The Hindu : Business : Reverse mortgage: An answer for old age pension

Online edition of India's National Newspaper
Monday, Oct 18, 2004

Business

Business

Reverse mortgage: An answer for old age pension

Through reverse mortgage a property owner will be able to secure an increasing life pension, says R. Ramakrishnan

CAN ONE have the cake and eat it too? Impossible will say age-old wisdom. Possible, says modern wisdom. But how, one may ask. The answer lies in Reverse Mortgage. This concept, yet to be developed on a commercial scale in India, can provide the answer for the old age pension issue.

What is the priority for `saving for old age pension' in an individual's financial planning? Not surprisingly, the lowest.

The item that tops the list, after providing for basic necessities, is to save for the higher education/marriage of children. Now one is able to do this through life insurance policies which ensure that even if one's life is cut short unexpectedly, the planned saving is not affected. Next comes the acquisition of a house. Easy availability of housing loans and attractive tax concessions on repayment of and interest on such loans, are added incentives. Only if some money is still left, one thinks of contributing to a pension plan to provide for old age pension.

Few avenues

A few decades ago, when the joint family system was still in vogue, providing for the future of children automatically ensured old age care for the parents. But not so now. The problem has been aggravated by the ever increasing longevity and changing life styles and values. So, one faces the dilemma — to buy a house or save for old age? Since very few have the resources for both, the immediate need, a house, wins. Even if one prefers saving for old age, not many satisfactory avenues are available.

Saving through a pension policy of a life insurance company has good tax advantages. However, no insurance company is willing to quote the premium required to be paid till the date of one's retirement for getting a life pension of, say, Rs.1,000 per month after retirement. Ironically, one could get such a quotation from the Life Insurance Corporation of India in the days before liberalisation of the insurance sector. Recurring Deposits with banks, though one of the safest methods, that also give reasonable returns, is not popular because of lack of tax incentives and taxability of the interest earned.

Only alternative

When no attractive, direct methods of saving for old age pension are available, investing in a house appears to be the only alternative. Can this investment be converted to old age pension after retirement? Selling the house cannot be a solution since there will then be no roof to live under. Mortgaging the house and investing the loan amount cannot also be a solution since a substantial portion of the interest income will go towards interest on loan. The interest income may also attract tax. Is it possible to continue to stay in the same house and receive regular monthly payments, without having to pay tax or interest? In other words, can one have the cake and eat it too? Yes, through Reverse Mortgage.

Tax free annuity

What is reverse mortgage? The web site, www.investorwords.com, defines it as "an agreement by which a home owner borrows against the equity in his home and receives regular tax free payments from the lender'' and equity is defined as "the difference between what the property is worth and what the owner owes against that property.''

In a mortgage, the borrower receives a lump sum payment and makes regular payments to the lender, for a specified period of time, towards repayment. In a reverse mortgage, the lender makes regular payments in order to acquire the right over the property (or a part of it, say 25 per cent) he intends to buy. The period of such payments is not `a specified number of years,' but `the remaining life time of the owner (and his/her spouse) of the property.' That is, a life annuity. But, whereas annuity instalments attract tax, the reverse mortgage payments received from the lender do not since they are purchase values.

There is an added advantage in this system. To begin with, the equity value of the property will be its market value. With every instalment received from the lender, the equity value comes down.

At the same time, it will continuously go up because of all round appreciation in property values. At the end of, say, five years, using this appreciation in property value, the owner may be able to get enhanced instalments over his remaining life time. Through reverse mortgage a property owner will thus be able to secure an increasing life pension.

In other words, by procuring a good house through a housing loan and repaying the loan during his working life time, one will not only have a roof to stay under throughout his (and his spouse's) life time, but also secure a joint life pension, that keeps in step with inflation, after retirement. If his children are keen on retaining the property, they can repay to the lender the equity value of the property after the death of both parents.

The above solution may appear straight forward and simple. But a lot of research needs to be done before this concept can be given a final shape and launched as a viable financial product. If financial institutions are to show interest in this method, legal snags have to be cleared first.

A legislation, as stringent as the Public Property Act, has to be enacted to protect these institutions from protracted litigations initiated by successors of those availing of life pension through the reverse mortgage route.

The problem of domain determination will also have to be resolved. The life insurance companies may claim monopoly over the reverse mortgage sector under the plea that, since the lender has to pay the instalments over the life time of the property owner, the transaction will come under the definition of life insurance given in Sec. 2(11) of the Insurance Act, 1938. As per one of the subsections of this section, the granting of annuities upon human life is a life insurance contract.

The same transaction can however be also viewed as a pure investment activity, namely, purchase of a property, the purchase price being paid in instalments over the life time of the property owner, subject, of course, to a minimum number of instalments. If this broader interpretation is accepted, any financial institution will be able to deal in reverse mortgage.

The life insurance sector has been enjoying, for the past two decades, the benefits of liberal interpretations. Else, its immediate annuity plans with provision for return of corpus and cash accumulation schemes under group contracts would have been treated as pure banking operations. The deferred annuity plans being marketed by life insurance companies during the last three years do not have any life insurance element in them. It is time the banks and mutual funds too benefit by such liberal interpretations.

Life insurance companies, banks and mutual funds should compete on equal footing in the development of the reverse mortgage market. The potential is so vast that it can accommodate all. Such a development will not only bring the much needed relief to old people but also give a big boost to property financing and property development.

A lot of research needs to be done before this concept can be developed as a viable financial product. The research work will involve many disciplines such as legal, finance, actuarial, property development, and marketing. Universities and management institutes will be the ideal centres for organising such research. Let us hope that some of the leading banks and financial institutions will come forward to fund these research projects since they will be the ultimate gainers.

(The author is an Actuary)

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