Variable Annuity: How It Works, Pros and Cons, Fees, and Who It’s Best For

What Is a Variable Annuity?

A variable annuity is a long-term financial product offered by insurance companies that combines investment and income features. It allows individuals to invest in a selection of market-based subaccounts, similar to mutual funds, with returns that fluctuate based on market performance.

Variable annuities are typically used for retirement planning since they offer tax-deferred growth and the option to convert accumulated savings into a stream of income payments.

Key Features of Variable Annuities

Variable annuities are designed to provide both growth potential and retirement income flexibility. Some of the key features of this annuity include:

• Market-Linked Returns: Investment performance depends on underlying subaccounts, allowing for potential higher returns.
• Tax-Deferred Growth: Earnings grow without immediate taxation until withdrawals are made.
• Income Options: Can be converted into periodic payouts, including lifetime income streams.
• Death Benefit Protection: Beneficiaries may receive a guaranteed minimum amount upon the investor’s death.
• Optional Riders: Additional features like guaranteed income or withdrawal benefits can be added for extra security.

How Does a Variable Annuity Work?

Variable annuities operate in two core phases: accumulation and annuitization. During the accumulation phase, contributions are invested in market-linked subaccounts, allowing the contract value to grow or decline based on performance. 

In the annuitization phase, this accumulated value is converted into income payments. Also, optional riders which come at an additional cost, such as Guaranteed Minimum Income Benefit rider, can provide income without requiring full annuitization and convert your annuity into an income generating source.

Step-by-Step Breakdown

A variable annuity follows a structured lifecycle that transitions from funding and investment to income generation. Here’s a step-by-step guide on how it works:

• Purchasing the annuity: The annuity contract begins when you make an initial investment, either as a one-time lump sum or through a series of periodic contributions. 
• Accumulation phase: During this phase, the invested funds grow on a tax-deferred basis, meaning earnings are not taxed until withdrawn. The account value will increase or decrease based on the performance of the selected investments.
• Investment in subaccounts: Contributions are allocated to subaccounts, which operate similarly to mutual funds and may include equities, bonds, or diversified portfolios. 
• Annuitization (income phase): In the final stage, the accumulated value is converted into a stream of income payments. These payments can be structured for a fixed period or for life. The payout amount may fluctuate depending on underlying investment performance and selected payout options.

What are Subaccounts?

Subaccounts are the investment options within a variable annuity that determine how your money is allocated and grown. They function similarly to mutual funds, pooling investments into assets such as stocks, bonds, or money market instruments.

Most variable annuities also offer a fixed account, where the insurer provides a set interest rate. This gives investors the flexibility to balance growth potential with stability within the same contract.

The overall value of your annuity depends on how these subaccounts perform, making them an important aspect of returns and risk exposure.

How Returns are Generated In a Variable Annuity

Returns in a variable annuity are driven by the performance of the underlying subaccounts you choose. Since these investments are market-linked, the annuity’s value rises or falls based on how those assets perform over time. 

Key factors that influence returns include:

• Subaccount performance: Returns depend directly on how the selected investments (equities, bonds, etc.) perform in the market.
• Asset allocation: The mix of investments impacts both growth potential and risk exposure.
• Market conditions: Economic trends, interest rates, and market cycles can significantly affect returns.
• Tax-deferred compounding: Earnings grow without immediate taxation, allowing gains to compound over time.

What Happens During Market Volatility?

During periods of market volatility, the value of a variable annuity can rise or fall depending on the performance of its underlying investments. Since returns are market-linked, downturns may reduce the account value (including the loss of principal) and future income potential. 

However, some annuities offer optional features such as guaranteed minimum benefits or income riders that provide a level of downside protection. Long-term investors may also adjust subaccount allocations to manage risk and respond to changing market conditions.

Read: Types of Annuities

Types of Variable Annuities

Variable annuities are primarily categorized based on when income payments begin and how long they may last. Choosing the right type of variable annuity depends on your time horizon, income needs, and risk tolerance.

Some of the most common types of variable annuities may include:

• Immediate Variable Annuity: Income payments begin soon after a lump sum investment, typically within a year. This type is suitable for individuals who need immediate cash flow access.
• Deferred Variable Annuity: Payments are delayed to a future date, allowing investments to grow during the accumulation phase. It is one of the most common types of variable annuities available and is widely used for retirement planning, as it provides time for tax-deferred compounding.

Why Do People Buy Variable Annuities?

People choose variable annuities for retirement planning to balance long-term investment potential with income security and protection features. Here are a few reasons why individuals may prefer variable annuities:

• Tax-deferred growth: Earnings within a variable annuity are not taxed until withdrawals are made, allowing investments to compound more efficiently over time.
• More upside potential than a fixed annuity: Since funds are invested in market-based subaccounts, there is greater potential for higher returns compared to fixed annuities, though this comes with increased risk, including loss of principal.
• Optional income guarantees: Many variable annuities offer riders, such as guaranteed minimum income or withdrawal benefits, which can provide a predictable income stream regardless of market performance, although they typically come at an additional cost.
• Death benefit features: These annuities often include a death benefit that ensures beneficiaries receive a minimum payout, helping protect the invested capital even if market performance is unfavorable.

Variable Annuity Fees Explained 

Variable annuities include multiple layers of fees that cover insurance protection, investment management, and optional benefits. These charges can vary by the product that you may choose, such as¹:

• Mortality & Expense (M&E) Fees: These are core insurance charges that compensate the insurer for risks such as providing death benefits and income guarantees. They are typically deducted annually and generally range between 0.15% and 1.50%.
• Administrative Fees: These fees cover contract servicing, including recordkeeping, statements, and customer support. They may be charged as a flat annual fee (often around $25–$50) or as a percentage of assets, usually in the range of 0.1% to 0.3%.
• Investment Management Fees: Charged on the underlying subaccounts, these fees function similarly to mutual fund expense ratios. They typically range from 0.5% to 1.5% and are reflected in overall fund performance. For complete information about fees and expenses associated with this product and its underlying subaccount options, please refer to the prospectus carefully before investing
• Rider Costs: Optional features such as guaranteed income, withdrawal benefits, or enhanced death benefits come with additional charges. These costs commonly range from 0.5% to 1.5% or more, depending on the level of protection selected.
• Surrender Charges: These are early withdrawal penalties applied if funds are accessed during the surrender period, which often lasts 5 to 10 years. The surrender period typically applies to each payment made into the annuity, not the entire contract. Charges usually start around 5% to 7% and gradually decline each year.

Comparing variable annuities fees structure

Variable Annuity Vs. Fixed Annuity: Key Differences

Variable and fixed annuities are both insurance-based retirement products, but they differ significantly in how returns are generated and the level of risk involved.

While variable annuities offer market-linked growth potential, fixed annuities focus on stability and guaranteed returns. Here’s a side-by-side comparison between the two types of annuities:

Who Should (and Shouldn’t) Consider a Variable Annuity?

While variable annuities offer tax advantages and optional guarantees, they may not suit every investor due to costs and market exposure. Here’s who may or may not invest in this type of annuity:

Who Should Consider Variable Annuities

• High-income earners: Can benefit from tax-deferred growth, especially when looking for additional ways to manage taxable income beyond traditional investments.
• Maxed-out retirement accounts: Suitable for individuals who have already utilized 401(k) or IRA limits and want another tax-advantaged vehicle for long-term savings.
• Long-term investors: Investors with extended time horizons (due to relatively lower liquidity and associated surrender charges) are better positioned to handle market fluctuations and benefit from compounding within subaccounts.
• People needing guaranteed income: Those planning for retirement income may value optional riders that provide predictable payouts, regardless of market performance.

Who Should Avoid It

• Short-term investors: Variable annuities are not ideal for short-term goals due to surrender charges and the need for time to realize growth.
• Individuals concerned about hefty fees: The combination of management fees, insurance charges, and optional rider costs can reduce net returns compared to simpler investment options.
• Investors preferring control: Investors who prefer direct control, flexibility, and lower-cost strategies (such as ETFs or stocks) may find variable annuities restrictive.
• Low risk tolerance investors: Since performance is tied to market-based subaccounts, contract value can fluctuate and losses, including principal loss, are possible.

Read: Fixed Indexed Annuity: How It Works, Pros and Cons

What are The Pros and Cons of a Variable Annuity?

Variable annuities offer a mix of investment growth and insurance-based benefits, making them appealing for certain retirement strategies. However, they also come with risks, costs, and complexity that may not suit every investor.

Pros of Variable Annuities

• Tax-deferred growth: Earnings grow without immediate taxation, allowing investments to compound more efficiently over time.
• Market-linked growth potential: Investments in subaccounts provide the opportunity for higher returns compared to fixed annuities, especially over the long term.
• Flexible income options: Can be converted into a stream of income payments, including lifetime income, helping support retirement planning.
• Optional guarantees: Riders such as guaranteed minimum income or withdrawal benefits can provide downside protection and income stability.
• Death benefit protection: Beneficiaries may receive a guaranteed payout, offering a level of financial security even during market downturns.

Cons of Variable Annuities

• Higher fees and expenses: Multiple charges, including M&E fees, administrative costs, investment fees, and rider charges, can reduce overall returns.
• Market risk exposure: Returns are not guaranteed and depend on investment performance, which can lead to losses during market downturns.
• Complex structure: The combination of investment options, insurance features, and optional riders can make variable annuities difficult to fully understand.
• Surrender charges: Early withdrawals may trigger penalties, limiting liquidity and making them less suitable for short-term needs.
• Taxation on withdrawals: Withdrawals are typically taxed as ordinary income rather than capital gains, which may result in a higher tax liability.

How are Variable Annuities Taxed?

Variable annuities are taxed on a tax-deferred basis, meaning you don’t pay taxes on investment gains until you begin withdrawals.

This allows earnings to compound over time without annual tax drag, which can be beneficial for long-term retirement planning. However, the tax treatment at withdrawal is different from many other investments, such as:

• Tax-deferred growth: Earnings accumulate without being taxed each year, improving compounding potential.
• Ordinary income taxation: Withdrawals are taxed as regular income rather than at lower capital gains rates.
• Last-in-first-out (LIFO) withdrawal rule: This rule is mostly applicable for lump sum withdrawals from non-qualified annuities. Earnings are withdrawn first and taxed before your original investment (principal).
• Early withdrawal penalty: Withdrawals before age 59½ may incur a 10% penalty in addition to income tax. Qualified annuities are funded with pre-tax dollars (e.g., rollovers from IRAs or 401(k)s), while non-qualified annuities are funded with after-tax dollars. The penalty generally applies to the full withdrawal for qualified annuities and only to earnings for non-qualified annuities. Rolling over a qualified account into an annuity does not provide additional tax benefits.

Is a Variable Annuity a Good Fit For You?

A variable annuity can be a suitable option for investors seeking long-term growth combined with future income security, especially in retirement planning.

It works best for individuals who can stay invested over time, benefit from tax-deferred compounding, and are comfortable with market-linked returns. However, higher fees, limited liquidity in the early years, and complexity mean it’s not ideal for everyone. 

Questions to Ask Before You Buy

Evaluating your financial goals, risk tolerance, and time horizon is essential before deciding if a variable annuity aligns with your overall investment strategy.

Here are a few questions to ask yourself before you make the buying decision:

• How long is the surrender period?\ Understand how long your money will be locked in and what penalties apply for early withdrawals.
• What is the total annual cost?\ Review all fees, including M&E charges, administrative fees, investment expenses, and rider costs. 
• What exactly is guaranteed, and what is not?\ Clarify which benefits are guaranteed (such as certain income riders or death benefits) and which depend on market performance. 
• What happens if I need the money early?\ Check withdrawal rules, penalties, and any restrictions. Early access may come with surrender charges and tax implications.