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

What Is a Variable Annuity?

What sets a variable annuity apart from every other annuity type is straightforward: real investment risk is on the table. The money goes into subaccounts — essentially mutual-fund-style portfolios — and the account value rises and falls with market performance. There's no floor. No guaranteed rate. No safety net on the account value itself, though optional riders can protect income (more on that shortly).

Why would anyone choose this? Two reasons: unlimited upside potential and tax-deferred growth. Unlike fixed and indexed annuities where the insurance company limits returns, a variable annuity lets you fully participate in market gains. An 18% subaccount return delivers 18% (minus fees). An 18% loss is, well, an 18% loss.

Variable annuities are insurance contracts, regulated by both state insurance departments AND the SEC (because the subaccounts qualify as securities). They're sold by people who hold both insurance and securities licenses. They come with a prospectus — often 200+ pages of dense paperwork that nobody wants to read, which is a big part of how variable annuities end up in portfolios where they don't belong. Read it, or have an advisor walk through the sections that actually matter.

These are the most complex annuity products on the market, and easily the most controversial. Some people love them. Some people hate them. Both camps have a point. What follows is the full picture — the good, the bad, and the expensive.

How Subaccounts Work

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

• 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)

Money can be allocated across these subaccounts in any combination, and reallocations don't trigger a taxable event. That's one of the genuine advantages — switching from a stock subaccount to a bond subaccount inside a variable annuity creates no 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, 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 beneficiaries will receive at least the original investment back at death (the standard death benefit) plus the company's profit margin and risk charge. M&E is charged as a percentage of the account value and deducted daily. It's the biggest single fee component.

Administrative Fee: 0.10%–0.30%

Covers the carrier's 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 — 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%

Living benefit riders (GLWB, GMIB) and enhanced death benefits each come with their own annual charge. These are typically calculated as a percentage of the benefit base (which can be larger than the account value), so the dollar amount of the fee grows over time.

Stacking 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: on withdrawal, 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 gap. So the tax deferral gained during accumulation gets partially clawed back through higher tax rates at withdrawal.

That doesn't automatically make variable annuities a bad deal tax-wise. Over 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 working years. But the math requires a long holding period to tilt in the buyer's favor.

Death Benefits: The Standard and the Enhanced

Every variable annuity includes a standard death benefit at no additional charge: at death, beneficiaries receive the greater of the current account value or total premiums paid (minus withdrawals). This protects heirs from receiving less than was contributed, 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 when legacy is a primary goal, but the annual fees reduce the living account value. And remember — 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, a minimum level of income or account value will be available. They're the safety net — the insurance part of this insurance product.

GLWB — Guaranteed Lifetime Withdrawal Benefit

The most popular rider. The mechanics:

1. Buy the variable annuity and add the GLWB rider.
2. The rider establishes an income benefit base — typically equal to the premium, growing at a guaranteed roll-up rate (5%–7%) or stepping up to the highest account value on anniversaries.
3. Once activated, a guaranteed percentage of the benefit base (typically 4%–6%, depending on age) can be withdrawn every year for life.
4. Even if the 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, the account value grows and the income base may step up. If the market crashes, income is protected.

GMIB — Guaranteed Minimum Income Benefit

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

GMAB — Guaranteed Minimum Accumulation Benefit

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

Who Variable Annuities Are Best For

This is where specifics matter, 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 keeping 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 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

It's worth addressing this head-on, because anyone shopping for one will encounter strong opinions on both sides.

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. The tax treatment at withdrawal (ordinary income vs. capital gains) can also leave 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 an income plan. For someone who needs that specific protection and has exhausted other options, the fees can be justified.

The honest take: Variable annuities are a tool. Like any tool, they can be used well or used poorly. They're appropriate in a narrower set of circumstances than they've historically been sold into. The single most important question to answer before buying: "What specific problem is this solving that a lower-cost alternative can't?" A clear, honest answer to that question is what separates a reasonable purchase from a regrettable one.

Things to Watch Out For

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

Understand what happens to your account value. Living benefit riders protect income, not account value. It's entirely possible to receive guaranteed income while watching the account balance decline to zero. The payments still arrive, but there's nothing left for 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. Buying a variable annuity inside an IRA (which is common) adds a surrender period to money that was already in a tax-deferred account.

Watch for 1035 exchange churning. If an advisor recommends replacing an 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 investment in specific "managed volatility" or balanced subaccount options. You can't go 100% aggressive stocks and still keep the income guarantee. These restrictions limit upside — which is the whole reason to choose 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 does: full market participation paired with guaranteed lifetime income protection. But that power comes with real costs, real complexity, and real potential for misuse.

When evaluating a variable annuity, going it alone isn't the right move. The prospectus is dense, the rider mechanics are intricate, and the fee math requires careful comparison against alternatives. An independent walk-through of the numbers — honestly and without a commission incentive — is the way to figure out whether the guarantees are worth the cost for a specific situation.

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