WEEKLY COMMENT 1-09-2016
By Barry Edwards
To many the mere mention of equity release evokes bitter memories of the home income plans that got a bad name in the 1980s. Back then many were convinced to take out these uncapped plans, only to see interest rates rise, house prices fall and their homes repossessed as a consequence which sometimes created claims on the beneficiaries of the estate if death occurred during the process.
However, the industry has come a long way since those dark days. The most important change was the introduction of the no negative equity pledge which was introduced to ensure that any debt could not outstrip the value of the property. The range of products available has become more flexible allowing more and more people who are arriving in retirement, less endowed with assets, to utilise the equity in their homes as part of their pension planning.
To those of you who are not familiar with equity release, it is basically a lifetime mortgage with options or a part sale of the property to an institution who participates in any increase in value. Most of the deals are compound or interest only mortgages and you have to be 55 years old before you can apply although it is used mainly by retired people. You can opt to pay the interest or allow it to accumulate and pay off 10% of the loan each year or if interest rates go up, you have the option to repay without penalty charges.
Most people use this product to provide a lump sum of cash for all kinds of reasons and let the mortgage continue for life. The maximum sum that is usually advanced is about one third of the value of the property but if you are much older than average, a bigger amount could be taken out. This product is most suitable for people with assets that do not generate income possibly as part of a pension plan to reduce the amount of inheritance tax payable on death. The main condition is that you continue to live in the property and maintain it appropriately.
The institutions offering this product tend to be insurance companies looking for better yields for their investment funds since currently the average interest is 5% which is difficult to achieve these days anywhere in the financial markets, especially since the rate is set for the entire life of the loan until repaid. The equity release market is expanding at about 30% each year and if rates continue to remain low for investment bonds it is likely to grow even faster while that is the situation.
In my view, equity release is an attractive flexible product for older people to be used to cover commitments people wish to make if there is no other sensible option to raise sizable sums of cash. There are few products that actively encourage borrowing by people over 70 years old with the flexibility to manage how interest is paid and a repayment schedule that can be incorporated with pension enhancement for life. It is likely further options and new techniques will be devised to make this product even more suitable for retired people to have more control over their financial affairs in later life.
The low interest environment we are currently experiencing makes pension planning extremely difficult since most fund managers are seeking long-term returns to satisfy their commitments. Many economists and advisors are predicting that we are likely to endure low returns for some time which means extra cash has to be found to pay the pensions or financial expectations for retirement have to be reduced or pension funds have to broaden the investment criteria to improve returns.
Some pension funds, notably the Canadian Ontario Teachers fund are actively investing in running secure cash generative businesses directly to gain the extra yield as well as spreading the range of assets they will consider for long-term investment. At the moment, they are achieving an annual return of 8.7% and expect to maintain that yield for some time. Other pension funds are trying to emulate that strategy which means the traditional approach of pension investment will change dramatically.
For many people these days managing their own pension assets, it is not feasible to take some of the risks large funds can to increase yield. Consequently, it is inevitable that private homes will play a bigger role in the future since it is by far the largest asset most people own. The whole business of pensions is very complicated and the tax rules keep changing but governments are attempting to make pension assets accessible for people to manage as they wish.
Innovation will certainly play a role in devising new techniques for people to access the value in their homes without actually having to take out a mortgage. At the moment beyond equity release there is nothing available but it is certainly possible that utilising the value by receiving a fee for supporting infrastructure projects in conjunction with government could be devised to provide extra income on top of the state pension. It is something we are working on at the moment and propose to prepare a paper to suggest a viable method of making that happen. That will be something for a future weekly comment when it is ready.
That’s all for this week, more observations next week.