Asset Location: Variable Annuities

Household Demand for Variable Annuities

Brown, Jeffrey R. and Poterba, James M., "Household Demand for Variable Annuities" (March 2004). Boston College, Center for Retirement Research Working Paper No. 2004-08.

Abstract:

Between 1990 and 2000, total sales of variable annuities in the U.S. grew from just over $5 billion to nearly $140 billion. These products now account for approximately half of all private market annuity sales. Variable annuities resemble mutual funds, but they qualify for special tax treatment as insurance products because they provide an option to convert to a life annuity. This paper describes the tax treatment of variable annuities and presents summary information on the ownership patterns for variable annuities. It also explores the relative importance of several distinct motives for household purchase of variable annuities. We use household data from the 1998 and 2001 waves of the Survey of Consumer Finances to examine ownership patterns and to test for the importance of tax and insurance considerations in variable annuity demand. We find that variable annuity ownership is highly concentrated among high income and high net wealth sub-groups of the population, although the concentration is lower than for several other categories of financial assets. We find mixed support for the role of tax considerations in generating variable annuity demand, and we outline a set of research issues that focus on household annuity purchases.

The Titanic Option: Valuation Of The Guaranteed Minimum Death Benefit In Variable Annuities And Mutual Funds

Milevsky, Moshe and Posner, Steven E.,The Journal of Risk and Insurance, 2001, Vol. 68, No. 1, 91-126.

ABSTRACT

The authors use risk-neutral option pricing theory to value the guaranteed minimum death benefit (GMDB) in variable annuities (VAs) and some recently introduced mutual funds. A variety of death benefits, such as returnof- premium, rising floors, and “ratches,” are analyzed. Specifically, the authors compute the fair insurance risk fee, charged to assets, that funds the embedded option. The authors derive analytic option prices for a simplified exponential mortality model and robust numerical estimates in the case of a properly calibrated Gompertz model. The authors label this contingent claim a Titanic option because its payoff structure is in between European and American style but is triggered by death. The authors’ main objective is to compare theoretical estimates against a cross-section of insurance risk charges, as reported by Morningstar, Inc. The authors’ main conclusion is that a simple return-of-premium death benefit is worth between one and ten basis points, depending on gender, purchase age, and asset volatility. In contrast, the median Mortality and Expense risk charge for return-of-premium variable annuities is 115 basis points. Presumably, the remaining markup can be attributed to profits, model imperfections, or, more cynically, to an implicit payment for the tax-deferral privilege.

Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options

Milevsky, M.A. and Panyagometh, Kamphol, "Variable Annuities versus Mutual Funds: A Monte Carlo Analysis of the Options" (September 2001). York-Schulich-Finance Working Paper No. MM10-1.

Abstract:

This paper quantifies the impact of return uncertainty when measuring the relative benefits of mutual funds versus variable annuities by calculating the certainty equivalents of utility. This paper points out that the possibility of an investment loss endows the holder of the mutual fund with a 'real option' to harvest those losses and this 'real option' has value and must be factored into any decision in advance.

Our main practical observation is that although we find that low-cost Variable Annuities are indeed superior to low-cost Mutual Funds for investors with a long time horizon, the critical threshold is at least 10 years for typical levels of risk aversion. If, however, we ignore the embedded options, the erroneous break-even horizon drops to 5 years. The stochasticity increases the break-even horizon.