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Introduction to Profiting with Synthetic Annuities: Option Strategies to Increase Yield and Control Portfolio Risk

Michael Lovelady introduces his book, which covers adding options to the design set—not as trading devices, but as structural long-term components of securities and portfolios.
This chapter is from the book

If you Google the term synthetic annuity, you won’t find much. There is a reference to an obscure tax issue, as well as an article about design projects by several investment firms and insurers who believe the next Holy Grail is an annuity-like product for 401(k) plans that allows participants to convert highly volatile assets into defined benefit type payments.

According to the article, the product rollouts are moving slowly, despite the names behind them: Alliance Berstein, AXA, Barclays Global Investors, John Hancock, MetLife, and Prudential. The products, called hybrid 401(k)s, combine investment portfolios with annuity contracts. The annuities are purchased gradually over time. As plan participants get closer to retirement, the annuities become a larger portion of the total portfolio, providing more stability in later years. The idea behind the product is great, especially considering the massive shift from defined benefit (DB) plans (traditional pension plans) to defined contribution (DC) plans.

The problem is, few people are interested. Because interest rates are currently so low, annuity prices, which move in the opposite direction from interest rates, are some of the highest in two generations. And the hybrids won’t protect investors against market crashes, at least for the portfolio assets.1

DC plans such as 401(k)s and IRAs already have about $3½ trillion in assets and are growing fast. Retirement experts believe the growing DC asset base and lack of protection against market risk is a critical problem. The model of retirement income for the last generation involved three primary legs: defined benefit pension plans and Social Security for the two stable core elements, and 401(k) plans as a savings supplement. But with companies shutting down DB plans that leaves DC plans as the primary source of private retirement income, a role they were never really intended to play. It is estimated that in less than ten years, DC plans will have three times the assets of corporate pension plans. And the market risk of those assets will belong to the individual rather than being backstopped by corporate sponsorship.

The transfer of market risk is happening at a bad time. Low interest rates are limiting what can be done in new product design, 70 million Baby Boomers are getting ready to retire and there is no obvious successor to modern portfolio theory (MPT) for building risk-controlled portfolios.

Current low interest rates are also causing managers to rethink asset allocations. In most portfolios, reducing risk means allocating more of the portfolio to bonds, a traditionally less volatile asset class. But in today’s market, with interest rates at 50- to 60-year lows, high allocations to bonds might be the most risky thing an investor can do. At the short end of the yield curve the risk is created by near-zero yields, causing investors to fall behind accumulation goals. At the long end of the curve, the risk is that interest rates might start to go up, causing the value of the bonds to go down. Bond markets can experience the same kind of extended bear markets as equities. From the 1940s until the 1980s, Treasury bonds lost about two-thirds of their value as rates increased, making this one of the worst bear markets in any asset class. Warren Buffett said recently that bonds should come with a warning label.

In terms of building risk-controlled portfolios, MPT has failed repeatedly to protect investors during market crashes, which we saw again during the 2008-2009 financial crisis. Diversification, the main risk-management mechanism of MPT, breaks down during extreme events. With MPT behind both institutional portfolios and today’s most popular retail products such as balanced mutual funds, target date and life-cycle plans, corporations and individuals are facing the same challenges. How to generate yield in a low interest rate environment? How to control volatility in the equity markets? And how to construct portfolios with limited downside?

These are industry-wide issues. The need to focus not only on accumulating wealth, but also on products that offer yield and protection against market risks has been identified as a major trend. In a 2010 report, The Research Foundation of the CFA Institute said “As the world moves from DB to DC plans, the financial services industry will have to meet two big challenges: to engineer products that offer some sort of downside protection and to reduce the overall cost to the beneficiary.”2

Working within the constraints of low bond yields and traditional design tools is unlikely to produce anything investors will get excited about. That is why these are described as big challenges. They require moving outside the current design sets. The challenge of providing downside protection is not simple. There are theoretical and practical obstacles that have become engrained in investment practice. Reducing the overall cost to the beneficiary means finding higher yields than are currently available in the bond markets.

This book presents an approach to meeting these challenges by adding options to the design set—not as trading devices, but as structural long-term components of securities and portfolios. Options-based strategies are exciting today for many reasons. For active traders, options create incredible flexibility for taking advantage of tactical opportunities. For investors and portfolio managers, options create new yield and risk management capabilities. For asset managers and insurance companies designing products, options offer new ways of translating design principles into product offerings.

The next section looks at the design principles used for a fairly conservative, long-term investor form of synthetic annuity. The remainder of this chapter puts the two big challenges in historical and theoretical context in order to understand why these problems have persisted for so long and why it is difficult to find solutions.

What a Synthetic Annuity Is—and Is Not

Normally in finance, the term synthetic describes a look-alike security. For instance, if you want to create a stock position without holding stock, you buy a call option, sell a put option, and hold a specific bond. Because the payoff of this combination is the same as that of the stock, it is referred to as a synthetic stock.

The synthetic annuity described in this book, the SynA, is not a true synthetic in that sense. It is not designed to replicate the guaranteed cash flows of a simple annuity, although it does have features similar to those of an equity-indexed annuity, and it attempts to accomplish some of the same objectives as the hybrid 401(k). Instead of looking at the SynA as, well, a synthetic annuity, I view it more as a style of investing that reflects the following beliefs:

  • Market volatility is damaging to investment results; having a mechanism other than diversification alone for managing it is important.
  • Dividends have played a critical role in total returns; there are effective ways to increase them for dividend-paying stocks and manufacture them for non-dividend-paying stocks.
  • Current methods of measuring risk, such as backward-looking volatility of returns, are limited. Real-time and forward-looking measures are needed to dynamically manage risk.
  • Risk allocations and risk budgeting offer new ways to limit losses by including elements of hedging and insurance
  • Behavioral finance is useful in recognizing behavioral influences on decision-making and the value we place on investment outcomes.

By using options in combination with underlying securities, you can emphasize any or all of these objectives to create SynAs ranging from conservative to aggressive. And you will be able to quantify exactly how much volatility is in the position, how much current income is being generated, and how stable the position is.

In its most simple form, a SynA translates beliefs and objectives into investable securities. In its generalized form, it can be used to encompass almost any options strategy and simplify them into basic metrics. Rather than having to think about many different strategies, SynAs use a common language of payback periods, market exposure and stability, the properties that are common to all structured securities.

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