Variable Annuities: Investment Upside, Real Risk, and the Fee Question

What Is a Variable Annuity?

Let's start with what makes a variable annuity different from every other annuity type: you're taking real investment risk. Your money goes into subaccounts — essentially mutual fund-like portfolios — and your account value rises and falls with market performance. There's no floor. No guaranteed rate. No safety net on your account value (though optional riders can protect your income, which we'll get to).

Why would anyone choose this? Two reasons: unlimited upside potential and tax-deferred growth. Unlike fixed and indexed annuities where the insurance company limits your returns, a variable annuity lets you participate fully in market gains. If your stock subaccount returns 18%, you get 18% (minus fees). If it loses 18%, well... you lose 18%.

Variable annuities are insurance contracts, regulated by both state insurance departments AND the SEC (because the subaccounts are securities). You'll need to work with a financial professional who holds both insurance and securities licenses. There's a prospectus. It's thick. And yes, you should actually read it — or at least have someone walk you through the key parts.

These are the most complex annuity products on the market, and they're also the most controversial. We're going to give you the full picture — the good, the bad, and the expensive.

How Subaccounts Work

Think of subaccounts as mutual funds that live inside an insurance wrapper. A typical variable annuity offers 30 to 100+ subaccount options spanning:

• Domestic stock (large cap, mid cap, small cap, growth, value)
• International stock (developed markets, emerging markets)
• Bonds (government, corporate, high-yield)
• Balanced/allocation (pre-mixed stock and bond portfolios)
• Money market (cash equivalent — very low return, very low risk)
• Specialty (real estate, commodities, sector-specific)

You allocate your money across these subaccounts however you want, and you can rebalance or reallocate without triggering a taxable event. That's one of the genuine advantages — inside a variable annuity, you can move from a stock subaccount to a bond subaccount without owing any capital gains tax. In a regular brokerage account, that switch would be a taxable sale.

The subaccounts are managed by well-known fund families — Fidelity, Vanguard, PIMCO, BlackRock, American Funds — but they're technically separate from the retail versions of those funds. Expense ratios inside subaccounts tend to be similar to, or slightly higher than, their retail counterparts.

The Fee Layer Cake

Here's where things get real. Variable annuities stack multiple fee layers on top of each other, and the total cost is the number one reason they draw criticism.

Mortality and Expense (M&E) Charge: 1.0%–1.5%

This is the cost of the insurance wrapper — the guarantee that your beneficiaries will receive at least your original investment back if you die (the standard death benefit) plus the company's profit margin and risk charge. M&E is charged as a percentage of your account value, deducted daily. It's the biggest single fee component.

Administrative Fee: 0.10%–0.30%

Covers the carrier's cost of recordkeeping, processing, and contract maintenance. Sometimes expressed as a flat annual fee ($25–$50) instead of a percentage.

Underlying Fund Expenses: 0.25%–1.0%

Just like retail mutual funds, each subaccount has its own expense ratio. This is the cost of managing the investments inside the subaccount. These vary widely — an index subaccount might charge 0.25%, while an actively managed international stock subaccount might charge 0.85%.

Optional Rider Charges: 0.75%–1.50%

If you add a living benefit rider (GLWB, GMIB) or an enhanced death benefit, each comes with its own annual charge. These are typically calculated as a percentage of the benefit base (which can be larger than your account value), making the dollar amount of the fee grow over time.

Let's add it all up:

A middle-of-the-road variable annuity with a living benefit rider commonly costs around 3% per year. On a $300,000 contract, that's $9,000 annually in fees.

Tax-Deferred Growth: The Double-Edged Sword

Variable annuities grow tax-deferred. No annual capital gains distributions, no dividend taxes, no tax drag from rebalancing. Over long periods, this compounding advantage is real.

But here's the catch that trips people up: when you eventually withdraw money, ALL gains are taxed as ordinary income. Not long-term capital gains. Not qualified dividends. Ordinary income — the highest rate.

In 2026, the top federal long-term capital gains rate is 20%. The top ordinary income rate is 37%. That's a 17-percentage-point difference. So the tax deferral you gained during accumulation gets partially clawed back through higher tax rates at withdrawal.

This doesn't automatically make variable annuities a bad deal tax-wise. If you invest for 15–20 years, the compounding benefit of deferral can outweigh the rate differential — especially if you're in a lower tax bracket in retirement than during your working years. But it means you need a long holding period for the tax math to work in your favor.

Death Benefits: The Standard and the Enhanced

Every variable annuity includes a standard death benefit at no additional charge: if you die, your beneficiaries receive the greater of your current account value or your total premiums paid (minus withdrawals). This protects your heirs from receiving less than you put in, even if the market tanked.

Enhanced death benefits are optional riders that cost extra. Common varieties include:

• Highest anniversary value — beneficiaries receive the highest account value recorded on any contract anniversary, even if markets have since declined.
• Ratcheting death benefit — the benefit base locks in gains periodically (annually or more frequently) and never decreases.
• Rising floor — the death benefit grows at a guaranteed rate (say 5% per year) regardless of investment performance.

Enhanced death benefits can be valuable if protecting a legacy is a primary goal, but the annual fees reduce your living account value. And remember — your beneficiaries will owe income tax on the gains.

Living Benefits: The Main Event

For many buyers, living benefit riders are the entire reason to own a variable annuity. These riders guarantee that regardless of what happens in the market, you'll receive a minimum level of income or account value. They're your safety net — the insurance part of this insurance product.

GLWB — Guaranteed Lifetime Withdrawal Benefit

The most popular rider. Here's how it works:

1. You buy the variable annuity and add the GLWB rider.
2. The rider establishes an income benefit base — typically equal to your premium, growing at a guaranteed roll-up rate (5%–7%) or stepping up to your highest account value on anniversaries.
3. When you activate the rider, you can withdraw a guaranteed percentage of the benefit base (typically 4%–6%, depending on age) every year for life.
4. Even if your account value drops to zero, the withdrawals continue. The insurance company pays from their general account.

This is powerful. It essentially creates a personal pension with market upside. If the market does well, your account value grows and your income base may step up. If the market crashes, your income is protected.

GMIB — Guaranteed Minimum Income Benefit

Similar in concept but requires you to annuitize the contract to receive the guarantee. After a waiting period (often 10 years), you can annuitize at the benefit base value — even if your account value is much lower. The guaranteed income is based on annuity purchase rates specified in the rider (which are typically less favorable than current market rates, but the higher benefit base compensates).

GMAB — Guaranteed Minimum Accumulation Benefit

Protects your account value rather than your income. After a waiting period (usually 10 years), the insurance company guarantees that your account value will be at least equal to your original premium — even if the market lost money. This is essentially a 10-year put option on your portfolio.

Who Variable Annuities Are Best For

This is where we get specific, because variable annuities are genuinely right for some people and genuinely wrong for others.

They may make sense if you:

• Have maxed out all other tax-advantaged accounts (401k, IRA, HSA) and want additional tax-deferred growth.
• Specifically want guaranteed lifetime income (GLWB) while maintaining market exposure and upside potential.
• Have a long time horizon (10+ years) that allows the tax deferral to overcome the higher fee structure.
• Value the ability to rebalance between asset classes without triggering capital gains taxes.
• Are a high-income earner in a state with high income taxes, where tax deferral is especially valuable.

They're probably NOT right if you:

• Haven't yet maxed out your 401(k) and IRA contributions.
• Have a short time horizon (under 10 years).
• Are primarily interested in accumulation and don't need guaranteed income — a low-cost index fund portfolio will almost certainly outperform after fees.
• Are buying primarily for the death benefit — life insurance is usually more cost-effective for legacy goals.
• Can't tolerate investment losses, even with a living benefit rider protecting income.

Why Variable Annuities Are Controversial

We want to address this head-on because you'll encounter strong opinions about variable annuities, and you deserve to understand why.

The case against them comes down to fees and suitability. For decades, variable annuities were sold aggressively — often to people who didn't need them, hadn't maxed out their 401(k), or were better served by a simple low-cost portfolio. The high commissions (typically 5%–7% to the selling agent) created a financial incentive to recommend them broadly. Additionally, the tax treatment at withdrawal (ordinary income vs. capital gains) can actually make investors worse off than a taxable account in many scenarios.

The case for them centers on the living benefit guarantees. Nothing else in the financial world offers the combination of market participation plus guaranteed lifetime income. A well-structured GLWB rider genuinely solves a retirement planning problem — the risk that a market crash early in retirement devastates your income plan. For someone who needs that specific protection and has exhausted other options, the fees can be justified.

Our position: Variable annuities are a tool. Like any tool, they can be used well or used poorly. We believe they're appropriate in a narrower set of circumstances than they've historically been sold into. If you're considering one, the single most important question is: "What specific problem is this solving that a lower-cost alternative can't?" If you have a clear, honest answer to that question, it might be the right product.

Things to Watch Out For

Beware the "tax-deferred" sales pitch. Tax deferral alone rarely justifies a variable annuity's fees. You need a long holding period AND a lower tax bracket in retirement AND the guarantees for the math to work. If someone is selling you a variable annuity purely on the tax deferral story, dig deeper.

Understand what happens to your account value. Living benefit riders protect your income, not your account value. It's entirely possible to receive guaranteed income while watching your account balance decline to zero. You'll still get paid, but there's nothing left for your heirs — the death benefit may have been consumed.

Check the surrender schedule before buying. Typical surrender periods are 5–8 years, with charges starting at 7%+ in year one. If you're buying a variable annuity inside an IRA (common), remember that you're adding a surrender period to money that was already in a tax-deferred account.

Watch for 1035 exchange churning. If an advisor recommends replacing your existing variable annuity with a new one (via 1035 exchange), ask why. A new surrender period starts, a new commission is paid, and the "improved" benefits may not justify restarting the clock. Exchanges can be legitimate, but they're also a common source of abuse.

Read the investment restriction requirements. Many living benefit riders require you to invest in specific "managed volatility" or balanced subaccount options. You can't go 100% aggressive stocks and still keep the income guarantee. These restrictions limit your upside — which is the whole reason you chose a variable annuity over a fixed index annuity.

The Bottom Line

Variable annuities are the most powerful — and most expensive — tool in the annuity toolbox. They offer something nothing else can: full market participation paired with guaranteed lifetime income protection. But that power comes with real costs, real complexity, and real potential for misuse.

If you're evaluating a variable annuity, don't go it alone. The prospectus is dense, the rider mechanics are intricate, and the fee math requires careful comparison against alternatives. We'll help you run the numbers honestly and figure out whether the guarantees are worth the cost for your specific situation.

Sometimes they are. Sometimes they aren't. Either way, you'll know.