Concerned with clients’ peace of mind, advisors naturally make recommendations to accommodate their risk tolerances and assuage their fears.

Toward this goal, many advisors suggest popular buffered or structured equity-based products. Although some clients genuinely fear the volatility that these products are sold to protect against, some advisors’ assumptions about the source of this anxiety may reflect fears of their own.

Structured/buffered products give clients peace of mind, but this peace comes at the cost of substantially lower net returns—to protect against risk that’s demonstrably so minimal as to be insignificant. This is clear from the findings of my firm’s recent comparison study of the S&P 500 and versus some present-day buffered products.

The retrospective study examined hypothetical returns from a currently common type of buffered CD investment linked to the performance of the S&P 500—one with a three-year term and another with a five-year term. Each product guarantees return of principal, plus 100% of the index’s positive return—capped at about 22% for the three-year and 45.5% for the five-year.

Nearly Twice The Returns
Our comparison study tracked hypothetical returns from 1946 through 2022. Investors who bought the index did far better than owners of the buffered products would have. This really shouldn’t be surprising, considering that in the 77 years between 1946 through 2022, there were 61 positive total-return years and only 16 negative years for the S&P 500. Over rolling three-year periods since 1946, only 8 out of 75 were negative—a super All-Star-level batting average of .893.

Since 1946, using three-year rolling returns, $100,000 invested would have grown to an average of over $142,000. However, during the last 20 years that same $100,000 would have only grown to a bit more than $132,000. The poorer returns from 2002 through 2022 are probably due to the dotcom, Great Recession and Covid-19 related bear markets.

Even though gains were mediocre during this period, the index’s returns far outpaced what would have resulted from buffered products. For those 20 years, the total cumulative return of the index from rolling three-year periods was 9.9% per year, compared with little more than half that figure, 5.4%, for the three-year buffered CD. Investors in this product would have missed out on average gains of 4.5% per year.

Regarding rolling five-year periods since 1946, the index’s total average annual return was 8.9% compared with only 4.7% for the buffered five-year CD. So, investors in this product would have missed out on 4.2% in annual returns.

The contrast in extrapolations for wealth creation over time is nothing less than jaw- dropping. Using an annual return advantage of only 3% (to be conservative), we ran a hypothetical accumulation-phase comparison of returns from an equities portfolio starting with $1,000,000. With the additional 3% per year, the assumed average annual return was 9% from direct investment versus 6% from buffered products. After 10 years, direct investment resulted in an account totaling nearly $2.4 million, compared with about $1.8 million for the buffered products. After 25 years, this difference would be $8.62 million versus $4.92 million. Millions and millions left on the table.

Whose Fear Is It?
When advisors suggest structured or buffered products, many clients are, of course, inclined to embrace the idea. Yet advisors first might want to consider these two questions:

1.  What fears actually drive your clients’ notions of risk?
2.  Are these your clients’ fears—or your own?

More than a few advisors tend to get twisted up about volatility. Some actually fear volatility but many others are simply afraid that its short-term impacts on account totals might jeopardize client relationships.

Yet long term, volatility really isn’t a risk, and more clients may know this than some advisors probably think.

About 39% of individual investors middle-aged and older have said in surveys that volatility has been so common in recent years that they don’t worry about it anymore. Only about 15% of older investors say volatility keeps them up at night, compared with 54% of millennials. Instead, these older clients say they worry about loss of capital.

A Solution Without A Problem
They are in good company. “Volatility is not synonymous with risk,” Warren Buffett once said, explaining that business schools teach this subject all wrong. Other renowned institutional investors agree. The biggest actual risk, they say, echoing the view of many individual investors, is permanent loss of capital. Hence, for such clients, structured or buffered products would be a solution without a problem.

HNW clients with ample and varied resources can leave money in the market to reap its returns, inherently girded against risk by long-term averages. While many of these clients may know that volatility isn’t a real risk, outliving their money might be—but not for the reason they probably assume.

Many clients and advisors focus on life expectancy at birth—currently 73 years for men and 79 for women, according to the Organization for Economic Co-operation and Development. But clients approaching retirement should instead be focusing on average life expectancy after 65. For men individually, that number is 17 years and for women individually, 20 years.   

But for 65-year-old couples, life expectancy is longer. There’s a 50% chance that one of the two partners or spouses will live to between 93 to 95, according to actuarial projections.

Growth Amid Withdrawals
So living much longer than expected can be a real risk to the staying power of retirement resources. The superior returns of direct investing can go a long way toward reducing that risk.

The same conservative hypothetical return assumption used in the accumulation-phase comparison—a 3% average annual advantage for direct investing—would result in an equally dramatic difference during the distribution (decumulation) phase. After withdrawing 4.8% annually (plus a CPI increase) from a $1 million equities portfolio for 25 years, direct investors would have a rising account total of $2.9 million and buffered investors, a declining account of only $390,000.

If they retire at 65 and live well into their 90s, the buffered investors in this scenario might run out of money. Even if they didn’t, they wouldn’t have much of a legacy for their children—in sharp contrast with the rich legacies accumulated by direct investors.

Investment companies offering structured and buffered products generally buy puts to protect against downside risk, while investment managers who monetize volatility sell puts to earn income for clients. Some clients might accept a bit more volatility in exchange for higher average returns. Instead of spending clients’ money on fees for investment insurance they’re extremely unlikely to need, why not position them to collect money indirectly from other people who are buying insurance that they rarely, if ever, collect on?

Investors who use these products may give up 4 to 5% in returns annually for insurance, while investment managers selling puts as part of S&P 500 options-overlay strategy can collect roughly the same amount. Not surprisingly this is about the same difference between implied and realized volatility.

The similarity of these numbers illustrates the give-and-take dynamic between the business of harvesting volatility on one hand and that of insuring against it on the other.

The question for advisors is which side of this trade they want their clients to be on. Making this choice intelligently may require education on the true impacts of volatility—in some cases, for advisors as well as clients.

Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Innovative Portfolios, an institutional money management firm, and Sheaff Brock Investment Advisors, a firm serving individual investors. Based in Indianapolis, the firms manage assets of about $1.3 billion. Investments mentioned in the article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons.