Concerned about loss?
Dividends and options can
Help create buffers

Of the various risks to retirement financial security, sequence of returns risk is among the spookiest. Down markets will happen on average one year out of four. When this happens, retirees depending on distributions from investment accounts to pay for monthly living expenses expose themselves to sequence of returns risk.

This happens when stocks, mutual funds, or ETFs are sold to free up cash to spend on living expenses. By selling an investment while prices are down, the retiree ensures that those funds are not available to participate in the eventual market recovery. When inflation is running high, as it is now, the problem is compounded because more investments must be sold to afford the higher prices at the gas station, grocery store, and just about everywhere else.

How can a person avoid this financially dangerous situation altogether? If down markets are going to happen 25% of the time, isn’t sequence of returns risk inevitable? If the retiree in question has a good income plan, the answer is NO, they do not have to expose themselves to sequence of returns risk.

By “good retirement income plan,” I mean this: having systems in place that will allow a retiree to avoid touching market-based investments when they are down. By simply not touching investments while prices are low, a retiree ensures that they will be able to participate fully whenever the recovery starts.

What is a good retirement income plan? A retirement income plan, like every other part of financial planning, is not one-size-fits-all. However, good retirement income plans will generally share this characteristic: there will be mechanisms in place to generate income from investments without selling them.

Investments that produce income pay dividends to shareholders. These companies pay dividends based on the number of shares a person owns, not the price of those shares. Companies can raise or lower dividends, though, so diversification is crucial. By having a number of dividend-paying positions in a portfolio, a retiree may protect him or herself against the risk that a single company may reduce its dividend.

In general, it is a reasonable expectation that a diversified dividend portfolio will generate sustainable income at a rate of 3-4%. This means that a dividend stock portfolio worth $1,000,000 may generate $30-40,000 of income annually. If certain requirements are met, that income may be taxed at favorable capital gains rates.

This income can also be viewed as a buffer against market losses, and an enhancement of market gains. If a stock paying a 3% dividend falls in price by 5%, the total return of that stock is -2%. If the price increases by 5%, the total return including the dividend is 8%. The income produced by the stock has created a buffer against the decline in the price of the stock, and has enhanced the price increase of the stock.

A retiree can also generate income from a stock portfolio by using options-based strategies. Options are a right to buy or sell a stock at a certain price. A call option is the right to buy a stock. A put option is the right to sell a stock.

If someone buys ABC stock at a price of $50, they could sell a call option on their stock to an investor who wants to buy that stock if the price hits $60. This is called “writing a covered call.” The person who buys the call option pays the stock owner a premium. This premium is income to the stock owner. This concept is similar to the owner of an apartment building collecting rent from tenants. The owner is the option writer, the tenants are the option buyers.

In this example, if the price of the stock never hits $60, the option will expire worthless and the option writer – our retiree – gets to keep their income. If the stock hits $60, the option will be exercised, and the stock owner will sell the stock to the option buyer at $60. The stockholder now has cash from selling at an appreciated price that he or she can use to buy more stock and write more options.

Put options can be used as portfolio insurance. A stockholder can buy a put option that guarantees he or she can sell the stock at the exercise price. Someone who buys ABC stock at $50 can buy a put option that gives them the right to sell the stock if the price falls below, for example, $45. If the price falls to $40, they could exercise their option and sell their stock at $45. The investor pays a premium for the put option so that they have certainty concerning their maximum loss on an investment.

By combining put options and covered calls, a retiree can generate income and reduce downside risk without having to sell investments in their portfolio. This increases their portfolio income and, once again, buys time for the investor to wait out a market crash and recovery.

However, use caution. Options investing is extremely complex and can amplify losses if investors make mistakes or get greedy. If the complexity of options is unappealing or feels too risky, investors have a relatively new instrument available to help create buffers in their portfolio.

Registered Index-Linked Annuities - or “RILAs” for short - are issued by some insurance carriers, and essentially package an options-based strategy without directly exposing the investor to the complexities of options trading.

These annuities credit growth to an investor’s account by tracking indexes like the S&P 500 for one, two, three, or six years, depending on what the specific product allows. This crediting is generally competitive with the performance of index funds. For example: as of this writing, one such product can credit as much as 140% of the performance of the S&P 500, gross of fees, over a 6 year period.

Fees on RILA accounts range from 0%-1.25%. Generally, lower fees mean less participation in index performance, and/or lower caps on performance. Higher fees mean more participation, higher caps, and more flexibility, or some combination thereof.

What makes RILAs interesting however is their risk-management features. RILA accounts protect against market losses by providing buffers against a stated percent of loss. Depending on the specific contract, these buffers can protect against 10% or 20% of market losses over the index tracking period.

Suppose an investor starts tracking the S&P 500 over a two year period using a 20% buffer. Suppose also that a market disaster happens right as the index is scheduled to credit. The index goes all the way down to 25% of its price from two years ago. Our investor’s 20% buffer means he or she is only down 5% gross of fees.

Using dividend income, options strategies, and RILA accounts, investors have several strategies to choose from to buy time to avoid sequence of returns risk and create buffers against market losses. This is by no means an exhaustive list. If you want to learn more about risk-management strategies, we’d love to hear from you!