Predatory equity release practices in the US

Last time on equity release I came to the double conclusion that (a) equity release is expensive so people think its unfair and (b) most of the issues around equity release actually arise from mis-selling practices rather than the product itself.

Today I can’t resist a peek at what’s going on in the US. Not ten years ago either but current practices.

Investor warning issued

In March this year the Financial Industry Regulatory Authority (FINRA) – they describe themselves as the largest non-governmental regulator for all securities firms doing business in the United States – issued an investor warning regarding Reverse Mortgages (US term for equity release).

FINRA says:

Holiday today, poverty tomorrow!

“Reverse mortgages were originally designed as a tool for allowing ageing, low-income homeowners to keep their homes by providing a source of additional monthly income to meet expenses. Now, as lenders are realizing that more and more Americans are retiring and sitting on large pools of home equity, they are beginning to aggressively market reverse mortgages to younger retirees as a way to finance a more extravagant retirement lifestyle than they could otherwise afford. The trouble is, those same homeowners may need their home equity some day for something far more pressing than a vacation, only to find that it has already been spent.”

In the US the minimum age for equity release is usually 62 with some lenders starting at 60. In the UK some start as low as 55 years. And in my last post on this topic we saw Norwich Union advertising equity release as a way to fund a holiday. It’s at times like this that I’m embarrassed to be in marketing. Who sat down one day and said “I know, we’ll encourage old people to fritter away their only real asset!”? Did nobody stop to think how they would feel if somebody did that to their grandparents? By the way, I have nothing against retired people enjoying life. I do have a problem with marketing an expensive last-resort product to people as a casual purchase to fund something frivolous like a holiday.

Forget the holiday, this is a purse snatch

“Be sceptical of Reverse Mortgages as Part of an Investment Strategy,” says FINRA. “If someone urges you to obtain a reverse mortgage to make an investment or purchase an insurance product or a security, such as a deferred annuity, be very sceptical, particularly if they are promising high returns. In essence, they are encouraging you to speculate with your home equity, which you may need for more critical purposes down the road.”

Oh dear, it gets worse. Now we’ve gone beyond advertising equity release for a dream holiday. Now we’re telling people to release their equity in order to buy another (high risk) product that locks away their money so they can’t access it if they need it in a hurry. This predatory practice is known as equity stripping.

Excerpt from a press release, 13 Dec 2007:

“Senate’s concern was raised by lawsuits against Financial Freedom filed in San Diego, California. Such as the one filed on behalf of Ernestine Boach who was allegedly conned into purchasing a reverse mortgage with exceptionally high fees and then sold several insurance and annuity products with the proceeds. The case, Ernestine Boach v. Financial Freedom Senior Funding Corporation was filed in San Diego Superior Court on January 11, 2007 and alleges that the Boach was advised to take out a reverse mortgage from Defendant Financial Freedom Senior Funding Corporation for $171,000 on the home she owned. The proceeds of which were to be used to purchase insurance products, including, a Fidelity and Guaranty deferred annuity with enormous surrender charges for $80,000, and a $44,350 immediate annuity to fund payments on a $250,000 flexible premium life insurance policy (also containing surrender charges).”

An isolated incident? A survey released last year by AARP, formerly known as the American Association of Retired Persons, of more than 1,500 reverse mortgage borrowers found that almost one in 10 were urged to buy other financial products, like annuities.

So it seems all is not well in the world of American equity release. Next time, some investigation a little closer to home.

Equity release – rip-off or reformed character?

Equity release earned itself a well deserved reputation as a dangerous rip-off product in the late 80s and early 90s. Most people still hold this view of equity release or at least remember the scandals (if you don’t remember then you are probably far too young to be reading a blog about financial services!) and view it with extreme scepticism. A lot has changed since then but has it made a difference and does equity release now deserve to be considered a legitimate option?

Before we get started, what is equity release?

Essentially, all equity release products are ways of getting cash from the value of your home without having to move out of it. There are actually different product types available including Lifetime Mortgages and Home Reversions with a number of different variations within those types. If you want a more in-depth guide then you could do worse than to look at the Financial Services Authority’s (FSA) consumer website. There is a PDF guide to equity release on this page.

So why are we even talking about equity release?

Many people these days are approaching retirement or have retired capital-rich but income-poor. This is largely as a result of both rapidly rising house prices (combined with around 70% owner occupation in the UK) and inadequate personal and state pension provision. With increased life expectancy there is now a fear, and indeed a genuine risk, that we will outlive our financial reserves and have a vastly reduced quality of life during retirement.

It seems to me that viewing property as a pension is increasingly prevalent – just look at the boom we’ve had in buy-to-let over the last decade. And many people already use alternative means of releasing equity – borrowing money against their home, downsizing, selling up and renting instead – so there is no reluctance to make use of cash tied up in property, just a reluctance to use specific equity release schemes.

Equity release by any other name

I think there’s a lot more equity release around than people admit – we just have different names for it. If I increase the borrowing against my home by remortgaging with an interest only mortgage is that not equity release? Of course it is but I don’t need to go to a specialist equity release company to do it. There is more competition in the equity release market now than there was 5 years ago – Norwich Union, Northern Rock, Prudential and Scottish Widows have equity release products – but still nothing like a full range of big name providers.

Why are all the big players not in the market? It may be true to say that if all the household names offered the service it would help to overcome the public scepticism. However, there was a rather scathing report by consumer watchdog Which? that pulled no punches when criticising household name Norwich Union. So perhaps the reputational risk is perceived to outweigh the opportunity. The fact is that many household names offer equity release products but they are kind of under the radar.

Is the poor reputation still justified?

Steps have been taken to clean up the equity release market. A trade body, Safe Home Income Plans (SHIP), was launched in 1991 and is in their own words “dedicated entirely to the protection of planholders and promotion of safe home income and equity release plans”. All providers who sign up to SHIP offer certain guarantees. For example, you cannot lose your home – whatever happens to the stock market or to interest rates. And under their no negative equity guarantee you will never owe more than the value of your home. These protections do not exist for standard mortgages. But let’s be honest, who trusts self-regulated companies? Especially those that have misbehaved in the past.

The Financial Services Authority (FSA) took on responsibility for the regulation of mortgage lending, arranging, administration and advice on 31 October 2004 – including Lifetime Mortgages. On 6 April 2007, Home Reversion plans also became authorised. So now the general public have more protection than ever before and recourse to complain should anything go wrong sales volumes have shot up right? Well, no actually. They are on the increase but are still pretty small beer in comparison to the mortgage market generally.

Is it just too expensive to be considered fair?

I think this might be the root of the issue. On a variety of Lifetime Mortgage known as a Roll-up Mortgage you borrow a lump sum or arrange a drawdown facility. Interest is added to the loan on an annual or monthly basis but you do not pay the interest until your home is sold. This means that interest is charged on your interest and this compound interest effect quickly makes your loan quite large. I think people see this and are horrified at how much they eventually owe. The article by Which? that I mentioned above provides an example:

If a 60-year-old borrowed an £80,000 lump sum with a typical equity release lifetime mortgage, it could cost them £256,570 by the time they were aged 80, and £343,350 if they reached 85.

Well that’s just the effect of compound interest for you. Why are we horrified? Just think of it the other way around and imagine you deposited £80,000 in a high interest account. Why, after 25 years it could be worth…

Equity release is expensive – that’s not a criticism of the providers though, just a fact about compound interest and borrowing money over a long period of time. Still, we don’t like to think we’re getting a bad deal. Equity release is a last resort product for those people who really really don’t want to move home but have no other way to release cash to improve their lifestyle in retirement.

As my old high school English teacher said ‘don’t open a whole new can of worms in your closing paragraph!’… Which? also claimed equity release mortgages are advertised irresponsibly, citing Norwich Union’s suggestion that its scheme could pay for a trip to New York or ’something for the family’. Illustrating this is the finding that the minimum £15,000 loan with Norwich Union would cost £28,000 after ten years’ time. I completely agree – advertising equity release as a way to fund a holiday is irresponsible. In my research for this article I’ve uncovered some interesting and rather scandalous practices going on in the US with equity release – they call it reverse mortgages – and I’m going to write something about that and other irresponsible/immoral practices next.

Life insurance prices and transparency

There is an interesting piece in Freakonomics, Levitt & Dubner, 2005 (there is a freakonomics blog) regarding the pricing of term life products in the US. It talks about the information advantage that experts enjoyed over consumers prior to the advent of the internet. Essentially, term life products are simply commodities and, as such, are perfect for online comparison.  Because of this ability to search online and compare, the prices fell dramatically.  Now prices still look lower, but are they?

More complex products such as whole life insurance did not decrease in price to the same extent as term life. This would suggest that comparison shopping only really works when you feel confident enough to compare product features other than the price – in other words more complex products still require skill and knowledge to compare.

Insurance companies reacted to this change as points of difference other than price obviously needed to be found in order to preserve some competitive advantage. Life insurance is not a pure commodity like oil or gas – in fact, I’m not sure I can think of a single consumer product that is sold purely on a commodity basis… People are still influenced by brand, perceived product benefits (Hiscox advertise insurance on the premise that they provide more complete cover) and also by added incentives such as affinity marketing deals with other companies who provide a free or reduced cost service for the insurance company’s customers.

If you were an insurance company, what else could you do to reduce the commoditisation of your product? Perhaps you might make it more difficult to compare? Or you might even advertise a low price but charge a whole load of extras once the customer starts getting deeper into the process. Insurance companies are not alone in this practice – budget airlines now advertise low fares that get them to the top of the price comparison engines but add a plethora of charges afterwards for such ‘luxuries’ as priority boarding, paying by credit card, checking in at the airport and checking in luggage. The net effect is that customers feel cheated. And rightly so. But what ‘extras’ can insurance companies charge you for?

Just like the airlines, insurers advertise low prices. However, after the application process, which can be lengthy enough to discourage more searching and comparison, many people are offered premiums higher than those advertised. People face higher premiums because insurers have tightened the criteria they use to calculate the cost of cover. An article I saw in the Sunday Telegraph a few years back (2005 but I can’t remember the exact date) revealed that insurers charge higher premiums to applicants previously considered normal weight. Is this because they genuinely feel these people are now at an increased risk of ill health due to obesity or is it just a way of restricting the number of applicants that get the cheapest rate?

Perhaps the higher prices are justified and the only thing they do wrong is list cheaper prices in the comparison engines.  But then if your competitors are all doing that then how do you attract customers when you’re at the bottom of the list on comparison sites?  I’m not sure what the solution is – more sophisticated comparison engines?  The trouble is that access to more information does not make you an expert and more sophisticated searching may require the skills of an insurance broker to use it.