Variable Annuities in 2026: A Comprehensive Guide to Risks and Returns

Variable annuities are tax-deferred insurance contracts where your account value fluctuates based on the performance of selected sub-account investment portfolios. These products combine insurance features with market-linked growth, but they often carry higher internal costs than standard brokerage accounts.

How Do Variable Annuities Work in 2026?

Variable annuities are investment contracts that link account value to sub-account market performance while offering optional death benefits.

What Agents Don’t Tell You About Variable Annuity Fee Structures

When you sit down to review a contract, the complexity of the internal costs often obscures the true drag on your long-term wealth accumulation. While variable annuities function by linking your account value to the performance of selected sub-account investment portfolios—much like mutual funds that track equities, bonds, or money market instruments—the actual returns you realize are the net result of market gains or losses after significant deductions. Insurance carriers often bundle several layers of expenses, including mortality and expense (M&E) risk fees, which typically range between 1.00% and 1.50%, along with administrative fees and rider costs. These combined internal costs frequently result in annual expense ratios between 2% and 4%. Most investors fail to realize that these hidden costs, particularly when elective income protection riders are added, can total over 3% annually, which significantly reduces your potential net gains compared to standard brokerage accounts. Furthermore, surrender charges act as an insurance company’s mechanism for recovering the initial commission paid to the agent, creating a situation where your net surrender value is substantially lower than your account balance during the initial 7 to 10 year period. Being aware of these high-fee structures is critical before committing capital to these tax-deferred insurance contracts.

What are the primary components of a variable annuity?

A variable annuity consists of an accumulation phase, sub-account investment options, and optional insurance riders for income guarantees.

During the accumulation phase, your principal is invested in sub-accounts, which function similarly to mutual funds. These accounts track equities, bonds, or money market instruments. Unlike a fixed annuity, there is no guaranteed interest rate on these funds.

Insurance carriers offer “riders” that provide guaranteed minimum withdrawal benefits or death benefits. These riders act as a safety floor for your principal, but they increase your annual contract fees significantly. As I have noted in my practice, many investors pay for guarantees they never actually trigger.

How are returns calculated for variable annuities?

Returns are the net result of market gains or losses in chosen sub-accounts after deducting annual administrative and insurance fee costs.

• Gross Sub-account Return: Total market performance of underlying assets.
• Mortality and Expense (M&E) Fee: Typically 1.00% to 1.50% for insurance coverage.
• Administrative Fees: Flat annual charges for managing the contract.
• Rider Costs: Additional percentage fees for elective income protection features.

What Are the Hidden Costs of Variable Annuities?

Variable annuities include M&E fees, surrender charges, and rider costs that often total over 3% annually, significantly reducing net gains.

How do surrender charges impact your capital access?

Surrender charges penalize early withdrawals, typically starting near 10% and decreasing on a sliding scale over a 7 to 10 year period.

The surrender charge is the insurance company’s mechanism for recovering the initial commission paid to the agent. If you exit the contract during the first few years, your net surrender value will be substantially lower than your account balance.

I often see clients who were unaware that their surrender schedule resets if they perform a 1035 exchange. This “churning” practice can keep an investor locked in high-fee products indefinitely. Always request a clear schedule of these charges before you sign.

What is the tax treatment for annuity withdrawals?

Withdrawals are taxed on a LIFO basis, meaning earnings are withdrawn first and subject to ordinary income tax rates upon distribution.

Factor	Tax/Penalty Impact
Earnings	Ordinary income tax rates
Principal	Tax-free recovery of cost basis
Under 59½	10% IRS penalty on earnings

How Do You Compare Variable Annuities to Other Vehicles?

Variable annuities offer tax-deferred growth, while index funds or ETFs typically provide lower fees and higher long-term liquidity options.

When should you consider a 1035 exchange?

A 1035 exchange allows you to move funds between annuities without immediate tax consequences if specific IRS transfer rules are followed.

If you have an older, high-fee variable annuity, you might consider moving to a newer product with lower costs. However, you must evaluate if the benefit of lower fees outweighs the cost of a new surrender charge period. For those looking to exit entirely, consult our guide on calculating annuity surrender values.

What are the alternatives to variable annuities?

Alternatives include low-cost index funds, tax-efficient brokerage accounts, and fixed indexed annuities for capital protection needs.

• Low-Cost ETFs: Offer broad market exposure with expense ratios often below 0.10%.
• Fixed Indexed Annuities: Provide protection against downside market risk with capped upside potential.
• Traditional IRAs: Offer tax-deferred growth without the high insurance-related contract fees.

Frequently Asked Questions

Can I lose money in a variable annuity?

Yes, the sub-accounts are market-linked and can decline in value, meaning your account balance may drop below your initial contribution.

Does the death benefit protect the full principal?

Only if you purchase a specific death benefit rider, which incurs an additional annual fee deducted from your total account value.

Is the 10% penalty avoidable?

The 10% penalty is generally avoidable only via specific exceptions like disability, death, or substantially equal periodic payments.

How can I check my current surrender charge?

Contact your insurance carrier directly to request a “net surrender value” statement, which details your current exit costs today.

Are variable annuities considered securities?

Yes, variable annuities are regulated as securities by the SEC because the investor bears the underlying investment market risk.

What happens at age 59½?

At age 59½, you are no longer subject to the 10% IRS early withdrawal penalty, though ordinary income tax still applies to earnings.

Can I withdraw my principal without taxes?

Yes, your cost basis is returned tax-free, but IRS rules require you to exhaust all gains before accessing the original principal amount.

How are agents compensated?

Agents receive commissions often ranging from 5% to 8% of your initial premium, which is a structural cost built into the annuity.

Is the 10% free withdrawal really free?

The 10% free withdrawal waives the surrender charge, but it remains fully taxable and subject to IRS penalties if under age 59½.

Why do insurers prefer I keep the policy?

Insurers maintain your assets as part of their capital base and continue to collect annual M&E fees as long as the contract remains open.