Prof Kevin Davis - University of Melbourne
Home Equity Access to Wealth
Shelley Wettenhall: It's my pleasure to introduce Kevin Davis to the Third Pillar forum. Kevin is a professor of Finance at Melbourne University and has been since 1987. And before joining Melbourne University, he was a senior lecturer of Economics at the University Of Adelaide. His primary research interests are in the areas of financial institutions and markets, financial engineering and corporate finance. In 2013, Kevin was appointed to the Commonwealth Government's financial system inquiry panel, which examined how the financial system could best meet Australia's evolving needs and support economic growth. This report was presented to the Federal Treasurer in November of 2014. Welcome, Kevin.
Kevin Davis: Thank you, pleasure to be here. I guess the starting point for my comments is, isn't this a weird era? We spend time worrying about people not saving enough pre-retirement, and then worrying about them saving too much in retirement. Retirees don't run down their wealth at an optimal rate, and that occurs both in the context of their financial wealth. We know that people aren't spending as much of their superannuation as would be optimal in some sense, and also in the context of their real wealth, particularly the home tied up in real assets. I guess an obvious question is why is that? I think there's suitable explanations; one is greater concerns about risks. We're uncertain, once you get to my age, about what's gonna happen to you. How long will you live, what medical care and age-care cost will you need? And of course we only live once, so we don't have as many personal experience to draw on. I think also what's important for most people, and I think I've put myself in this category even, even though I'm a professor of finance, a lack of understanding of, and the complicated design of the various financial products that might be there for accessing wealth.
Josh Funder: Now, I'm in the finance system inquiry, the Murray inquiry. We get, grapple with this issue, the question of how do we go about trying to design what we called CIPR, comprehensive, income, products and retirement. And perhaps I should just say that an alternative name, which was retirement, income, products but the acronym for that R-I-P doesn't actually sound so good when you talk about this area. And of course, one of the issues in this whole area is, whereas in the accumulation phase, we might say that there are default products that makes sense in the retirement phase, everyone is different. There's no one-size-fits-all, so a particularly complex problem was, how do you design retirement income products or arrangements to deal with that? And one of the big issues, how do you incorporate the use of wealth from the family home into funding retirement consumption? And I think here there's a problem of what we have is that sort of housing policy and superannuation are two separate pillars and never the same, the two will meet.
Kevin Davis: So there's an issue of how do we get those two integrated into an appropriate form of retirement incomes policy? And here we've got a real issue. One is that these two things, superannuation and home ownership, are the two most tax-advantage forms of savings for households. There's some quite different, significant differences however. The former, superannuation, is pretty easily accessed for retirement income needs. The latter, home ownership, isn't so easy. And then you've also got the problem that the super-balance is included in accessing the Age Pension, comes into the assets test but the family home doesn't count. So we've got these diverse approaches there. And what we all know, and I guess part of the rationale for this conference and so on, is that we have problems of people being asset-rich and income-poor. And when you think about ways in which you might overcome that, possible solutions like downsizing, moving to a smaller home is problematic.
There's all sorts of transactions costs, so is limited in doing that. It also means you'll be shifting some of your assets out of tax and pension benefit protected areas, ie the home, into non-protected cash assets. And then of course there's also the psychic costs of leaving home, and we might be [04:35] ____ which is looking after those ungrateful kids, really important. But I think it's fair to say that reverse mortgages haven't been taken up at a scale that was hoped for. It looked like there was gonna be some growth, if you go back prior to the GSC, but that's sort of got... Well, didn't happen. Why haven't they been taken up at the same scale? I think, an important one, and this is one of the things that product designers have to deal with, is a psychological switch that's required from spending most of your life try to pay off your mortgage, to then going into running up debt.
I think also there's a problem of the complexity of the products. I think the average person, I hate to say it, but after years of teaching finance, I seem to have no effect whatsoever. Financial literacy is really not that great, and it's very hard for people to understand these sorts of products. It could be that maybe people don't trust the financial product providers, banks and so on, but even the government's pension loan scheme. Assuming people trust the government, which may be a big assumption. To reverse mortgage scheme available to pensioners, that doesn't mean particularly popular either. One reason for that is actually the fact that the marketing of it is abysmal. When you look on the website, it's just... I can't see why anybody would flock to it. But I think it's just hardly surprising that people haven't rushed to that scheme, but it is actually potentially a very useful thing. And of course major banks have got out of the area so lot of the advertising that might have been there to encourage people to think about these products disappeared.
So I think the question, and obviously the question that you guys are focused on is, can reverse mortgage or equity release-style products become a part of the retirement income solution? And I reckon one thing going for them at the moment is the really low level of current interest rates. Basically, that means that the accumulation of the outstanding balance owed is gonna be slower, and the rate of decline of the home equity share of the owners is going to be smaller than the decline. But I guess one of the issues, again there, is that... If you think about the generation that would be focused on these products at the moment, this sort of my generation, maybe a bit younger, and they have lived through periods where those interest rates can change quite dramatically. Most of them I'm sure would remember the period, sometime in the past, and I've forgotten exactly the dates, when mortgage interest rates [07:10] ____.
Josh Funder: '87 and '92.
Kevin Davis: Yeah, got up to, what, 17%, 18% or something like that? And so I think for most people that say, "Oh, yes. Interest rates are really low the moment, but gee, who knows what might happen, and we could suddenly find ourselves locked into a situation of really high interest rates." So I think one of the issues here is the extent to which you can design these products in a way that has, either a fixed interest rate, or some cap on the maximum interest rate. And, of course, the trouble is if you try to do that, that creates a lot of inflexibility on what payment rates you can apply and other risks for the providers and so on. But I think that's one of the issues that needs to be looked at. I think the other sort of areas that run into problems are things like the interaction of a home ownership with aged care accommodation.
Now, people might say there's not that much interaction, but for most people, aged care accommodation is just a bloody nightmare. I know I've looked at it, not for myself but for... And trying to understand it and what the implications are associated with your home ownership and whether you need... It's just too hard. So I think this... Ideally, the government should do things in that area, to try and make that a lot simpler. I think, for example, they should get rid of the refundable accommodation deposit. Yeah, that's an interest-free loan, basically, to the providers of aged care. Who knows what the rationale for that is? Well, I can think of rationales, but who can give you a justification for it? I don't know. And of course, given the interest rates are so low, it's probably a good time to abolish it, because it's not providing much benefit to them.
Kevin Davis: [08:46] ____, what I think is a really weird announcement by the government, to remove responsible lending obligations. This area is one where I think the banks takes it to this area because it's just too up, the risks associated with RLOs, responsible lending obligations, was, "Let's get out of it. It's just not worth it." But realistically, these products are potentially quite complex products. There are good products, but there can also be bad eggs, bad products, that can cause all sorts of problems and put a stain on the whole industry. And I think also... Looking around, I saw that some of the promoters of these reverse mortgages are actually getting referral fees from third-party providers. And of course, that's exactly the biggest concern that the Hayne Royal Commission was on about. So I would have thought that the good providers of reverse mortgages or equity release-type products, that'll be in favor of responsible lending obligations, 'cause that's what you're in there for, is to provide people with products that are at their advantage and they understand. So, I think looking ahead...
Josh Funder: Can I just jump in there, Kevin? I think you are absolutely singing with the chorus in looking back, to say there were problems with reverse mortgages in the past and the banks pulled out. We need to reduce the complexity of financial products in general, including these, and do better for people to be able to make decisions about what is a very wide variety of different types of retirement with information that meets their understanding. So looking back, I think we agree. If we put ourselves in the situation of Australian retirees today, we actually have the best performing credit regulations for home equity access, the 2012 regulations didn't come up in the Royal Commission and the recent ASIC review found no clear breaches. But I would absolutely concur that responsible lending needs to apply to all lines but these, and there should be no ambiguity about our collective commitment to make sure that customers understand exactly what's going on at full levels of transparency and responsible lending.
Josh Funder: The other thing there is it needs to be responsible long-term, to meet the needs through retirement. But if you put yourself in the shoes of retirees today, they've just had two major shocks, to their health and to the economic outlook, based on COVID. And at the same time, they've been staying safe at home. Their homes have been the safest place for them to be, health and economically, through COVID, and they face a low yield, low retirement income, long-term environment. At the same time, a relatively stable low interest rate environment into the future, which presents opportunities and challenges. So putting yourself in that situation, how can we help retirees much better knit together those three pillars that are currently very disparate in our delivery? The pension, getting that clear, that alone is complex enough. Superannuation, and access to home equity where it is conceived of, not only as a place to live but a way to fund your retirement. How do we get those three pillars working for retirees in that outlook?
Kevin Davis: Wow, you ask... Why do you have to ask me difficult questions right at the moment?
Josh Funder: Well, you're a professor.
Kevin Davis: I think it's very hard. I actually was thinking that maybe one thing you could do would be to make some tax changes. It wouldn't be popular, and that of course rules 'em out, but things like maybe saying we're going to include the...
That's why you're a professor, not a politician, Kevin. But go ahead. [laughter]
Kevin Davis: Maybe one thing would be to include home equity above some minimum level in the assets test, and that might encourage people to think about reducing their home equity and getting a cash flow stream from a reverse mortgage, and not including that cash flow stream as part of the income test. But that's really messy, and I think the whole... Part of the trouble is, all of the arrangements are messy already and they don't interact very well. I've actually come to think that there's a lot of merit in a universal [13:01] ____ test in pension. It'd reduce a whole lot of unnecessary financial planning, a whole lot of attempts to try and beat the tax and benefits scheme. [13:15] ____. Now, that might not sound like it's that relevant to this question of how do we promote equity-release products, but I think if you did something like that...
And of course, if you're going to make it a universal pension, I think you'd also have to make some tax changes, to call back the gift that you're giving to the rich people. But I think what it would do is it would certainly change and simplify retirement planning, and of course, people to focus less on tax and benefit arbitrage and look at more sensible ways to boosting their retirement income, at which one is the next type program. So I think it may need a shock like that to actually get people to start thinking in different ways to what they're doing currently, which far as I can see is primarily about saying, "How do we minimize our tax? How do we maximize our benefit? How do we exploit the system in the best way, in a way that generates the most, privately?" And I think it just needs that change in... It needs something to get people to change their thinking about what's the best way of dealing with this.
Josh Funder: I think that's right. I think people understanding transparently their options, but being empowered to go forward with confidence to make some decisions. And not game the system, but draw on their own wealth and their entitlements to live long and happy lives. That's the nirvana. I think it's going to be messy again, Kevin, as we go forward to try and get that right.
Kevin Davis: Yes.
Josh Funder: Integrating those three pillars of the pension, superannuation, and home equity, is going to form a part of making sure retirees have got the funding to go the distance. In the interest of time, we have to draw to a close here, but Kevin, your thinking from the financial services report and right into this space has been a real contribution to the Third Pillar forum in 2020, and warm thanks.
Kevin Davis: No worries. Happy to be involved.