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The investment tool that might just save your retirement
Australian investors have to begin thinking creatively about how they will preserve their standard of living in retirement. This is not unique to Australia. Indeed, in many ways Australia is better positioned to meet the demographic challenges of the coming decades than most of the Western world. But that does not mean that it will not be challenging. In fact, if recent comments from all three key Australian economic mandarins can be taken at face value, the crux of the challenge is coming sooner than many expected.
The first sign that the issue was hotting up came at the start of April. The head of Treasury, Martin Parkinson, and the Reserve Bank Governor, Glenn Stevens, each delivered a speech on Australia’s economic future. So similar were the speeches, both in content and conclusion, that more than one commentator has wondered aloud whether they were co-ordinated.
Then, just one week later, Treasurer Joe Hockey gave a major speech to the G20 in Washington. He warned that an imminent ‘demographic bulge’ meant that the Australian budget would be in deficit for the next decade unless households, business and the public sector all made changes. “Achieving long-run fiscal sustainability will require winding back some spending that our population have come to take for granted” he said.
Demographic pressures on Australia
There are three key and closely-related demographic drivers that sit behind this urgency.
First, there is the issue of life expectancy. It surprises no one to hear that Australians are, on average, living longer. But the sheer magnitude of progress in life expectancy is staggering and largely undiscussed. In fact, the numbers frequently discussed in this context are misleading. We are used to hearing that life expectancy in Australia has risen to just under 80 for males and just over 80 for females. However, as the Productivity Commission showed in its November 2013 An Ageing Australia: Preparing for the Future, if ‘cohort’ life expectancies are used (which take into account likely improvements in life expectancy over time), we can see that the life expectancy of a girl born in 2012 is projected to be more than 94 years. For boys, it will be nearly 92 years.
The effect that this will have on Australian society is profound. On current policy settings, the average Australian would be living in retirement for nearly 30 years. Health services, which are understandably drawn on more heavily by older Australians, would be stretched to breaking point. The pressure on budgets would be immense.
Secondly, the increase in life expectancy will create an ageing population. The number of Australians aged 75 or more is expect to rise by 4 million from 2012 to 2060, increasing from 6.4% to 14.4% of the population. In 2012, there was roughly one person aged 100 years old or more for every 100 babies. By 2060, that number is expected to increase to around 25.
Thirdly, and a result of the first two issues, labour participation rates will fall from around 65% to 60%, with overall labour supply per capita to contract by 5 per cent. This is despite the likelihood that, in nearly every relevant age group, especially among older Australians, projected engagement in the workforce will increase.
The net result of these three factors is deep and profound changes to Australia’s budgetary position. The dependency ratio – the number of Australians not in paid work compared to the number of Australians in paid work – will deteriorate. To put it starkly, less people will be trying to pay for more services.
Putting the family home into the asset test
Already, a range of possible policy responses has been considered. The retirement age is already being moved to 67 – expect to see continued changes on that front. There will be continued moves to limit so called ‘middle class welfare’. Worryingly for pensioners, this will be significant pressure to put limits around pension eligibility.
There are a number of ways that this could be put into effect. Most simply, the raw amount paid to pensioners could be reduced. Whilst simple, this is surely unattractive, as it is generally accepted that the pension is already set at a very basic level. More probably, there could well be significant changes to the technical requirements around pensions and the assets tests that act as gatekeepers for eligibility.
One policy that is under significant pressure from many lobbyists is the exemption of the family home from the age pension asset test. Both the Productivity Commission and the Grattan Institute in its report Balancing Budgets: Tough choices we need, which was also released in November 2013, both advocate some form of mandatory ‘equity release’ from the family home as part of future funding mix for the aged pension.
What is a reverse mortgage?
Obviously, the notion of ‘equity release’ puts reverse mortgages very much in the picture. A reverse mortgage targets asset-rich, income poor investors (like many pensioners) and allows them to access the equity in their home to support their lifestyle, without imposing hefty servicing costs. According to the Australian Securities and Investments Commission’s MoneySmart website
“A reverse mortgage allows you to borrow money using the equity in your home as security. The loan can be taken as a lump sum, a regular income stream, a line of credit or a combination of these options.
While no income is required to qualify, credit providers are required by law to lend you money responsibly so not everyone will be able to obtain this type of loan.
Interest is charged like any other loan, except you don't have to make repayments while you live in your home - the interest compounds over time and is added to your loan balance. You remain the owner of your house and can stay in it for as long as you want.
You must repay the loan in full (including interest and fees) when you sell your home or die or, in most cases, if you move into aged care.”
As is the case with all financial products, reverse mortgages do carry risks and these need to be considered carefully. Most importantly, you need to have a clear view as to how much your debt is likely to increase over time as the interest on your loan compounds.
Having said this, the modern reverse mortgage embodies significant consumer protections for borrowers. First by industry code (from members of reverse mortgage industry body SEQUAL) and then by law since 18 September 2012, all reverse mortgages are subject to ‘negative equity protections.’ This means that you cannot end up owing the lender more than your house is worth.
Reserve Mortgage Case Study
Take, for example, a couple who are both aged 70 years old. They own outright a $500,000 home that is expected to increase in value by a modest 4% p.a. They enter into a reverse mortgage arrangement with a $2,000 establishment fee and $15 monthly account keeping fee. They receive a lump sum payment of $125,000.
Accordingly to the ASIC MoneySmart website, on this scenario, at age 85 they would still retain equity in their home of $463,428. In fact, the equity in their home would last until they were well over 100.
Every scenario depends on its own facts and circumstances. The couple in the case study above could do better or worse depending on a range of factors. But the case study does show how effective an equity release product can be in assisting investors retain control of both their lifestyle and their financial future.