Indeed, those in the risk zone are likely to withdraw money from their nest egg during market corrections or, even worse, bear markets. And this combination of portfolio pullbacks and market corrections can shorten the life of a portfolio by seven years or more, according to Milliman.

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According to Milliman and others, buffered or defined-outcome ETFs, a strategy that was historically only available through insurers and investment banks, can be used to manage and mitigate so-called risk. sequence of returns, as well as other pesky retirement risks. (inflation, longevity and volatility).

So what is a buffered or defined outcome ETF?

“Buffer ETFs are funds that seek to provide investors with the upside of an asset’s returns (usually up to a capped percentage) while providing downside protection on the first predetermined percentage of losses (for example, on the first 10% or 15%),” wrote Emily Doak, director of ETF research at Charles Schwab Investment Advisory, in a recent report.

“Most buffer ETFs in the market today have a one-year earnings period,” according to Doak. “This means that the caps and buffers (as shown) only apply to investors who buy on the rebalance date and hold the ETF for the entire outcome period.”

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It should be noted that investors “who buy after the rebalance date will receive different caps and buffers depending on the performance of the benchmark between the rebalance date and the time they bought the fund,” Doak wrote. .

And these funds have become very popular recently. There are now 148 buffered ETFs representing $14.15 billion in assets under management, and the largest buffered ETF is the FT Cboe Vest Fund of Buffer ETF BUFR,
-0.14%,
according to ETF.com.

Reasons to Consider Buffered ETFs

According to Graham Day, vice president of products and research at Innovator Capital Management, Innovator launched the first-ever buffered ETF in 2019, and investors are turning to buffered ETFs because they offer known levels of risk management for the most core equity exposures in the portfolios. .

“While rates rose at a pace that surprised most advisors and led to historic losses for many fixed income asset classes in the first quarter and year to date, retirees have been given a rude awakening by the reality that bonds don’t offer the kind of portfolio defense they’ve offered in decades past,” he said in an email. “As the Fed has just begun its rate hike cycle , investors prefer equities to bonds, but don’t want to be fully exposed to the downside of equities, and they want to know they have risk management built in instead of hoping that their risk management will work.

Given this and other benefits, several experts have said that these buffered ETFs have a place in a retiree’s or pre-retiree’s portfolio. “These are useful tools,” said Dave Nadig, financial futurologist at VettaFi. “They do exactly what they say they are going to do.”

Consider, for example, Innovator’s recently rebalanced June Series ETFs, which provided investors with new upside caps and downside buffers. According to Day, the Innovator US Equity Power Buffer ETF – June PJUN,
-0.41%
offers investors upside potential of 14.3% with a built-in buffer of 15% over the next year.

“We believe these ETFs can help provide stability for retirees as they both offer significant upside potential for stocks in a rally, but at the same time provide the known downside buffer against SPY 15% losses” , Day said in an email. “If the market continued to sell off due to the myriad of factors currently weighing on stocks and SPY returned -18% over the earnings period – through May 2023 – an investor in PJUN over that entire period would be in decrease of -3% gross of fees.”

And that, Day said, “can be a nice peace of mind for investors in the ‘retirement risk zone’ who can’t afford to make their money twice – and, critically important, suffer less loss and volatility has a behavioral benefit in that it can help a pre-retiree or retiree stay invested and participate in the potential capital appreciation that accompanies equity exposure over time.

Buffered ETFs can also help manage longevity risk, the risk of outliving one’s assets.

Consider: A traditional portfolio of 40% stocks and 60% bonds, under current assumptions, can last around 25 years or more, according to Milliman Financial Risk Management. By contrast, allocating just 15% of your portfolio to buffered ETFs can extend the life of your portfolio well beyond a traditional 30-year planning horizon, according to Milliman Financial Risk Management.

Expensive and complicated to understand?

To be fair, buffered ETFs are not without their drawbacks. “My only issue with them is that they’re expensive and complicated to explain or understand,” Nadig said.

According to ETF.com, the average expense ratio for buffered ETFs is 0.81%. In contrast, stock index ETF expense ratios were 0.18% in 2020, according to the Investment Company Institute.

Before buffered ETFs became available, the only way to get this kind of exposure was through structured products from insurers and investment banks, Day said. And these products are illiquid, expensive and opaque, according to Barron’s report quoting Morningstar’s Ben Johnson.

“The majority of our ETFs are priced at 79 basis points, which compared to alternative structures, i.e. insurers and investment banks, is quite cheap,” Day said. In contrast, fees for structured products are sometimes embedded and can exceed 2%, according to Johnson.

Additionally, Day notes that there is a very liquid secondary market and that there are no commissions or redemption fees with defined outcome ETFs.

As for complexity, well, buffered ETFs use options to guarantee an investment outcome, according to ETF.com. For example, the Innovator’s Defined Outcome ETF is typically made up of three main layers of options: the first layer is to buy and sell one or four options positions – one or two calls and two puts at prices d exercises to provide a 1:1 synthetic exposure to the Reference Asset; the second layer, the downside buffer layer, incorporates a put spread; and the third layer, the upside cap layer, is to sell a call, which “funds” the downside buffer and creates the upside cap.

Others are not so sure. These strategies hold great promise and are worth considering as part of a portfolio, but calling them a “definite outcome” is a little misleading, according to David Blanchett, managing director and head of retirement research at PGIM DC. Solutions.

“I’m not necessarily a fan of the term ‘definite outcome,’ because the outcome really isn’t any more defined than investing in the general market,” he said. “It is only the distribution of yields that has been reshaped. While someone might say I’m too technical… what happens when/if an investor buys a 10% buffer ETF and then loses 20% if the market drops 30% over time?

“While buffer ETFs and floor ETFs both come under risk management, there is certainly a distinction between knowing the maximum loss of a strategy and the amount of potential market protection or loss of an asset. benchmark,” Day said. “It is important to note that the level of cushion is, in fact, certain or definite at the time an investor buys stocks and, therefore, helps shape an investor’s outcome relative to the reference asset. The amount of the upside is also known, as is the duration of the earnings period.

Despite his criticism of the term defined outcome, Blanchett thinks that “the general strategy used by these products/solutions could be useful in causing an investor to assume market risk that he/she would not otherwise have”.

There are other “wealth-protected strategies” investors could consider besides buffered ETFs, Blanchett points out. These include Registered Indexed Annuities (RILA) and Fixed Indexed Annuities (FIA).

Learn more about Blanchett’s view on protected wealth strategies: Defined outcome ETFs don’t really have defined outcomes; It’s good to have options: the potential benefits of allocating to protected wealth strategies; It’s good to have options, part 1: Discover registered index-linked annuities (RILA); It’s good to have options Part 2: DIY vs ETF vs RILA; It’s Good to Have Options, Part 3: Pads vs. Floors; and It’s Good to Have Options, Part 4: Optimal Allocations.

Bottom line: In a world where retirees need to make their portfolios last a lifetime, all investments and products need to be considered. But whether investments such as buffered ETFs, RILAs or AIFs have a place in your portfolio can only be determined in the context of your personal facts and circumstances. And trying to figure out what’s best for your wallet will take more than a little due diligence.