All My Thoughts On Reverse Mortgages

House_bills

I’m not the right age for reverse mortgages1 but a reader asked me for my help. Some deep-down part of me will always be a mortgage guy, so I decided to learn more about these things.2

The reader, named Jesse, aged 73, called to relay his experience trying to get a reverse mortgage on his house, and to ask for my advice.

He’d seen advertisements by Tom Selleckfor a company called American Advisors Group and it seemed to fit his financial circumstances.3

For Jesse, his idea was to use the money he could pull out of his house to help pay for taxes and insurance in the coming years.

Although I had never paid much attention to reverse mortgages, I previously had a vaguely negative feeling about them. I’ll describe those and sure, there are reasons to be cautious.

In the course of following up on Jesse’s inquiry, I also earned a bunch of unique and kind of awesome features of reverse mortgages which I had never seen in any other loan product. My overall thought is that under the right circumstances, these could be very useful mortgages.

No Payments, Ever

The first weird thing is that a borrower can decide to never make any principal and interest payments on the loan. For life! The debt accrues interest of course but the borrower can choose to never pay on that interest or principal. The lender gets paid back eventually, when the house is either sold or the owner dies, but in the meantime the loan doesn’t require any payments. Ever. I’ve never seen that on a loan structure before.

Second, as long as the homeowner complies with the mortgage agreement – which means staying current on taxes and insurance – neither the homeowner nor the homeowner’s spouse can be evicted from the house. Ever. It’s a bank loan backed by collateral, but the bank can’t take the collateral for the life of the borrowers. This is also something I’ve never seen before.

As it turned out, Jesse couldn’t move forward with the reverse mortgage, however, because his husband Ralph is only 51, and Texas requires both spouses to be over age 62.4

Other states have more lenient spousal rules, but Texas has its own way of doing things, as you may have heard.

I’ll describe my three previous issues with reverse mortgages, as well as my evolving views.

Complexity is the Enemy of the Good

An important worry is that as a relatively unusual loan product, consumers could be more likely to make bad choices about a thing they don’t understand very well. Even a traditional home mortgage can seem complex but it resembles other products we’re familiar with, like an automobile loan or a personal loan.

A reverse mortgage, by contrast, acts a bit like a retirement account or annuity, in that you can take money out over time as you get older. It’s also a bit like a credit card or home equity line of credit, in that it “revolves,” meaning you can take money out but also pay it back as often as you like. But it’s also different than a credit card or home equity loan, because you don’t have to pay it back with regular or even any payments (until you die). One of my guiding principles of finance is simplicity. Reverse mortgages may be a complicated form of debt for some people, and complicated is the enemy of the good.

Somewhat reducing my fear, however, is that every prospective reverse mortgage borrower must take a financial counseling course by phone, mandated by the Federal Housing Authority (FHA), which regulates reverse mortgages. Guy Stidham, owner of Mortgage of Texas and Financial LLC, a San Antonio-based mortgage broker who offers both traditional and reverse mortgages, says these courses cost about $150 and take a few weeks to schedule, which serves as a kind of “cooling off” function for prospective borrowers.5

Borrowing capacity

One of the more complicated topics of a reverse mortgage is how much you can borrow. Big picture, you should know two things: First, you can generally borrow much less initially with a reverse mortgage than with a traditional mortgage. Second, the amount you can borrow against your house trends upward over time, at the same rate as your mortgage’s interest rate. Let me fill in a few details on this issue.

Your initial borrowing amount is calculated according to an FHA formula by taking into account three things: The value of your house, your interest rate, and your age.

House_billsThe FHA says that the younger you are, the less you can borrow against your house. This makes sense since time will eat away at your home equity, and you are not required to make payments on a reverse mortgage. The FHA also says that the higher the interest rate, the less you can borrow. This also makes sense because a higher interest rate, compounding over time with no payments, will also eat away at your home equity.

With an online calculator you can see how much of your home value you are allowed to borrow against. If you test out the calculator, you’ll see a 70 year-old charged 4.5 percent can borrow less than 50 percent against their house. The typical range of borrowing is between 40 and 65 percent of home value, substantially less than the 80 percent standard with a traditional mortgage.

Here’s a weird quirk of reverse mortgages, however, The amount you can borrow against your house increases over time, precisely in line with the interest rate you are charged. If you’re charged 5 percent interest, your available borrowing limit increases by 5 percent per year. For reverse mortgage borrowers using this as a home equity line of credit, the annually increased borrowing capacity will seem like a cool feature. For people concerned with reverse mortgages eating up your home equity, this increased borrowing capacity may seem pernicious.

I won’t rule either way, except to say that debt in all forms is always a drug, which may be used for good or evil. The increasing borrowing limit just ups your dosage of the drug over time.

Are these high cost mortgages?

My second big worry was that reverse mortgage would be high cost products for borrowers. This fear turns out to be somewhat true, although there’s some nuance to the cost issue.

reverse_mortgageThe biggest cost of a reverse mortgage is mandatory mortgage insurance. Reverse mortgage borrowers are charged by the Federal Housing Authority (FHA) 2 percent of the appraised home value. For a $500,000 appraised home, the FHA would charge $10,000, which would be rolled into your loan balance at the time of origination. The FHA also charges 0.5 percent annually on the balance, as further insurance against losses. I think this is the biggest contributor to reverse mortgage costing more than traditional mortgages.

Next, what kind of interest rate should we expect on a reverse mortgage?

Most reverse mortgages charge a variable interest rate. According to Greg Groh, a reverse mortgage originator with All Reverse Mortgage, last week the starting variable interest rate was 4.32 percent which, added to the insurance cost, would mean a borrower’s cost of 4.82 percent.

What do I think of those rates? They’re slightly higher than a traditional mortgage, but also less than the rate I’m currently charged for my home equity line of credit, on which I pay 5.49 percent, and happily so. So, the floating interest rate isn’t a big knock on reverse mortgages.

Joe DeMarkey, Strategic Business Development Leader of Reverse Mortgage Funding estimated fixed rates now between 4.375 and 5.125 percent, in the same ballpark as a traditional 30-year mortgage. So, again, the cost of a reverse mortgage isn’t particularly from an above-market interest rate.

DeMarkey points out that 80 percent of reverse mortgages have floating interest rates rather than fixed rates. With floating rate loans, the initial interest rate often starts out reasonably low but there’s always a risk that future higher interest rates make that same debt more expensive later.

Broker commissions and origination fees

Stidham allows that a broker like him can be compensated more by the lender to sell a reverse mortgage in part because they are a less competitive product. His fee for brokering a reverse mortgage could be up to 3 times higher than with a traditional mortgage.

Finally, there’s the issue of origination fees. The maximum origination fee is capped at $6,000, and would actually be smaller for smaller loans.

Closing costs like attorney fees, title insurance, and bank appraisals are all basically the same as a traditional mortgage. Groh reports that a reverse mortgage bank appraisal cost might run slightly higher, but on the order of $550 for a reverse mortgage appraisal rather than $450 for a traditional mortgage. Not a big deal there. The main big cost difference, as I said earlier, is the FHA-charged insurance, which is pretty hefty.

Servicing Details

The servicing component of reverse mortgages is slightly different than for a traditional mortgage. Since borrowers must live in their house, does that force a sale if an elderly person moves out to a nursing facility? Yes, and no.

Borrowers may live outside of the home up to 12 continuous months, meaning even an extended hospital stay or stint in a nursing home does not trigger any change with the mortgage.

Each year a lender sends an “occupancy certificate” letter to the home which must be signed and returned, according to Cliff Auerswald of All Reverse Mortgage. If the borrower does not return that certificate, then the servicer may send someone over to do a drive-by inspection of the property.

If the borrower decided to leave the home for more than 12 months, then in fact the loan would become due. For that reason, any borrower who doesn’t plan to stay in their home “for life,” should probably look for another product rather than a reverse mortgage.

Hollowing out Equity

My third big problem with reverse mortgages was that they clashed with my traditional view of the incredible wealth building potential of home ownership– a way to automatically build up a store of wealth by making affordable monthly principal and interest payments on your house over a few decades. Because reverse mortgages drain that value over time, they made me want shout “Wait…But that’s…that’s not how it’s supposed to work!

Look, my strongest advice would be to fully pay down your home mortgage over 15 to 30 years, don’t borrow against your house, and depend solely on accumulated retirement savings plus social security to support you in your old age. There’s nothing wrong with that advice except for the fact that it sounds a bit like: “My strongest advice to you is to be rich in your old age.”

And, you know, that’s not very actionable advice by the time you actually retire.

If you can’t be rich, my second strongest recommendation would be to take out a home equity line of credit, since these are revolving lines, they allow you to flexibly borrow as needed, and act like a low-interest emergency credit card. They are awesome and we used one to renovate our kitchen and paint our house. I love my HELOC. A reverse mortgage therefore is really a third-best option, but it seems to me a pretty fine choice under many scenarios.

As my wife reminded me recently, one of my other long-standing theories of personal finance is that kids shouldn’t inherit stuff. Since we don’t intend to bequeath our house to our girls, I shouldn’t be opposed to draining the house of our home equity once we hit our 70s or 80s. At that age, the goal shouldn’t be to continuously build up assets (For what? For whom?) but rather to spend money to make our lives better.

If we planned to stay in our house, my wife and I recently agreed we’d be open to a reverse mortgage in our 70s.

 

Please see related posts:

Homeownership – Part I

Ask an Ex-Banker: HELOCs

 

 

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  1.  You have to be age 62, minimum.
  2.  This post is a combination of a couple of columns I wrote for the newspaper, combined into one long post.
  3.  A reverse mortgage, sometimes called a home equity conversion mortgage (aka HECM), is targeted to 62 year olds and up. Home equity, I should clarify, is the difference between the value of a house and the amount of debt on the house. That means a $300,000 house with a $100,000 mortgage has $200,000 in home equity. A reverse mortgage is a kind of home equity loan, specifically to borrow in old age without having to make payments, if you don’t want to.
  4.  As an aside, Jesse wondered if discrimination from the bank was at play because he’s gay. I told him he should hope for that, as a class-action attorney could solve all his financial needs and he wouldn’t need the mortgage any more. Alas, Texas law says your spouse can’t be younger than 62 to take a reverse mortgage, whereas in other states your spouse can be younger than 62. It’s age discrimination, not LGBT discrimination. No big discrimination win for Jesse.
  5.  Disclosure: I have done consulting projects for Stidham in the past.

TRS – A Texas Pension Too Big To Fail

TRSTexas State Senator Paul Bettencourt, (R-Houston) poked the bear when he filed Senate Bills 1750 and 1751, which would allow the Teachers Retirement System of Texas (TRS) and Employee Retirement System of Texas (ERS) to study, and possibly implement, changes in their public pensions. Change would mean moving – in an as-yet unspecified way – from a traditional “defined benefit” to a more 401K-style “defined contribution” plan. The effect would be to shift the burden of paying for retirement, somewhat, from taxpayers to employees. The bills as written specifically would only affect newly hired employees, not existing employees or retirees.

The bear he poked, of course, is public school teachers.

Public school teachers in Texas face steeper challenges planning their retirement than other professionals, in part because the vast majority cannot participate in Social Security, in part because of modest pay increases throughout a full career of service, and in part due to barriers to good retirement advice.

I don’t blame teachers, their union, and groups like the Texas Public Employees Association and Texas Retired Teachers Association (TRTA) that have come out in opposition to the bills. Tim Lee, Executive Director of TRTA, told me that an estimated 120 thousand text messages had been sent to legislators regarding changes toward a hybrid plan, such as suggested in SB 1751. Lee regards a shift to a hybrid system – even for only new hires – as undermining the strength of the entire TRS. A change caused by these bills would cause his organization to rethink their strategic approach to everything, including whether to advocate for joining the Social Security system. They don’t currently, but might in the future if they thought a hybrid system weakened TRS.

And yet, (and here’s where I become a target for the next 10,000 angry text messages from teachers) Bettencourt has an important point to make, by filing these bills. “Long term, what I hope to do is start a discussion about the real cost of pensions,” Bettencourt told me.

paul_bettencourtAs a finance guy, I want my public officials staying up late worried about public pensions, seeking ways to reduce their systemic risks. TRS has more than 1.5 million members, more than $130 billion in net assets, and represents the ultimate “Too Big To Fail” public pension in Texas.

Reasonable people can disagree on the following, but on the four biggest measurements of a pension plan’s health, the TRS according to its 2016 audit is worse off than we’d wish for, although maybe still within acceptable bounds.

  1. We want at least an 80 percent “Funded Ratio” – the percent of money owed to pensioners that’s covered by money already in the investment portfolio. TRS is now at 79.7 percent. Too low.
  2. We want less than 30 years to “amortize” or pay down, pension debts, and would prefer 15 to 20 years. TRS is at 33 years. Too long.
  3. We would prefer a low, or conservative, annual return assumption, compared to a national average of 7.47 percent annual return assumption in pension plans. The TRS assumes an optimistic 8 percent return. Too high.
  4. Finally, the unfunded liability part of the pension – money owed to retirees but not yet paid for – has grown from zero in the year 2000 to approximately $35 billion this year. Too big.

None is this spells catastrophe today, in my view. It just means the TRS is not, currently, building in room for error. As a teacher, if TRS is my main safety net, these numbers do not make me comfortable.

Actually, let me restate: Were I a young teacher, or a prospective teacher facing a new career, I would be livid about those TRS numbers. Older teachers – those close to retirement or already retired – are probably fine, and realistically won’t get benefits chopped to make up any future shortfalls. Rule changes in pensions always hurt the young ones.

In fact, one of the main flaws of the TRS design is this “generational inequity” in favor of older teachers rather than younger teachers, according to Josh McGee, who is both a pension-plan economist for the John Arnold Foundation and the Chairman of the Texas Pension Review Board. McGee has written extensively about how traditional pensions like TRS strongly favor veterans over younger teachers, especially those who change jobs or leave the system at any point in their career.

Defined benefit plans are most generous to veterans of over 20 years, but McGee cites figures that only 28 percent of teachers nationwide stay for that long. The early-departing teachers lose many of their hard-earned retirement rewards.

A defined contribution plan or hybrid plan theoretically could allow teachers the chance to self-fund part of their retirement, which could accompany them to another career or another location.

Then there’s the issue of pension plan solvency.

“When you look around the state, the Dallas [Police and Fire] Pension is a smoking crater at this point in time. Houston is not far behind,” Senator Bettencourt notes, referencing existing problems in public employee pensions in the state’s largest municipalities.

The following are my words, not Sen. Bettencourt’s, but I regard public pension plans as ticking time bombs. Not because the managers of TRS are bad, or because anyone is doing anything particularly wrong. It’s just that small decisions to underfund a public pension can, over decades, compound into giant problems. Make a few wrong assumptions – the 8 percent return assumption seems way high to me for example – and you end up with a big fiscal hole in the state.

A safer approach for teachers and taxpayers might in fact be to shift, over time, some of the risks away from taxpayers. Currently 13 states have a version of a hybrid system of the type that Bettencourt’s bill would allow, while 38 states continue with a “defined benefit” plan like Texas’ current TRS.

It’s a debate worth having now, before anything bad happens.

 

A version of this post ran in the San Antonio Express News and the Houston Chronicle.

Please see related post:

Teachers and the struggle to get good financial advice

I Finally Say How To Invest

Interview with Mint: I give ALL the answers

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Variable Annuity Salespeople: Just Because You’re Paranoid Doesn’t Mean I’m Not Out To Get You

variable_annuity
Variable Annuity = Shit Sandwich

A funny email note went out yesterday from the National Tax-Deferred Savings Association (NTSA) about my article on the terrible retirement product teachers generally get, from an organization funded by the people selling those terrible products. By their note I gather they support the selling of shit-sandwich annuities to retirees, stuffing unsophisticated people’s retirement accounts with high cost, illiquid, low return, garbage.

Anyway, in a newsletter to their constituents, the NTSA wants you to know there’s something fishy about the timing of my column:

“An article titled, “Texas Teachers Get Poor Retirement Advice and Worse Options,” ran in the Houston Chronicle over the weekend. Its timing is probably not coincidental.”

I honestly have no idea what the ‘coincidental timing’ they are referring to is. But I know that if you have something you’re doing that seems kind of wrong, truth-telling at any time can seem threatening.

I write what I want, when I want to. Unlike the NTSA, I’m not selling anything terrible, or anything at all. By their paranoid response, I gather they are.

 

 

Please see related post in the San Antonio Express News and Houston Chronicle

And the post on Variable Annuities = Shit Sandwich

 

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Teachers and Their Retirement Problems

teachers_financial_advice
Public School Teachers are the Glengarry Leads

A majority of people struggle to prepare financially for their retirement, but public school teachers and employees face a particularly difficult set of circumstances.

I’m enough of a fiscally hard-assed finance guy to think that every public school teacher should self-fund his or her retirement to supplement their pension plan, which for people in my state is the Teachers Retirement System of Texas (TRS).  Unfortunately, there’s the grim reality facing many teachers about how hard this is to actually do. I learned a lot recently from my teacher friends about why that’s so.

My friend Dina Toland has worked as a public school teacher in Texas for 23 years and described the typical way she and her colleagues obtain their “retirement advice.”

First, a representative salesperson for an insurance or investment management company gets invited, for some unclear reason, to a faculty and staff meeting, where they have a captive audience from which they can collect email sales leads by offering raffles or some other minor incentive.

The salespeople then attempt to schedule one-on-one teacher meetings using these leads, at which the pitch usually involves scaring teachers about their insecure retirement and the need for certain specific investment products. Thus made anxious, teachers are often urged to invest in variable annuities, which I consider one of the four horsemen of your personal financial apocalypse because of their high fees, illiquidity, low returns, and generous sales commissions for these same salespeople.

TRSDina was convinced to buy into this mess when she was a young teacher just starting out. Ironically, the salesperson herself was so inexperienced that she convinced Dina and her cohort of similarly clueless young teachers to take out too much money from their paychecks, such that they all had trouble paying their bills in subsequent months. Besides taking too much money, they all bought into these terrible variable annuities. As Dina says, how would they have known any better?

This problem afflicting teacher retirement planning isn’t limited to Texas. The New York Times ran an excellent 6-part series last year with provocative and true headlines like “Think Your Retirement Plan is Bad? Talk To A Teacher” and “An Annuity for the Teacher – And the Broker” about precisely these difficulties, featuring public school teachers in Connecticut who were sold products with this combination of high fees, low returns, illiquidity, and hefty commissions for insurance salespeople.

My friend David Nungaray, in his 6th year of teaching and administration in public schools in Texas, has a similarly discouraging story.

Early in his career, a representative salesperson of an insurance company was invited to speak to new teachers like him, at which he was of course urged to purchase an annuity. He did, to my chagrin when I later learned what had happened. This year he resolved to open up his 403(b) employee-sponsored retirement account, the next big option for self-funding one’s retirement.

Helping my friend David set up his 403b account was anything but easy and straightforward. David is himself extremely competent. But we agree this would never have gotten done without both of us working hard to do it.  As a first step, David asked six of his colleagues in the public school system – chosen by David for their seeming prudence and likelihood to have a 403(b) account – if they had any advice for him. Only one of the six had ever signed up for a 403b account. Not an auspicious start. David then contacted his school district to look for help. Could David get any investment advice from his school district? No. The human resources department at his school district referred David to TCG Group, which administers all employees’ 403b plans for his school district, as well as many others in the state. The TCG Group website provides a list of 51 approved annuity and investment firms, with links to contact them.

shark_sandwich
“Shit Sandwich”

David had no idea which investment firm to pick. Could TCG Group help? No, that’s not their job. They are 403(b) plan administrators only.

As a side note, I tried for three days to have a substantive conversation with folks at TCG Group, for the purposes of this post. Let’s just say they were as helpful and open with me as they were with David.

The next step was to pick an investment firm and to open an account. I helped him do that. Having done that, he returned to TCG Group to give them instructions to have 403b contributions deducted from his paycheck. Of course, then he needed to select an investment, or series of investments, at his chosen investment firm. That’s easy for me to help him with, so I did.  But this hand-holding happened over the course of four weeks, with many barriers along the way. The barriers would have deterred a less determined employee, especially one without a friend willing to do it, in a non-conflicted way, for free.

Of course any of the investment firms could have “helped” him too, but he might have ended up with terrible annuity-like products totally inappropriate for the retirement account of a teacher still in his twenties. I’m all for self-funding and self-reliance as a theory, but I’ve become concerned about the reality of doing this well, for most teachers.

The stakes are high because most public school teachers in Texas – like those in many other states – can not count on Social Security in retirement, as 95 percent of school districts opt out of the federal system. So teachers fall back on the TRS and do little else.

If you are one of the over 1.5 million Texans who are members of the TRS, you should ask at least two big questions about your retirement. First, as my main safety net, is TRS financially strong? Second, will payments from TRS be enough to cover my needs in retirement, personally?

If you are not a member of the TRS, then as a citizen and taxpayer you should hope that state leadership is also asking important questions and having a good dialogue around these challenges and solutions. In a subsequent post I’ll talk about the finances of TRS, and that dialogue.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle

 

Please see related post:

 

Public Policy Debate on Teachers Retirement in Texas

 

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My Self-Directed IRA

DIY_investingWith a little time to go before tax day, you’ve still got time to fully fund – up to $5,500 or $6,500 if you’re at least 50 years old – your Individual Retirement Account (IRA). As a certain former Governor of California used to say in the movies: Do it.

Today’s lesson is a departure from the solid, sensible, (maybe boring?) advice I’d usually give you regarding IRAs, and instead is about a do-it-yourself (DIY) version of IRAs that you should know about. But you shouldn’t necessarily “do it.”

But first, the boring, correct thing you should do with your retirement money: Set up automatic regular contributions to a low-cost (probably indexed) 100 percent stock fund at a brokerage house, and never, ever, sell. Also, be sure to do this starting at age 22. That’s how you guarantee your wealthy retirement.

While most of my retirement money is sensibly invested as described above, a portion of my retirement money is in a self-directed IRA. What does that mean? That means I like to make things difficult for myself. For some good reasons, and some bad reasons, which I’ll explain.

save_for_retirementA self-directed IRA greatly expands the category of things you can purchase into your IRA. With a self-directed IRA, You can buy real estate, like raw land, a commercial building, or even a house. (You can’t live in a house owned by your IRA, however, that’s a clear No-no.) With a self-directed IRA you can invest directly in a hedge fund, a venture capital fund, or simply shares in a privately-held business or limited partnership. (Although you can’t own a business that also pays you a salary, that’s also a clear No-no.) You can even buy physical commodities like gold, for example. (You shouldn’t, but you can.).

The folks at the self-directed IRA service provider I use offer further examples of odd but potentially interesting ways to invest that go beyond the bread-and-butter stocks-and-bonds of a traditional brokerage or bank IRA. Some clever real estate folks, for example, by options on real estate for small sums of money, and then line up real estate buyers above their option price. This form of real estate flipping is a difficult but cool trick that could turn a very small IRA into something meaningful. I don’t really recommend you try this at home, I’m just mentioning things that some folks do in their self-directed IRA.

There’s definitely nothing ‘guaranteed’ about self-directed IRAs. In fact, it’s probably safe to say that one of the main disadvantages of a self-directed IRA is that there’s (almost) nobody to sue when things go wrong. That’s your own self-inflicted wound when you lose money.

An analogy I like to use for a self-directed IRAs is that it’s a lot like building your own car in your own garage. It will take a lot more work than the alternative. You probably need specialized knowledge. It may cost you more money than buying your basic Hyundai at the dealership. You can install some cool tricked-out features if you have particular skills. Still, most people would be better off, with most of their money, if they just went to a professional brokerage instead of building their own investment vehicle.

But if you build it yourself and then the brakes fail going down hill, well then I don’t know what to tell you except you made some bad choices. And also, like, you should have gone to GEICO.

The best reason for opening a self-directed IRA – probably – is that you really derive a lot of satisfaction from the act of investing itself. Maybe you enjoy taking risks. Maybe you have a very particular expertise in real estate or private investing or high-interest lending. Possibly you have access to unusual deal flow because of your professional background. Those are the scenarios that lend themselves best to self-directed IRA investing.

Mobile homes, Yay! (Not the actual mobile home in Arkansas)

Personally, I’ve done this now for seven years.

The service I use in Texas, Quest IRA out of Houston allows me to invest in some weird things, which I’ve found fun. My wife’s IRA, for example, receives regular monthly payments on a mobile home loan in Arkansas. Whenever a monthly payment comes in, I forward her a note saying “Yay Mobile Homes!” (True story.)

quest_iraFrom my own IRA, I’m currently lending money to a friend here in San Antonio who needed to buy a piece of property and erect a structure for his business. It felt nice, beyond the annual interest rate I earn, to offer him an easier option than a bank for that purpose.

In my self-directed 401K, I acquired a fractional interest in an odd-ball piece of land in Bexar County that has at times enhanced my knowledge of real estate arcana and other times has frustrated the heck out of me. I plan to write about some of that arcana next week.

In investing via my self-directed IRA, I violate all sorts of investing rules that I urge on other people. Things like:

  1. Don’t spend any more than the minimal time necessary on investing activities. Guilty as charged.
  2. Have an expert analyze all the risks. Since I don’t know all the risks I’m taking, and since a professional money manager hasn’t looked into them for me, there are certainly more than the usual number of unknowns in these investments.
  3. Don’t lend money to friends, as you risk losing both the money and the friend.
  4. Don’t pay higher fees than necessary.

I know I pay higher fees for my self-directed IRA accounts than I do for my basic index stock fund at a major discount brokerage. I get charged an average of 0.15 percent management fee on assets with my basic stock index fund, or let’s say $150 per $100,000 per year. Although the self-directed accounts don’t have a management fee, I pay in the range of $1,000 per year, or let’s say 1 percent for a variety of account fees, on $100,000. In other words, this is more than six times more expensive than my basic stock index fund.

entrust_iraSo again, this is as much about the fun of DIY than anything else. Have I convinced you not to do this yet? Heck, I’ve almost convinced myself. Just kidding, I enjoy it too much. And also, I probably need better hobbies.

 

A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Agricultural Tax Exemption

DIY IRA

Tax Liens in my life

 

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Houston We’ve Got a (Pensions) Problem

danger_will_robinsonHouston’s three public pensions may not be in total distress today, but some of the instrument panels are beginning to flash orange.

One of the warning signs is the hit to the city’s credit-ratings earlier this year, as

Moody’s Investors Service downgraded the City of Houston’s debt on March 16 2016.

You might guess that the main problem with the City of Houston’s credit rating is the slowdown in the oil services business, and that’s certainly a short-term issue.

But Moody’s specifically cited large unfunded pension liabilities as one of the four main reasons to downgrade city debt to Aa3 and keep it on “negative outlook,” calling the liabilities “among the highest in the nation.” Lacking a plan to address the pensions, Moodys wrote in March, could lead to a further downgrade in the city’s bond rating.

moodys_houstonLet’s review some statistics on the pensions for firefighters (acronym: HFRRF), police officers (acronym: HPOPS), and municipal employees (acronym: HMEPS).

Things to monitor

Remember, the first two things to monitor, with respect to the health of a pension plan, are the funded ratio – roughly how much of future payments are already covered by investments – and years to amortization, otherwise known as the time needed to pay down debts. I’ve previously said that an 80 percent funded ratio is considered ok, although closer to 100 percent would be preferred. For years to amortization, a 15 to 20 year time frame seems manageable, while 40 years to infinity invites state monitoring and restrictions.

So what do we worry about the Houston plans in particular when we see the funded ratio and the years to amortization?

Here are the two measurables on the three Houston pension plans:

HFRRF – 86.6 percent funded ratio, 30 years amortization

HMEPS – 54 percent funded ratio, 32 years amortization

HPOPS – 79.8 percent funded ratio, 23 years amortization

Honestly, using just those measurements, only the HMEPS funded ratio makes me worried. If you’re not frightened by the first two measurements of funded ratio and amortization – and when I look at them I don’t personally get panicked – the next thing to monitor gets trickier.

You see, the firefighters’ and municipal workers’ plans assume an 8.5% annual return on investments, while the police plan assumes an 8% return. Not only do all three assumptions seem too high, but the first two plans are complete outliers. In a survey done by the National Association of State Retirement Administrators in early 2016, only 1 out of 127 plans assumed an 8.5% return. So, Houston firefighters and muni workers have an aggressive – actually my preferred word would be unrealistic – set of assumptions.

Last Fall, the Chairman of the HFRRF Todd Clark defended their outlier return assumptions in the Wall Street Journal, saying “We strongly believe, and past history shows, we can continue to achieve the 8.5% long term.” Clark resigned in July. HFRRF Executive Director Ralph Marsh declined to comment on my questions about the assumed return, or others posed about their pension fund.

houston_we_have_a_problemThe last 20 years’ average pension returns were 7.47 percent, according to the Wall Street Journal.

As a finance guy, I wish I could intuitively explain to the non-finance reader the uncomfortable tingly feeling in my toes that I get about that math. The effects of being wrong by just 1 percent, compounded over decades in a pension plan, are huge. We can see some of the scary implications from a presentation done by the Houston plans for the Texas legislature in June.

In that presentation, they showed that if you shift the return assumptions on Houston’s police and municipal employees down by 1 percent, suddenly the police pension plan only has a 54.6 percent funded ratio, while the municipal employees plan goes to a 49 percent funded ratio. So, like, only half the money needed to pay out retirees is currently available in the plans. Ugh. The instrument control panel not only shows blinking green lights turning into red lights, but sparks are starting to shoot out of the dials. Danger Will Robinson!

Now you start to get a sense for why Moodys downgraded the City of Houston in March, and why the Chairman of the Pension Review Board is trying to sound the alarm on Houston pensions.

City Budget Constraints

You see, the next big problem is that fixing pension shortfalls begin to eat into city budgets, a process already underway in Houston.

Josh McGee, who serves as both the Vice President of the Laura and John Arnold Foundation – a Houston think-tank focused on public finance, as well as the Chairman of the Texas Pension Review Board – points to a worrisome trend for Houston’s city budget.

houston_pensionIn 2001, required pension contributions made up just 6.7 percent of general fund revenue, or the amount of money in the city budget not otherwise allocated to specific purposes. By 2015, the required pension contributions have climbed to 19.2 percent of the general fund.  The trend here, tracked by McGee, has been steadily upward.

McGee compares Houston’s situation today with Chicago’s situation a decade ago. In Chicago, the comparable pension payment to the general fund rose from 19 percent to a stunning, and devastating, 54 percent today.

That means city leaders can’t decide to pay for stuff in a city without dedicating half their discretionary budget to fill in holes in pension plans – money already owed to workers, for work already performed. You have to rob Peter to pay Paul. Chicago is in a terrible bind today, and McGee openly worries Houston will follow down that path without a course correction.

So what happens if these plans stay in trouble? Realistically, political leaders don’t just say “Whoops” and send a shrugging emoji to pensioners. They especially don’t do this with politically sensitive pensioners like police, fire and city employees.

No. Instead, they fund the plan, and then taxes go up. Or they fund the plan, and other discretionary city services go way down.

The only other fix is to significantly reduce benefits for future employees.

Either way, residents previously blissfully unaware of such boring actuarial minutia as funded ratios, amortization schedules and actuarial unfunded liabilities unhappily begin to care, deeply and late, about such problems.

 

A version of this post ran in the San Antonio Express-News and the Houston Chronicle.

 

Please see related posts

The Dallas Police and Fire Pension Mess

Pension Plan Heuristics

The Big Four Texas Pensions

 

 

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