How Retirees Can Invest with Downside Protection

Retirement presents a unique set of financial challenges for portfolio construction. Many retirees look for ways to generate returns while minimizing risk, especially after spending decades accumulating wealth. At Client First Capital our goal is to protect, preserve and compound.  Our portfolio construction is built with two independent portfolios and, depending on our client’s needs, we tailor the mix between these two solutions based on meeting their retirement planning goal and ability to take on risk. 

1. One Portfolio – This portfolio takes on market risk with a flexible, sector-based approach.

2. Defined Outcomes Portfolio – A lower-risk portfolio designed to offer downside protection.

For the past several years through Covid our Defined Outcome portfolio has mainly been in Treasuries between 1-9 months as we have had an inverted yield curve and increasing rate environment.  That has changed with the Fed reducing rates by 50 basis points several weeks back.  With this rate change, other opportunities have become more attractive, and we have started to layer in buffered ETF solutions into our portfolio construction for our Defined Outcomes portfolio. 

What are Buffered ETFs?

Buffered solutions are not a new product; they have existed since the early 90s in the form of LP agreements such as interval funds or structured notes.  What is new however is the construction of this solution in an ETF that provides delayed liquidity.  This financial instrument allows retirees to participate in the market while having daily liquidity, making it an attractive option for retirees.  In this article we aim to explain the first buffered ETF added (Ticker SMAX) to our model.

How Do Buffered ETF’s Work?

Below is a simplified explanation of how the SMAX ETF works:

Step 1 - Equity Exposure: The ETF invests in the iShares Core S&P 500 ETF (IVV), which tracks large U.S. companies and forms the growth part of the investment, and provides broad equity market exposure to large-cap U.S. stocks. This forms the foundation of the ETF’s growth potential and  is the same ETF that we use in our One Portfolio.  

Step 2 - Downside Protection: To implement the downside protection, the ETF buys downside protection via an at-the-money put option. This option ensures that if the underlying asset declines in value during the hedge period, the ETF will receive a payout that helps offset losses, effectively providing the full buffer against market downturns.

Step 3- Paying for Protection: To pay for the protection the ETF sells away the upside potential via selling a call option.  The revenue from the upside call option is equal to the cost of the protection. The sale of this call option results in a cap on the gains the ETF can achieve during the hedge period. This trade-off allows the ETF to offer up to 100% downside protection while still participating in market gains up to the cap.  The SMAX ETF was issued with a gross cap of 7.91%.  Meaning that the minimum income needed to cover the protection resulted in a cap = 7.91%.

Step 4 - Timeframe: Each buffer ETF operates within a hedge period, during which both the downside buffer and upside cap are active.   This allows the pricing, cap and downside protection to be maximized based on current conditions on the start of the interval period. Therefore, the ETF will renew each year with a new value(NAV) based on the outcomes of the previous year and a new cap based on the cost of the options to protect the next period.  

Most buffered ETFs have 4 main time horizons: 3 months, 6 months, 1 year and 2 years.   In our defined outcome portfolio we are targeting a duration of less than 3 years of all assets in this model.  SMAX specifically has a duration of 12 months.  We believe that the Fed is reducing interest rates in an environment that will create increasing pressure on inflation to re-accelerate in the back half of 2025.  We don’t have a crystal ball but we are watching the core components of inflation and the rate of changes within core CPI and we will adjust accordingly.  

How Buffered ETFs Help Retirees

The key feature of the iShares SMAX Buffer ETFs is their ability to protect against virtually 100% of losses over a specified 12-month period, if held for the entire duration. This offers retirees peace of mind during periods of market decline, helping them avoid significant losses that could harm their financial stability during retirement.   While the downside protection provides a safety net, SMAX also allows investors to participate in market gains. However, this upside is capped (7.91% gross), meaning that there is a limit to how much return investors can expect over the hedge period. The cap is determined at the start of each 12-month hedge period, based on market conditions, and resets annually.

Why Include Buffered ETFs in a Retirement Portfolio?

For retirees, safeguarding the wealth they have worked hard to build is often a primary concern. Here are several key advantages make Buffer ETFs a valuable addition to retirement portfolios:

1. Protect Against Market Volatility
The bond markets can be unpredictable, especially in times of economic uncertainty. The downside protection offered by Buffer ETFs allows retirees to stay invested without the fear of losing a significant portion of their assets. If the market experiences a decline during the hedge period, the buffer feature steps in to minimize losses, providing a cushion against volatility.  However if the markets continue to grow then retirees can earn a higher total return than being invested in short duration bonds.

2. Low Costs 

Buffered products used to cost in excess of 1.5% and with no liquidity until the end of the term but with competition and evolution in the ETF space the structure of this product is now offered with daily liquidity and low fees. With a net expense ratio of 0.50%, iShares Max Buffer ETFs offer one of the lowest-cost options available in the industry. This helps to maximize returns over time by minimizing the impact of fees on investment performance.  After surveying many other ETF options for the 3rd quarter, this is the strongest competitor found we found in this space (ZOCT - Innovator Equity Defined Protection ETF (innovatoretfs.com)).

3. Peace of Mind
To provide a competitive solution that helps hedge against inflation in a way that limits downside there are very few options.  About half of our clients are approaching 75+ and the balance of having funds available today and being able to sleep well, as well as continuing to grow a legacy provide complex challenges.  Buffered ETFs have the potential to become about 20-50% of our Defined Outcome Portfolio if rates continue to decline.  

For retirees who have a larger allocation to our Defined Outcome portfolio, max buffered ETFs have an ability to reduce concerns about market volatility but still participate in market growth.  By offering up to 100% downside protection with capped upside potential, these ETFs strike a unique balance between risk and reward. While there are always risks to consider, Max Buffer ETFs can provide retirees with peace of mind and financial security in uncertain markets.

As always, it’s important to review your balance between our low risk defined outcomes solution and our CFC One Portfolio. If you have questions about whether your tailored investment strategy aligns with your retirement objectives, please reach out.   

Finding the Right Balance

At Client First Capital, we tailor investment strategies to meet your retirement goals. Buffered ETFs like SMAX offer retirees a unique opportunity to protect their wealth while still participating in market gains. If you’re unsure about how your current investments align with your objectives, feel free to reach out to us for guidance.

Go Padres!