The Legacy of Buffer Annuities

Taking Ownership of Risk Management

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A commonly held but overly simplistic investment objective is to make as much money as possible with no risk. A more reasonable approach is to earn a competitive return with limited risk. A more efficient strategy will focus on risk-adjusted returns. And professionals will target above market returns that anticipate market trends.

In all these scenarios, risk and return are correlated - and the better that relationship is understood and respected, the more rational will be your investment strategy decisions. At the same time, there is that nagging inclination to earn as much as possible or eliminate the possibility of losing money.

Structured Products

For decades, investment banks have assisted corporate clients raise capital with the creation of new stock and bond offerings. And in addition to primary market access, they have given their institutional investors secondary market liquidity through their trading desks. And with the rise of big data and computing power in the 1980s, investment banks learned how to create a new type of security that catered to the specialized needs of their institutional clients like pension funds, insurance companies, foundations, mutual funds and banks.

These hybrid securities are known as Structured Products, and they combine traditional equity, fixed income or commodity securities with derivatives like options and futures. Their purpose is a define a range of potential outcomes based on a customized risk and return profile. Naturally, these can be complex instruments that cater to a specific need or investment objective.

To concretize that, as an Area Training Manager at Morgan Stanley in the 1990s, I was told by corporate syndicate that this “is in our DNA.” I was also told by a university business school professor that investment banks were recruiting math majors. And while econometrics may detract from the economics profession, it is quite useful for short-term risk management techniques in a world of capital market uncertainty.

Hedged Mutual Funds

Also, during the 1980s, equity mutual funds hedged by option writing strategies became commonplace and hugely successful at raising capital. Basically, a mutual fund would own a large portfolio of common stocks and sell call options with the stocks as collateral (covered calls). If any of those stocks rose above the strike price of their option contracts, the fund would sell the stocks at that price. In either case, it would keep the cash from the sale of the option contracts and lose the potential growth of the stocks above the strike price.

In turn, the dividend paid by the fund would be increased by the amount of the option premium collected - and if the stock was “called away,” the fund would reinvest the proceeds and sell more call option contracts. Ultimately, the downside risk is lowered by the amount of the option premium collected and the upside potential is capped at the strike prices of the option contracts.

As you can see, there is nothing new about the appetite for above market yields or returns and below market risk. And it makes perfect sense that insurance companies would also create sophisticated risk-management vehicles. Innovation and capital drive prosperity, this benefits everyone, and about ten years ago Buffer Annuities hit the market.

Buffer Annuities

To keep things simple, these are variable annuity contracts with stock market-based growth potential and some degree of downside protection from market losses. To be clear, a variable annuity means a variable rate of return depending on market performance. The return is not guaranteed like a fixed annuity has guaranteed rate of interest. In addition, there are internal expenses and liquidity features that are important but not discussed here.

There are also many possible structures for defined outcomes, but to further simplify, let’s assume the underlying stock market index is the S&P 500, your participation in the growth of the index is 60% of the actual return, and your participation in the potential losses is the first 10%. There can also be ceilings and floors on gains and losses, and it is important to know when those are calculated and triggered.

Obviously, there’s a lot of complexity here, but how do they do it? Without getting into the math or explanations of how options work, selling covered call options as described above is one way to cap the growth potential and reduce risk exposure. On the downside, the insurance company can buy “at the money” put options on the S&P 500 index as an insurance policy and sell “out of “the money” put options with a strike price that is 10% lower. This reduces the investor’s potential loss by 10%, but it does not put a floor on those losses.

The Moneyball Method

Known as a bear put spread, there is a cost for this, and it can be partially funded by the sale of the covered call options. For their part, the insurance companies have done the math and has run the simulations. Their profit margin is a function of the option premiums collected, and the likelihood of different market outcomes compared to the participation rates to the annuity investors. For your part, you get to sound smart at cocktail parties about your covered call bear put spread iron condor derivative plays. In the next installment, I will discuss Buffer ETFs. Stay tuned!

To the objective investor, it is more important to ditch the complexity, illiquidity, and fees of buffer annuities. Instead, you know our spending and risk capacities for the only performance benchmark that matters - your confidence. And by controlling the risks you can control and running simulations using the most reliable data possible, your returns will be weighted in dollars of future wealth that never underperform.