We all have our unique vision of what retirement will be. Transforming your own vision into reality may depend on how effectively you can protect your wealth and maintain your lifestyle as you enter retirement.
Generating returns necessary to keep pace with the cost of living usually means having to increase your allocation to riskier asset classes such as equities or commodities. In retirement, however, it is especially important to find the right balance between risk and return. One way is to add structured products to your holdings, which can provide potentially higher returns of riskier asset classes while limiting your downside exposure.
Structured product strategies can help protect your capital while participating in market returns.
100 PERCENT PRINCIPAL PROTECTION NOTES (PPNS)
PPNs are an attractive complement to traditional bond investments. PPNs protect 100% of your investment if held to maturity and provide participation in the growth of an underlying asset such as a stock, basket of stocks, indexes and commodities. The return on PPNs at maturity varies based on the performance of the underlying asset, providing the opportunity to outperform the total interest payments you would have received on a typical bond.
A recent retiree, Michael is concerned about taking on additional investment risk. But exposure to riskier asset classes may provide the returns necessary for the retirement he envisions. His portfolio is 50% equities, 40 percent bonds and 10% cash. His bond holdings include several fixed interest rate bonds paying an average interest rate of 5%.
Michael’s financial advisor recommends investing a portion of his bond portfolio in to a 100 percent principal protection note linked to the S&P 500, which would protect his investment at maturity and pay an additional payment if the index rises over the term of the note.
Investment in PPN: $10,000 Additional payment at maturity (if index return is positive) Index return x $10,000 Time to note maturity: seven years
The index rises by 75percent during the seven-year term of the PPN. At maturity, Michael receives his initial $10,000 investment plus an additional $7,500 payment based on the return of the index (75 per- cent index return x $10,000 investment), or a gain of 75 percent, equivalent to an annualized return of 8.32 percent.
If Michael had kept his bond portfolio unchanged, he would have been paid an average interest rate of 5 percent for seven years, for a total return of 35percent (or $3,500 in interest per $10,000). In this example, the PPN would have outperformed the bond portfolio.
Conversely, if the index declined by 20 percent during the seven- year term of the PPN, Michael would receive his $10,000 investment and be protected from the decline in the market. Because no additional payment was made on the PPN, the PPN would have underperformed the bond portfolio by the interest paid on the bond portfolio (35 per- cent or $3,500).
PPNs allow you to participate in the positive performance of the under- lying market while protecting your investment at maturity from any negative performance.
PERFORMANCE SECURITIES WITH PARTIAL PROTECTION (PSPPS) PSPPs protect the first 10 to 25percent of your investment at maturity and provide greater participation than PPNs in the growth potential of a specific market. With PSPPs, you will only have downside market exposure beyond a specified protection level.
George is five years from retirement and looking for strategies to grow his investment portfolio, which is 55 percent equities, 40 percent bonds and 5 percent cash. He has some international exposure through an Exchange Traded Fund (ETF) and wants more international exposure, but is concerned about taking on more risk.
George’s financial advisor recommends investing a portion of his equity portfolio in a PSPP linked to an international index. The PSPP provides him with international equity exposure but also provides protection from moderate market declines if held to maturity.
Investment in PSPP: $10,000 Participation rate: 120 percent Protection percentage: 20 percent Time to note maturity: four years
The level of the index rises by 40 percent over the four-year term of the PSPP. George receives his initial $10,000 plus an additional $4,800 based on the return of the index (120 percent participation x 40 per- cent index return x $10,000 investment). His investment results in a gain of 48 percent, or an annualized return of 10.30 percent.
Had George invested his $10,000 in an ETF that tracked the performance of the index, he would have a gain of $4,000, or 40 percent, equivalent to an annualized return of 8.78 percent.
Conversely, if the market had declined by 30percent over the term of the PSPP, he would have been exposed to any decline in the index beyond the 20 percent protection percentage, and would have received back $9,000 of his investment at maturity, a loss of $1,000, or 10 per- cent, equivalent to an annualized return of -2.60 percent.
Had George kept his $10,000 invested in an ETF that tracked the performance of the index, he would have realized a loss of $3,000, or 30 percent, or an annualized return of -8.53 percent.
PSPPs can provide enhanced exposure to the performance of the underlying market while protecting a portion of the investment at maturity.