Taxation, Ratchets, and Cash Funds in Variable Annuity Withdrawal Design
Summary
This paper studies policyholder withdrawal and surrender choices in variable annuities with guaranteed minimum withdrawal benefits. The contracts include taxation and a ratchet that can raise the benefit base during the contract. The authors model the policyholder’s choices by solving a backward dynamic program that maximizes the discounted risk-neutral value of contract cash flows.
The analysis also considers hybrid contracts with a cash fund that holds earnings and accrues interest at a specified rate. The paper reports that a cash fund and a ratchet can each raise policyholder valuation, and that both may be needed to encourage demand when taxes are sufficiently high. Ratchets tend to discourage early surrender by improving downside protection; cash funds can discourage active withdrawals as policyholders may transfer guaranteed withdrawals into the fund. These are model-based conclusions whose implications depend on contract terms, tax rules, and assumptions about policyholder behavior.
Key ideas
- The study models withdrawal choices in variable annuities with guaranteed minimum withdrawal benefits.
- A backward dynamic program values discounted cash flows from the policyholder’s perspective.
- Ratchets can increase the benefit base and tend to reduce incentives for early surrender.
- A contract cash fund can change withdrawal choices through its interest rate and tax treatment.
- The reported effects depend on the modeled contract and tax conditions.
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Full text
# Variable annuities: A closer look at ratchet guarantees, hybrid contract designs, and taxation # Variable annuities: A closer look at ratchet guarantees, hybrid contract designs, and taxation 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 from the policyholder's perspective. Furthermore, inspired by 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. The policyholder's valuation of the contract increases when a cash fund is included in the contract or when the benefit base updates via a ratchet mechanism. When the tax rate is sufficiently high, including both features is necessary to stimulate demand for the contract. Furthermore, the ratchet mechanism tends to discourage early surrender as it provides enhanced downside market risk protection. Similarly, 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 and the varying taxation rules around interest earnings.
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