The Tenure Option As An Annuity Alternative

Tenure Payments Or Income Annuities: Which option is right for you?

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Wade Pfau April 25, 2019

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For the tenure payment, the higher interest rate helps support higher payments than those from an income annuity. But the assumption that “life expectancy” is age one hundred supports lower payments relative to the income annuity. It is not clear in advance whether the higher-interest-rate assumption will counterbalance the age one hundred assumption, such that the implied payout rate from the tenure payment is more or less than that of the income annuity.

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For example, as I write, the ten-year LIBOR swap rate is about 2.25 percent. For a tenure payment to a sixty-five-year-old with a lender’s margin of 2.25 percent, the payout rate for the tenure payment option is 5.44 percent. This is calculated as a monthly tenure payment of $624 on a $300,000 house for a sixty-five year-old financing the full up-front costs of $13,500. The payout rate is the $7,491 of annual income from the tenure payment as a percentage of the $137,700 initial principal limit (45.9 percent of $300,000). We can compare this rate to annuity quotes with cash refunds offered through for sixty-five-year-olds. The payout is 6.59 percent for a single male, 5.82 percent for a female, and 5.39 percent for couples. The tenure payment offers a lower payout rate except for the case of a couple purchasing a joint-income annuity. Women and couples benefit from the tenure payment on a relative basis, as it does not penalize them for their longer relative life expectancies.

Another interesting aspect to consider for tenure payments is that, surprisingly, the monthly tenure payment amount for a given home value decreases as interest rates rise, at least for expected rates in excess of 3.5 percent. Higher interest rates allow for a higher payout rate from the principal limit amount as just discussed. This is documented at the top of Exhibit 7.4 for expected rates between 3 percent and 10 percent, in the case of a sixty-five-year-old borrower with a $300,000 home. The payout rate from the principal limit increases from 4.53 percent when the expected rate is 3 percent, to 8.58 percent when the expected rate is 10 percent. However, the initial principal limit that the payout rate is applied to decreases as rates rise, creating a stronger counter-effect. For a sixty-five-year-old borrower, an expected rate of 3 percent supports a principal limit factor of 54.2 percent. The principal limit factor falls to 22.9 percent when the expected rate is 10 percent. Overall monthly tenure payments fall from $614 to $491 with this rate increase. The surprising implication is that tenure payments will represent a higher percentage of the home’s value when interest rates are low.

With income annuities, a given lump-sum premium would support a larger monthly payment when interest rates are higher. Of course, the principal limit rather than the home value would provide an equivalent amount to annuitize, but the interesting point is that low interest rates allow for more annuitized spending from home equity for a household with a given ratio of home value to portfolio size.

About whether to choose tenure payments or income annuities, Exhibit 7.5 describes circumstances that would favor one or the other. First, as noted, couples and single females would experience lower payout rates from income annuities, as their pricing considers their increased longevity relative to single males. Single males can receive the highest relative payout rates from income annuities and would have a stronger reason to consider them, relatively speaking. Second, tenure payments make more sense for those planning to remain in their homes, as they have more opportunity to spread out any up-front costs and potentially receive a windfall from the nonrecourse aspect of tenure payments. For those likely to move or who otherwise do not live in an eligible home, income annuities have an edge.

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Next, for those with less risk aversion, tenure payments are worth considering as a way to obtain more guaranteed cash flows without having to take dollars out of the stock market. For income annuities, I suggest treating the annuitized assets as part of your bond holdings, but in practice this can be difficult, because the remaining investment portfolio becomes more stock-heavy and volatile. In practice, real-world considerations probably mean that partial annuitization will also reduce stock holdings for most retirees, but the full portfolio and original asset allocation can remain intact more easily with the tenure-payment option.

Next, as noted, in a low-interest-rate environment, a given home value can support a higher tenure payment than otherwise. This gives tenure payments an edge to provide more spending power for a given home value to financial portfolio ratio, relative to income annuities. Finally, the tenure payments are not added to adjustable gross income, whereas annuity income is subject to taxes when initiated from either tax-deferred or taxable resources.

Tenure payments have many favorable characteristics. A tenure payment allows for an annuitized spending stream generated by home equity, subject to the caveat that it may not last for life if the borrower moves or cannot maintain the home. It does not require assets to be extracted as a large lump-sum annuity premium. For individuals uncomfortable with increasing their stock allocation for remaining assets after partial annuitization, the tenure payment option would allow more assets to remain in the stock market and focused on growth with a lower portfolio stock allocation.

This is an excerpt from Wade Pfau's book, Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement (The Retirement Researcher's Guide Series), available now on Amazon.

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