A variable annuity is primarily intended to offer a consistent income stream during retirement. However, it is more complex, expensive, and risky compared to other types of annuities.

While there’s potential for growth if the investments within the annuity perform well, the complexities and costs involved may make it less appealing. Many investors might find simpler and more cost-effective methods for growing their retirement savings.

What is a variable annuity?

A variable annuity is a contract with an insurance company that helps you build retirement savings and provides a steady income stream during retirement.

You agree to make either a lump sum deposit or a series of premium payments to the insurer. In return, the company promises to pay you a stream of income for the duration of your retirement or for a period you select.

Unlike traditional fixed annuities with a guaranteed return, variable annuities have their value tied to the performance of underlying investments. You choose from a selection of sub-accounts, similar to mutual funds, which invest in stocks, bonds, or a combination of both. As a result, the value of your annuity can fluctuate based on the performance of your chosen investments.

How a variable annuity works

A variable annuity has two main phases: the accumulation phase and the payout phase.

Accumulation Phase: This phase typically lasts several years, during which you invest money into the annuity and let it grow. The growth on your investments is tax-deferred, meaning you won’t owe taxes on the earnings until you withdraw funds from the annuity. Some variable annuities offer the option to allocate part of your investment to a fixed account, which guarantees a minimum return, usually between 1% and 3%.

Payout Phase: When you reach retirement or decide to start receiving payments, you enter the payout phase. At this point, your accumulated funds are converted into periodic payments, which can be structured to last for a specific period or for your lifetime. During this phase, known as annuitization, you may be restricted from making withdrawals from the account.

The amount of income you receive from a variable annuity depends on several factors, including the performance of your investments, your age, and the duration of your payment schedule.

Death benefit and other features

Variable annuities often include a death benefit, which ensures that your beneficiaries receive a specified amount if you pass away before annuitization.

Depending on your contract, your beneficiary will receive either the full account balance or a guaranteed minimum amount, whichever is greater.

Additionally, variable annuity contracts can have optional features, known as riders. For example, long-term care riders can assist with paying for assisted living expenses, while income riders guarantee a minimum income stream regardless of the performance of the underlying investments. Keep in mind that these riders come with extra costs.

Variable annuity fees

Understanding the fee structure of a variable annuity is essential before committing to a contract, as these fees can significantly affect the growth of your retirement savings over time.

Here’s an overview of common fees associated with variable annuities:

  • Surrender Charge: If you withdraw funds from the annuity before a specified period, usually the first five to ten years, you may incur a surrender charge. This fee is intended to discourage early withdrawals.
  • Mortality and Expense Risk (M&E) Charge: This fee covers the insurance company’s cost of providing the guaranteed death benefit and other administrative expenses. It is typically a percentage of your account value, usually 1.25 percent or more annually.
  • Administration Fee: This fee covers the insurer’s ongoing costs for managing your account and can be charged as a flat rate or a percentage of your account value.
  • Underlying Fund Expenses: These fees are related to the management of the sub-accounts within the annuity and are similar to the expense ratios found in mutual funds and ETFs.
  • Other Fees and Charges: Additional costs may apply for optional riders attached to the annuity.

Combined, these annual fees can total 2 to 4 percent of the annuity’s value, compared to the typical 1 percent annual fee charged by financial advisors for managing investment portfolios.

Additionally, if you withdraw funds from an annuity before age 59½, you will face a 10 percent penalty from the IRS.

Can you lose money with a variable annuity?

Absolutely. Variable annuities come with no guarantees on returns, and there’s a risk of losing money.

Unlike fixed and fixed index annuities, variable annuities do not guarantee your principal. Instead, the value of your account fluctuates based on market performance. High fees and penalties can further diminish the value of your annuity.

Both the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have issued warnings about variable annuities. The SEC points out the high costs and complexity of these products, while FINRA advises caution regarding aggressive sales tactics. Variable annuities are also a frequent source of investor complaints to FINRA.

Consumer interest in variable annuities is declining. In 2023, variable annuity sales fell by 17 percent, while sales of fixed annuities surged. According to LIMRA, the leading insurance industry trade association, variable annuities accounted for only about 13 percent of the total $385.4 billion in annuity sales for the year, marking the lowest sales year ever recorded by LIMRA.

Benefits of variable annuities

Variable annuities are typically better suited for investors with a higher risk tolerance who have already maxed out other retirement savings options, such as a workplace 401(k) plan.

Here are some key benefits they offer:

  • Growth Potential: Variable annuities can provide the potential for higher returns compared to fixed annuities, thanks to the growth of the underlying sub-accounts.
  • Professional Management: You select your investments, and the insurance company manages the account, which can alleviate the stress of managing your withdrawals during retirement.
  • Tax-Deferred Growth: Earnings within the annuity grow tax-deferred until you make withdrawals.
  • Guaranteed Income Stream: Annuities offer a predictable income stream in retirement, which can supplement Social Security and help ensure you don’t outlive your savings.

Drawbacks of variable annuities

Every investment carries risk, and variable annuities have notable drawbacks to consider:

  • Market Risk: The value of your annuity is subject to market fluctuations, meaning your principal can rise or fall based on the performance of the underlying investments.
  • High Fees: Variable annuities often come with higher fees compared to many other investment and financial products.
  • Sales Practices: Some financial advisors or insurance brokers may promote variable annuities due to the high commissions they earn, rather than because they are the best fit for your financial goals.
  • Limited Liquidity: Early withdrawals are usually subject to surrender charges, and canceling your annuity contract after you start receiving payments can be both difficult and costly.

How to buy a variable annuity

Purchasing a variable annuity involves several steps, and understanding the sales process is crucial for making an informed decision.

Start by researching and comparing variable annuity products from reputable insurance companies. Focus on key factors such as fees, investment options, optional riders, and the financial strength of the insurer.

Once you find a variable annuity that suits your needs, reach out to a licensed insurance agent or financial advisor authorized to sell annuities. They will guide you through the process and help explain the terms of the annuity contract.

The agent or advisor will provide you with a prospectus, a disclosure document containing detailed information about the annuity and its investment options. Review this document thoroughly and ask questions about anything you don’t understand.

Before finalizing the contract, consider these questions:

  • Do I understand the fees and charges? Variable annuities can have various fees, including sales and administrative charges. Ensure you know how these fees are applied and whether they are competitive compared to other investment options.
  • Can I handle the risk? The value of a variable annuity fluctuates with market performance, meaning you could experience gains or losses.
  • Do I need access to my money? Variable annuities may have restrictions on accessing funds, such as surrender periods or withdrawal fees.
  • Have I maxed out tax-advantaged retirement accounts? Consider whether you have already contributed the maximum to accounts like 401(k)s and IRAs, which offer similar tax benefits with potentially lower costs.
  • Do I need additional features? Variable annuities may offer extra benefits, such as long-term care riders, for an additional cost. Determine if these benefits can be obtained separately at a lower price.

By addressing these questions, you can make a well-informed decision. Additionally, remember that annuity contracts often come with a 10 to 30-day “free look period,” allowing you to cancel the contract without penalties if you change your mind.

In Conclusion

Variable annuities are not a universal solution for retirement planning. While they might be suitable for investors seeking higher growth potential and a guaranteed income stream, the associated fees and complexity may outweigh the benefits for others.

Before investing in a variable annuity, take the time to evaluate your investment goals, risk tolerance, and retirement timeline. Consulting with a qualified financial advisor can help you assess your specific needs and determine if a variable annuity aligns with your overall investment strategy.