Variable Annuities: A Complete Guide to How They Work, Benefits, Risks, Fees, and Retirement Income
Retirement planning often involves balancing two competing goals: growing your money and creating reliable income for the future.
A variable annuity is one financial product designed to address both goals. It combines an investment component with insurance features and tax-deferred treatment. Unlike a traditional fixed annuity, however, the value of a variable annuity can rise or fall based on the performance of the investment options selected within the contract.
That distinction is extremely important.
A variable annuity is not a guaranteed-growth product, and investors can lose money. At the same time, variable annuities may offer features that are difficult to replicate with a traditional investment account, including certain death benefits, lifetime income options, and optional living benefits.
The U.S. Securities and Exchange Commission’s Investor.gov defines a variable annuity as a contract between an investor and an insurance company that can function as a tax-deferred investment account while also providing insurance features. The investment value generally depends on the performance of investment options selected by the contract owner.
This guide explains what variable annuities are, how they work, how they differ from fixed annuities, their potential benefits and risks, fees, taxation, withdrawals, death benefits, living benefits, and what investors should consider before purchasing one.
What Is a Variable Annuity?
A variable annuity is an insurance contract issued by an insurance company that combines investment options with insurance features.
When you purchase a variable annuity, you make either a single purchase payment or a series of payments.
Your money is then allocated among investment options available within the contract. These options are commonly referred to as subaccounts.
The subaccounts may invest in:
- Stocks
- Bonds
- Money market instruments
- Balanced portfolios
- Other investment strategies
The value of the contract can increase or decrease depending on the performance of the investments you select.
This makes a variable annuity fundamentally different from a traditional fixed annuity.
With a traditional fixed annuity, the insurance company guarantees a minimum interest rate according to the contract.
With a variable annuity, the owner generally assumes the investment risk associated with the selected investment options.
The National Association of Insurance Commissioners explains that variable annuity contributions can be allocated among separate-account subaccounts and that policyholders assume the investment risk because these accounts are valued based on market performance.
How Does a Variable Annuity Work?
A variable annuity generally has two major stages:
- The accumulation phase
- The payout or income phase
Understanding these two stages is essential before purchasing a variable annuity.
1. The Accumulation Phase
During the accumulation phase, your money remains invested in the variable annuity’s available investment options.
For example, suppose you invest $100,000 and allocate:
- 60% to a stock-focused subaccount
- 30% to a bond-focused subaccount
- 10% to a money-market-oriented option
If the investment options perform well, the value of the contract can increase.
If they perform poorly, the value can decrease.
For example, if the underlying investments decline significantly, your $100,000 account could potentially fall below $100,000.
This is one of the biggest differences between a variable annuity and a traditional fixed annuity.
Variable annuities involve investment risk.
The SEC specifically warns that investors can lose money if the investment options selected within a variable annuity perform poorly.
2. The Payout Phase
At some point, you may choose to begin receiving income from the annuity.
This can happen through annuitization, in which the contract value is converted into a stream of periodic income payments.
Depending on the contract, you may be able to choose payments for:
- A specific number of years
- Your lifetime
- Your lifetime and your spouse’s lifetime
- Other periods or structures offered by the contract
The amount of income can depend on several factors, including:
- Contract value
- Age
- Selected payout option
- Interest assumptions
- Annuitization terms
- Whether payments are based on one life or two lives
Some contracts may provide fixed payments, while others may allow payments to vary based on the performance of the underlying investment options.
Once a contract has been annuitized, access to the original account value can become significantly more restricted.
Therefore, investors should understand the payout options before making an irrevocable decision.
Variable Annuity vs. Fixed Annuity
The two products share the word “annuity,” but they work very differently.
Fixed Annuity
A traditional fixed annuity generally provides a guaranteed minimum interest rate according to the contract.
The insurance company assumes the investment risk associated with the assets supporting its contractual obligations.
Variable Annuity
A variable annuity allows the owner to select investment options.
The account value can rise or fall depending on the performance of those investments.
The owner therefore assumes investment risk.
The basic difference
Fixed annuity: More predictable interest and less direct exposure to market fluctuations.
Variable annuity: Greater investment flexibility and growth potential, but also greater investment risk.
Neither is automatically “better.”
The appropriate choice depends on the individual’s objectives, time horizon, risk tolerance, income needs, and overall financial plan.
What Are the Potential Benefits of Variable Annuities?
Variable annuities can provide several features that may be valuable for long-term retirement planning.
1. Tax-Deferred Growth
One of the most frequently discussed benefits of a variable annuity is tax deferral.
Generally, investment gains inside a nonqualified annuity are not subject to current federal income tax until money is withdrawn or distributed.
This means investors can potentially reinvest returns without paying current federal income tax on those gains each year.
However, tax deferral should not be confused with tax-free growth.
Taxes may become due when taxable distributions are taken.
The SEC also points out an important consideration: when gains from a variable annuity are withdrawn, they are generally taxed as ordinary income rather than at potentially lower long-term capital-gains rates.
For investors considering a variable annuity, this distinction can have a significant impact on the long-term economics of the investment.
2. Investment Options
Variable annuities generally provide a menu of investment choices.
Depending on the contract, investors may be able to choose among options designed to provide exposure to:
- U.S. stocks
- International stocks
- Corporate bonds
- Government bonds
- Money market investments
- Balanced portfolios
- Various asset classes and investment strategies
This can allow investors to construct a diversified portfolio within the annuity.
However, having many choices does not necessarily mean the choices are inexpensive or appropriate.
Every investment option should be evaluated based on its objectives, risks, expenses, and role within the overall portfolio.
3. Potential Lifetime Income
One of the primary reasons people purchase annuities is the possibility of creating retirement income that lasts for life.
A variable annuity can provide annuitization options that turn the contract value into periodic income payments.
This can help address longevity risk—the risk of living longer than expected and running out of money.
For retirees concerned about how to convert retirement savings into sustainable income, this feature can be attractive.
However, income guarantees and payout provisions vary substantially from one contract to another.
The specific contract language matters.
4. Death Benefits
Many variable annuities include a standard death benefit.
Depending on the contract, if the owner dies before income payments begin, a beneficiary may receive at least a specified amount.
In some contracts, the death benefit may be based on:
- Original purchase payments
- Contract value
- A guaranteed minimum amount
- A stepped-up value
- Another formula defined in the contract
Some contracts also offer enhanced death benefits for an additional cost.
The exact benefit, eligibility requirements, charges, and investment restrictions vary by contract.
Therefore, an investor should never assume that every variable annuity provides the same death benefit.
5. Optional Living Benefits
Some variable annuities offer optional benefits designed to provide guarantees while the investor is alive.
These may include features commonly referred to as:
- Guaranteed minimum income benefits
- Guaranteed lifetime withdrawal benefits
- Guaranteed accumulation benefits
- Enhanced withdrawal benefits
- Long-term-care-related benefits
These features can be complicated.
They may provide valuable guarantees, but they typically come with additional costs and conditions.
For example, an income benefit might guarantee a certain withdrawal amount even if the actual investment account value falls below the amount used to calculate the benefit.
However, the benefit may require specific investment allocations, withdrawal limits, or other conditions.
A large withdrawal can also reduce or even eliminate certain benefits depending on the contract.
What Are the Risks of Variable Annuities?
Variable annuities offer investment flexibility, but they also have significant risks.
Understanding these risks is essential.
1. You Can Lose Money
This is perhaps the most important point.
A variable annuity is not a guaranteed-return investment.
The investment options can lose value.
If the underlying investments perform poorly, the contract value can decline.
For example, an investor who puts $100,000 into a variable annuity could potentially see the account fall below $100,000 if the underlying investments decline.
Insurance features may provide certain guarantees, but those guarantees do not necessarily protect the entire account value from investment losses.
2. Fees Can Be Significant
Variable annuities can have multiple layers of fees.
Potential charges can include:
- Mortality and expense risk charges
- Administrative fees
- Investment management expenses
- Contract fees
- Surrender charges
- Optional benefit fees
- Rider charges
- Transfer fees
- Sales-related charges
These expenses reduce the amount of money that remains invested and can significantly affect long-term returns.
The SEC specifically warns investors to understand all variable-annuity fees and expenses before investing.
Understanding Mortality and Expense Charges
One of the fees commonly associated with variable annuities is the mortality and expense risk charge, often abbreviated as M&E.
This charge compensates the insurance company for certain insurance risks and contractual guarantees.
It may also help cover distribution and administrative expenses depending on the contract.
Even a seemingly small annual percentage can have a substantial effect over many years because the charge is generally applied repeatedly.
For example, consider a hypothetical $100,000 account.
An annual charge of 1% would equal approximately $1,000 in the first year if the account value remained at $100,000.
As the account value changes, the dollar amount of the charge can also change.
This is why investors should examine the actual fee structure rather than focusing only on projected investment returns.
Surrender Charges
Many variable annuities have surrender periods.
If you withdraw money during the surrender period, the insurance company may charge a surrender fee.
The charge generally decreases over time.
For example, a hypothetical contract could have a surrender schedule such as:
| Year | Hypothetical Surrender Charge |
|---|---|
| 1 | 7% |
| 2 | 6% |
| 3 | 5% |
| 4 | 4% |
| 5 | 3% |
| 6 | 2% |
| 7 | 1% |
| 8+ | 0% |
This is only an illustration.
Actual surrender schedules vary by contract.
Some contracts may have longer or shorter surrender periods, different percentages, or special provisions.
Some contracts also allow a certain percentage of the account value to be withdrawn each year without a surrender charge.
Always review the actual contract before assuming that a withdrawal is penalty-free.
Tax Penalties for Early Withdrawals
In addition to surrender charges, certain withdrawals can have tax consequences.
Under federal tax rules, distributions from annuity contracts before age 59½ may be subject to an additional 10% tax on the taxable portion unless an exception applies.
This means an investor could potentially face:
- Income tax
- An additional federal tax penalty
- A surrender charge
These are separate issues.
A withdrawal that avoids a surrender charge is not necessarily tax-free.
Likewise, a withdrawal that is not subject to the 10% additional tax is not necessarily free from surrender charges.
Investors should evaluate both the contract and applicable tax rules before taking money out.
Variable Annuities and Ordinary Income Tax
Another important consideration is how investment gains are taxed.
For a nonqualified variable annuity, taxable earnings withdrawn from the contract are generally taxed as ordinary income.
That can be different from investing in a taxable brokerage account, where certain investments held for more than one year may qualify for long-term capital-gains tax treatment.
Therefore, the tax-deferred feature of an annuity should be evaluated alongside its tax treatment when money is eventually withdrawn.
Tax deferral can be valuable, but it does not automatically make an annuity more tax-efficient than every alternative.
Variable Annuities Inside an IRA or 401(k)
An important question is whether an investor actually needs the annuity’s tax-deferral feature.
IRAs and employer-sponsored retirement plans such as 401(k)s already provide tax advantages.
If a variable annuity is purchased inside a tax-advantaged retirement account, the investor generally does not receive an additional tax-deferral benefit simply because the account is an annuity.
The SEC specifically highlights this issue.
Therefore, investors should carefully evaluate why they are considering an annuity inside an already tax-advantaged retirement account.
The reason may instead be the insurance features, lifetime-income benefits, death benefits, or other contractual guarantees.
Variable Annuity vs. Mutual Fund
At first glance, a variable annuity may look similar to owning mutual funds because many annuity subaccounts invest in portfolios resembling mutual funds.
However, there are important differences.
Mutual Fund
An investor purchases shares directly through an investment account.
The investor pays the fund’s applicable expenses and any applicable account or transaction costs.
Variable Annuity
The investor purchases an insurance contract.
The contract may contain:
- Investment options
- Insurance benefits
- Death benefits
- Optional living benefits
- Additional insurance-related fees
- Surrender charges
- Tax-deferral features
The added insurance features can provide benefits, but they can also make the product more expensive and complex.
Therefore, investors should compare the total cost and benefits rather than comparing only the underlying investment performance.
Variable Annuity vs. Traditional Brokerage Account
A brokerage account generally provides greater liquidity and flexibility.
An investor can typically buy and sell investments without an annuity surrender schedule.
A variable annuity may offer benefits that a standard brokerage account does not, particularly contractual insurance guarantees.
However, the annuity may also involve additional fees and restrictions.
The choice therefore depends on what the investor needs.
If the primary goal is flexible access to investments, a brokerage account may be more suitable.
If the investor values certain insurance guarantees or lifetime-income features, a variable annuity may deserve consideration.
Variable Annuity vs. Fixed Annuity
The simplest way to think about the difference is:
Fixed annuity = more predictable contractual interest.
Variable annuity = investment-based growth potential with market risk.
A fixed annuity generally provides a guaranteed minimum interest rate under the contract.
A variable annuity generally gives the owner investment choices whose values fluctuate with market performance.
The trade-off is therefore between predictability and investment participation.
What Is a Separate Account?
One of the technical concepts investors should understand is the separate account.
Variable annuity investment options are generally held through separate accounts maintained by the insurance company.
These accounts contain the investment assets associated with variable annuity contracts.
Unlike the insurer’s general account used to support many fixed insurance obligations, the separate-account investments are tied to the investment options selected by contract owners.
The value of these investments changes with market performance.
This structure is one reason variable annuities can provide market-based investment exposure.
Are Variable Annuities FDIC Insured?
No.
Variable annuities are not FDIC-insured bank deposits.
They are insurance contracts issued by insurance companies.
The guarantees provided by the contract depend on the financial strength and claims-paying ability of the issuing insurer.
This is an important distinction when comparing an annuity with a bank savings account or certificate of deposit.
What Happens If the Insurance Company Fails?
Annuity guarantees are obligations of the insurance company that issued the contract.
They are not backed by FDIC deposit insurance.
State insurance guaranty associations may provide certain protections to eligible policyholders if an insurer becomes insolvent, but coverage rules, limits, and eligibility vary by state.
This means investors should pay attention to the financial strength of the insurance company before purchasing a significant annuity contract.
It is also important to understand that state guaranty association protection should not be treated as equivalent to FDIC insurance.
Should You Exchange One Variable Annuity for Another?
Annuity exchanges deserve special attention.
A financial professional may recommend replacing an existing variable annuity with a newer contract offering:
- Lower fees
- A larger death benefit
- New investment options
- A guaranteed income rider
- A bonus
- Other features
But an exchange can create costs.
You may face:
- Surrender charges on the old annuity
- A new surrender period
- New contract fees
- New benefit charges
- Different investment restrictions
- Different guarantees
An exchange may also have tax implications if it is not structured correctly.
Therefore, an investor should compare the existing contract and proposed replacement side by side before making a decision.
The SEC specifically recommends carefully evaluating the benefits, fees, risks, and financial incentives associated with an annuity exchange.
Be Careful With “Bonus” Variable Annuities
Some variable annuities advertise bonus credits.
For example, a hypothetical contract might advertise a 4% bonus on a purchase payment.
At first glance, this can look attractive.
But a bonus does not automatically mean the contract is better.
A contract offering a bonus may have:
- Higher annual expenses
- Longer surrender periods
- Higher rider costs
- Restrictions on withdrawing the bonus
- Requirements to remain invested for a certain period
- Conditions under which the bonus may be reduced or forfeited
The SEC has specifically warned investors to examine bonus annuities carefully because higher expenses can potentially outweigh the value of the bonus.
The correct question is not:
“How large is the bonus?”
The better question is:
“What is the total economic value of this contract after all fees, restrictions, investment performance, and benefits are considered?”
Who Might Consider a Variable Annuity?
A variable annuity may be worth considering for an investor who:
- Has a long-term investment horizon
- Wants tax-deferred growth
- Is comfortable with investment risk
- Wants access to professionally managed investment options
- Values certain insurance features
- Wants potential lifetime income
- May benefit from a death benefit
- Understands and accepts the fees
- Does not need unrestricted access to the money
However, a variable annuity may be less appropriate for someone who:
- Needs short-term liquidity
- Wants the lowest possible investment costs
- Is uncomfortable with market losses
- Does not understand the contract
- Needs unrestricted access to retirement savings
- Has not established emergency savings
- Is primarily seeking a simple investment account
Questions to Ask Before Buying a Variable Annuity
Before purchasing a variable annuity, ask the financial professional to answer these questions in writing.
Investment Questions
- What investment options are available?
- What are the expenses of each investment option?
- What happens if the underlying investments lose money?
- Can I change investment allocations?
- Are there restrictions on investment choices?
Fee Questions
- What is the mortality and expense charge?
- What administrative fees apply?
- What are the investment-management expenses?
- How much do optional riders cost?
- Are there sales charges?
- Are there transfer fees?
Withdrawal Questions
- How long is the surrender period?
- What is the surrender charge?
- How much can I withdraw each year without a surrender charge?
- Does each new premium payment start a new surrender period?
Income Questions
- Can I receive lifetime income?
- How is the income amount calculated?
- Is the income guaranteed?
- Can withdrawals reduce the income benefit?
- What happens if the account value reaches zero?
Death Benefit Questions
- What is the standard death benefit?
- Is an enhanced death benefit available?
- What does the enhanced benefit cost?
- How does the death benefit change after withdrawals?
Tax Questions
- How are withdrawals taxed?
- What happens if I withdraw before age 59½?
- Is the annuity being purchased inside an IRA or retirement plan?
- What tax advantages am I actually receiving?
Exchange Questions
- What happens if I replace my existing annuity?
- Will I have to pay a surrender charge?
- Will a new surrender period begin?
- Are the new benefits worth the additional costs?
How Much Should You Invest in a Variable Annuity?
There is no universal percentage that every investor should place into a variable annuity.
The appropriate amount depends on the person’s overall financial situation.
A retirement strategy may include:
- Social Security
- Employer retirement plans
- IRAs
- Brokerage accounts
- Cash reserves
- Bonds
- Stocks
- Real estate
- Pensions
- Annuities
A variable annuity should be evaluated within this broader picture.
Liquidity is particularly important.
An investor should understand how much money needs to remain readily accessible for emergencies, healthcare expenses, major purchases, and unexpected financial needs.
Putting too much money into a product with surrender restrictions can create unnecessary financial pressure later.
Are Variable Annuities a Good Investment?
There is no universal answer.
A variable annuity can be useful when its benefits justify its costs and restrictions.
For some investors, the combination of tax deferral, investment choices, insurance protections, death benefits, and lifetime-income options may be valuable.
For others, the fees and restrictions may outweigh those benefits.
The important point is to evaluate the entire contract, not simply its projected investment return.
A variable annuity should not be judged solely by asking:
“How much can it earn?”
A more complete evaluation asks:
- What are the investment risks?
- What are the total fees?
- What guarantees are included?
- What guarantees are optional?
- How long is the surrender period?
- How liquid is the investment?
- How are withdrawals taxed?
- What happens to the benefits after withdrawals?
- What happens to the contract when the owner dies?
- How does it compare with less expensive alternatives?
The Bottom Line
A variable annuity is an insurance contract that combines investment options with insurance features and tax-deferred treatment.
Unlike a traditional fixed annuity, the value of a variable annuity can fluctuate based on the performance of the investment options selected by the contract owner.
Potential advantages include:
- Tax-deferred growth
- Access to multiple investment options
- Potential lifetime income
- Death benefits
- Optional living benefits
- Insurance-based guarantees
But variable annuities also involve significant considerations:
- Investment losses are possible
- Fees can be substantial
- Surrender charges may apply
- Liquidity can be limited
- Early withdrawals may have tax consequences
- Optional guarantees generally cost extra
- Contract provisions can be complex
- The insurer’s financial strength matters
For these reasons, variable annuities should generally be considered long-term financial products, not short-term savings vehicles.
The best variable annuity is not necessarily the one with the highest projected return or largest bonus.
The better choice is the contract whose costs, investment options, guarantees, liquidity, and income features fit the investor’s actual financial objectives.
Before purchasing a variable annuity, read the contract and prospectus carefully, understand every fee and restriction, compare alternatives, and consider consulting appropriately licensed financial and tax professionals.
Frequently Asked Questions About Variable Annuities
What is a variable annuity?
A variable annuity is an insurance contract that allows the owner to invest in a selection of investment options while also providing certain insurance features. The contract value generally fluctuates according to investment performance.
Can you lose money in a variable annuity?
Yes. Variable annuities involve investment risk. If the selected investment options decline in value, the account value can decline and may fall below the original amount invested.
Are variable annuities guaranteed?
Some features may be guaranteed by the insurance company according to the contract, such as certain death benefits or optional income benefits. However, the investment account itself is generally subject to market risk.
Are variable annuities FDIC-insured?
No. Variable annuities are insurance contracts, not FDIC-insured bank deposits.
Are variable annuities tax-deferred?
Generally, yes. Investment gains inside a nonqualified variable annuity are generally tax-deferred until distributed. However, taxes can apply when taxable distributions are taken.
Are variable annuity withdrawals taxed?
They can be. Tax treatment depends on the type of contract and distribution. Generally, taxable earnings from a nonqualified annuity are taxed as ordinary income when distributed.
Can I withdraw money from a variable annuity?
Many variable annuities allow withdrawals, but surrender charges may apply during the surrender period. Withdrawals may also affect certain benefits and can have tax consequences.
What happens if I withdraw money before age 59½?
Depending on the circumstances, the taxable portion of an annuity distribution made before age 59½ may be subject to an additional 10% federal tax. Exceptions may apply.
What are variable annuity subaccounts?
Subaccounts are investment options within a variable annuity. They may invest in stocks, bonds, money market instruments, or other investments.
Do variable annuities have fees?
Yes. Potential expenses include mortality and expense charges, administrative fees, investment expenses, surrender charges, and fees for optional benefits.
Can a variable annuity provide lifetime income?
Yes. Depending on the contract and payout option selected, a variable annuity may be annuitized to provide income for life or another specified period.
Is a variable annuity better than a fixed annuity?
Not necessarily. Fixed and variable annuities are designed differently. Fixed annuities generally provide more predictable interest, while variable annuities provide investment exposure with the possibility of greater growth and greater losses.
Should I put my IRA into a variable annuity?
Not automatically. An IRA already has tax advantages, so the tax deferral provided by the annuity may not add an additional tax benefit. The decision should instead consider whether the annuity’s insurance features, income guarantees, death benefits, or other provisions justify its costs and restrictions.
Authoritative Resources
For readers who want to verify the information or research variable annuities further, the following organizations provide authoritative resources:
- U.S. Securities and Exchange Commission / Investor.gov — Variable Annuities
- U.S. Securities and Exchange Commission / Investor.gov — Annuities
- National Association of Insurance Commissioners (NAIC) — Annuities
- Internal Revenue Service (IRS) — Pension and Annuity Income
- FINRA — Investor education and annuity-related resources
Disclaimer: This article is provided for general educational and informational purposes and does not constitute individualized financial, investment, insurance, legal, or tax advice. Variable annuity features, fees, guarantees, investment options, surrender periods, and tax treatment vary by contract and jurisdiction. Investors should review the applicable contract and prospectus and consult appropriately licensed professionals regarding their individual circumstances.
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