Variable Annuities: Market Upside, Fee Drag, and Hidden Complexity

When a Retirement Product Loses 30% in a Down Year

During the 2008 financial crisis, variable annuity holders who had invested in equity subaccounts watched their account values drop 30% to 40%—nearly identical to the S&P 500's decline. Unlike fixed or indexed annuities, variable annuities offer no floor on losses. They are securities, regulated by the SEC and FINRA, sold through licensed broker-dealers. The upside is real market participation; the downside is real market risk, compounded by a fee structure that can erode returns by 2% to 4% annually even in flat years.

How Subaccounts Work

The defining feature of a variable annuity is the subaccount. Subaccounts function like mutual funds inside the annuity wrapper—investors allocate premiums among stock funds, bond funds, balanced funds, and money market options. Returns depend entirely on the performance of those subaccounts.

Unlike owning a mutual fund directly, subaccount gains are tax-deferred. No capital gains taxes are owed while money stays inside the annuity. Distributions in retirement are taxed as ordinary income, not at the lower long-term capital gains rate—a disadvantage for high earners holding taxable investments for many years.

• Most variable annuities offer 20–80 subaccount options
• Subaccount performance mirrors the underlying fund but net of an additional insurance layer fee
• Investors can rebalance between subaccounts without triggering a taxable event
• Some variable annuities now offer ETF-based subaccounts with lower internal expense ratios

The Fee Stack That Kills Returns

Variable annuities carry multiple overlapping fee layers that compound over time. A typical variable annuity sold by an insurance company in 2024 might look like this:

Add these layers together and total annual fees routinely reach 2.5% to 4.0%. An investment earning 7% gross returns nets only 3% to 4.5% after fees. Over 20 years, the difference between a 7% gross return and a 3.5% net return on a $200,000 investment is the difference between $773,000 and $394,000—a fee drag of nearly $380,000.

Surrender Charges: The Exit Penalty

Most variable annuities impose surrender charges if the owner withdraws funds within a specified surrender period—typically six to eight years from purchase, though some extend to ten years. Charges typically start at 7% to 8% and decline by 1 percentage point per year until they disappear.

• A $150,000 annuity surrendered in year two with an 8% charge costs $12,000 in penalties
• Most contracts allow a 10% free withdrawal per year without surrender charges
• Surrender charges do not apply after the surrender period expires
• 1035 exchanges allow moving from one annuity to another tax-free, though new surrender periods typically restart

Surrender charges create a liquidity trap. Investors who need their money before the surrender period ends face a choice between paying a significant penalty or waiting. This makes variable annuities inappropriate for money that might be needed in the near term.

Death Benefit Riders: What You Actually Get

The standard death benefit in a variable annuity guarantees that beneficiaries receive at least the amount originally invested if the account value has declined due to market losses at the time of the holder's death. Insurers sell enhanced riders that step up this guarantee.

A common enhanced death benefit resets the guaranteed minimum to the highest account value ever achieved on each contract anniversary. If a $200,000 contract grew to $280,000 and then fell to $220,000, beneficiaries receive $280,000, not $220,000. This protection has real value—but it costs 0.20% to 0.75% per year, and it only matters if markets are down when the annuitant dies.

When Variable Annuities Actually Make Sense

They're not always the wrong choice. Specific circumstances favor them.

FINRA Rule 2330 requires broker-dealers to review variable annuity recommendations to ensure suitability. Regulators have fined numerous firms for selling variable annuities inside IRAs—where tax deferral already exists—making the insurance wrapper's primary benefit redundant while adding significant cost.

No-Load Variable Annuities

A narrow category of variable annuities—sold by Vanguard, Fidelity, and a handful of others—carries no sales commissions, lower M&E charges (often 0.25% or less), and lower subaccount expenses. These products exist and are worth examining if you've exhausted other tax-deferred options. The difference between a 0.57% total annual fee and a 3.5% total annual fee is enormous over two decades.

This article is for informational purposes only and does not constitute financial advice. Variable annuities are complex insurance products. Consult a fee-only fiduciary financial advisor before purchasing.