The Best Solution for Protecting Retirement Portfolios: Put and Call Options versus GLWBs
Retirees cannot be exposed to severe – or even modest – market losses. They need to protect their savings in a costeffective manner. I will compare the projected outcomes for two types of strategies: options, which can reduce volatility, and products that guarantee lifetime income, such as variable annuities with guaranteed lifetime withdrawal benefits (VA/GLWBs).
The full range of alternatives that can provide downside protection includes absolute return funds, hedge fund replicators, longshort funds, low volatility funds and a variety of other approaches. But those strategies work indirectly, hoping for continued low correlation with stock performance. For this analysis, I'll concentrate on strategies that directly provide downside protection.
Combinations of call and put options can reduce volatility, while still leaving room to participate in stock market performance. The purchase of put options can be used to set a floor under returns. Selling calls can provide a steady income by sacrificing some upside. Combinations of buying puts and selling calls, known as collars, sacrifice some of the upside to protect against poor performance.
Another way to provide downside protection is to purchase a variable annuity with a guaranteed lifetime withdrawal benefit (VA/GLWB), or a similar product, the standalone living benefit (SALB), which combines mutual funds with a GLWB. This is quite different from using an options strategy, but these products achieve a similar result. The GLWB payments continue for life even if underlying investments in the VA or mutual funds perform poorly and the funds run out. Both these products have been covered extensively over the past year and a half in Advisor Perspectives articles by Wade Pfau and me (see here, here and here, for example), but this is the first attempt at a comparison with options strategies.
Options strategies
Let’s examine three different options strategies using the example of a 65yearold female who needs to withdraw $5,000 per year from $100,000 of retirement savings. She relies on a 65/35 stock/bond portfolio with an average annual return of 5.5% (including inflation) and a standard deviation of 13.5%. I used Monte Carlo simulations of investment performance to generate retirement outcomes, treating longevity as a variable with an average remaining lifespan of 22 years. The analysis is pretax.
The chart below compares projected retirement outcomes under three different option strategies with the 65/35 portfolio. Two of the measures shown are often used in financial planning evaluations – "average bequest" and "probability of plan failure" (i.e., probability that funds will run out during retirement). I've also included two additional measures. The "average failure" represents the average shortfall (akin to a negative bequest) for the cases where funds are depleted during retirement, thus providing a measure of the magnitude of failure. The "loss metric" is the probability of failure multiplied by the average failure, combining frequency and severity into a single measure.
Retirement outcomes with various option strategies 

Strategy 
Average Bequest* 
Probability of Failure 
Average Failure* 
Loss Metric 

(1) Investment only (65/35) 
$73,774 
15.5% 
$17,109 
$2,656 

(2) Put option 
$47,687 
18.0% 
$14,810 
$2,671 

(3) Covered call 
$56,046 
12.7% 
$15,013 
$1,901 

(4) Costless collar 
$37,223 
14.3% 
$11,892 
$1,700 

(1A) Inv only 50/50 stock/bond 
$56,133 
14.6% 
$14,631 
$2,133 

(1B) Inv only 35/65 stock/bond 
$39,397 
16.5% 
$13,258 
$2,184 
*Present value at retirement based on an assumed risk free rate of 2.5%
The first strategy uses regular investments only, with no puts or calls, and a 65/35 stock/bond allocation throughout the course of retirement. The second strategy uses the same investment allocation and annual purchases of oneyear put options that cap any investment losses at 5%. Based on 13.5% volatility and an assumed riskfree rate of 2.5%, the cost of such a put option is 2.316% of each beginningofyear fund balance, according to the BlackScholes pricing model. The covered call strategy assumes that the investor can buy call options each year that cap returns at 11.4% and that the price for this particular cap is the same as the cost of the put option in strategy 2. The "costless collar" involves combining strategies 2 and 3 so that the cost paid for the put option exactly offsets the premium received from selling the call option. This strategy effectively restricts annual returns to a band between 5% and 11.4%. Using puts and calls to reduce volatility has similar effects to using regular investments and reducing stock allocations, so I've included strategies 1A (a 50/50 mix) and 1B (a 35/65 mix) for comparison.
Strategy 2 turns out to be ineffective, even though it uses put options to provide pure downside protection. The average bequest is substantially reduced, reflecting the drag on returns from the 2.136% annual put cost, but the strategy fails to reduce the loss metric. The takeaway here is an important one: Downside return protection may not be the best way to provide downside retirement protection.
The covered call strategy, which generates income by selling annual calls, does better than the put option strategy, both in terms of the average bequest and the loss metric. The costless collar does the best on the loss metric, but with a significant decrease in average bequest.
At a given bequest level, one can produce lower loss metrics with option strategies 3 and 4 than by lowering stock allocations (strategies 1A and 1B). So, option strategies are more efficient at decreasing risk than are reduced stock allocations.
Practical considerations for options strategies
For those considering options strategies, there are mutual funds and exchangetraded funds that use options to reduce volatility. Funds that use covered calls are mostly closedend, like Madison/Claymore Covered Call (MCN) and Nuveen Equity Premium Income (JSN). Funds that use collars include the Gateway Fund (GATEX) and the aptly named Collar Fund (COLLX). There are no funds I am aware of that use put options only, perhaps because of the poor performance for this strategy shown in the chart. Mutual fund and ETF investments include expense charges for active management that would need to be factored into financial projections.
Another strategy for downside protection involves purchasing structured notes, where investment banks use options and derivatives to provide principal protection, but with stockmarket upside. These investments are designed for accumulation rather than income generation, so setting up a portfolio of structured products for retirementincome generation would involve a complex laddering exercise. These products also contain credit risks, such as the solvency of the issuer, as was highlighted a few years back by the Lehman bankruptcy.
A product closely related to structured notes is the equityindex annuity, which is essentially a commissionbased structured note built on an annuity chassis. Like structured notes, these products typically guarantee principal and provide some stockmarket upside. They tend to be marketed for the accumulation phase of retirement. They are also complex – even actuaries have a hard time understanding all the product features (see here, for example).
Doityourself investors, if they wish to use options strategies at minimal cost, may want to rely on buying puts or selling calls on instruments like the S&P 500 index option (SPX). This is a lowcost approach that is appropriate for passive investors who plan to follow a repetitive process that they set up in advance.
The GLWB strategy
Vanguard offers a VA/GLWB guaranteeing a 5% lifetime withdrawal rate, which matches up with the example of $5,000 in annual withdrawals from a $100,000 initial portfolio. Using this product for this example eliminates the risk of running out of money during retirement (except for possible insurance company credit losses, which historically have been negligible.) The chart below compares the previously discussed option strategies with two VA/GLWB options. The first, Vanguard VA/GLWB, has total annual charges of 1.54%. For comparison, I’ve included a VA/GWLB option with fees of 3.50%, a more typical fee level for popular commissionedbased VA products.
Comparing option strategies to GLWBs 

Strategy 
Average Bequest 
Probability of Failure 
Average Failure 
Loss Metric 

(1) Investment only (65/35) 
$73,774 
15.5% 
$17,109 
$2,656 

(2) Put option 
$47,687 
18.0% 
$14,810 
$2,671 

(3) Covered call 
$56,046 
12.7% 
$15,013 
$1,901 

(4) Costless collar 
$37,223 
14.3% 
$11,892 
$1,700 

Low cost VA/GLWB (1.54%) 
$41,106 
0.0% 
$0 
$0 

Higher cost VA/GLWB (3.50%) 
$19,383 
0.0% 
$0 
$0 
The level of fees makes a big difference in average bequest values. The lowcost GLWB is competitive with the option strategies in terms of average bequest, and it has the advantage of reducing the failure risk to zero. It accomplishes this by pooling longevity risk. Those who live shorter lives subsidize those who live a long time and are likely to make heavier use of the guaranteed withdrawals. The highercost VA/GLWB also makes use of mortality pooling and provides this same protection against failure. But the bequest values are no longer competitive with the option strategies. Pay attention to costs in VA products.
Practical considerations for GLWBs
Those contemplating a VA/GLWB must consider whether to go with a lowcost product or opt for one of the more prevalent highercost products. The latter are almost always commissionbased and typically offer more investment choices and complex product features. Still, investors need to ask themselves if the extra costs are worth it.
An alternative way to utilize a GLWB is with a standalone living benefits product (SALB) like Aria's RetireOne, which uses a mutualfund chassis rather than variableannuity subaccounts. This product was described in detail by Wade Pfau in this October 2012 Advisor Perspectivesarticle, which also provided a pointbypoint comparison with Vanguard's VA/GLWB product. Overall costs of the RetireOne product are similar to Vanguard's. However, a key difference is that RetireOne currently guarantees only a 4% withdrawal rate for a 65yearold whereas Vanguard will guarantee 5%.
The most important advantage for products with GLWBs is that withdrawals are guaranteed, effectively reducing portfolio failure rates to zero. In comparison, the various option strategies only modestly reduce the downside risk.
Recommendation
For downside protection in a retirement portfolio, I would stay away from options strategies and choose an annuitylike approach providing guaranteed lifetime income. In today's environment, the Vanguard VA/GLWB is a strong contender. I would also compare financial outcomes for the Vanguard product with projected outcomes for lowcost versions of other types of annuities, such as immediate annuities and deferredincome annuities.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.