Advisor Case Studies

Advisor Case Studies

Covering Required Minimum Distributions with Covered Calls

The couple had worked in the Texas oil industry for years. They had a combined $1 million in two 401(k)s. But that money was invested entirely in the stock of their former employer. Both were over the age of 70 1/2 and had to take required minimum distributions (RMDs). However, they didn't want to sell any of their stock to do so.

The pair brought their dilemma to Tom Badgett, a financial adviser with Bay Area Asset Management, which manages approximately $22 million for 55 clients in Baytown, Texas. Mr. Badgett is also affiliated with independent broker-dealer MoneyBlock.

"I was initially concerned about the single-stock concentration, but the couple had loyalty to the company and wanted to stay invested in it," Mr. Badgett says. So he undertook a full portfolio review to determine a course of action.

The couple had more than $5 million worth of other investments, including stocks, bonds, cash and real estate, which gave them plenty of diversification. They also each had a pension that provided them with enough income to cover their living expenses. Given the breadth of their potential income sources, Mr. Badgett felt comfortable crafting a plan that allowed them to keep all their company shares.

The combined RMDs from their 401(k)s were $36,500 a year. Their shares of company stock provided a dividend of about $27,600 a year - so Mr. Badgett only needed to find a way to make up the remaining $8,900 without cashing in any of those shares.

His solution: A covered call strategy. The premium the couple would earn from selling the calls could generate the cash to cover their RMD shortfall. However, 401(k)s typically don't allow investors to do any sort of options trading, so the first step was to roll the stockholdings into two individual retirement accounts.

Once that was done, Mr. Badgett had to decide on a price at which to sell the calls. To do so, he looked at the two-year returns for the stock, which were about 1.2% a month. Then, to minimize the possibility of the options being exercised by the buyer, he tripled that average return number to establish a strike price--making it unlikely that the shares would reach the call point.

For example, if the company stock was selling for $102 a share, Mr. Badgett would set a call price 3.6% higher, or about $106. Mr. Badgett gets about 15 cents a share by selling calls, so by creating option contracts on a total of 10,000 of the couple's shares, he can generate about $1,450 a month, after commissions.

Mr. Badgett suggested using weekly option contracts to provide flexibility in case market conditions were unfavorable. Then, they only had to use the strategy eight times a year to cover their RMD shortages.

The adviser also made sure that his clients understood the risk of the strategy - primarily that the stock could be called away. However, he explained that he could protect against that scenario by buying the option back before it could be exercised. In a worst-case scenario, if the stock is called away, he could buy shares back if the price fell below the strike price again.

The clients were willing to accept those risks, figuring that the strategy offered them a chance to preserve shares they would otherwise have to sell just to make their RMDs.

MoneyBlock is an independent broker-dealer supporting investment professionals, including those using options. Options involve risk and are not suitable for all investors. Prior to investing in options, please read ?Characteristics and Risks of Standardized Options? available from The Options Clearing Corporation or MoneyBlock (call: 1-800-591-8243) upon request.