Arno Kitts and Olivier Defaux suggest that lifetime mortgages can be attractive for investors looking for income-generating assets
In the pursuit of yield, investors are searching more widely as government bonds and other traditional income-generating assets have become increasingly expensive and therefore more risky. For some investors, such as pension funds and insurers, investing in lifetime mortgages (LTMs) can offer a combination of factors that long-term investors may find attractive in the current environment, including high duration, yield, correlation with mortality and, if desired, inflation protection by linking returns to the Consumer Price Index (CPI) or the retail price index (RPI) .
An LTM is a form of mortgage for over-55s, the average borrower being around 70. The mortgage proceeds are used by borrowers to meet their retirement expenses and/or to refinance maturing interest-only mortgages that require repayment of the mortgage capital.
Unlike traditional mortgages, they typically have no monthly payment and no term. Interest payments 'roll-up' into the mortgage balance at an agreed interest rate (typically a fixed rate but it can be linked to consumer or retail price inflation or LIBOR or some other index), with the loan repayable on the borrower's death or their move into long-term care, at which time the home is sold.
Important variants to the lump sum product exist as follows:
? Interest served: If borrowers wish, some LTM products allow interest payments to be made. At any time, the borrower can cease interest payments, at which point, the loan switches to the traditional interest roll up.
? Drawdown: Where borrowers regularly borrow against their home up to a given amount rather than in one single borrowing. Each drawing rolls up along with the interest. This form represents around 65% of the current market.
Borrowers cannot be evicted before death or long-term care as they are not required to make monthly payments, and recourse is solely to the property, not to the borrower's estate or beneficiaries. Initial loan-to-values (LTVs) are much lower than for standard mortgages, typically around 30%. As the interest rolls up LTVs increase over time.
Lifetime mortgages in a cashflow matching portfolio
While any investment in providing LTM finance will be illiquid, it distributes cashflows over time as borrowers pass away, enter long-term care or repay early due to other 'life events' such as divorce or moving to a smaller property.
These mortgages therefore offer investors a secure and long-dated set of cashflows.
Owing to the high yield on these assets, pension schemes have an opportunity to meet their liability cashflows at a potentially significantly lower cost than investing in a portfolio of government bonds.
By originating new LTMs, the mortgage portfolio of any investment can be tilted to the investor's requirements - for example, inflation-linked return exposure, interest rates, LTVs and borrower age - subject to market response. Owing to their long duration, longevity linkage, low-risk cashflows and diversification potential LTMs are particularly appealing as an investment opportunity for pension schemes. The main investment risks associated with LTMs are to house prices and longevity.
Figure 1 (above) shows the liability cashflow profile of an example pension scheme and illustrates how these mortgages can be used as part of a pension scheme liability cashflow matching strategy. In addition, given the yields that can be achieved, incorporating a 10% allocation to lifetime mortgages in the cashflow matching profile reduces the cost of meeting the liability cashflows by 4%.
The market for LTMs is currently small in relation to the overall mortgage market at £1.6 billion in annual flows compared with £209 billion for the overall mainstream market. Typically, borrowers have used them to supplement inadequate pensions or fund lifestyle purchases. However, demand has been growing significantly as LTMs become a key component of retirement planning. They have also been popular with borrowers with maturing interest-only loans who have insufficient means to fully repay these, because of a shortfall on an endowment policy. The Financial Conduct Authority (FCA) estimates there are 1.25 million so-called 'interest-only prisoner' borrowers in the UK, representing around 12% of all mortgage borrowers outstanding.
Figure 2 shows the estimated volume of interest-only mortgages maturing in the coming years, either 'sold as' such, or having 'converted' to interest-only terms at some point.
Mis-selling: perception and reality
LTMs benefit from a lending code of conduct (the Safe Home Income Plan rules managed by the Equity Release Council), as well as the introduction of mortgage regulation by the FSA in 2004. Among many features designed to protect consumers, this code requires the use of a solicitor to meet the borrower prior to purchase and also that they have in-built provisions regarding transparency and fairness.
It is important for all involved to ensure that LTMs are entered into with full knowledge of the implications. Instances of complaints with the Financial Ombudsman Scheme have been limited, with no decisions upheld in favour of the consumer compared with a lender.
In addition, as of February 2015, research commissioned by BlackRock indicated no reported decisions by English courts upholding any mis-selling. They therefore stand out in terms of their low incidence of complaints compared with other consumer financial products, such as current accounts, pensions, insurance and investments.
Why consider LTMs?
LTMs can provide long-term investors with an asset class that helps solve a number of asset-liability challenges. In return for accepting illiquidity, an investor can receive long-dated secure cashflows, inflation protection and a substantial increase in yield over government bonds.
Traditionally, the finance for this type of product has been provided by insurance companies riginating mortgages for their own portfolios. As such, the product has traditionally been viewed as relatively niche, with product features tailored to the constraints of insurance companies. Through partnerships with established residential LTM lenders, asset managers are able to acquire new mortgage loans that meet the cashflow characteristics required by investors.
An additional advantage for some investors may be the social benefit these products offer - for example, through helping to finance retirement or enabling older homeowners to stay in their homes while unlocking stored equity value.
With the ability to capture an illiquidity premium, pension schemes - particularly those open to future accrual, such as local government pension schemes - are best placed to take advantage of these opportunities.
An investment in LTMs could help to not only reduce the cost of providing benefits but also provide cashflows that can be used to meet liability payments as they fall due.
Arno Kitts is head of UK institutional client business at BlackRock
Olivier Defaux is head of European mortgage strategies at BlackRock
