What Is a Variable Annuity: How It Works, Fees, and Considerations

What Is a Variable Annuity?

A variable annuity is a contract between an individual and an insurance company in which the investor contributes funds—either as a lump sum or through periodic payments—and the insurance company agrees to make periodic payments beginning at some future date, or to pay a death benefit to designated beneficiaries. The word "variable" refers to the fact that the investment returns—and therefore the eventual income—vary based on the performance of underlying investment options chosen by the contract holder.

Variable annuities combine features of investment accounts (market participation through subaccounts) with insurance features (death benefits, optional income guarantees). They are sold by insurance companies and distributed through banks, brokerages, and insurance agents. They are registered as securities with the SEC and must be sold with a prospectus.

How Variable Annuities Work

The Accumulation Phase

During the accumulation phase, the contract holder directs contributions into subaccounts—investment funds similar to mutual funds covering asset classes such as domestic equities, international equities, fixed income, and balanced strategies. The value of the account fluctuates based on the performance of selected subaccounts. Earnings within a variable annuity grow tax-deferred, meaning no income tax is owed on gains until withdrawals are made.

The Distribution Phase

When the contract holder is ready to receive income—typically in retirement—the annuity enters the distribution phase. Options include:

• Annuitization: Converting the accumulated value into a stream of guaranteed payments (monthly, quarterly, or annually) for a specified period or for the rest of the annuitant's life.
• Systematic withdrawals: Taking periodic withdrawals from the account without annuitizing.
• Lump-sum withdrawal: Receiving the entire account value at once (surrender charges and taxes may apply).
• Guaranteed income riders: Optional living benefit riders that provide contractually guaranteed income regardless of market performance.

Subaccounts vs. Mutual Funds

Subaccounts within variable annuities function similarly to mutual funds but differ in key ways. They are held within an insurance wrapper, which provides tax deferral. The same underlying investment strategy (e.g., an S&P 500 index fund) will typically carry higher annual expenses inside a variable annuity than if purchased directly as a mutual fund or ETF.

Fee Structure: A Critical Component

Variable annuities are often criticized for their complex and layered fee structures, which can significantly erode returns. Understanding all applicable charges is essential before purchasing.

Surrender Charges

Most variable annuities include a surrender charge period—typically 6 to 10 years—during which withdrawals above a specified free withdrawal amount (commonly 10% per year) are subject to a surrender charge. The charge typically starts at 7%–10% in the first year and decreases by 1% per year until it reaches zero.

For example, a contract with an 8-year surrender schedule might impose charges of 8%, 7%, 6%, 5%, 4%, 3%, 2%, and 1% for each of the first eight years. Withdrawing $100,000 in year two would incur a $7,000 surrender charge. This illiquidity risk is a significant consideration for investors who may need access to their funds.

Tax Treatment

Variable annuities offer tax-deferred growth on investment gains. However, withdrawals are taxed as ordinary income (not at the preferential capital gains rate), which is less favorable than the tax treatment of gains in a taxable brokerage account for long-term investors in lower tax brackets. Additionally, withdrawals before age 59½ are subject to a 10% early withdrawal penalty.

Because retirement accounts such as 401(k)s and IRAs already provide tax deferral, placing a variable annuity inside a tax-advantaged retirement account (called a "qualified annuity") adds annuity fees without providing additional tax benefit beyond what the account already offers.

Living Benefit Riders

Many variable annuities are sold with optional living benefit riders—contractual guarantees that provide income protection regardless of investment performance. Common types include:

• Guaranteed Minimum Withdrawal Benefit (GMWB): Guarantees that the contract holder can withdraw a specified percentage of a guaranteed benefit base annually, even if the account value is depleted.
• Guaranteed Minimum Income Benefit (GMIB): Guarantees a minimum annuitized income regardless of actual account performance, subject to a waiting period (typically 10 years).
• Guaranteed Lifetime Withdrawal Benefit (GLWB): Combines lifetime income guarantee with flexibility to continue taking withdrawals as long as the contract holder is alive.

These riders have significant value in protecting against sequence-of-returns risk in retirement but add 0.5%–1.5% annually to the cost of the contract.

Variable Annuities vs. Other Retirement Vehicles

Who May Benefit from a Variable Annuity

Variable annuities may be appropriate for individuals who have maximized contributions to all other tax-advantaged retirement accounts (401(k), IRA, HSA), have a long time horizon that justifies the higher fees relative to additional tax deferral benefits, are specifically seeking longevity protection through guaranteed income riders, and can tolerate the illiquidity of surrender charge periods.

They are generally less suitable for investors who have not first maximized lower-cost tax-advantaged accounts, need liquidity, are investing over short time horizons, or primarily seek market exposure without insurance features.

This article is for informational purposes only and does not constitute financial advice. Consult a qualified financial advisor before making investment decisions.