Purposes of Options
While options are used for a wide range of purposes from hedging to sheer speculation, at the most basic level options simply allow investors to "reshape" the distribution of future returns by either buying into, or hedging out of, various parts of the upside or downside spectrum of outcomes.
Options Address Sequence of Return Risks
From a retirement planning perspective, the use of options can be especially appealing given how sequence of return risk can adversely impact retirement income sustainability; if options make it possible to carve out the 'worst' parts of the (downside) return outcomes, it's possible that retirees could spend more even if their returns aren't higher, simply by ameliorating sequence-of-return risk.
3 Options
The practical question, though, is how to actually construct such options-based portfolios. In this article, David Blanchett analyzes three choices:
Which Option is the Best?
In theory, there would be no difference between the three - given that they're all ostensibly doing some combination of buying bonds, selling out-of-the-money call options, and using the option proceeds plus bond interest to buy (at-the-money) call options to produce the upside participation rate. In practice, though, Blanchett finds that annuity products may actually have better pricing than DIY (or packaged ETF) options, both because RILAs typically have specific product terms (e.g., 6 years) which allows the strategy to be implemented with longer-duration bonds that produce more interest yield (and thus have more money in play to generate higher participation rates), and also because insurance and annuity companies have at least some ability to 'leverage' their balance sheets with a more diversified (albeit still conservative) portfolio to generate more than 'just' the government bond yield that would likely be obtained in the DIY or ETF scenarios.
The Conclusion
Thus far, annuity companies have actually been pricing their RILA products at a lower product cost than ETFs (e.g., the Allianz Index Advantage Variable Annuity has an annual expense ratio of 25bps, compared to 74bps for the similar Allianz Buffered Outcome ETF). Or stated more simply: while annuities have long been criticized for their surrender charges and the associated illiquidity, the irony is that when it comes to hedging sequence of return risk, a commitment to a less liquid annuity can actually generate a more favorable options profile to secure retirement income (where any surrender charges are a moot point because the product is intended as a buy-and-hold retirement income strategy over the intended term anyway).
While options are used for a wide range of purposes from hedging to sheer speculation, at the most basic level options simply allow investors to "reshape" the distribution of future returns by either buying into, or hedging out of, various parts of the upside or downside spectrum of outcomes.
Options Address Sequence of Return Risks
From a retirement planning perspective, the use of options can be especially appealing given how sequence of return risk can adversely impact retirement income sustainability; if options make it possible to carve out the 'worst' parts of the (downside) return outcomes, it's possible that retirees could spend more even if their returns aren't higher, simply by ameliorating sequence-of-return risk.
3 Options
The practical question, though, is how to actually construct such options-based portfolios. In this article, David Blanchett analyzes three choices:
- "DIY" approach where the advisor directly purchases options to hedge their clients,
- "Packaged" solutions via ETFs that use options strategies, and
- Registered Index-Linked Annuities (RILAs) which package the options strategy within an annuity wrapper.
Which Option is the Best?
In theory, there would be no difference between the three - given that they're all ostensibly doing some combination of buying bonds, selling out-of-the-money call options, and using the option proceeds plus bond interest to buy (at-the-money) call options to produce the upside participation rate. In practice, though, Blanchett finds that annuity products may actually have better pricing than DIY (or packaged ETF) options, both because RILAs typically have specific product terms (e.g., 6 years) which allows the strategy to be implemented with longer-duration bonds that produce more interest yield (and thus have more money in play to generate higher participation rates), and also because insurance and annuity companies have at least some ability to 'leverage' their balance sheets with a more diversified (albeit still conservative) portfolio to generate more than 'just' the government bond yield that would likely be obtained in the DIY or ETF scenarios.
The Conclusion
Thus far, annuity companies have actually been pricing their RILA products at a lower product cost than ETFs (e.g., the Allianz Index Advantage Variable Annuity has an annual expense ratio of 25bps, compared to 74bps for the similar Allianz Buffered Outcome ETF). Or stated more simply: while annuities have long been criticized for their surrender charges and the associated illiquidity, the irony is that when it comes to hedging sequence of return risk, a commitment to a less liquid annuity can actually generate a more favorable options profile to secure retirement income (where any surrender charges are a moot point because the product is intended as a buy-and-hold retirement income strategy over the intended term anyway).
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