personal finance

Equity release mortgages are riddled with poor incentives


Imagine two UK householders, both aged about 70. Each owns a home worth £500,000. It’s their largest pot of savings excluding their pensions. Both wish to extract equity from these properties to help finance their post-retirement lives.

Householder A sells up for cash and moves into a smaller property which she buys for £300,000. She’s left with £200,000 on which she can earn investment income pending its consumption. Householder B prefers to stay in his home because it has happy associations. 

So he enters into an “equity release” mortgage (ERM), in which he borrows £200,000 against his home (which he continues to occupy) at an interest rate of 5 per cent, after paying one-off fees of 3-5 per cent of the amount borrowed. (It’s a popular formula; recent data from the insurer Aviva showed the UK equity release market growing at 7 per cent a quarter.) The interest on B’s loan then rolls up until the owner either dies or goes into a home, vacating the property, which is then sold to repay the debt.

So in example A, the householder extracts her cash and acquires a smaller home with cheaper running costs. Householder B’s cash flows may seem superficially similar. But not only does he maintain a larger property; the rolled up interest is quietly nibbling away at his estate. That said, he does have one protection: the mortgage company has in effect sold him a complex option, known as the No Negative Equity Guarantee (NNEG), which limits his repayment obligation to the value of the mortgaged property. 

So that’s the deal from the homeowner’s side. Now turn it around and let’s look at how these products are financed. The main investors are defined benefit pension schemes, whose members need to match their long-term liabilities with assets of a similar maturity. ERMs do this, although they’re far from a perfect match. 

First, the mortgages are heavily exposed to house prices. Should prices fall — and ERM investors sometimes brood on the 1990-2010 period in Japan when they roughly halved over two decades — ERM assets could be seriously impaired.

Second, ERMs do not offer pension funds a sound hedge against changes in longevity. Imagine a situation where a medical breakthrough suddenly extended life expectancy by, say, a decade. Pension funds would still have to pay the same retirement incomes for longer, but ERMs would not rise in value by anything like a compensating amount. 

So, an imperfect and fiddly product from both sides’ perspectives. One player, however, benefits from the complexity: the intermediary. The householder may be largely protected by the NNEG. But he is still vulnerable to being targeted by deal-hungry salesmen. It does not inspire confidence that Age UK, a charity, had subcontracted its advisory portal to Just Group, one of Britain’s larger ERM providers, without disclosing this to consumers. Age Concern takes a fee for each mortgage sold.

The pension funds, meanwhile, are dependent upon the intermediary correctly valuing the NNEG and having sufficient issued capital and retained earnings to meet any potential shortfall. Unfortunately, the accounting for these products suggests the incentives are poorly aligned.

To calculate their profit, providers take the gap between the amount the assets earn and the amount that accrues to the annuitants (pension funds), and capitalise it out decades into the future, taking a slice each year as reported income. This creates the appearance of large short-term earnings which can be paid out in dividends, bonuses and commissions. Yet this is a fair value accounting method as used by the likes of Enron: for fast-growing providers, the number is little more than an estimate. The reality might prove very different were house price or longevity expectations to change.

Long-term savings products are very prone to such timing mismatches. Complex transactions today yield upfront rewards for practitioners, but the outcomes for savers only unfold many decades hence.

And as for the losses, well, once the ERM provider has eaten through its capital, the recourse for the pension fund is to turn to the Financial Services Compensation Scheme (ie tax other pension scheme members). Beyond that, the losers’ only option is to fall back on the state.

The government has welcomed the ERM product as a way to make up the shortfall in UK citizens’ saving.

Maybe it can help at the margin, although the advantages for consumers over real sales seems slender. But the state must be sure it hasn’t unwittingly created a mechanism which mainly enriches insiders; one by which private profits are seized today, leaving the losses for taxpayers at some later date.

jonathan.ford@ft.com



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