Portfolio Choice in Retirement—What is The Optimal Home Equity Release Product?

• Author: Michael Sherris,Katja Hanewald,Thomas Post
• Date: 01 June 2016
• DOI: http://doi.org/10.1111/jori.12068
• Published date: 01 June 2016

PORTFOLIO CHOICE IN RETIREMENT—WHAT IS THE

OPTIMAL HOME EQUITY RELEASE PRODUCT?

Katja Hanewald

Thomas Post

Michael Sherris

ABSTRACT

We study the decision problem of the optimal choice between home equity

release products from a retired homeowner’s perspective in the presence of

longevity, long-term care, house price, and interest rate risk. The individual

can choose to release home equity using reverse mortgages or home

reversion plans, to buy annuities, and long-term care insurance. The

individual enjoys utility gains from having access to either one of the two

equity release products. Higher utility gains are found for the reverse

mortgage, as its product features allow for higher lump-sum payouts and

provide downside protection for house prices.

INTRODUCTION

We study the decision problem of the optimal choice between different home equity

release products from the perspective of a retired homeowner in the presence of

longevity, long-term care, house price, and interest rate risk. For elderly homeowners,



Katja Hanewald is at the Australian Research Council Centre of Excellence in Population

Ageing Research (CEPAR), Australian School of Business, University of New South Wales,

Sydney, Australia. Hanewald can be contacted via e-mail: hanewaldk@gmail.com. Thomas

Post is at the Department of Finance, School of Business and Economics, Maastricht University

and Netspar. Post can be contacted via e-mail: t.post@maastrichtuniversity.nl. Michael Sherris

is at the School of Risk and Actuarial Studies and Australian Research Council Centre of

Excellence in Population Ageing Research (CEPAR), Australian School of Business, University

of New South Wales, Sydney, Australia. Sherris can be contacted via e-mail: m.sherris@unsw.

edu.au. The authors acknowledge the support of ARC Linkage Grant Project LP0883398

“Managing Risk with Insurance and Superannuation as Individuals Age” with industry

partners PwC and APRA and the Australian Research Council Centre of Excellence in

Population Ageing Research (Project number CE110001029). We thank the editor, Keith

Crocker, and two anonymous reviewers for their suggestions to improve the paper. For their

comments and suggestions we would like to thank Kevin Ahlgrim, Hua Chen, and the

conference participants at the 20th Annual Colloquium of Superannuation Researchers and

the 2012 Annual Meeting of the American Risk and Insurance Association. Rachel Nakhle and

Yu Sun provided excellent research assistance.

© 2015 The Journal of Risk and Insurance. Vol. 83, No. 2, 421–446 (2016).

DOI: 10.1111/jori.12068

421

the home’s equity is often the most significant asset. For example, the value of the

primary residence for U.S. households aged 65þcomprises on average (median) 49

percent (52 percent) of total assets, with 82 percent of households owning a house

(2009 Survey of Consumer Finance). To use the home’s equity for consumption

purposes generally would require selling the home and renting a place instead

(a decision problem covered, for example, in Yao and Zhang, 2005). However, many

homeowners are reluctant to sell the home. They prefer to “age in place” (Davidoff,

2010c). For these homeowners, home equity release products allow elderly

homeowners to convert the equity in their home into liquid wealth without having

to move. Home equity release contracts differ substantially in the way house price

risks, interest rate risk, and longevity risk are shared between the homeowner and

the provider of the product. To make the right product choice is an important

question for an elderly homeowner—we address this normative research question in

this article.

Markets for equity release products for retirees exist in numerous countries including

the United States, the United Kingdom, Australia, Canada, New Zealand, and several

countries in the European Union. The two main forms of equity release are reverse

mortgage schemes (“loan model”) and home reversion schemes (“sale model”) (see,

e.g., Hosty et al., 2008; Reifner et al., 2009a). Reflecting those market conditions, we

model a retiree’s choice between a reverse mortgage and a home reversion plan.

Reverse mortgages are the mo st common products interna tionally and dominate

the U.S. market (Consumer Finan cial Protection Bureau, 2012) . When taking out a

reverse mortgage, the home owner receives a lump-sum pa yment (or annuity or

line of credit) through borrow ing against the home’s value. There are no regular

interest payments on the mortgag e; instead, interest is added (rolle d up) to the

loan balance over time. The loan is paid back when the homeowner mo ves out

or dies. Even if the loan balanc e becomes larger than the home ’s value, the

homeowner has the right to cont inue residing in the home and the loan amount that

has to be paid back is typicall y capped by the home’s value (no n egative equity

guarantee [NNEG]).

Home reversion has existed for a long time in the form of private arrangements, for

example, in France, Portugal, and Poland (Reifner et al., 2009b). Commercial home

reversion is available, for example, in Australia, France, Finland, New Zealand, and

the United Kingdom. With a home reversion plan, the homeowner sells (a part of) his

home in exchange for a lump sum. The homeowner keeps the right to live in the home

as long as he lives. When the homeowner moves out or dies there is no payment to the

provider of the home reversion plan. However, as compensation for the life-long right

to live in the home, the provider of the plan reduces the upfront lump-sum payment

by the present value of future rent payments.

Alai et al. (2014) compare the cash flows and risk profile of stylized reverse mortgage

and home reversion plans from the perspective of the product provider. The

comparison shows that for loan-to-value ratios (LTVs) of less than 50 percent reverse

mortgages are more profitable and less risky for the provider than home reversion

plans. The opposite is true for higher LTVs (which are rare outside of the U.S. market).

This finding may explain why more reverse mortgages than home reversion

422 THE JOURNAL OF RISK AND INSURANCE