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Robert Bloink and William H. Byrnes

Portfolio > ETFs

Can Buffer ETFs Protect Your Client From Sequence of Returns Risk?

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What You Need to Know

  • Clients are more likely to suffer long-term financial consequences when they must withdraw retirement savings in a down market.
  • Buffer ETFs offer a degree of downside protection — for example, against the first 10% or 15% of losses.
  • Unlike annuities, buffer ETFs don’t contain surrender fees and aren’t commission-based. They’re also more liquid and can be cheaper.

Nearly all clients are feeling the strain of today’s protracted down market conditions. Unfortunately, clients who are approaching retirement age or who have just retired may experience the most negative outcomes in this environment.

That’s because of a concept called sequence of returns risk — meaning that these clients are more likely to suffer long-term negative financial consequences because they’re forced to withdraw hard-earned retirement savings during a down market (or even a bear market).

Many different strategies could be used to mitigate this risk, including defined-outcome ETFs. The defined outcome, or “buffered” ETF strategy, can be extremely complicated — and it’s important to understand all angles before electing to use the strategy for any given client.

What Is Sequence of Returns Risk?

Sequence of returns risk is a market volatility issue surrounding the order in which returns on a client’s investments occur. Essentially, if a greater proportion of low or negative returns occur in the early years of retirement, the client’s overall returns are going to be lower than if those negative or low returns occurred at a later point in the client’s (and the investment’s) lifetime.

Logically, this is because the investment has had less time to grow in the early years of ownership, so there is a danger that negative returns could even cause a portion of the principal investment to be lost. Even if the return is simply lower than average in the early years, the investment will generate a lower overall return because the investment will gain less value early on, meaning there will be a lower account value to generate growth even in later, higher return periods.

When the client is making withdrawals from their investment accounts, this risk of outliving the retirement assets is magnified when negative returns occur in early years — especially considering today’s increased life expectancies.

Can ETFs Provide the Answer?

Defined outcome ETFs, which are also called buffer ETFs, provide clients with the opportunity to participate in a certain level of market gains while also providing downside protection. Typically, the client will be able to participate in the underlying asset class’s gain up to a certain percentage. The investment also provides a degree of downside protection, much like an annuity. For example, the client may be protected against the first 10% or 15% of losses.

The ETF investment lasts for only a predetermined amount of time. Most ETFs have a one-year outcome period, so that the cap and protection against loss apply only during that one-year period. That period begins on what’s called a “rebalance date.” If the client purchases the ETF after that date, a different cap and “buffer” will apply, depending on how the asset has actually performed.

This type of ETF can be beneficial to clients looking for a degree of protection from equity market losses, as the government begins to raise interest rates. The buffer ETF is particularly valuable for clients looking for protection against sequence of returns risk as they enter retirement.

The defined outcome ETF might sound similar to an annuity. Like most annuities, they’re a complicated asset and should be considered only by advisors and clients who fully understand the product. But these ETFs don’t contain surrender fees and aren’t commission-based products. They’re also more liquid and can be cheaper than an annuity.

Nevertheless, the buffer ETF is extremely complicated. It can offer risk protection because the investment itself is made up of different put and call options. Clients should also be aware that they aren’t fully protected against market losses — and it’s very possible that they could still lose assets with the investment.

Conclusion

Buffer ETFs are an investment type that’s unknown to many clients. For those looking to manage risk in today’s turbulent market, they can provide a degree of protection while still allowing clients the possibility of participating in some market gains.

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