Variable Annuities: Full Market Access, Full Market Risk, Full Fee Transparency

What Is a Variable Annuity?

Variable AnnuityVariable Annuity

An insurance contract that invests the owner’s premium in market-based sub-accounts (similar to mutual funds) with tax-deferred growth. Unlike fixed annuities, the account value fluctuates with market performance — it can increase or decrease. Variable annuities are securities regulated by the SEC and FINRA in addition to state insurance departments. They carry the highest fees of any annuity type (typically 2–3%+ annually) but offer full market participation and optional guaranteed living and death benefits. All insurance guarantees are backed by the issuing insurer’s financial strength and claims-paying ability. Not FDIC-insured.

Variable annuities are the most polarizing product in the annuity world. Critics point to fees that can exceed 3% per year — a cost that compounds into a massive drag over decades. Proponents note that no other product combines tax-deferred market growth with a guaranteed death benefit and optional lifetime income guarantees.

Both sides have a point. The truth is that variable annuities are a narrow-use product appropriate for a specific set of circumstances. For most investors, a low-cost index fund in a taxable account is a better choice. But for high-income individuals who have exhausted all other tax-advantaged accounts and specifically need an insurance guarantee alongside market exposure, a variable annuity fills a gap nothing else can.

This guide explains exactly how they work, breaks down every layer of fees, and gives you a clear framework for deciding whether the guarantees justify the costs — because in most cases, they do not.

How a Variable Annuity Works

1. You invest a premium with an insurance company. Minimums are typically $5,000–$25,000. The premium can come from savings, a 1035 exchange from another annuity, or a qualified account rollover.
2. You allocate among subaccounts. A typical variable annuity offers 30–100+ subaccounts — investment options similar to mutual funds covering domestic and international equity, fixed income, balanced strategies, and money market. You choose how to allocate your premium and can reallocate between subaccounts without triggering taxes.
3. Your account value fluctuates with the market. If your subaccounts gain 12%, your account goes up (minus fees). If they lose 15%, your account goes down. There is no floor, no cap, no buffer. This is direct market exposure inside an insurance wrapper.
4. Growth is tax-deferred. No annual taxes on capital gains, dividends, or rebalancing within the annuity. This is the primary tax advantage — you can trade between subaccounts without triggering taxable events.
5. Insurance guarantees apply. The standard death benefit (GMDB) ensures beneficiaries receive at least your total premiums paid. Optional living benefits (GLWB, GMAB) can provide lifetime income guarantees or principal protection at additional cost.
6. At withdrawal, gains are taxed as ordinary income (not capital gains rates). Early withdrawals before age 59½ incur a 10% IRS penalty. Surrender charges apply during the surrender period (typically 5–8 years).

Variable Annuity Fees: The Complete Picture

This is the section that determines whether a variable annuity makes financial sense for you. Variable annuities have multiple layers of fees that stack on top of each other. Understanding the total annual cost is essential.

Total fee examples

The compounding cost of fees

Fees do not just reduce your return in a single year — they compound against you over time. Consider a $200,000 investment over 20 years assuming 8% gross market return:

These are illustrative projections assuming 8% gross return, compounded annually. Actual returns will vary. Tax treatment differences are not reflected in this comparison.

The fee question you must answer: In the table above, the fully loaded variable annuity costs $420,000 in fees over 20 years compared to a low-cost index fund. The question is: are the insurance guarantees (death benefit, lifetime income, accumulation floor) worth $420,000 to you? For some investors in specific circumstances, the answer is yes. For most, it is not.

Variable Annuity Guarantees: Death Benefits and Living Benefits

The insurance guarantees are the only reason to pay variable annuity fees instead of investing in a low-cost fund. If you do not need these guarantees, you do not need a variable annuity.

Guaranteed Minimum Death Benefit (GMDB)

Included in virtually all variable annuity contracts at no additional explicit cost (it is covered by the M&E charge). The standard GMDB guarantees your beneficiary receives at least the total premiums paid, minus any withdrawals, regardless of market performance.

Example: You invest $200,000. The market drops and your account is worth $140,000 when you die. Your beneficiary receives $200,000 — not $140,000. If your account had grown to $280,000, the beneficiary receives $280,000 (the greater of account value or guaranteed minimum).

Enhanced GMDB options (at additional cost of 0.20–0.60% annually) may include: Highest anniversary value (ratchets the guaranteed minimum up to the highest account value on any contract anniversary), or Roll-up (grows the guaranteed minimum at a stated rate, e.g., 5% per year).

Guaranteed Lifetime Withdrawal Benefit (GLWB)

An optional living benefit rider (0.60–1.25% annually) that guarantees you can withdraw a specified percentage of a benefit base each year for life, regardless of account performance. The GLWB works similarly to an FIA income rider but with full market exposure in the base contract.

• Benefit base: May grow via step-ups (locks in account highs) or roll-up rate during deferral
• Withdrawal percentage: Typically 4–5.5% of benefit base depending on age at activation
• Lifetime guarantee: Withdrawals continue for life even if account value reaches $0
• Market upside: If the account grows beyond the benefit base, the base may step up, increasing guaranteed income

Guaranteed Minimum Accumulation Benefit (GMAB)

An optional rider (0.25–0.75% annually) guaranteeing your account value will be at least equal to your premium after a specified holding period (typically 10 years). Essentially a principal protection floor with a time lock. If the market declines over 10 years and your account is below the premium, the insurer makes up the difference.

Are these guarantees worth the cost? Always compare: a GMDB can often be replicated more cheaply with a term life insurance policy. A GLWB can be compared to an FIA income rider or a SPIA/DIA at lower total cost. A GMAB protects over 10 years, but historically, a diversified equity portfolio has been positive over every 10-year period. The guarantees have value — but quantify that value against the annual fee before committing.

How Variable Annuities Are Taxed

Tax Disclaimer: The following is general educational information only and does not constitute tax advice. Consult a qualified tax professional before making decisions based on tax considerations.

When does tax deferral actually help?

The value of tax deferral in a variable annuity depends on your time horizon and tax rates. The longer you hold, the more deferral benefits you. However, the higher fee drag and ordinary-income taxation can offset the deferral benefit — especially for investors who would otherwise hold low-turnover index funds (which are already highly tax-efficient). Academic research suggests the “breakeven” holding period where tax deferral overcomes the fee drag is often 15–20+ years, and only when the investor is in a lower tax bracket at withdrawal.

Variable Annuities vs. Alternatives

The honest assessment: For the vast majority of investors, a low-cost index fund in a taxable account or a maximized 401(k)/IRA is a better choice than a variable annuity. The variable annuity’s 2–3%+ annual fee drag, ordinary income taxation, and lack of step-up in basis create a significant headwind that tax deferral alone rarely overcomes. The variable annuity is appropriate only when a specific insurance guarantee justifies the cost — and the investor has already exhausted all lower-cost tax-advantaged options.

Variable Annuity Share Classes

Variable annuities come in different share classes that trade between surrender charges and ongoing fees:

I-Share/Advisory variable annuities have the lowest insurance costs but are only available through fee-based financial advisors (who charge their own advisory fee, typically 0.75–1.25%). Despite the advisor fee, total costs can still be lower than a traditional B-share. If you work with a fee-based advisor, always ask whether an advisory share class is available.

Variable Annuity Misconceptions

“The tax deferral makes up for the fees”

In most cases, it does not. A 2–3% annual fee drag is extremely difficult to overcome with tax deferral alone, especially when you factor in that: (1) gains are taxed as ordinary income, not capital gains; (2) there is no step-up in basis at death; and (3) low-turnover index funds are already highly tax-efficient. Academic analysis consistently shows that for most investors holding diversified equity portfolios, the fee-and-tax combination of a variable annuity produces worse after-tax results than a taxable index fund over 10–20+ years.

“I need a variable annuity for tax-deferred growth”

You may — but only if you have already maximized your 401(k) ($23,500 + $7,500 catch-up for 2025), Traditional or Roth IRA ($7,000 + $1,000 catch-up), HSA ($4,300 individual / $8,550 family), and 529 plans if applicable. All of these provide tax advantages at a fraction of the cost. A variable annuity should be the last tax-advantaged vehicle you use, not the first.

“Variable annuities are always bad”

This is the opposite misconception, often heard from fee-only advisors. Variable annuities are not inherently bad — they are expensive and narrow-use. For a high-income individual who has maxed all other options, specifically needs a guaranteed death benefit or lifetime withdrawal benefit, plans to hold for 15+ years, and will be in a lower tax bracket at withdrawal, a variable annuity can be the right tool. The problem is not the product — it is the frequency with which it is sold to people who do not fit this profile.

“The guaranteed 5% roll-up means I earn 5%”

Identical to the FIA income rider misconception. A GLWB roll-up rate applies to the benefit base (an income calculation figure), not your actual account value. Your real account is subject to market performance minus 3%+ in annual fees. The benefit base may show $300,000 while your actual account is worth $180,000. You cannot withdraw the benefit base as cash.

Already Own a Variable Annuity?

If you already own a variable annuity and are wondering whether to keep it, consider the following:

Reasons to keep it

• Still in surrender period: Surrender charges can be 5–7% in early years. It may be cheaper to hold until the surrender period expires.
• Valuable legacy riders: Some older contracts have GLWB or GMDB riders with terms no longer available in new products (e.g., 7%+ roll-ups). Surrendering means losing these legacy benefits permanently.
• Large embedded gains: If significant gains have accumulated, surrendering triggers ordinary income tax on all gains in the year of surrender. A 1035 exchange to a new annuity defers this tax.
• Using the death benefit: If you are in poor health and the GMDB exceeds the account value, the death benefit has real, current value for your beneficiaries.

Reasons to consider a change

• Surrender period has ended: You can exit without charges. Evaluate whether the ongoing 2–3%+ fees are justified by the remaining guarantees.
• Paying for riders you don’t use: If you are paying 0.95% annually for a GLWB you never plan to activate, that is dead cost.
• Better options available: A 1035 exchange to a lower-cost variable annuity, an FIA, or a fixed annuity avoids current taxation while potentially reducing ongoing fees.
• Estate planning concerns: The lack of step-up in basis means your heirs will owe ordinary income tax on all embedded gains. This may make the annuity the worst asset to leave behind.

Before making any changes: Consult both a tax professional and a licensed agent. A 1035 exchange can be complex, and the tax implications of surrendering a variable annuity with large gains can be significant. Evaluate legacy rider values carefully — some are worth more than the ongoing fees.