Protect your Nestegg with a 'Retirement Collar'

[intercst]

http://www.ifid.ca/pdf_workingpapers/WP2005JUNE20.pdf

Exhibit #14 provides an example of how this would work for a retirement
portfolio. Imagine that at retirement you decide to allocate your $100 nest egg
(which can arbitrarily be scaled up or down) and consume $4 per year from this
nest egg. If all of the money is invested in equity-based products, the simulation
results suggest that the probability of retirement ruin is 7.3% for a male (and
8.4% for a female, as per Exhibit #15). But, if you or your client purchase a 3-
month put option that is 5% out-of-the-money, which means that the strike price
is initially at $95, and you fund this purchase by selling a call option that is 6.6%
out of the money, the put/call combination will reduce the dispersion of your
portfolio and will reduce the probability of ruin to 1.5% for a male and 2.4% for a
female.

Essentially, we obtain this improvement in probability because we have
removed the very large negative returns from all scenarios, thus increasing the
chances that your initial nest egg is sufficient to maintain your desired standard
of living. We emphasize, though, that this “collar strategy” is not a free lunch
since large negative returns are reduced at the expense of reducing the upside
potential of the portfolio. This is yet another manifestation of the universal tradeoff
between financial risk and return. Thus, although the portfolio's income will
"last" longer by "delaying its date" with zero, the portfolio will not grow or increase
in value as rapidly as the un-collared or unprotected portfolio. A sample path of
the wealth in retirement with and without “collar protection” can be seen in Exhibit
#16.

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intercst

 

[bosco]

I have a book called

"Safer Investing in Volatile Markets" by Carolann Doherty Brown

that goes into this strategy in great detail. It also goes into other risk-mitigation strategies such as asset allocation and sector rotation.

IMO, its section on sector rotation is weak.

I am very reluctant to cap my potential returns by selling covered calls. Read the book, and concluded that I'd just ride things out and count on asset allocation and a variable withdrawal strategy to get me through.

 

[Nords]

Essentially, we obtain this improvement in probability because we have
removed the very large negative returns from all scenarios, thus increasing the
chances that your initial nest egg is sufficient to maintain your desired standard
of living. We emphasize, though, that this “collar strategy” is not a free lunch
since large negative returns are reduced at the expense of reducing the upside
potential of the portfolio. This is yet another manifestation of the universal tradeoff
between financial risk and return.

I wonder if this study includes all the investment costs and the taxes incurred if the options are executed.

Seems awful complicated if the goal is just to reduce volatility. Isn't that what diversification & bonds are for?

 

[brewer12345]

It seems to me that the biggest boost one would get is protection vs. a big downside move in, say the first 5 years after retirement. I don't know how to do this easily, but I wonder if anyone has studied what survivability looks like if a small part of the portfolio is invested in out of the money puts in the first 5 years?

 

[kramer]

I took a look at this article and did find it interesting.

I would be interested if anyone with more knowledge of long term calls and puts could comment on how one would actually put the collar strategy into practice for a 40 year retirement timeline. I wonder how different this strategy would be than putting more money into long term TIPs, which also would bring your returns away from the extremes.

I would think that taxes caused by a collaring strategy would be much less of an issue during the distribution phase as compared to the accumulation phase, so I wouldn't think tax issues would be a deal killer, even if I am skeptical about a the effectiveness of a collar strategy.

Most of us will already have an inflation-adjusted, lifetime annuity in retirement, social security.

The article seemed to focus more on 25-30 year timelines, and not a 40 year ER timeline. Presumably, 40 year timeline means even more sensitivity to returns early in retirement, making a collar strategy potentially more worthwhile.

Thanks,
Kramer

 

[kramer]

bosco wrote: "Safer Investing in Volatile Markets" by Carolann Doherty Brown

Thanks for the pointer. Readers on Amazon seem to recommend the book. Would you recommend it?

Kramer

 

[brewer12345]

I took a look at this article and did find it interesting.

I would be interested if anyone with more knowledge of long term calls and puts could comment on how one would actually put the collar strategy into practice for a 40 year retirement timeline. 

Options markets are far more liquid in the shorter term contracts, so to get reasonable execution costs you probably wouldn't want to go farther out than 3 months. That means you would have a rolling collar reconstituted 4 or more times a year. Not that hard to do, especiallt in the case of index options, but definately more labor intensive than rebalancing once a year.

 

[kramer]

Thanks, Brewer -- that makes complete sense.

I wonder if there is an insurance premium for protection against downside in the options markets for large indices, similar to the way there is a premium paid by commodity owners to hedge their risk? In other words, you are getting a slightly better deal to bet that the markets go up, rather than betting that they go down, and this would show up in long term results to the detriment of the collaring strategy.

This would have to get captured in any analysis. I suppose historical data would be a good start.

Kramer

 

[bosco]

bosco wrote: "Safer Investing in Volatile Markets" by Carolann Doherty Brown

Thanks for the pointer. Readers on Amazon seem to recommend the book. Would you recommend it?

Kramer

Yes, I can recommend the book. Although I don't intend to immediately implement the strategies it discusses, it is well written and thoughtful. I would consider it "intermediate" level, not advanced, which made it right for me (in some areas it was a bit too simplistic but I did get quite a bit out of it). I think it has a very good discussion of risk tolerance, how to assess it, and what tools are available to a person to mitigate risk. It is very conscientious about pointing out the tradeoffs in any risk-mitigation strategy.