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

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.