Variable annuities were once one of the most popular retirement products in America. In the 1990s and early 2000s, they were sold by the millions, often to retirees who were told they offered the best of both worlds: market growth potential and guaranteed income. The reality, for many of those buyers, turned out to be considerably more complicated.
Understanding what a variable annuity actually is, how it works, and where it fits (or does not fit) in a retirement plan is worth your time, even if you already own one. Especially if you already own one.
What a Variable Annuity Is
A variable annuity is an insurance contract that allows you to invest your premium in a set of investment options called subaccounts. These subaccounts function similarly to mutual funds, and their value rises and falls with the market. Unlike a fixed annuity or a fixed indexed annuity, there is no floor on your account value. If the markets decline, your account value declines with them.1
In exchange for taking on that market risk, you receive two things that a standard brokerage account does not provide: tax-deferred growth (you do not pay taxes on gains until you withdraw them) and access to optional insurance features, such as a guaranteed lifetime income rider or a death benefit guarantee.
The contract is technically an insurance product, which means it is regulated by state insurance departments. However, because the subaccounts are securities, variable annuities are also regulated by the SEC and FINRA, and the agents who sell them must hold a securities license.2
The Fee Structure: What You are Actually Paying
This is where most variable annuity conversations go wrong. The fees are real, they are significant, and they are almost never presented clearly in a sales conversation.
A variable annuity with a guaranteed lifetime withdrawal benefit (GLWB) rider costs the average contract owner roughly 3.3% per year in total annual charges.3 That figure does not appear on any single line of the contract, because the costs are distributed across multiple layers, each disclosed separately in the prospectus.
The six fee layers are as follows. The mortality and expense (M&E) charge, which averages 1.19% annually, compensates the insurer for guaranteeing a death benefit and assuming administrative expense risk. The administrative charge, averaging 0.18%, covers recordkeeping and statements. Subaccount management fees, averaging 0.94%, cover portfolio management within each investment option (similar to a mutual fund expense ratio). A contract maintenance fee may apply, though it is often waived on larger balances. Optional rider costs, such as the GLWB, average 1.06% per year of the benefit base. And surrender charges (contingent deferred sales charges) typically start at 5% to 8% on withdrawals that exceed the annual free withdrawal allowance, declining by roughly 1% per year over a 6- to 8-year period.3
To put this in concrete terms: on a $500,000 variable annuity with a GLWB rider, a 3.3% total annual cost equals $16,500 per year in charges. Over 20 years, even before compounding, that is $330,000 in fees. The actual drag on wealth accumulation is considerably higher when you account for the investment returns those dollars would have generated if they had not been deducted.
The Tax Deferral Argument: Less Compelling Than It Sounds
The most common justification for variable annuities is tax deferral. Gains inside the contract grow without being taxed each year, which sounds appealing. But this argument has several important limitations.
First, if you are purchasing a variable annuity inside an IRA or 401(k), you are already getting tax deferral from the retirement account itself. Adding an annuity wrapper inside a tax-deferred account provides no additional tax benefit, and the SEC has specifically noted this concern in its investor guidance on variable annuities.4 You are paying insurance fees for a tax benefit you already have.
Second, when you eventually withdraw money from a variable annuity, all gains are taxed as ordinary income, not at the lower long-term capital gains rates that apply to investments held in a taxable brokerage account. For investors in the 22% or 24% federal bracket, this can actually make the variable annuity less tax-efficient than a simple taxable brokerage account over long holding periods, particularly if the investments inside would otherwise qualify for the 15% or 20% long-term capital gains rate.
Third, the tax deferral benefit only materializes if you hold the contract long enough for the compounding advantage to outweigh the fee drag. At a 3.3% annual cost, the math rarely works in the investor's favor unless the holding period is very long and the investor is in a high tax bracket throughout.
The Principal Risk That Often Goes Unmentioned
Fixed annuities and fixed indexed annuities protect your principal from market losses. Variable annuities do not.
Your subaccount investments are subject to full market risk. If the S&P 500 falls 40%, as it did in 2008 and 2009, and your subaccounts are invested in equity funds, your account value falls accordingly. The insurance wrapper does not change this.1
Many variable annuities include a "guaranteed minimum death benefit" (GMDB) that ensures your beneficiaries receive at least the amount you originally invested if you die when the account is underwater. But this is a death benefit, not a living benefit. It protects your heirs, not you.
The GLWB rider does provide a form of living protection: it guarantees a minimum withdrawal amount for life, even if the account value drops to zero. But this guarantee comes at a cost (that 1.06% annual rider charge), and it only applies to withdrawals taken according to the contract's rules. Accessing your money outside those rules, or surrendering the contract, forfeits the guarantee entirely.
Surrender Charges: The Liquidity Trap
Most commission-based variable annuities impose surrender charges on withdrawals that exceed the annual free withdrawal allowance (typically 10% of contract value per year) during the surrender period.
A common surrender charge schedule looks like this: 7% in years one and two, declining by 1% per year to zero after year seven. That means if you invest $500,000 and need to access more than $50,000 in year one, you pay a 7% penalty on the excess, which could amount to thousands of dollars.
One detail that is frequently misunderstood: each new deposit into the contract starts its own surrender clock.3 A client who invests $300,000 in year one and adds $100,000 in year four has two separate surrender schedules running simultaneously. The original deposit may be fully liquid by year seven, while the later addition remains subject to charges for several more years.
When a Variable Annuity Might Make Sense
Variable annuities are not universally bad products. There are specific situations where they can serve a legitimate purpose.
For high-income earners who have already maxed out their 401(k), IRA, and other tax-advantaged accounts, a variable annuity in a taxable account can provide additional tax deferral on investment gains. In this scenario, the tax benefit is real because there is no other vehicle providing deferral. The math still requires careful analysis, but the argument is at least coherent.
For investors who want equity market exposure combined with a guaranteed lifetime income floor, a fee-based variable annuity (sometimes called an I-share contract) with low-cost index subaccounts and a GLWB rider can be a reasonable tool. Fee-based contracts carry significantly lower base costs, with total annual charges (excluding the rider) as low as 0.35% to 1.05%.3 Adding a GLWB rider brings the total to roughly 1.85% to 2.70%, which is still meaningful but considerably more defensible than a commission-based contract.
The key distinction is whether the product was designed for the client's actual needs or sold primarily because it generated a large commission. FINRA's 2023 examination report flagged variable annuities as an area of heightened sales practice violations, noting that suitability concerns remain common in this product category.2
What to Do If You Already Own One
If you own a variable annuity and you are not sure whether it is working for you, the first step is to get a clear picture of what you are actually paying. Request a full fee disclosure from the insurance company, including the M&E charge, subaccount expenses, and any rider charges. Add them up.
Then ask two questions. First, is the total annual cost justified by the specific guarantees the contract provides, and are those guarantees ones you actually need? Second, would you be better served by surrendering the contract (if you are past the surrender period) and moving to a simpler, lower-cost strategy?
Surrendering a variable annuity triggers a taxable event on any gains, so the analysis is not always straightforward. But paying 3% per year in fees for guarantees you do not need or understand is a slow drain on retirement wealth that compounds over time in the wrong direction.
A review of an existing variable annuity is one of the most valuable conversations a financial planner can have with a client. It is also one of the most commonly avoided, because the answers are sometimes uncomfortable.
References
Smart Annuity Review provides independent, educational content on annuities and retirement income. If you'd like an honest, experienced review of your existing variable annuity or annuity strategy, book a complimentary SMART Annuity Review here.
Footnotes
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SEC. "Updated Investor Bulletin: Variable Annuities." October 30, 2018. https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/updated-5 ↩ ↩2
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FINRA. "Variable Annuities." https://www.finra.org/rules-guidance/key-topics/variable-annuities ↩ ↩2
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Institute of Business & Finance (ICFS). "Variable Annuity Charges and Fee Structures." Updated February 2026, data as of year-end 2024. https://icfs.com/financial-knowledge-center/variable-annuity-charges ↩ ↩2 ↩3 ↩4
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SEC. "Investor Tips: Variable Annuities." https://www.sec.gov/investor/pubs/varannty.htm ↩