Buffer ETFs vs. Annuities: Which Are Better for Retirement Income?

What Is a Buffer ETF?

A buffer ETF is an exchange-traded fund that uses options to limit downside exposure and to cap upside potential over a 12-month period. These ETFs typically invest in an index like the S&P 500. Investors need to buy into the fund on the first day of the defined outcome period to ensure that they receive full protection against losses.

If the fund offers downside protection of up to 10%, then a loss of 15% in the index would result in a 5% loss to investors, who can hold until the end of the guaranteed period and either sell or keep their money invested. Like with any ETF, they can sell the fund at any time if they need the cash.

Buffer ETFs have been growing at a significant rate over the past years. Since 2019, the number of buffered ETFs has increased from 23 to just under 300, while assets in these funds have grown significantly as well.

Buffer ETFs offer a number of pros and cons for clients nearing or in retirement.

Pros:

• They can be purchased in the same fashion as an ETF, often with no transaction costs.
• They are liquid and can be sold if clients need cash.
• They offer a low-cost way to mitigate portfolio volatility.
• They offer a low-risk way to participate in the market’s potential upside with low downside risk. 
  

• They are pricier than most conventional ETFs. Expense ratios can be in the 70- to 80-basis-point range, compared with fees of 10 to 15 basis points or lower for many conventional index ETFs.
• In order to get the full benefit of the downside protection and any upside potential, investors need to buy the buffer ETF at the beginning of the “opportunity period.” Any investment made after this period might have a different level of downside protection. 

Understanding Annuities

Annuities come in several varieties including fixed, variable and several types of indexed annuities. They are typically purchased with an upfront lump sum or a series of premium payments over time. Annuities offer lifetime guaranteed payments and also often come with high fees and expenses.

Annuities offer a number of pros and cons for clients nearing or in retirement.

Pros:

• They offer a guaranteed lifetime income stream for contract owners. 
• They are backed by the insurance company offering the contract. 
• They can offer an additional vehicle to accumulate tax-deferred retirement savings. 
  

• They can be costly in terms of fees and expenses connected with the contract. 
• It can be difficult to access the money in the annuity if needed. This may involve taxes, early withdrawal penalties or surrender charges.

Which Is a Better Fit?

Both buffer ETFs and annuities can be appropriate for clients, depending on their retirement situation and income needs.

Buffer ETFs might be a better fit for clients who don’t want to tie up sums of money in an annuity and want some investment flexibility. Buffer ETFs offer upside potential with solid downside risk protection and are a good option for clients who want additional flexibility that annuities cannot provide.

Clients can keep investing in buffer ETFs to participate in the equity markets with substantial downside protection, but they retain the flexibility to direct that money elsewhere if it makes sense for them.

For clients nearing or in retirement, buffer ETFs provide the opportunity for growth with downside protection without tying up the client’s money in an annuity. Buffer ETFs can be treated as a conservative part of clients’ portfolios and their overall asset allocation.

When looking at buffer ETFs, be cognizant of the designated fund outcome period. If the ETF is held for a shorter period or a different time frame than the designated outcome period, the return will likely be different and often lower.

An annuity can also play a key role in a client’s retirement planning. For clients who are pre-retirement, paying annuity premiums over time can be a way to add tax-deferred retirement funds if they have maxed out their 401(k) or similar employer retirement plan as well as their individual retirement account.

For clients seeking a guaranteed stream of lifetime income, an annuity provides this. Whether this is needed will depend on their situation, including their level of Social Security benefits and whether they have a pension. Another data point is savings outside of retirement and the monthly income they are able to generate from these savings.

Indexed annuities offer the ability to participate in stock market upside based on a capped upside percentage of the index that the annuity is tied to. They also offer downside protection.

Clients Can Do Both

Clients conceivably could have both an annuity and buffer ETFs in their portfolios; they are not mutually exclusive.

An annuity can be used as a permanent source of guaranteed retirement income for clients where that is appropriate, providing a degree of certainty. Many contracts can be tailored to their needs with riders and other add-ons.

The absence of a permanent commitment with buffer ETFs makes them very flexible. They offer moderate growth and reduced downside, and they can even serve as a placeholder for a future annuity for clients who may not be ready to commit but still want a low-risk portfolio component with moderate upside.