Editor’s note: This is Part 3 of a six-part series. Read Part 1, Part 2, Part 4, Part 5 and Part 6.
Some seniors who have most of their equity in their home want the security of a fixed lifetime annuity, and don’t care about not leaving any equity behind for their heirs. A Home Equity Conversion Mortgage, or HECM, which is insured by the Federal Housing Administration, can fund the purchase of a lifetime annuity in two ways.
One way is for the senior to exercise the "tenure" option under the HECM program, and receive a fixed annuity payment for as long as he remains in the house. The second way is for him to exercise the credit-line option under the HECM program, drawing the maximum amount permitted, and use it to purchase an immediate annuity from a life insurance company.
I shopped both options in early December 2009 for a man, 86, with a house worth $400,000. This senior had a "Net Principal Limit" (NPL) under the HECM program of $288,000. That is the maximum amount of cash available for purchase of either annuity, after deducting HECM origination costs.
The NPL of $288,000 would purchase a tenure annuity of $2,444 within the HECM program. Alternatively, the senior could draw the $288,000 in cash, maxing out the HECM, and use it to purchase an annuity of $3,778 from a life insurance company. This is 55 percent higher than the tenure annuity. (I found this quote on www.immediateannuities.com.) However, the two annuities are not completely comparable, and the differences can be important.
First, the HECM tenure annuity is guaranteed by the federal government. The life insurance company annuity is only as good as the promise of the insurance company, loosely backed by state guarantee programs. While defaults on annuities are rare, I would not purchase an annuity from a company that did not have an AA rating. The quote above was from an AA-rated company.
A second important difference is that the borrower who takes an HECM annuity retains ownership of the reserve account underlying the annuity. This allows him to change his mind after a few years and switch to a credit line for the reserve amount still available. And if he dies soon after making that switch, the amount remaining in the reserve will go to his estate.
In contrast, on a life insurance company annuity, early death terminates all payments unless the policy has a guaranteed payout, which would reduce the annuity amount. For example, the lifetime annuity could be purchased with a 10-year guaranty, so if the annuitant dies early, the heirs would continue to receive the payment for 10 years. But this would reduce the annuity amount to $2,467, which is little more than the HECM tenure annuity. …CONTINUED
On the other side of the ledger, if the borrower gets sick and has to go to a nursing home, the HECM annuity will terminate after a year of non-occupancy. That’s why it is called a "tenure annuity" rather than a "life annuity." The lender takes the house after the year and sells it, with any equity remaining going to the borrower’s estate. With a life insurance company annuity, in contrast, the senior could be in a nursing home forever without shutting off the annuity.
In sum, the advantage of the HECM is that it preserves the senior’s freedom of action and may preserve some equity for heirs. The disadvantage is the lower annuity amount. The senior who seeks the largest possible monthly payment, and has no regard for how much equity passes to heirs, will purchase a life insurance company annuity.
I write this with some trepidation because some serious abuses have arisen in connection with reverse mortgages that have been used to purchase life annuities. However, seniors can easily avoid the hazards by following two simple rules. Rule No. 1 is to keep the HECM transaction and the annuity transaction separate. That allows you to shop for both individually. Packaging two very different types of transactions into one deal obscures the pricing of both.
If a loan provider or an insurance agent talks to you about drawing funds from an HECM to purchase an annuity, run like a thief. He is looking to make two commissions from you, and they both are likely to be extortionate.
Rule No. 2 is to do it yourself. It turns out to be really easy to find the best available deal on an HECM, and I’ll explain how to do it next week. Shopping online for a life annuity is also very easy.
Doing it yourself means that you avoid being solicited. Seniors who are taken advantage of are almost always seniors who have been solicited by fast-talking scamsters. You refuse to be exploited by refusing to be solicited.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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