Cheaper by the Bundle: The Interaction of Frictions and Option Exercise in Variable Annuities

Abstract

Typical Variable Annuity products combine complex baseline contracts at considerable fees with optional guarantees. We argue this product design is driven by benefits of bundling to the provider, to the extent that the baseline option features can reduce total replication value. This is possible due to market frictions, and particularly taxation rules, affecting policyholder exercise behavior. We demonstrate the relevance of this mechanism in the context of popular withdrawal guarantees, both theoretically and empirically. Specifically, we show that in the presence of personal taxes, adding on a common death benefit at baseline decreases the total contract value to the provider.