Could Buffered Index Funds Help Struggling Public Pensions?

Commentary

Could Buffered Index Funds Help Struggling Public Pensions?

Matt Levine, author of Bloomberg’s Money Stuff blog, recently commented on an interesting financial instrument offered by Vest Financial. The CBOE (Chicago Board Options Exchange) S&P 500 Buffer Protect Strategy Fund is an index fund with a twist that could be advantageous for pension funds looking to seek the benefits of equities, which traditionally have higher rates of return, while mitigating risk.

Called a “buffered note” in bond form, it is essentially an index fund with bounded gains and a cushion to reduce losses. Investors keep all returns up to 11%, or greater depending on the particulars of the fund. For example, if the index makes a 20% return, investors keep 11%. If it makes a 5% return, the investor keeps the full 5%.

In exchange for this cap on gains, investors are protected from the first 10% of losses. If the fund experiences losses of 7%, the investor makes a 0% return, but if it experiences 12% losses, the investor experiences a loss of only 2%.

Could this be a useful tool for pension funds struggling to increase returns while minimizing risk? Using historical data from NYU, I determined what the returns for such an instrument would be for various time intervals over the past 15 years. I assumed an index based on the S&P 500, with a loss buffer of 10% and a cap on gains of 11%.

Here are the results:

Arithmetic Average Geometric Average Standard Deviation
Date Range S&P 500 Buffer Strategy S&P 500 Buffer Strategy S&P 500 Buffer Strategy
2000-2015 5.71% 3.82% 4.29% 3.48% 17.86% 10.12%
2006-2015 9.03% 4.84% 8.08% 4.61% 17.78% 11.10%
2008-2015 8.65% 3.99% 7.42% 3.60% 19.70% 12.19%

The returns are rather modest, underperforming a simple S&P 500 index fund in every time period examined, often by a wide margin. However, the standard deviation—an indicator of risk that shows the range that the rate of return is expected to fall within given a particular degree of certainty—for the buffer strategy was significantly lower than that of an S&P 500 index.

Is this buffered index fund a solution for pension funds pursuing higher gains? Clearly no. But it’s not clear that these gains are even achievable in the first place. For reference, the average assumed rate of return for pension funds in FY 2015 was about 7.62%, a figure most funds failed to meet last this year.

Still, the buffered index could be an excellent way for systems with more modest (read: realistic) rates of return to hedge against future risk. For example, the cash-balance plan set up for the Kentucky Retirement System guarantees 4% annualized returns, plus 75% of any returns above that threshold. While the data above show that this buffer strategy doesn’t quite meet that threshold, it could potentially complement the investment portfolio of a pension fund that promises modest, but consistent, returns.

Daniel Takash is a policy analyst for Reason Foundation's Pension Reform Project.