“Retirement is like a long vacation in Las Vegas.
The goal is to enjoy it to the fullest,
but not so fully that you run out of money.”
– Jonathan Clements
The strategies we discussed last week emphasized maximizing your Social Security benefits. But what if even the maximum from Social Security isn’t enough?
For most people, living on Social Security alone isn’t the ideal scenario. Here’s a video from a few years ago that explains the problem.
Social Security was never intended to be the American worker’s sole retirement plan. It was designed to keep older Americans from starving.
The father of Social Security, President Franklin D. Roosevelt, described it in a 1938 radio address:
The [Social Security] Act does not offer anyone, either individually or collectively, an easy life — nor was it ever intended so to do. None of the sums of money paid out to individuals in assistance or in insurance will spell anything approaching abundance. But they will furnish that minimum necessity to keep a foothold; and that is the kind of protection Americans want.
Let’s look at two additional ways to generate income in retirement: reverse mortgages and annuities.
Reverse mortgages are aptly named. As with any mortgage, you apply through a lender. But these loans pay you every month, rather than the other way around. You convert home equity into cash, without having to sell or make payments. Possibly perfect for retirees with lots of equity but little income.
Here’s the quickest way to understand reverse mortgages: Forget the “reverse,” focus on the “mortgage.” At the end of the day, that’s all it is — a mortgage.
In years past, pretty much any homeowner 62 or older who could fog a mirror and had home equity could qualify for a reverse mortgage. Since the Great Recession, however, there are more hoops to jump through.
While you don’t face the income qualifications you’d expect when applying for a traditional mortgage or refinance, you’ll need to prove you can pay the taxes, insurance and other costs of maintaining your home. If not, part of your loan proceeds can be set aside for these expenses.
Now you know why there are so many commercials on TV for reverse mortgages. Lenders make a ton of money on these loans.
You’ll need to own the home outright or have a low mortgage balance. There’s no need to give up the title to your home.
If you have bad credit, you’ll need to explain it. The lender will decide if your explanation qualifies as an extenuating circumstance.
You can repay a reverse mortgage at any time. But it must be repaid when you (or possibly your spouse, depending on your contract) die or when you no longer live there.
If you or your heirs can’t or don’t repay the loan, your home may be sold by the lender to pay off the mortgage. If there isn’t enough equity to repay the loan, that’s the lender’s problem, not yours.
There are different types of reverse mortgages. The most common is the HECM (home equity conversion mortgage), backed by the U.S. Department of Housing and Urban Development.
Reverse mortgage proceeds are tax-free. You can get the money in one of several ways:
- Fixed monthly payments over a defined number of months
- Fixed monthly payments for as long as you live in the home
- A line of credit to draw on when and as much as you’d like
- A combination of monthly payments and line of credit
- A lump sum ( for some of the amount)
The amount of your loan and payments will vary based on your equity, your age and the size and length of the payments. To get an idea, use this calculator.
What’s the catch?
Catch No. 1: Big fees
I once interviewed a homeowner who insisted he paid no fees for his reverse mortgage. He was right, in a sense: He didn’t write a check to cover the fees. But that’s because the fees were rolled into the mortgage. That doesn’t make the mortgage fee-free.
In fact, reverse mortgages “are usually more expensive than other home loans,” says the Consumer Financial Protection Bureau. “With a reverse mortgage, you’ll be charged in two ways: upfront and over time. Upfront costs include lender fees, upfront mortgage insurance, and real estate closing costs.”
I’ll use my home to illustrate rates and fees, using the calculator mentioned above.
I was born in 1955 and own a home in Fort Lauderdale, Florida. Let’s say it’s worth $400,000, there is no mortgage and I want to borrow $100,000. I’m married, but to keep it simple, we’ll say I’m single.
Example: My (fictitious) reverse mortgage:
- Fixed interest rate: 5 percent, including the loan interest rate and mortgage insurance required with a HECM. (Compare current interest rates on conventional mortgages at Money Talks News.)
- Maximum available to borrow: $178,400 (about 45 percent of my home’s $400,000 value).
- Loan origination fee: $6,000. Ouch!
- Mortgage insurance: $8,000. Super ouch!
- Additional closing costs: $7,283.50. OMG!
Add it all up and I’d pay over $20,000 ($6,000 + $8,000 + $7,283) to borrow $100,000 — more than 20 percent in fees! Not exactly a sweetheart deal. I’m not paying this out of pocket; it’s coming out of the loan proceeds. But it’s money I or my estate ultimately pays. If you must get a reverse mortgage, pay upfront fees in cash if you can; it’s cheaper than using loan proceeds.
Now you know why there are so many commercials on TV for reverse mortgages. Lenders make a ton of money on these loans.
Catch No. 2: Your loan can grow
Although you are receiving checks in the mail, your reverse mortgage is accruing interest, and that unpaid interest is growing the size of the loan. The longer it’s outstanding, the bigger it gets. In mortgage lingo, the mortgage is “walking backwards.”
Should you choose lifetime payments and stay in your home for decades, you’ll probably have little, if any, equity to leave to your heirs. Unless the home’s value grows faster than the interest.
Catch No. 3: You’re responsible for taxes, insurance and maintenance
Because you still own the house, you are responsible for these homeowner expenses and can lose the home if you neglect to pay them.
Reverse mortgages: The bottom line
Whether a reverse mortgage makes sense for you depends on your situation and any other options you have.
Before you’re allowed to take out a reverse mortgage, you’ll be required to receive counseling from a HUD-approved reverse mortgage counselor.
So if you’re thinking of a reverse mortgage, you might as well call one in advance with your questions. The vast majority are happy to help free of charge. (When you actually receive reverse mortgage counseling, however, you’ll typically pay $125 for it, unless you qualify for a fee waiver.)
Although the fees are high and I’ve met people who didn’t realize they were paying them, a reverse mortgage can be the difference between living and merely surviving. If it will enhance your life and you understand the costs, do it.
As with any mortgage, shop carefully, compare products and learn about fees. Some fees may be set by law but others could vary by lender. Learn the details from this Consumer Financial Protection Bureau discussion guide.
Earlier in this lesson we discussed the appeal of Social Security. It’s a simple, monthly income you’ll receive for life that requires no risk, no investment expertise and no fiddling around. It even has a survivor benefit.
Annuities have some of the same benefits as Social Security: a simple, monthly income for life that requires no risk, no investment expertise and management expertise or work. They can substitute for that pension your dad had.
Over the years I’ve answered lots of questions about annuities. Here’s one:
I have a question regarding annuities. I’m looking to provide some future security for my wife, and I’m being told that these are guaranteed, can’t-lose programs. I’m always concerned when anyone tells me something is guaranteed. Are these annuities really can’t-lose investments? What’s the catch?
Let’s look under the hood. Here’s how annuities work.
Investing with an insurance company
There are many types of annuities. They have one thing in common: They’re offered by insurance companies.
Here are the various kinds of annuities, their features, pluses and minuses:
Fixed annuities: CDs from an insurance company instead of a bank
Back in my investment adviser days, I’d use the exact words in the heading above to explain single premium deferred annuities, also known as fixed annuities, to clients. Because when you boil it down, that’s what they are: insurance company CDs.
Like bank CDs, when you take out a single premium deferred annuity, you agree to deposit a lump sum for a fixed amount of time. The insurance company agrees to pay you a fixed rate of interest.
Unlike a bank CD, however, the annuity is guaranteed only by the insurance company. It’s not federally insured. Also, unlike a CD from a bank, annuities are tax-deferred, meaning as long as you let the interest accumulate, you won’t pay taxes on the earned interest.
Variable annuities: Mutual funds from an insurance company
A variable annuity is the insurance company’s clone of a mutual fund — like a mutual fund wrapped in an insurance contract.
Like many mutual funds, you’ll have numerous fund options, including growth (stocks), income (bonds) and balanced (stocks and bonds). You can switch among them without tax implications as long as you don’t withdraw your money. As with a fixed annuity, you won’t pay taxes on the earnings until you take them out.
Variable annuities offer something mutual funds don’t — a death benefit guaranteeing that, no matter how the funds perform, your beneficiary won’t receive less than your original investment.
Learn more about variable annuities from the Financial Industry Regulatory Authority: “Variable Annuities: Beyond the Hard Sell.”
Immediate annuities: Pensions from an insurance company
This is what most people think of when they hear the word “annuity.”
With an immediate annuity, you give the insurance company a lump sum of cash, and they pay you a monthly income. The income can be doled out in many ways. A few examples:
- For a fixed number of years
- For the rest of your life
- For the rest of your life and your surviving spouse’s life
- For life, but with a minimum of 10 years
And your monthly payout amount depends on:
- How much you deposit
- How long you expect to receive payments
- Market interest rates
This is because the insurance company is taking your lump sum and investing it. If they lock in higher rates, you get higher monthly payments.
A calculator like this one from ImmediateAnnuities.com give you an idea of what you can expect to receive.
I entered my age (63) and the sum I’d invest ($100,000). The calculator estimated I’d get $535 a month for life.
If I wanted my wife to get a monthly payment for life after I’m gone, our monthly payment would drop to $347. (My wife is much younger than I am. If she were closer to my age, our locked-in payout would be more.)
Bottom line? If you’re looking for predictable monthly income in your retirement years, in other words, a pension substitute, this option might work for you.
Guaranteed Lifetime Withdrawal Benefit annuities: A hybrid
A relatively recent hybrid of variable and immediate annuities is the Guaranteed Lifetime Withdrawal Benefit (GLWB). This product is also called a variable annuity with a secure income rider.
It combines a variable annuity — essentially an insurance company mutual fund — with a guaranteed monthly minimum benefit, like those offered by immediate annuities.
With a GLWB, as with a variable annuity, you’re investing in stocks and bonds. For example, your variable annuity may have a portfolio of 60 percent stocks, 40 percent bonds. If the stock market goes up, your account goes up in value: You’ll get a higher monthly payment.
If you’re looking for a pension substitute, annuities might work for you.
If the market goes down, however, your monthly income will not drop below the guaranteed level.
You can fund a GLWB while you’re working, letting it accumulate, taking monthly income after retirement. You can withdraw the amount you want, up to an established maximum annual withdrawal limit, or withdraw nothing at all.
Sounds like a no-lose situation, right? Market goes up, you win. Market goes down, you don’t lose.
Unfortunately, there’s a high price for that income guarantee. At Vanguard, for example, the cost is 1.2 percent per year — in addition to the other fees associated with variable annuities. That may not sound like much, but over time it is.
To boil it down: GLWBs protect your downside by charging a fee that erodes your upside.
This doesn’t necessarily make them a bad idea. If you’re an investor who’s terrified of a big market decline as you approach retirement, or if you have barely enough to fund the retirement you envision, the guarantee could be money well spent. If you’re someone who can take market risk in stride, it may not be.
Potential problems with annuities
Annuities are not all wine and roses.
- Your money is tied up. There’s no unwinding the contract if a health care or other crisis creates a need for cash.
- Excessive fees. As with mutual funds, your fees often are not apparent or disclosed. For example, single premium and variable annuities routinely have back-end “surrender” fees for up to a decade. Variable annuities can have annual management and other fees in excess of 2.5 percent — 10 times more than some low-cost mutual funds. You’ll also pay a fee for the death benefit offered by variable annuities.
Are annuities for you?
There are situations where annuities can fit into a financial plan. As with any investment, however, annuities aren’t all created equal, so comparison shopping is a must.
- Immediate annuity: Compare monthly income and options.
- Fixed annuity: Compare rates and surrender fees.
- Variable annuity: Look at total fees, plus the performance.
And finally: Remember that a guarantee is only as solid as the company making it.
Where to buy annuities
Trustworthy companies offering lower-fee products include:
- Companies like Vanguard. Known for low-fee mutual funds, also offers low-fee annuities.
- TIAA-CREF. You’ll have to meet eligibility requirements.
- USAA. Also known for lower costs. Has eligibility requirements.
- ImmediateAnnuities.com. Shops among various annuity providers for you.
- IncomeSolutions.com. Also shops the marketplace for individual investors.
Once you understand what you’re shopping for, this is something you can do yourself.
If you enlist professional help from a commissioned insurance salesperson or financial planner, remember: The more a salesperson is trying to jam something down your throat, the more cautious you should be.
In my opinion, you should always avoid commission-based financial advisers and insurance salespeople. If you’re not paying them by the hour, you’re probably paying them in ways you’re not aware of.
Your task for this week
Take a few minutes to plug some realistic numbers for your retirement into:
Now, think seriously about whether either of these products fits into your financial plan.