Variable annuities versus mutual funds: a Monte-Carlo analysis of the options

Abstract

Mutual funds and variable annuities are similar instruments that differ mainly in their tax treatment. Their relative appeal is the subject of intense debate in the industry. This paper contributes to the literature by quantifying the impact of investment return uncertainty when comparing the two. We focus on the embedded tax options using Monte-Carlo simulations. We conclude that although low-cost variable annuities are superior to low-cost mutual funds over long time horizons, the critical threshold is at least 10 years for typical levels of risk aversion. If, however, one ignores the tax options, the erroneous break-even horizon drops to 5 years.