Put and Call Options versus GLWBs
April 30, 2013
Retirees cannot be exposed to severe – or even modest – market losses. They need to protect their savings in a cost-effective 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, long-short 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 stand-alone 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.
Let’s examine three different options strategies using the example of a 65-year-old 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 pre-tax.
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