Variable annuities: A closer look at ratchet guarantees, hybrid contract designs, and taxation

TL;DR

This paper analyzes variable annuity contracts with ratchet guarantees, hybrid features, and taxation, revealing how these elements interact to influence policyholder behavior and contract attractiveness.

Contribution

It introduces a comprehensive model incorporating taxation, cash funds, and ratchet mechanisms, highlighting their combined effects on policyholder decisions and contract value.

Findings

Taxation significantly impacts policyholder incentives.

Ratchet mechanisms discourage early surrender.

Cash funds influence withdrawal strategies.

Abstract

This paper investigates optimal withdrawal strategies and behavior of policyholders in a variable annuity (VA) contract with a guaranteed minimum withdrawal benefit (GMWB) rider incorporating taxation and a ratchet mechanism for enhancing the benefit base during the life of the contract. Mathematically, this is accomplished by solving a backward dynamic programming problem associated with optimizing the discounted risk-neutral expectation of cash flows from the contract. Furthermore, reflecting traded VA contracts in the market, we consider hybrid products providing policyholders access to a cash fund which functions as an intermediate repository of earnings from the VA and earns interest at a contractually specified cash rate. We contribute to the literature by revealing several significant interactions among taxation, the cash fund, and the benefit base update mechanism. When tax rates are high, the tax-shielding effect of the cash fund, which is taxed differently from ordinary withdrawals from the VA, plays a significant role in enhancing the attractiveness of the overall contract. Furthermore, the ratchet benefit base update scheme (in contrast to the ubiquitous return-of-premium specification in the literature) tends to discourage early surrender as it provides enhanced downside market risk protection. In addition, the cash fund discourages active withdrawals, with policyholders preferring to transfer the guaranteed withdrawal amount to the cash fund to leverage the cash fund rate.