Pension Plans and the Writing of Fully-Covered Exchange Traded Call Options

Abstract

A question facing pension managers is whether fully-covered call option writing strategies should be pursued. This study is designed to provide an answer by comparing the risk and returns of two buy-and-hold option portfolios to those of the underlying stocks and the market as a whole for May 1973 through April 1977. The conclusions are: I ) covered call options reduce the risk of equity portfolios, 2) no evidence supports the belief that a learning period favorable to option writing existed during the early years of CBOE existence, and 3) options are most likely to improve the risk-adjusted returns of equity portfolios when overall market prices are declining. With the passage of the Employee Retirement Income Security Act (ERISA) of 1974, investment managers and other fiduciaries of pension funds found themselves subject to vague, but potentially strict standards of conduct. Among other requirements, ERISA provides that individuals in charge of pension assets must act the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims [29 U.S.C.A., sec. 404(a) (1974)]. Because of this requirement, some investment managers suggested that exchange-traded call options on some or all the common stocks in pension portfolios be written in order to derive additional income from the stock portfolio while obtaining some protection against stock price declines. Rather than causing insurers and trust departments to rush to the options market to write call options for their pension business, ERISA's prudence requirement usually has been cited as a major reason for ignoring options. Some of the specific fears have been: the absence of complete regulatory acceptance, the expenses associated with managing option portfolios, conSandra G. Gustavson is Assistant Professor of Finance in the College of Commerce and Business Administration, University of Illinois at Urbana-Champaign, where she specializes in risk and insurance. She holds the Ph.D. degree and has completed several examinations administered by the Society of Actuaries. The author thanks Sophie H. Chang, Doris Gustavson, and Kathleen A. Levy for their assistance in collecting and analyzing the data. The author also is indebted to Robert I. Mehr, Frank K. Reilly, and three anonymous referees of The Journatil of Risk andbl Insurance for their helpful suggestions. This research was financially supported in part by the Research Board of the Graduate College, University of Illinois at Urbana-Champaign, and by the Department of Finance, College of Commerce and Business Administration, University of Illinois at Urbana-Champaign. Thanks are due both these academic units.