08/01/2018

How Much Protection Do Longer Term Buffered Products Actually Provide?

Barron’s wrote a cover article, “The Annual 50 Best Annuities Review”, in their July 22, 2018 edition with a section that highlighted the growing success of Structured Annuities. The article helped answer a question that has been weighing on me as of late, the question being: why are buffered products so much more popular than floor (aka Shield) products? My firm had done both qualitative and quantitative research on market preferences in regards to market exposure and found that a buffer product and a floor product had similar demand. However, when looking at issuance of Structured Annuities, the vast majority are of the buffer product variety. The answer came in an added comment at the end of an expressed view: “Generally, the upside caps on the floor products are a little lower”, she adds. (Thanks Jessica!)

To review, a buffer product provides initial protection to the downside while a floor product provides tail-risk, or second level protection to the downside – a “floor” (or shield) to your risk rather than a “buffer” of risk. For example, a 10% buffer on the S&P 500 is designed to protect on the first 10% decline but provide no protection thereafter. So a 10% decline in the S&P 500 should result in the investor recouping their capital while a 30% decline in the S&P 500 should result in a 20% loss for the investor. A 10% floor (or shield) product should protect declines that surpass the floor level. So a 10% decline in the S&P 500 should result in a 10% loss for the investor while a 30% decline in the S&P 500 should also result in only a 10% loss for the investor.

 

What is interesting is that the longer the duration of the buffer the more the investor has to spend on upside participation as compared to a floor. Most of the structured annuity issuers provide one year, three year and either five or six year maturities. The recent low volatility and low yield environment has resulted in better seeming characteristics in longer termed maturities. As can be seen from the graph below, the buffered note provides materially more to spend as duration increases.

Floor vs Buffer Crediting for One, Three, and Five Year Durations

As can be seen from the graph above, on a five year 10% buffer product, the buffer provides close to 10% of credit that can be applied towards upside participation on behalf of the investor. Meanwhile, the floor product provides 3.5% of credit in year five, close to 1/3 the level of the buffer and a similar value to that provided in the one year product (~3.0%). As a result, the buffer product can indeed provide more upside as durations increase.

When we had conducted our research comparing buffered and floor products, we had used one year products where the upside participation is similar. Some participants liked the idea of first loss protection (buffer) while others appreciated the idea of tail-risk protection (floor / shield) – the concept of taking first losses in order to protect the vast majority of potential downside. The surveys taken showed interest in both products with no true outperformer. In fact, in qualitative interviews, many saw the use of both either for different clients or as two exposures that can work well together given the different qualities of defined protection.

When one expands out to five years, the results of a survey would be obvious and has played out in the product offered by the issuers of structured annuities (just in case: buffers win out!). There are two items in play here:

  1. Due to the better upside participation offered by the 5 year buffer as compared to what a 5 year floor can provide, it simply does not allow for a fair comparison of the superior protection a 5 year 10% floor should provide as compared to the 5 year 10% buffer.
  2. While priced properly, the features of the 5 year floor simply do not pass the eye test in that they do not provide inspiring upside vs downside characteristics. For example, characteristics of a 5-year 10% floor are not meaningfully better than a 5 year principal protected product. This is a result of the fact that the credit received for a floor product is more or less optimized for one year and does not get better in a longer duration environment.

The buffer increases in value as duration increases due to the fact that possible market outcomes expand over time while the buffer remains fixed at 10%. Given a constant volatility, a 2 standard deviation event over a one year period may be 25% up or down while a 2 standard deviation event over a three year period may be 50-60% up or down. In both instances the buffer is only 10% meaning that the buffer protects in most instances over a year period but can take material losses in the three year period. Simply stated, a 10% buffer is much more meaningful for a one year period then it is for a five year period. It does not provide as much protection from a reasonable downturn over a longer period of time and provides less and less protection over time in an increasing return environment as the market moves further away from the product’s initial strike.

 

The floor product meanwhile has a limit to what it can credit due to the fact that it is a 10% spread as compared to the buffer which is open-ended to a 90% level on the downside.[1] This fact places a natural limit on an initial valuation of a floor. Given bear markets tend to be relatively violent and quick moving, a floor product with one year duration – which is within the range where a floor prices optimally – provides meaningful protection when comparing to past material bear markets.

In conclusion, a buffer will provide better upside characteristics as maturity is elongated primarily due to the fact that the buffer provides less protection over time. Participants in this market should better weigh the benefits when comparing a 10% buffer over one year to that of a 10% buffer over five years as the shorter term buffer provides more protection at the cost of upside. Meanwhile a floor strategy is best priced as a shorter duration product. Considering the proclivity of advisors to prefer longer term buffers due the upside characteristics, it may make sense to supplement downside hedging with either shorter term floor products which may match particularly well with buffers in material market drops or shorter term buffers which will provide better protection early on in exchange for a lower cap.

[1] In reality, though a bit more complex of a concept, options, whether puts or calls, allow for the ability to profit in both up and down markets with single options (like a buffer) providing more opportunity and risk as opposed to spreads (like a floor) which provides a more defined set of outcomes (e.g., 0% – 10%).