It’s Good to Have Options, Part 3: Buffers versus Floors

In the first article in this series, I provided an overview of registered index-linked annuities (RILAs) and in the second article, I contrasted different approaches (DIY, ETF, and RILA)to implement options-based strategies. In this article, I’m going to more dig into buffer-and-floor strategies, with a particular focus on the underlying options-pricing dynamics. Buffers subject the investor to tail risk (i.e., large possible negative returns), while floors limit losses to some predefined level (e.g., 10%).

Options-pricing dynamics mean the relative attractiveness of floors and buffers is going to vary over time, where buffers will be more attractive when implied volatility is higher (e.g., now). Overall, though, historical evidence shows that buffers are likely to offer more attractive return profiles than floors, given the shape of the historical implied-volatility curve. While buffers subject the investor to tail risk, the risk exposure is effectively identical to what an investor would experience if he or she owned the underlying index directly (e.g., the S&P 500). Therefore, the tail risk needs to be considered in the correct context.

In the next (and final) piece of this series, I’m going to provide some context as to how these options-based strategies can fit within a total-portfolio structure, using a utility-based resampled optimization framework.

Buffers and floors: A brief review

There are two primary options-based strategies considered in this series, both of which are common in RILAs as well as a growing number of ETFs: floors and buffers. With floor products, the downside is limited to a stated percentage, such as 10%. For example, if the floor is 10%, you can’t lose more than 10% regardless of the return of the underlier (e.g., the S&P 500). A RILA (or ETF) with a 0% floor would have the same risk profile as a fixed-index annuity (FIA).

With buffer products, some of the loss is absorbed first by the product, based on the buffer level; the investor suffers any loss beyond that point. For example, if the buffer is 10% and the return of the underlier is -40%, the annuitant would lose 30%. If the return of the underlier is negative, but not less than the noted buffer, the investor return would be 0%.

Floors are considered more “bond-like” than buffers, since the maximum negative return is known in advance; however, their risk depends on the respective level. For example, a product with a 20% floor is still relatively risky (i.e., relatively “equity-like”).