Reversal of fortune

There’s at least one financial planner out there who views the emergence of reverse mortgages as a compliment to financial planners. Paul Moran, principal financial planner at Melbourne-based Cameron Walshe, says anyone who needs to take out a reverse mortgage in retirement should “probably have seen a planner earlier in the piece”.

Endless cash for retirees

One of Moran’s key concerns is that reverse mortgages, one type of equity release product, will come to be seen by retirees as a “magic bullet, offering as much income as they want, no matter how much in the way of investments they have”.

“I fear the products will encourage people to spend more than they would have otherwise. Australians haven’t been fantastic at managing credit, and this product is a form of credit,” he says.

Moran’s concerns are exacerbated by “most reverse mortgages currently being sold by mortgage brokers as a sales-based product, without the need to go through a comprehensive client needs analysis and risk profile”.

He is “more confident” of reverse mortgages that are sold through planners, particularly “in the context of explaining to clients the impact of compounding interest”.

He says clients generally would have difficulty “conceptually understanding” that a loan of 20 per cent on a $500,000 property reverse compounding at up to 8.5 per cent, is going to double every 7 or 8 years, and then double on the double again.

“They tend to think of $100,000 of a $500,000 property as a small loan, but in 25 years that $100,000 is going to be up around $800,000.”

Based on these calculations, Moran says a borrower could end up “technically owing more than the property is worth, resulting in the proceeds of its entire value going to the lender rather than to the estate”.

He explains: “A no negative equity guarantee [NNEG] does protect the borrower from this eventuality, in that an estate can’t owe the lender any money. But a borrower can still effectively be borrowed with a loan to value ratio (LVR) of more than 100 per cent.”

Increasing property values

While Moran has “not yet” recommended a reverse mortgage to a client, he says there are clients that these products will be suited to.

“But we would be looking to borrow a lot less than the maximum that we can in the marketplace. And these clients would be asset rich, owning homes worth more than $500,000 and living on the age pension. If these people can supplement their age pension by a draw-down of about $10,000 a year, that’s a significant amount of money.”

Trowbridge Deloitte partner James Hickey says Moran’s calculations are broadly correct if you exclude the fact that property has a capital growth rate.

It should be emphasised, however, that if the $500,000 property were to grow at about 8 per cent per annum, it would be worth about $1 million over the course of the loan.

Even if the value of the property didn’t grow at all, and the loan continued to grow at 8 per cent, at a 20 per cent LVR it would still take about 20 years before the loan of $100,000 would reach $500,000.

Hickey says it’s a common misunderstanding with reverse mortgages that net equity in dollar terms will be eroded unless the level of future house price growth exceeds the rate of interest on the mortgage.

This is not the case, and it is due to the ‘gearing effect’ of the product. The gearing effect should ensure net equity grows while the level of debt is increasing, if house price capital growth continues to be at least greater than the current LVR times interest rate.

He adds that the property capital growth in a given year only needs to be at least the current LVR times the reverse mortgage interest rate for the consumer to retain their same level of equity in dollar terms.

“For example, a 70-year-old who is advanced a 25 per cent LVR at commencement would only need house price capital growth of 2 per cent per annum over the year if interest rates on the reverse mortgage were 8 per cent to retain the same net equity.”

A positive guarantee

Hickey says it’s equally important to emphasise that nearly all providers in Australia provide a NNEG. In the event that your reverse mortgage becomes worth more than the value of your property, this ensures that a client can never owe the provider more than the value of the property. No client can be evicted, and no beneficiary will end up inheriting an additional debt as a result of the product.

A more flexible version of the NNEG is available on the market in the form of a ‘protected equity’ facility, which generally offers up to 20 per cent equity protection, Hickey adds.

“This facility allows clients to select a percentage of a property’s value that they wish to preserve for themselves (or their beneficiaries), irrespective of what property/interest movements occur.”

Author of a newly released report commissioned by Bluestone Equity Release, entitled The Equity Release Opportunity for Financial Planners, Hickey describes reverse mortgages as a “win-win” situation for planners and clients.

“Planners get rewarded for their efforts, and clients get an alternative vehicle to convert a portion of their residential property asset into cash or an income stream, while still allowing an individual or couple to continue to live in the house,” he says.

Hickey says people who may be financially under pressure to take out a lump-sum loan are not the natural target market of planners using reverse mortgages.

“It’s more about planners using reverse mortgages to help their financially savvy clients supplement their retirement income to maintain and enhance their lifestyles. There’s also a target market in ‘mass affluent’ people: those who own their own house, or investment property, and have a couple of hundred thousand dollars in super.”

Benefits for planners

Reverse mortgages offer planners a source of enhanced revenue margins from these markets, to which ordinarily they wouldn’t be primarily attracted, according to Bluestone Equity Release chief executive Peter McGuinness.

“Typically, planner revenues reduce when a client enters the post-retirement phase as their wealth base diminishes (such as allocated annuity funds), resulting in reduced trail advice commission. However, by utilising a broader asset wealth base via reverse mortgages, planners may find their revenues from a client’s post-retirement remains quite attractive.”

The opportunity for enhanced revenue comes from “higher potential allocated annuity commissions and the equity release commissions per advance of funds”, he says.

“In the case of the annuity commission, this comes about as a result of the reverse mortgage funds enabling retirees to use minimum draw-downs, which in turn allows the annuity funds to remain intact for a longer time.”

The need for unbiased advice

As with all financial products, McGuinness says certain moral hazard risks can exist for planners when remuneration structures are based on a percentage of draw-down amount. “There needs to be unbiased advice as the basis for choosing a reverse mortgage for a client, as opposed to the planner choosing this option based on apparent attractive commissions,” he says.

In particular, he says the strategy of investing the proceeds from a reverse mortgage into another investment product (which itself pays a commission) needs to be carefully monitored.

He explains: “The planner in this case may receive two forms of commission from the one effective draw-down, and ultimately the client is implicitly paying for this.”

The risks can be “mitigated by implementing appropriate product design, disclosure administration, training and compliance procedures”. As reverse mortgages are not currently covered by the Financial Services Reform Act, he says there is an increased responsibility for providers, financial planning dealer groups, and planners themselves to ensure appropriate advice processes and disclosure are followed.

In addressing consumer risks, he says there is only so much that product design features can cover. The features of NNEG, lifetime fixed interest rates, choice of protected equity, and LVR limits by providers are all considered to be good fundamental mitigators for consumers.

However, he says consumer risks must also be addressed by education and advice at the point of sale, which is ongoing through the term of the reverse mortgage.

“It’s important that at the point of sale the client is made aware of their contractual obligations, the impact for wealth passed to beneficiaries, and the product’s implications for broader retirement planning.”