Compare Every Risk Before You Buy a Variable Annuity

Take Why Variable Annuities May Be the Riskiest Type of Annuity and What to Use Instead

Variable annuities are marketed as flexible, growth-oriented investment vehicles with insurance features. But they are also the most expensive, least predictable, and highest-risk type of annuity available. The risks don’t just come from the market—they’re baked into the product design. If you’re not careful, you could lose your money, overpay in fees, or lock yourself into an income plan that fails to meet your needs.

This complete breakdown explains each major risk of variable annuities, how it works, who it affects, and which products you should consider instead.

1. Market Losses Can Wipe Out Your Investment

How It Works: Variable annuities invest your premium into subaccounts—essentially mutual funds inside the annuity. These can include U.S. equity funds, international stocks, bonds, and even aggressive sectors like tech or emerging markets.

Why This Risk Is Unique: You can lose your original investment, even if you never withdraw a dime. This is not true for fixed annuities or fixed index annuities, which protect principal.

• Pros: Strong gains in bull markets; hundreds of investment choices.
• Cons: Direct exposure to market volatility. No downside protection. You can lose all your gains and original premium.
• Example: A $300,000 investment in subaccounts can drop to $200,000 in a crash—while still being charged fees on the full account value.
• Better Option: Fixed Index Annuities (FIAs) tie growth to a market index but protect against losses. Your worst-case return is 0%, not -30%.

2. You’ll Pay the Highest Fees in the Annuity Industry

How It Works: Variable annuities typically charge multiple layers of fees:

• Mortality & Expense Risk Fee (M&E): ~1.00%–1.25%
• Subaccount Management Fees: ~0.25%–1.50%
• Rider Fees (GLWB, enhanced death benefits, etc.): ~0.50%–1.50%
• Administrative Fees: Flat annual charges (usually $25–$50)

Why This Risk Is Unique: Fees are deducted monthly, even during market losses. Many investors don’t realize they’re paying 3%–4% or more annually, which amplifies losses and reduces compounding.

• Pros: Access to professional money management and optional benefits.
• Cons: You pay fees whether the market goes up or down. Most returns must beat a 3%–4% hurdle just to break even.
• Who Should Worry: Anyone using a variable annuity for growth. The fees will likely erode long-term returns.
• Lower-Fee Alternative: Fixed Index Annuities with a GLWB typically charge 0.95%–1.25%, or 0% for growth-only contracts without a rider.

3. Your Income Is Often Dependent on Investment Performance

How It Works: Many GLWB (Guaranteed Lifetime Withdrawal Benefit) riders in variable annuities require you to invest in “volatility control” or “balanced” subaccounts to qualify for income. Your income base may grow annually by a set percentage (often 4%–6%) or based on investment returns.

Why This Risk Is Unique: If the subaccounts perform poorly, your guaranteed income may never increase, or worse, fall short of your actual income needs in retirement.

• Pros: Flexibility in investment choice within limits.
• Cons: If the investment performs poorly or barely grows, your retirement income may fall far short of expectations.
• Example: You fund a VA with $500,000. The income base only grows to $550,000 due to poor market returns—far less than expected—and your lifetime income is lower as a result.
• Superior Strategy: Use a Fixed Index Annuity with a guaranteed income rider that grows the income base regardless of market performance.

4. You Could Be Locked Into a Long Surrender Period

How It Works: Surrender periods last 5–10 years. During this time, you’re penalized for withdrawing more than 10% annually (in most cases). The penalty starts high (up to 10%) and decreases yearly.

Why This Risk Is Unique: Surrender charges often coincide with high fees and poor liquidity, which makes accessing your own money both expensive and complicated.

• Pros: Encourages long-term commitment.
• Cons: No flexibility. If you need to cash out early for an emergency, you’ll pay.
• Who Is Vulnerable: Younger investors, people with variable income needs, or those who may need large withdrawals for emergencies or care expenses.
• Alternative: Use MYGAs (Multi-Year Guaranteed Annuities) or FIA with free withdrawal provisions. Many FIAs include penalty-free withdrawals for RMDs, nursing home stays, terminal illness, or confinement.

5. Complexity Hides the Real Costs and Risks

How It Works: Variable annuities are loaded with moving parts: multiple subaccounts, phantom income values, performance-based guarantees, and optional death or income riders. Most people don’t understand how the account value, income value, or death benefit values are calculated.

Why This Risk Is Unique: You may believe your annuity is performing well based on your “income base” or “benefit base,” but these are fictitious values that can’t be cashed out.

• Pros: Customizable contract features.
• Cons: Complex rules confuse most consumers. Misunderstanding terms leads to poor decisions and missed opportunities.
• What to Use Instead: Fixed Index Annuities with a clear income benefit. You’ll know exactly how your income is calculated and what your heirs will receive.

6. Poor Tax Efficiency on Withdrawals

How It Works: Withdrawals are taxed as ordinary income, not capital gains. The IRS uses the Last-In, First-Out (LIFO) method, meaning you pay taxes on earnings first. Withdrawals before age 59½ may also be hit with a 10% IRS penalty.

Why This Risk Is Unique: Unlike brokerage accounts or Roth IRAs, variable annuities do not benefit from lower long-term capital gains rates.

• Pros: Tax-deferred accumulation.
• Cons: High income taxes in retirement, especially for high-income households.
• Tip: Use non-qualified funds for an annuity if you’re in a lower tax bracket or need tax deferral.
• Alternative Strategy: Use permanent life insurance (IUL or whole life) with tax-free withdrawals or Roth IRAs for tax-free income in retirement.

7. Insurance Company Solvency Risk

How It Works: Your contract is backed by an insurance company, not a bank or federal agency. State Guaranty Associations only offer limited protection, usually $100,000 to $250,000 per contract owner, per company.

Why This Risk Is Unique: Many investors falsely believe annuities are “guaranteed,” not realizing the insurance company’s financial strength is critical.

• Pros: Top-rated insurers are very stable.
• Cons: B-rated carriers offering high bonuses may collapse in downturns, and you could lose guaranteed income and benefits above the state limits.
• Best Practice: Work with a broker who can split large premiums across multiple A-rated carriers to maximize coverage and safety.

Don’t Overlook These Safer Alternatives:

Final Verdict: Who Should and Shouldn’t Buy Variable Annuities

Buy a Variable Annuity If:

• You have maxed out your qualified plans and want to invest more tax-deferred money.
• You work with a fiduciary-level advisor who can monitor and adjust subaccounts regularly.
• You’re comfortable with risk and understand the complex structure of your contract.

Avoid Variable Annuities If:

• You need a guaranteed income soon.
• You want principal protection and lower fees.
• You dislike complexity or lack a strong advisor relationship.
• You want transparency, lower costs, and guaranteed income.

Conclusion: Given these risks, you might want to see the top reasons not to buy a variable annuity and why many financial experts recommend Fixed Index Annuities instead.

Your Next Steps

Don’t go it alone. The smartest way to plan is to reverse-engineer your goal:

• If you want a lifetime income, find the annuity that pays the highest guaranteed withdrawal.
• If you want safe growth, use a MYGA or FIA.
• If you want legacy planning and tax-free access, use permanent life insurance.

Contact The Annuity Expert for a free quote comparison and consultation. We’ll help you compare all types of annuities and insurance solutions side-by-side to make sure you don’t overpay, underperform, or risk your retirement income.

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