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Annuities

Variable Annuities: Growth-Focused Retirement Income

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Variable Annuities: Growth-Focused Retirement Income

A variable annuity is an insurance contract that ties your income and account value to the performance of investment subaccounts—pools of stocks, bonds, and other securities you select. Unlike fixed annuities, where your payment is locked in, a variable annuity's payout fluctuates based on market performance. The potential upside is higher income if markets perform well; the downside is volatility and, without protections, the risk of lower payments or even account depletion in a prolonged bear market.

Quick definition: A variable annuity links your income to market performance through investment subaccounts, offering growth potential but introducing market risk into your retirement income.

Key takeaways​

  • Variable annuities invest your premium in market-based subaccounts, so your account value and payments rise and fall with markets
  • They offer growth potential but lack the certainty of fixed annuities
  • Subaccount fees (1–2%) plus mortality and expense charges (1–3%) and riders can easily total 3–5% annually—a significant drag on returns
  • Guaranteed minimum income riders (GMIBs) and guaranteed minimum withdrawal benefits (GMWBs) can add insurance-like protections at an additional cost
  • Variable annuities are complex and often sold with high commissions; they require careful evaluation and are not suitable for all retirees

How variable annuities work​

When you purchase a variable annuity, your premium is allocated into subaccounts—investment options similar to mutual funds. The insurance company may offer 20–100+ subaccounts, ranging from aggressive stock portfolios to conservative bond funds. You control the allocation, and your account value grows (or shrinks) based on how those subaccounts perform.

For example, you invest $300,000 in a variable annuity, allocating 60% to a stock subaccount (tracking the S&P 500) and 40% to a bond subaccount. If the S&P 500 rises 10% and bonds rise 3% over the year, your account value would grow to approximately $300,000 × (1.06) = $318,000. The next year, if stocks fall 15%, your account value would fall to approximately $318,000 × 0.93 = $295,740. Your income (if you've begun taking distributions) would also fall because it's calculated as a percentage of your declining account balance.

Subaccounts and investment options​

Subaccounts are not mutual funds; they're insurance company-managed pools. But they function similarly: they hold stocks, bonds, or a mix, with managers making buy-sell decisions. The key differences are:

Subaccount fees are higher than mutual fund fees. An S&P 500 index mutual fund might cost 0.03–0.10% annually. The same index subaccount inside a variable annuity often costs 0.50–1.50% or more. This cost difference compounds dramatically over decades.

Subaccounts are managed separately. The insurance company maintains its own subaccounts, separate from the general account (which funds fixed annuities and insurance company operations). This separation protects annuity owners if the company faces financial trouble.

You cannot invest in the subaccounts outside the annuity. Unlike mutual funds, subaccounts are exclusive to the insurance company's annuity products. If you want those specific managers' strategies, you must own the annuity.

Fee structure: the complexity problem​

Variable annuities are known for complex fee structures:

Subaccount expense ratio: 0.50–2.00% annually (versus 0.05–0.20% for comparable mutual funds).

Mortality and expense (M&E) charge: 1.00–3.00% annually. This is insurance company overhead and profit; it's not a charge for any specific service but a percentage you pay for the insurance company to administer the contract.

Administrative fees: $25–$100 annually (sometimes waived).

Rider charges: If you add a guaranteed minimum income benefit (GMIB), guaranteed minimum withdrawal benefit (GMWB), or living benefits rider, that's an additional 0.50–2.00% annually.

Sales load (commission): If bought through a commission-based advisor, you might pay 5–7% upfront, though some variable annuities are sold with no front-end load (deferred sales loads are paid if you surrender early).

Adding these up is straightforward: 1.0% (subaccount) + 2.0% (M&E) + 1.0% (riders) = 4.0% per year. This is a massive headwind. For comparison, a diversified portfolio of low-cost index funds costs 0.10–0.30%. A variable annuity's 4% annual cost means your account must outperform a low-cost portfolio by 4% annually just to break even—a high bar.

Guaranteed income and living benefits riders​

To make variable annuities more appealing, insurance companies offer riders that provide guarantees. The most common are:

Guaranteed Minimum Income Benefit (GMIB): If your subaccount balance has declined, the insurer guarantees a minimum income level, typically a percentage of your original principal (e.g., 5% annually). If your $300,000 account has fallen to $200,000, the insurer tops up your income to $15,000 (5% of $300,000). This is insurance against poor market performance.

Guaranteed Minimum Withdrawal Benefit (GMWB): Similar to a GMIB, but you don't have to annuitize. You can withdraw a guaranteed amount annually (typically 5–10% of your original principal) for life, regardless of market performance. If markets fall, the insurer subsidizes the withdrawal to ensure you hit the guaranteed floor.

Guaranteed Minimum Account Value: Your account value is guaranteed never to fall below a percentage of your contributions (e.g., 100% or 110%). After major stock market declines, your account "steps up" to the new market value for protection going forward.

These riders are valuable insurance but they're not free. They typically cost 0.50–2.00% per year. And they incentivize you to stick with the annuity: if you surrender early and take a withdrawal, the guarantees may be forfeited or penalized.

Immediate variable annuities​

An immediate variable annuity begins paying you within 60 days, like an immediate fixed annuity. However, your monthly payment fluctuates based on subaccount performance. This is rarer than deferred variable annuities but useful for those wanting income now with growth potential.

For example, you buy a $300,000 immediate variable annuity, and the insurer calculates an initial monthly payment of $1,400 (based on your age, the portfolio mix, and historical returns). If your subaccounts rise 8% in the first year, your next year's payment might increase to $1,512. If subaccounts fall 10%, your payment might drop to $1,260. The volatility can be unsettling, especially for retirees on tight budgets.

Deferred variable annuities​

A deferred variable annuity accumulates for years (or decades) before you begin drawing. Your principal grows (or shrinks) based on subaccount performance. Then, at your chosen date, you can annuitize it into a fixed income stream, take systematic withdrawals, or access the balance.

For instance, you purchase a $200,000 deferred variable annuity at age 55, allocate it 70% stocks / 30% bonds. Over 10 years, if the portfolio returns average 6% annually, your balance grows to approximately $357,700. At age 65, you annuitize this $357,700 into a guaranteed monthly income of roughly $1,750–$1,900 for life (depending on rates and your choice of a single-life or joint annuity). Alternatively, you could take systematic withdrawals (perhaps 4% annually) or leave it invested.

Variable annuities vs. self-directed portfolios​

For many investors, a variable annuity is unnecessary. A simple portfolio of low-cost index funds or target-date funds offers:

  • Lower costs (0.05–0.30% annually vs. 3–5% for variable annuities)
  • More liquidity (you can withdraw anytime; some costs may apply, but no surrender charges)
  • Tax efficiency (especially in taxable accounts; you control when to realize gains and losses)
  • Flexibility (you can rebalance, adjust allocations, or exit whenever you want)
  • Transparency (you own actual mutual funds, not insurance-wrapped subaccounts)

The main advantage of a variable annuity over a self-directed portfolio is the income guarantee (if you add a rider). If you want guaranteed income but flexibility, you might compare a variable annuity with a living benefits rider to a simple portfolio plus an annuity for the guaranteed floor. The latter often costs less.

Tax efficiency considerations​

Variable annuities offer tax deferral inside the contract: gains are not taxed until you withdraw. However, this is redundant inside an IRA or 401(k), which already defer tax. In a taxable account, the tax deferral is valuable, but variable annuity fees often overwhelm the tax benefit. A low-cost portfolio in a taxable account (with tax-loss harvesting) is often more tax-efficient than a high-fee variable annuity.

When you withdraw from a variable annuity, the gains are taxed as ordinary income (not capital gains), which is less favorable than if you'd owned stocks directly (which receive long-term capital gains treatment). This is another reason variable annuities are best suited inside tax-deferred accounts like IRAs.

When variable annuities make sense​

Variable annuities are appropriate for a narrow set of situations:

  • You are in a high tax bracket, have maxed out all tax-deferred accounts (IRAs, 401(k), backdoor Roth), and want additional tax deferral. Then a low-cost variable annuity inside a taxable account, with minimal riders, might make sense.
  • You want guaranteed income but also growth potential and are willing to pay for riders that provide guarantees. A variable annuity with a GMIB or GMWB rider can provide both security and upside, though a simpler strategy (fixed annuity + low-cost portfolio) is often cheaper.
  • You expect very high returns from your subaccounts and can tolerate volatility. If you believe aggressive investing will outperform the cost drag, a variable annuity might be viable. (However, most investors are better off with a low-cost portfolio.)
  • You need creditor protection (in some states, annuities offer stronger creditor protections than brokerage accounts, though this is fact-dependent and should be verified with a lawyer).

For most retirees, variable annuities are unnecessarily complex and expensive.

Variable annuity flowchart​

Real-world examples​

Kevin, age 58 (tech executive): Kevin earns $400,000 annually, has maxed his 401(k) and backdoor Roth. He wants to invest $100,000 in additional tax-deferred vehicles. He purchases a low-cost variable annuity (0.75% M&E, 0.60% subaccount fees) outside any retirement account. The 1.35% total cost is significantly less than the 3–5% typical of variable annuities with riders. He allocates it 80% stocks / 20% bonds. Over 20 years, assuming 6% average returns, the account grows to roughly $320,000 after tax deferral—versus perhaps $290,000 in a taxable account paying taxes annually on gains. The tax deferral added ~$30,000 in value, justifying the cost.

Joan, age 70, health concerns: Joan has heart disease and expects a shorter-than-average lifespan. She has $500,000 in retirement savings. She purchases an immediate fixed annuity for $200,000, generating $1,100/month for life. She uses the remaining $300,000 to buy an immediate variable annuity (with a GMIB rider) for another $800/month in base payments. If markets soar, the variable annuity's payments might increase to $1,000+/month. If markets crash, the GMIB guarantees at least $800/month. She has guaranteed income ($1,900/month) with upside from the variable portion.

Marcus, age 55, conservative investor: Marcus wants to retire at 65 and is concerned about outliving his money. He purchases a $150,000 deferred variable annuity with a guaranteed minimum withdrawal benefit (GMWB), allowing him to withdraw 5% of his initial investment annually starting at 65, regardless of market performance. With a $150,000 initial balance, he's guaranteed $7,500/year (5%) for life, even if markets crash. He allocates the $150,000 conservatively (40% stocks, 60% bonds) to reduce the chance he'll need to claim the guarantee.

Common mistakes​

Buying a variable annuity without shopping for lower-fee options. Some variable annuities charge 2–3% in M&E fees alone (older contracts); newer ones sometimes offer 0.75–1.25%. The difference on a $300,000 account is $6,000–$5,250 annually. Always compare multiple carriers.

Adding unnecessary riders. Every rider (GMIB, GMWB, step-up guarantee) adds 0.50–1.50% to your annual costs. If you want guarantees, consider whether a cheaper fixed annuity plus a low-cost portfolio is simpler and less expensive.

Holding a variable annuity in an IRA, where the tax deferral is redundant. If you have a variable annuity inside a traditional IRA, you're paying 2–4% annually for tax deferral—but the IRA already defers tax. This is a waste. A low-cost mutual fund index inside the IRA is better.

Underestimating surrender charges and the cost of early exit. If you surrender a variable annuity in year 2 of a 7-year surrender period, you might face a 6% penalty on your balance. On a $300,000 account, that's $18,000. Ensure you can keep the money invested for the full surrender period.

Failing to understand the performance calculation. Some variable annuity illustrations show "past performance" of subaccounts, which is often cherry-picked. Average returns after fees are typically much lower. Always ask for returns after all fees and charges.

FAQ​

Are variable annuities suitable for my IRA?​

Generally no. An IRA already defers tax, so you're paying 2–4% annually for a benefit you already have. A low-cost mutual fund index inside an IRA is cheaper and more flexible. The exception: if you want a guarantee (through a GMIB or GMWB rider) inside your IRA and cannot get it any other way, a variable annuity might be acceptable—but even then, consider whether a fixed annuity inside the IRA plus a low-cost portfolio outside would be simpler.

Can I get out of a variable annuity if I change my mind?​

Yes, but surrender charges apply if you withdraw beyond the free-withdrawal amount (typically 10% annually) within the surrender period. After the surrender period ends, you can surrender the annuity without charges, though you lose any living benefits guarantees. Review your contract's surrender terms upfront.

What if the insurance company fails?​

State guarantee funds protect annuity holders, typically up to $250,000 per person, per insurer. Your guaranteed minimum income is protected, but the process can be slow. Buy only from highly-rated insurers (AM Best A or higher).

How do subaccount fees compare to mutual fund expense ratios?​

A stock index mutual fund costs 0.03–0.10% annually. The same index inside a variable annuity subaccount costs 0.50–1.50%. That 0.40–1.47% difference compounds significantly; over 20 years, it erodes roughly 8–35% of your gains. This is a major reason variable annuities are often not recommended for cost-conscious investors.

Should I prioritize a guarantee or potential growth?​

It depends on your longevity outlook, risk tolerance, and other income sources. If you have Social Security and a pension covering essentials, you can afford a growth-focused (no-rider) variable annuity. If you worry about outliving your money, a rider providing a guarantee makes sense—though a fixed annuity often provides better guarantees at lower cost.

Can I transfer a variable annuity to a new company?​

You can perform a 1035 exchange (under IRC Section 1035), which transfers the annuity to a new insurance company without immediate tax consequences. However, you may restart the surrender period with the new contract. Consult a tax professional; 1035 exchanges have rules and pitfalls.

Summary​

Variable annuities tie your income to market performance, offering growth potential but introducing complexity and high fees. They are rarely the best choice for most retirees due to cost structures averaging 3–5% annually. For those seeking guaranteed income with upside, a simpler combination—a fixed annuity for the floor, plus a low-cost portfolio for growth—often provides better value. Variable annuities are worth considering only for high-income individuals in peak tax brackets seeking tax deferral and willing to accept ongoing complexity.

Next​

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