How Variable Annuities Work
A variable annuity is an insurance contract that allows you to invest in a menu of subaccounts—essentially mutual fund clones inside an insurance wrapper. Your account value goes up or down based on the performance of these investments. The product is technically designed to grow your retirement savings and potentially provide income later through annuitization or a Guaranteed Lifetime Withdrawal Benefit (GLWB) rider.
You can fund a variable annuity using:
- Qualified funds (Traditional IRA, Roth IRA, 403(b), 401(k) rollover)
- Non-qualified funds (bank or brokerage accounts)
The growth inside the annuity is tax-deferred, but once you begin withdrawing, earnings are taxed at ordinary income tax rates, not capital gains.
Pros of a Variable Annuity
- Tax-deferred growth: Ideal for high-income earners investing non-qualified funds who want to defer taxes until retirement.
- Unlimited contributions (non-qualified funds): No IRS cap, like there is with IRAs and 401(k)s.
- Optional lifetime income: GLWB riders can turn the annuity into guaranteed lifetime income, regardless of market performance.
- Death benefit guarantees: Most contracts ensure your beneficiaries receive at least your initial investment (minus withdrawals) even if your investments lose value.
- Market participation: You can invest in diversified portfolios for potentially higher returns over the long term.
The High Cost of Variable Annuities: The Most Expensive Annuity Type
Variable annuities are by far the most expensive type of annuity. These products include several layers of fees that eat away at your returns—even in years when your investments perform well. Here’s a breakdown:
- Fee Type: Typical Cost – Explanation
- Mortality & Expense (M&E) Risk Charge: 1.25% – 1.50% – Covers the insurance company’s risk of guaranteeing benefits and providing services.
- Investment Subaccount Fees: 0.50% – 2.00% – Each subaccount charges fund-level management fees. These are ongoing and not optional.
- GLWB or GMIB Rider Fees: 0.90% – 1.50% – Lifetime income or benefit riders cost extra, even if you never use them.
- Administrative Fees: 0.10% – 0.30% – These may be added on top of other charges.
- Total Annual Fees: 2.5% – 4.5% – Some contracts exceed 4%, significantly reducing your long-term compounding power.
The high fees create a significant drag on performance. If the market returns 7% and you’re paying 4% in total fees, your net growth is only 3%—and that’s before taxes.
Cons of a Variable Annuity
- Most expensive annuity: Total annual fees are 3–4 times higher than other types, like fixed indexed annuities or MYGAs.
- Principal loss risk: Unless you pay extra for riders, your principal is subject to market volatility.
- Complicated riders and contract terms: Income benefit values, roll-up rates, and performance triggers can confuse even seasoned investors.
- Ordinary income tax on withdrawals: Unlike mutual funds or ETFs, you don’t receive long-term capital gains treatment.
- Surrender charges and lock-up periods: Withdrawing during the surrender period (often 7–10 years) results in penalties and tax consequences.
- Redundant tax deferral in retirement accounts: Using variable annuities inside an IRA is redundant and adds unnecessary costs.
Warning: The biggest “Con” is the risk profile. Read our breakdown of every variable annuity risk you need to know—from market losses to fee drag—before you sign a contract.
Who Should Consider a Variable Annuity
- High-income earners who’ve maxed out all other tax-deferred accounts and want market exposure with tax deferral.
- Individuals who want a guaranteed lifetime income and are willing to pay high fees to access future income via a GLWB rider.
- Those who expect to live a long time, making the income rider worthwhile despite high upfront costs.
Who Should Avoid a Variable Annuity
- Anyone who wants low-cost investing, mutual funds, or ETFs should consider them more transparent and cheaper.
- Pre-retirees seeking principal protection and low fees—a Fixed Indexed Annuity is safer and simpler.
- Investors funding the annuity with an IRA or 401(k)—since these accounts already offer tax deferral, there’s no added benefit and only added cost.
- For people who are uncomfortable with complex contracts and market losses, variable annuities are not beginner-friendly.
Better Alternatives for Most Americans
- Fixed Indexed Annuity (FIA): Offers market-linked growth with no risk of loss, an optional GLWB rider for lifetime income, and annual interest lock-in. No M&E fees.
- Multi-Year Guaranteed Annuity (MYGA): Works like a CD with higher, tax-deferred interest rates. No fees or market exposure. Ideal for 3–10 year savings goals.
- Deferred Income Annuity (DIA): Ideal for those who want to defer income for 5+ years. Offers predictable future payouts with no fees or complexity.
- Life Insurance with Long-Term Care Riders: Provides death benefit, cash value growth, and optional LTC funding—can be more efficient than annuities for legacy and care needs.
Annuities With GLWBs: The Better Way to Secure Lifetime Income
Fixed Indexed Annuities with GLWB riders allow you to secure lifetime income without ever risking your principal. Unlike variable annuities, FIAs don’t invest in the market—they measure the market. That means:
- You earn interest based on an index (like the S&P 500), but your money is never exposed to loss.
- Income payments can be higher than annuitization and remain in your control.
- Any remaining funds pass to beneficiaries—no loss to the insurance company upon death.
The Bottom Line
Variable annuities may look appealing on the surface—offering tax deferral, market growth, and income options—but they’re the most expensive annuity you can buy. The layers of fees, investment risk, and complexity make them a poor fit for most Americans. Unless you’ve exhausted every other option, you’re often better served with a Fixed Indexed Annuity with a GLWB or a MYGA for safe accumulation.
Compare before you commit. Contact The Annuity Expert for free quotes and guidance on which annuity is right for you, based on what you want to accomplish, not what a product wants to sell you.
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