There are two common strategies available that have relatively different risk characteristics: floors and buffers.
With floor products, the downside is limited to some stated percentage, such as 10%. For example, if the floor is 10%, apart from the insurer’s default or inability to honor its claims-paying commitments, you can’t lose more than 10% regardless of the return of the underlier (e.g., the S&P 500).
The larger the floor (e.g., 10% versus 20%) the more the potential upside. A product with a 0% floor would have the same general risk profile as an FIA and generally relatively small upside (given the small options budget).
With buffer products, some first amount of loss is effectively absorbed by the product, based on the noted buffer level, and the investor would experience any loss beyond that point.
For example, if the buffer were 10% and the return of the underlier were -40%, the annuitant would lose 30%. If the return of the underlier is negative, but greater than the noted buffer, the return would be 0% (e.g., if the buffer is 10% and the underlier returns -5% the investor return would be 0%). The higher the buffer (e.g., 10% versus 20%) the greater the potential upside (or cap).
One could potentially argue that floor products — especially those with no downside risk (i.e., a floor of 0%, which is effectively an FIA) — have a “defined outcome” since, even though the potential upside is unknown, if the floor is 0%, you can’t lose money.
I’d be OK saying 0% floor products have a “defined outcome.” The problem is that the ETF universe of strategies is incredibly diverse and buffers are by far the most common strategy offered. Buffers, by definition, have significantly more tail risk, which I would characterize as definitely not having a “defined outcome.”
Just because an investment has tail risk doesn’t mean it’s bad. Buffers benefit from the fact that out-of-the-money put options have been relatively expensive and, by selling them (to create the buffer), it’s possible to potentially create attractive upside. Investing in equities involves exposure to tail risk.
The question isn’t really if you’re going to have tail risk (assuming you are going to own equities), it’s the optimal way to obtain the exposure given your risk aversion, product attributes, etc.
I’m a fan of buffer and floor approaches, and I think these strategies have the potential to significantly improve portfolios, either as ETFs or annuities (i.e., FIAs and/or RILAs).
That being said, I don’t think it’s fair to say that a product where an investor can potentially lose 30% or more has a “defined outcome.” There’s a significant degree of variation in the return profiles across these strategies and a blanket term like “defined outcome” does not accurately reflect the differences.
While I’d like to think every investor who purchases a buffer product will understand the risks of the strategy, I don’t think that’s the case. I think other words like “defensive” or “protected” do a better job describing general approaches, but I’m definitely not a marketing guy. Regardless, I’d like to see this term revisited.
David Blanchett is head of retirement research for Morningstar Investment Management LLC. Views expressed are his own and do not necessarily reflect the views of Morningstar Investment Management LLC. This blog is provided for informational purposes only and should not be construed by any person as a solicitation to effect, or attempt to effect transactions in securities or the rendering of investment advice.