At its core, a variable annuity is designed to provide a steady stream of income during retirement. But these financial products are more complex, costlier and riskier than other types of annuities. 

Yes, you can potentially grow your annuity’s value if the underlying investments in the account perform well. But there are a lot of strings attached, and the average investor may find simpler, more affordable ways to grow retirement savings elsewhere. 

What is a variable annuity?

A variable annuity is a contract between you and an insurance company. It allows you to grow your retirement savings and receive a steady stream of payments later.

Like all annuities, you agree to make a lump sum deposit or a series of premium payments to the insurer, and in exchange, the insurance company promises to pay you a stream of payments for the length of your retirement, or however long you choose. 

Variable annuities are sometimes described as mutual funds wrapped in an insurance policy. Unlike traditional fixed annuities that offer a set rate of return, the value of a variable annuity is linked to the performance of underlying investments. You’ll pick from a menu of sub-accounts, similar to mutual funds, that invest in stocks, bonds or a mix of both. 

So, the value of your annuity can grow (or shrink) based on the performance of the investments you choose.

How a variable annuity works

There are two key components of a variable annuity: The accumulation phase and the payout phase. 

During the accumulation phase, which generally lasts several years, you’re essentially giving your initial investment time to grow. Any growth from those investments are tax-deferred, meaning you won’t pay taxes on earnings until you take money out of the annuity.

Some variable annuities also allow you to allocate a portion of your principal to a fixed account option that guarantees a minimum return, usually 1 to 3 percent. 

Once you reach retirement or choose to start receiving payments, you’ll enter the payout phase. At this stage, the accumulated funds are converted into a stream of periodic payments that can be structured to last for a set period or your lifetime. Once you enter this phase, also referred to as annuitization, you may be barred from withdrawing money from the account. 

The amount of income you receive from a variable annuity depends on multiple factors, including the performance of the mutual fund investments, your age and how long you want your payments to last. 

Death benefit and other features

Variable annuities often come with a death benefit, which pays out a designated amount to your beneficiaries if you pass away before annuitization.

Depending on how your contract is written, your beneficiary will receive the greater of either all the money in your account, or some other guaranteed minimum. 

Variable annuity contracts can include other features, known as riders. For example, long-term care riders can help pay for assisted living expenses while income riders can guarantee a minimum income stream regardless of how underlying investments perform. Riders always come with an additional cost. 

Variable annuity fees

It’s crucial to understand the fee structure of a variable annuity before signing a contract. The cumulative effect of these fees can significantly impact the long-term growth of your retirement savings. 

Here’s a rundown of the fees associated with variable annuities:

  • Surrender charge: During the accumulation phase, you may face a surrender charge if you withdraw funds from the annuity before a specified period, typically the first five to 10 years. This charge is designed to discourage early withdrawals.
  • Mortality and expense risk (M&E) charge: This covers the insurance company’s cost of providing the guaranteed death benefit and administrative expenses. These fees equal a certain percentage of your account value, usually 1.25 percent or more per year. 
  • Administration fee: This covers the insurer’s ongoing costs for managing your account. It can be charged as a flat account maintenance fee or as a percentage of your account value.
  • Underlying fund expenses: These are the fees associated with the management of the sub-accounts. They’re similar to expense ratios charged by mutual funds and exchange-traded funds (ETFs).
  • Other fees and charges: There may be additional fees for optional riders attached to the annuity.

Together, these annual fees can reach 2 to 4 percent of the annuity contract value. For context, financial advisors usually charge a 1 percent annual fee to manage a client’s investment portfolio. 

Finally, if you withdraw money from an annuity prior to age 59 ½, you’ll be subject to a 10 percent penalty from the IRS. 

Can you lose money with a variable annuity?

Absolutely. There’s no guarantee that you’ll earn any return on your variable annuity and there’s a risk you’ll lose money.

Unlike fixed annuities and fixed index annuities, variable annuities offer no guarantees on your principal, so the value of your account fluctuates with the market. High fees and penalties can also erode your annuity’s value. 

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have both issued warnings about variable annuities over the years. The SEC highlights the cost and complexity of these products, while FINRA cautions investors to be wary of pushy sales practices. Variable annuities are also a leading source of investor complaints to FINRA.

Variable annuities are becoming less popular among consumers, too. In 2023, sales of variable annuities dropped 17 percent, even as sales of fixed annuities soared, according to LIMRA, the largest trade association for the insurance industry in the U.S. Of the total $385.4 billion in annuity sales in 2023, only about 13 percent came from variable annuities, marking its worst sales year ever recorded by LIMRA. 

Benefits of variable annuities

Variable annuities tend to be more appropriate for investors with higher risk tolerances who have already maxed out other retirement savings options, like a workplace 401(k) plan. 

Here are some key benefits they offer.

  • Growth potential: Variable annuities offer the opportunity for higher returns compared to fixed annuities due to potential growth in the sub-accounts. 
  • Someone else manages everything: You pick your own investments and the insurance company handles the rest, which can reduce the stress of managing your own withdrawals in retirement.
  • Tax-deferred growth: Earnings within the annuity accumulate on a tax-deferred basis until withdrawal.
  • Guaranteed income stream: Annuities provide a predictable income stream in retirement that can supplement Social Security and potentially help you avoid outliving your savings.

Drawbacks of variable annuities

Every investment comes with risk, but variable annuities have some substantial drawbacks to consider. 

  • Market risk: Your principal is exposed to market fluctuations. This can cause the value of your annuity to go up or down depending on the performance of the investments.
  • Fees: Fees on a variable annuity are higher than many other investments and financial products on the market. 
  • Sales practices: Some financial advisors or insurance brokers may push variable annuities because of the high commissions they offer, not necessarily because they align with your financial goals.
  • Limited liquidity: Early withdrawals are typically penalized with surrender charges. It can be extremely difficult — and expensive — to cancel your annuity contract once you start receiving payouts from the insurer. 

How to buy a variable annuity

Purchasing a variable annuity involves multiple steps, and understanding the sales process is essential to making an informed decision. 

First, it’s important to research and compare variable annuity products from different reputable insurance companies. Consider key factors such as fees, investment options, optional riders and the financial strength of the insurance company itself. 

Once you’ve identified a variable annuity that interests you, the next step is to contact a licensed insurance agent or financial advisor who is authorized to sell annuities. They’ll guide you through the process and help you understand the terms of the annuity contract.

During this process, the agent or advisor will provide you with an important disclosure document called a prospectus, which includes detailed information about the annuity and its investment options. It’s crucial to review the prospectus carefully and ask questions about anything you don’t understand.

Before signing the contract, ask yourself the following questions:

  • Do I understand the fees and charges? Variable annuities can come with a host of fees, including sales charges and administrative fees. Make sure you understand how these fees are deducted from your account and whether they’re reasonable compared to other investment options.
  • Can I handle the risk? The value of your variable annuity can go up or down based on market performance. 
  • Do I need access to my money? Variable annuities have restrictions on when and how you can access your money, such as a surrender period or withdrawal fees. 
  • Have I maxed out contributions to tax-advantaged retirement accounts? Accounts like 401(k)s and IRAs offer similar tax benefits without the high fees and complexity. 
  • Do I want additional features?  Variable annuities offer other benefits, such as a long-term care rider, for an added cost. Consider whether you can purchase these benefits as a separate product at a lower cost.

By asking yourself these questions, you can make an informed decision that’s right for you. It’s also worth noting that annuity contracts typically include a 10 to 30 day “free look period,” during which investors can cancel the contract without penalties.

Bottom line

Variable annuities are not a one-size-fits-all solution to retirement planning. They may be suitable for some investors seeking a chance for higher growth and a guaranteed income stream, but for others, the fees and complexity far outweigh potential benefits.

Before investing in a variable annuity, carefully consider your investment goals, risk tolerance and retirement timeline. Speaking with a qualified financial advisor who can assess your specific needs and recommend appropriate investment strategies is highly recommended.