The Hindu Business Line : Reverse mortgage, forward security

To save for retirement, people have to become better at guessing how much they need and how long they will live. Both guesses are tricky. Most people underestimate their longevity and financial needs. Reverse mortgage overcomes a significant part of these problems. It spurs economic activity, provides security and retains the principal flavour of a defined-benefit scheme, say G. Ramachandran and Praveen Kumar Grandhi.

REVERSE mortgage derives its awesome power from its ability to motivate people to build or buy their homes and, thereby, save for their retirement voluntarily. Reverse mortgage serves two significant purposes; it spurs economic activity and provides economic security. From such a perspective, it would be rational to assert that reverse mortgage and India are made for each other.

Reverse mortgage is a financial contract between a homeowner and a financier (Business Line, March 15). This contract enables the homeowner to receive a stream of income, especially in retirement, from the future realisable value of the home. The principle of reverse mortgage can be applied to any asset, but its most utilitarian application is in the context of homes and retirement.

The case for reverse mortgage has been made at the right time. Its relevance to India has been enhanced significantly by three proposals included in the recent Budget. The proposals pertain to the tax treatment of savings up to Rs 1,00,000, continued deductibility of interest expenses on home loans and the legal framework for the issuance of mortgage-backed securities. Households will create more housing assets in the future. The incremental investment could be over Rs 29,000 crore each year. This estimate is based on the distribution of household incomes published by the Business Intelligence Unit (BIU). Reverse mortgages will accelerate the investment in housing assets.

Therefore, the aggregate impact on investment in housing assets could be as high as Rs 1,05,000 crore each year. This is good news. There is bankable evidence from the BIU that housing explains 83.24 per cent of incomes. Trade explains the most: 85.95 per cent of incomes.

If the contribution of housing to trade is reckoned with, housing is the foremost driver of the economy. Reverse mortgages will take the economy forward.

Funding old age

Old age impairs the capability of people to earn enough to pay for their needs. When needs pertinent to health care remain unfulfilled, further debilitation follows. To break this vicious cycle, governments of developed economies have funded many of the risks and costs of ageing of almost all their citizens. Social security is universal. Developed economies have shifted the burden of paying for pensions to those in employment. This has not been a problem as long as the developed economies and their workforces kept growing steadily. Moreover, people over 65 years of age have accounted for less than 3 per cent of the developed world's population throughout recorded time.

But this has changed alarmingly as a result of higher standards of living, better access to health care and higher life expectancy. People above 65 years now constitute about 15 per cent of the developed economies.

By contrast, social security is for the elite in the developing and least developed economies. Governments have focussed their energies solely on funding the pensions of their employees. But as standards of living and life expectancy rise, old age will become financially riskier in the third world too.

Fixing after it breaks

The comfortable demographic arithmetic of the developed economies has almost ended. It is expected to get very bleak within the next decade. Developed economies are now engaged in a struggle that has pitted the old against the young. Far too many old people have to be funded by a declining proportion of the young.

The problem is acute in the US, perhaps because of greater transparency there. The US will be unable to meet the demands on its resources made by the retirement of the baby-boom generation. Falling fertility is the villain.

The ever-rising cost of pensions and health care for the old has to be met from a smaller base of employees. The funding problem is worse in the European Union. It is a nightmare. It has not helped that the ten new entrants into the EU have brought in nearly the same proportion of the old as that of the 15 nations that constituted the EU prior to May 2004.

It is now clear that as the workforce shrinks and the number of its dependants grows, the West faces a spine-chilling funding gap. America's unfunded pension gap is over $11 trillion, the size of its economy. Continental Europe's unfunded liabilities have been estimated at 2.5 times the size of its economies.

West's weak fix

The West has recognised the importance of making more of its elderly fund the needs of retirement. It has recognised the need for individuals to save for retirement.

For example, private saving for retirement is set to become a more important source of income in old age than social security in the US.

Reverse mortgage overcomes a significant part of these problems. Insurance companies introduced the reverse mortgage in the US, the UK and Australia.

Their customers did not have to pay a lumpsum to receive an income during retirement. They merely had to contract to give away their home, and only when the grim reaper came calling.

The contract converts the capital value of a home into an annuity over the homeowner's lifetime. The annuity may be designed to rise, fall or stay steady over the lifetime. The aggregate value, however, depends on the capital value of the home.

But the attempts of the insurance companies to popularise reverse mortgages in the West have been in vain. Why? Falling fertility has not inspired confidence that home values will continue rising on the back of demand.

Nine-eleven (9/11) has not helped either. There is rising resistance towards immigration. Therefore, insurance companies dread the bursting of the housing bubble.

Betting on the bankable

India is a young country. The average age of its citizens is about 26. Moreover, its population is expected to grow at 1.6 per cent annually. The proportion of the working-age population will rise for a long time and remain at a high plateau for a longer time.

Therefore, India's economy would continue to grow at over 6.5 per cent at least until 2040. The demand for housing, as a result, will remain high.

The capital value of seasoned housing stock will rise at least as fast as incomes. Insurance companies would not have to dread any decline in home values for the next 35 years.

This also means that those who are 60 now will enjoy rising incomes or very certain incomes until they are 95.

Homeowners in reverse mortgages will be protected against inflation. When capital value adjusts to inflation, incomes too can be adjusted upwards. Goods and services will remain affordable to retirees.

Reverse mortgage is made for India. It is a bankable scheme that takes away the sting from defined-contribution pension plans.

Defined-contribution schemes impose two risks on savers. They may earn insufficient returns. Retirees may live unexpectedly long.

At the same time, reverse mortgage is a good bet. It retains the principal flavour of a defined-benefit scheme. It provides a guaranteed base income.

(G. Ramachandran is a financial analyst. Praveen Kumar Grandhi is manager, credit analysis, ING Vysya Bank; his views are wholly personal. Feedback may be sent to indiagrow@yahoo.com.)

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