Is use of long-term stock index call options effective for those approaching retirement with desires of limiting exposure to crashes without sacrificing all benefit of equity exposure? In his January 2015 paper entitled “Individuals Approaching Retirement Have Options (Literally) to Secure a Comfortable Retirement”, Bryan Foltice proposes retirement strategies that employ stock index options during the five years before retirement (when prospective retirees tend to become very risk-averse) to limit equity risk while retaining some reward. These alternatives to conventional (100% stocks, 60%-40% stocks-bonds and 100% minus age in stocks) asset allocation strategies put core funds in Treasury Inflation-Protected Securities (TIPS) to secure retirement income at a real 75% of final working income and funds in excess of the core to buy long-term at-the-money stock index call options. He considers three option-based strategies:
- Buy 5-year options at age 60.
- Buy a 3-year option at age 60 and a 2-year option at age 63.
- Buy 1-year call options each year using the final five annual contributions.
Base modeling assumptions use 1928-2013 historical return statistics, with robustness tests assuming (1) an increased equity risk premium and (2) expectations derived from 2014 data through October. Modeling includes expected costs/fees. Using simulations based on estimates for U.S. stock market capital gains/dividends and for the TIPS real yield, he finds that:
- Conventional retirement allocations for a 60-year old with funds estimated to support retirement at 80% of final working income for the next 20 years:
- Generate higher returns than the option-based strategies over next five years, and are thus preferable to investors who are not risk-averse.
- Fail to sustain retirement at age 65 at a real 75% (80%) of final working income about a quarter (third) of the time.
- Option-based allocations for the same prospective retiree:
- Exhibit more right-skewed return distributions than conventional allocations and thus become preferable over the next five years to investors with moderate to high levels of relative risk aversion.
- Never fail to provide sufficient funds for retirement at age 65 at a real 75% of final working income, and fail to provide a real 80% of final working income about a third of the time.
In summary, evidence from simulations indicate that individuals approaching retirement with moderate to high levels of risk aversion should consider substituting stock index call options for stocks late in pre-retirement.
- Findings are subject to modeling assumptions that may be inaccurate.
- As noted in the paper, five-year stock index call options are not widely available.
