature liquidation. Typically, bucket #1 includes up to two years of projected cash needs.
The down-side of the two-bucket strategy is that the cash reserve in bucket #1 needs significant funding to adequately protect the investment portfolio in bucket #2 from being eroded. Additionally, the large allocation of reserve funds creates an “opportunity cost” of less income or growth potential from a smaller investment portfolio.
A Better Approach: The Three-Bucket Investment Strategy (Combining Financial Wealth with Housing Wealth)
Academic researchers and financial planning experts now agree the time has come to include housing wealth (home equity) with financial wealth. The results are documented, and they are impressive. For example, a withdrawal rate of 4 percent is the generally accepted standard for a safe withdrawal rate to assure lifetime income from financial investments. However, this withdrawal rate can safely increase to 6 to 8 percent when accumulated home equity is included in the planning process.
The Three-Bucket Strategy
A three-bucket risk mitigation strategy uses a stand-by line of credit from a reverse mortgage – more fully explained here by Investment News. This strategy combines a more minimal cash reserve, typically six months (versus two years) of financial needs in bucket #1, thus enabling a greater allocation to long-term investments in bucket #2.
Bucket #3 (a stand-by line of credit) is added from a FHA Home Equity Conversion Mortgage (HECM) reverse mortgage. This line of credit, secured by accumulated home equity, provides a separate third source of funds. This prevents the need for a larger reserve fund, and eliminates the need to sell securities in declining market conditions. As a result, clients can preserve the value of their investment portfolio in bucket #2.
The HECM reverse mortgage credit line can be used to refill the cash reserve as needed with no transaction costs, no income tax consequences, and possible tax-deductible interest upon repayment. Additionally, the HECM reverse mortgage does not require any payments be made, and the unused HECM Line Of Credit grows, compounding monthly, at the same rate charged on the funds used.
Recent changes to the HECM reverse mortgage program have improved the terms, cost structure, and consumer protections. The new reverse mortgage should be considered as part of any comprehensive financial and retirement risk management plan.
Want to know more about how reverse mortgages might help mitigate retirement risk for your clients? We are happy to answer your questions and suggest strategies for incorporating reverse mortgages into your retirement planning practice.