The problem
Many homeowning retirees, not only in Australia but globally, are “asset rich but cash poor”. The standard product solutions (reverse mortgages and shared equity appreciation mortgages) provide additional spending money but at the cost of home equity, which may not accord with the wishes of retirees if they intend to leave their home to their children or other beneficiaries.
A new product may lead to an entirely new and very different class of equity release mortgage, which would meet the needs of the retirees for additional income without the downside of significant loss of equity in their home.
Actuaries will know that over the medium to longer term, investments in equity shares may reliably be expected to outperform risk-free investments (such as the Australian 10-year government bond). The “equity risk premium” (that is, the difference between the expected return on equities and the return on risk-free assets) is widely viewed as being in the range of 4%pa to 6%pa for developed equity markets and somewhat higher for developing markets. Mortgage borrowers pay interest rates a little above the risk-free rate (perhaps by something like 175 basis points), but there is still a substantial margin available for medium to long-term outperformance relative to home mortgage rates, which is why some homeowners (the author of this article included) have borrowed against their homes to buy shares. But there are obstacles: it may be difficult to arrange a new mortgage after retirement; time and effort are required; in the short term the dividends received may be insufficient to meet the loan repayments; and there are well known behavioural challenges to successful investing. Is it possible that there could be a product which would take advantage of the almost-certain medium to long term outperformance of equities, whilst overcoming all the obstacles?
A new solution
An index-linked mortgage called the Equity Preservation Mortgage®, the brainchild of insurance industry veterans Ian Innes and John Innes, co-founders of the Futureproof Financial Group Limited (FFG), may indeed meet the needs of many retirees. Index-linking of a mortgage is not an entirely new concept and usually refers to the use of a selected reference index for pricing purposes or pricing adjustments to better align loan cost with market conditions for borrowers and remove basis risk for lenders. The Equity Preservation Mortgage® uniquely uses index-linking in a different way that is fully embedded into the mortgage itself and used as part of the funding mechanism.
As with conventional mortgages, a borrower who takes out the new product may choose between two versions: a “principal and interest” version and an “interest-only” version. The borrower also specifies an annuity period (not exceeding the total mortgage duration) over which they wish to receive an annuity. The mortgage offers up to 80% LVR with full reversionary rights to the spouse or partner for borrowers with an unencumbered residential property. But in many other respects, the new product is very different from any existing mortgage. The Mortgage Agreement expressly provides that there are no circumstances under which the borrower is ever liable to pay loan interest. Credit risk is removed for the lender through a hybrid risk managed approach using capital markets and insurance market solutions, with any residual index risk underwritten by a new form of Lenders Mortgage Insurance (LMI), which instead of covering the risk of borrower default, covers the risk of long-term index underperformance. When a mortgage is taken out, the funds, instead of being directly advanced to the borrower, are apportioned by the product software, partly to an Annuity Sub-account and partly to a Mortgage Offset Sub-account. The lender deploys that offset capital for the entire loan duration.
Key Features
The minimum duration of the loan and the maximum annuity amount that may be paid to the borrower would be determined by the underlying software, and those parameters would be targeted to ensure that the risk to the lender is maintained at an acceptable level and the portfolio construction is compliant and fully mortgage insured. The assets in the two sub-accounts would be held partly in cash but mainly in one or two index-linked ETFs, with a strong equity allocation.
The purpose of the Annuity Sub-account is to pay the requested annuity amount regularly to the borrower, and the purpose of the Mortgage Offset Sub-account is to meet the “interest only” or “principal and interest” loan repayments to the lender. If the “principal and interest” version of the loan is taken out, then the amount of the annuity payments made to the borrower will be lower than would have been available in the “interest only” version, but on expiry of the loan term in the “principal and interests” case, the borrower owes the lender absolutely nothing, despite having received an annuity for some or all of the loan term.
That annuity is basically “free money” to the borrower. Alternatively if the “interest only” version of the loan is taken out, then the Mortgage Offset Sub-account is used to pay the interest due to the lender (but not any repayment of principal) in which case at expiry of the loan term or on sale of the property, the amount owing by the borrower to the lender would be equal to the sum of the annuity amounts paid over the duration of the annuity term. The “principal and interest” version of the product enables full home wealth to be transferred to the family, better addressing inter-generational unfairness by enabling the children to enter the housing market through inheritance of preserved home equity.
But what happens if the investment returns are not good enough to make the loan repayments and the annuity payments?
Investing the balance of the Mortgage Offset Account in index-linked ETFs only works effectively with long loan durations to smooth market cycles. The loan terms to be offered under the new product are likely to range from 15 years to 30 years. A variety of the risk management techniques (including interest holidays, hedging, bond insurance and pooling of surpluses across the loan book) will be utilised to maximise the probability that the annuity payments and home loan repayments to the lender can always be made. The risk management measures are intended to keep the risk of insufficient investment returns to an absolute minimum, but it is not possible to state with certainty that the loan repayments will always be able to be made from the asset pool available. But the critical point to note in this respect is, that unlike any other mortgage, the party that bears the risk that the asset pool is insufficient to meet the mortgage repayments is the lender, not the borrower. The lender, in turn, is protected from residual credit risk by the new form of LMI.
What happens if the borrower wishes to sell the home before the mortgage expires?
The borrower may sell their home at any time. However, if the borrower wishes to sell their home before the expiry of the mortgage, then the mortgage may be discharged immediately if the balance of the assets held in their Mortgage Offset Sub-account is sufficient to meet the total loan amount outstanding to the lender. If the total balance of the sub-accounts is less than the amount owing to the lender, the borrower may (if he or she chooses) pay the shortfall and terminate the mortgage loan. But there is another unique option available to the borrower if there is a shortfall: the borrower can allow their Mortgage Offset Sub-account to continue in run-off so that the investment arrangements continue as previously, until such time as the shortfall is made good, or the minimum mortgage period is reached, with any shortfall covered by the capital markets and insurance counterparties. In either case, the mortgage may then be discharged without any financial penalty on the borrower.
What are the taxation and Age Pension Testing consequences of the new product?
Legal advice provided to FFG indicates that the payments made to the borrower from the Annuity Sub-account will be regarded for tax and age pension testing purposes as capital items not income, so the payments will not contribute to the borrower’s taxable income, nor will the payments be regarded as income for income testing of the borrower’s age pension. However, it seems that the balance of both the Annuity Sub-account and the Mortgage Offset Sub-account, being held in the borrower’s name, will be deemed to be assessable assets for asset testing purposes. For this reason, it will be important for borrowers who may be affected by the age pension assets test to carefully consider (or obtain advice) on the impact of the arrangement on their age pension. (This consideration does not apply however in the USA or the UK, the other markets where a launch in the next year or two is planned.)
The Equity Preservation Mortgage® will be released in Australia in late 2025 and in the UK in 2026.
About the author
The author, John De Ravin, is a retired actuary whose career included work in the Office of the Australian Government Actuary, in two insurance companies and in two of the world’s leading reinsurers, Swiss Re and Munich Re. He has degrees in Science and Economics from ANU, an MBA from Macquarie University and a Graduate Diploma in Financial Planning from Finsia. He is a Fellow of the Actuaries Institute, a Fellow of Finsia and a CPA.
