Raj Saundh, Alex Davis and Alex Mockridge consider what is next for the equity release mortgage market
Equity release mortgages (ERMs) are an important part of the retirement planning toolkit for both customers and financial advisers. In the UK, this has been accelerated since the 2015 changes in retirement freedoms, and there has never been a greater need for carefully considered retirement planning.
ERMs allow customers to tap into the value of their homes without having to sell and move out. They have been the subject of significant public debate in recent years, with fourfold growth in annual lending between 2015 and 2019 and increased scrutiny around the appropriateness of the regulatory capital levels held for them.
The debate – in particular, the way property risks are measured within ERM portfolios under Solvency II – continues to be an important issue that is very relevant for actuaries, and has already been covered in numerous industry papers. However, a number of wider points warrant discussion, particularly those concerning the change in the market and competitive landscape, recent events such as COVID-19, and wider external pressures.
Various ERM products have existed in the UK, but the vast majority of today’s market is in the form of lifetime mortgages (LTMs). These can only be sold with appropriate independent advice, and tend to have simple features to help customers understand what they are buying.
LTMs can provide either a single lump sum at outset (around a third of the UK market) or provide access to a loan facility that customers can draw down on as and when they need it. For each amount drawn, the customer effectively takes out a loan against their home. LTMs are largely fixed-interest, and the loan rolls up at this fixed rate until redemption.
On the policyholder’s death or transfer into long-term care, the loan is repaid from the sales proceeds of the home. The products have an embedded no negative equity guarantee (NNEG), so the amount due is limited to the sale proceeds of the underlying property. Like most loans, customers also have the right to repay early; this may be subject to an early repayment charge and waiving of NNEG rights.
“The demand from pensioners for ERMs is long-term – the over- 65s account for almost half of the UK’s housing wealth (around £1trn)”
The current market landscape
From a funder’s perspective, with some restructuring to meet Solvency II matching adjustment rules, ERMs are one of a growing number of asset classes that provide attractive risk-adjusted yields that can be used to back annuity business. All other things being equal, the larger the matching adjustment, the lower the value of regulatory liabilities that these assets are used to back. The result is that it reduces the cost of capital – hence the price – that insurers can off er to both individual annuitants and the bulk annuity market. The industry expects that vast volumes of bulk annuities will continue to be written: around £40bn per annum on average this decade, according to Hymans Robertson’s Risk Transfer Report 2021. Barring wholesale changes in the matching adjustment framework, demand for LTMs and other ‘illiquid’ asset classes to back annuities is unlikely to abate soon.
Similarly, the demand from pensioners for ERMs is long-term – according to data sourced by the estate agents Savills, the over-65s account for almost half of the UK’s housing wealth (around £1trn). Given that the UK population is ageing, this proportion is likely to increase, and inheritance of this housing stock is unlikely to change this picture substantially. In fact, it’s likely that in many cases, pensioners will inherit from pensioners.
Looking further ahead, we expect the need for ERMs to increase as the proportion of pensioners supported by a defined benefit pension falls away and pensioners look for alternative income sources to supplement their defined contribution savings.
ERMs through COVID-19
Market data from the industry trade body the Equity Release Council (ERC), published in January 2021 (bit.ly/2QEq6g4), shows that although COVID-19 did block access to customers and property valuations, the volume of equity release lending during 2020 was roughly in line with prior years (2020: £3.89bn, 2019: £3.92bn).
If we consider the number of new plans agreed from 2017 to 2020 (Figure 1), 2020 compares less favourably to 2019, with a 14% decrease. There was a particular dip in new lending activity in Q2 2020, which was a difficult time to get property valuations done. However, we saw a revival in Q3 and Q4, with Q4 2020 activity roughly in line with Q4 2019 levels. It appears that originators have been able to adapt to the new environment, and although there was a modest fall in total lending, we didn’t see providers withdraw from the market.
In addition, before COVID-19 struck, the booming market attracted many parties interested in taking a slice of the pie; indeed, during 2018 and 2019, membership of the ERC almost doubled. We expect to see interest in the market continue as we emerge from COVID-19.
Product options, features, developments and interest rates
As lenders compete to earn a larger share of the market, product interest rates have tumbled – in January 2021, the ERC noted that the lowest product rates were at 2.30%. The arithmetic average rate across the market (as shown in Figure 2) also hit a low of 4.01% (in calculating this average, the ERC is unable to weight by the volumes of customers actually taking out loans at different levels).
In an attempt by providers to capture market share or drive up the product rate, product heterogeneity has increased – arguably driving better customer outcomes. This has included the emergence of the market for retirement interest-only mortgages, which can act as a bridge between standard mortgages and moving into an LTM in later life.
However, new options are quickly replicated elsewhere, meaning that products remain homogeneous in the long term, and in some senses price is currently king in the ERM market.
The future and opportunities
During the past two years, UK volumes have levelled out at around £4bn lending per year. The past 12 months have, of course, provided unique challenges due to the COVID-19 pandemic, but where does the market go from here?
Comparing the lowest product rates of 2.30% to the 15-year gilt yield of 0.53% on 31 December 2020 implies a total spread of less than of 1.8%. Comparison with the 1.51% spreads on BBB corporate bonds, a commonly used benchmark to assess attractiveness, at year ending 2020 suggests the economics on ERMs remained attractive, although with significantly compressed margins against prior years. However, we note that this is before any allowance for the costs of the restructuring that is required to meet the matching adjustment rules.
Given the annuity market, investor demand remains high and the reduction in pricing is a sign of a maturing ERM market, which is excellent news for customers. The change in pricing also helps to move ERMs away from being a product of last resort and towards being considered more actively as part of an overall retirement portfolio. The illustrative economics on 31 December 2020 also highlight that companies may soon need to find ways of growing the market and generating market share, other than price.
ERMs largely originate through advisers referring customers into a whole-of market advice process. In addition, some providers in the UK have built tied networks to help provide a funnel directly into their business. Broadening the distribution out to access more customers appears to be key if the market is to take the next step, and this leads to some fundamental questions:
- Is the product reaching the people that it can/should be offered to, and if not, why not?
- Is the product playing the right role in the range of retirement options?
- Is the education in the market good enough for people to understand the role ERMs can play in retirement?
Many think there is room for development in all of the above. If we get this right, the opportunities are clear, due to both the UK’s ageing population (by 2030 there are expected to be three to four million more over-55s in the UK than there are today) and the fact that the transition to pensions freedoms is still very much in its infancy.
“We expect the need for ERMs to increase as pensioners look for an alternative source of income to supplement their defined contribution savings”
Following the UK’s departure from the EU, the Treasury released a call for evidence on its review of Solvency II. The treatment of ERMs is one area that warrants consideration, in particular:
- The requirement to restructure ERM portfolios, typically achieved through securitisations, for use in the
- matching adjustment given that ERM cashflows are not fixed. This restructuring is costly and limits the use of ERMs to firms with the scale to absorb these costs, as well as introducing complexities and additional risks over and above those of the underlying assets.
- The standard formula capital treatment for these securitisations, with penal capital charges (up to 100%), which means that using ERMs for matching adjustment is only really an internal model play.
- The difficult regulatory approval process and the knock-on impact that time approvals have on the energy put into, and pace of, market innovation.
By no means do we advocate an inappropriate reduction in capital requirements. ERMs contain some real risks that are different to many other asset classes, and actuaries have a central role to play in enhancing the way they are measured and managed. For property risk in particular, this includes advances in both projection modelling and the way property prices are kept up to date through desktop and traditional surveying techniques. However, simplifying the operational aspects of the regulatory requirements around ERMs, alongside other asset classes, could allow insurers to focus more on managing risk and meeting customer needs with agility.
Ultimately, it will be interesting to see where the Treasury and the Prudential Regulation Authority (PRA) lands. There is no guarantee that there will be changes to regulation, but this is an excellent opportunity for the PRA and the Treasury to impact the ERM and broader investment landscape for the better.
ESG and climate risk
Environmental, social and governance (ESG) considerations are increasingly coming to the fore when insurers and asset managers make investment decisions. Many large companies have committed to net-zero emissions targets by 2050 or earlier, supporting the 2016 Paris Agreement on limiting global temperature rise.
ERMs are exposed to both physical and transition climate risk. Physical risk can be seen in the increasing risk of hazards such as river flooding, surface water flooding and sea level rise. Globally, natural disasters such as wildfires, storms and drought may also be considered. Transition risk applies to assets that may be heavily impacted by a rapid transition to reduced carbon emissions. The case can be made that the average UK home could be greatly improved in terms of energy efficiency, and a rapid transition towards this could send ripples through the property market.
Investor demand for ‘green assets’ is growing, so where can ERMs fi t within an ESG portfolio? The fact that ERMs are loans to individuals, not businesses, makes it more difficult to pinpoint green loan purposes, which may include funding environmentally friendly home improvements or upgrading to lower-emission modes of private transport. Some lenders may be willing to incentivise or otherwise encourage ERM loans taken out for green purposes, creating a mutually beneficial outcome for borrower, funder and environment. In this space, product innovation is unfolding over time.
Climate change is a huge challenge and opportunity, and ERMs should not be forgotten in this.
ERMs play an important role in the UK market today and the product covers a basic need that is not going away. There are a number of upcoming challenges, and it is important for the market to tackle these head-on.
The biggest opportunities for the market appear to be in creating a smoother path to customers, and in getting the reach, narrative and proposition right. This likely means that the market will need to pull together to deliver this.
Raj Saundh is chair of the IFoA Equity Release Mortgages working party and a director at EY
Alex Davis is a senior consultant at Hymans Robertson
Alex Mockridge is an actuary at Legal & General