Variable Annuities: How They Work, Pros & Cons, and Surrender Value Explained

A variable annuity is an insurance contract that allows you to invest premiums in sub-accounts similar to mutual funds, offering tax-deferred growth based on market performance, with future income payments that can vary depending on investment results.

What Agents Don’t Tell You About Variable Annuity Costs

When you sit down to discuss variable annuities, it is easy to focus on the tax-deferred growth potential, but the underlying cost structure is far more complex than many realize. While the average variable annuity offers 15-20 sub-accounts for your premiums, these come with annual expense ratios typically ranging between 0.5% and 2.0% for the sub-accounts alone. If you choose to add riders like guaranteed minimum income benefits (GMIBs) to promise lifetime payments regardless of market performance, you will encounter additional annual fees of 0.5-1.5%. These cumulative charges directly reduce your investment returns over time. Furthermore, if you decide the product no longer suits your needs, you face significant exit hurdles. Surrender charge schedules commonly last 7-10 years, starting as high as 7-8% in the first year, with some carriers charging up to 10% initially before decreasing by 1 percentage point annually. Although a 10% free withdrawal provision exists, any amount withdrawn is subject to ordinary income tax and a potential 10% IRS penalty if you are under age 59½. Because of these layers of fees and the long-term nature of surrender restrictions, it is crucial to understand that for investors under 55 with moderate risk tolerance, lower-cost vehicles like IRAs or index funds often provide superior long-term growth potential compared to variable annuities.

Disclaimer: This article is for informational purposes only. It is not legal, financial, or tax advice. Consult a licensed insurance professional, financial advisor, or tax professional for advice tailored to your specific situation. The information provided is based on general principles and may not reflect the most current regulations or product specifics.

• The average variable annuity offers 15-20 investment options (sub-accounts) ranging from aggressive growth to conservative bond funds, with annual expense ratios typically between 0.5% and 2.0% for the sub-accounts alone.
• Surrender charge schedules for variable annuities commonly last 7-10 years, starting at 7-8% in the first year and decreasing by 1 percentage point annually, though some carriers charge up to 10% initially.
• The 10% free withdrawal provision permits annual withdrawals up to 10% of contract value without surrender charges, but amounts withdrawn are subject to ordinary income tax and a 10% IRS penalty if taken before age 59½.
• Variable annuities often include guaranteed minimum income benefits (GMIBs) that promise lifetime payments regardless of market performance, but these riders add 0.5-1.5% annually in fees that reduce your investment returns.
• Verdict: For investors under 55 with moderate risk tolerance, low-cost index funds or IRAs typically provide better long-term growth potential with fewer fees and surrender restrictions than variable annuities.

What Is a Variable Annuity and How Does It Work?

A variable annuity is an insurance contract where your premiums are allocated to investment sub-accounts, offering tax-deferred growth tied to market performance, with future payouts that fluctuate based on those investments’ results.

Unlike fixed annuities that guarantee a specific interest rate, variable annuities expose your principal to market risk through underlying mutual fund-like sub-accounts. The insurance company promises to make periodic payments to you in the future, but the amount varies depending on how your chosen investment options perform. All growth within the contract accumulates tax-deferred until you begin withdrawals.

I’ve reviewed hundreds of variable annuity contracts, and the most consistent pattern I see is confusion between the contract’s stated value and what you’d actually receive if you surrendered today. The insurance company’s statement shows your ‘account value’ or ‘cash value’—this is the total of your premiums plus/minus investment gains/losses minus fees. However, your actual surrender amount is lower due to surrender charges, market value adjustments, and any outstanding loans against the policy.

How do variable annuities differ from fixed annuities?

Variable annuities invest premiums in market-linked sub-accounts with fluctuating returns, while fixed annuities guarantee a fixed interest rate set by the insurance company.

Fixed annuities provide predictable growth through a declared interest rate that resets periodically (often annually), similar to a CD but issued by an insurer. Variable annuities, by contrast, let you choose from dozens of sub-accounts ranging from aggressive stock funds to conservative bond funds, meaning your returns mirror the performance of those underlying investments. This market exposure offers higher growth potential but also risk of loss—something fixed annuities avoid by guaranteeing principal and a minimum interest rate.

According to SEC guidelines, variable annuities are considered securities because their value depends on the performance of the investment options you select, requiring them to be sold by licensed professionals with both insurance and securities registrations. Fixed annuities, being pure insurance products, only require an insurance license to sell.

What investment options are available in a variable annuity?

Typical variable annuities offer 15-20 sub-accounts including stock indices, bond funds, money market options, and sometimes specialized sectors like real estate or commodities.

The investment menu usually mirrors a mutual fund lineup: large-cap stock funds (like S&P 500 index), international equity funds, intermediate-term bond funds, and stable value options that aim to preserve principal. Some carriers offer ‘fixed account’ options within the variable annuity that guarantee a set interest rate for a period, blending features of both product types. Expense ratios for these sub-accounts typically range from 0.25% for index funds to over 1.5% for actively managed specialty funds, layered on top of the annuity’s base mortality and expense (M&E) fee.

In my experience, clients frequently overlook how sub-account fees compound with the annuity’s base charges. A sub-account charging 1.0% annually combined with a 1.25% M&E fee means 2.25% in total yearly costs before any surrender charges or rider fees—significantly eating into long-term returns compared to buying similar mutual funds directly.

How does tax-deferred growth work in a variable annuity?

Earnings inside a variable annuity grow tax-deferred, meaning you pay no taxes on dividends, interest, or capital gains until you withdraw funds.

This tax deferral allows your investment to compound without annual tax drag, similar to a traditional IRA or 401k. However, unlike those retirement accounts, there are no IRS contribution limits for non-qualified variable annuities (those bought with after-tax dollars). When you eventually take distributions, all earnings are taxed as ordinary income—not at the more favorable capital gains rate—and if you withdraw before age 59½, you typically face an additional 10% IRS penalty on top of ordinary income tax.

The exclusion ratio determines what portion of each annuity payment is considered return of principal (non-taxable) versus earnings (taxable). For non-qualified annuities funded with after-tax money, you only pay taxes on the earnings portion; for qualified annuities held within an IRA, 100% of distributions are taxable as ordinary income since no taxes were paid on the initial contributions.

What Are the Pros and Cons of Variable Annuities?

Variable annuities offer tax-deferred growth, investment flexibility, and optional lifetime income guarantees, but come with high fees, complex surrender charges, and market risk that can erode returns.

The primary advantages include the ability to invest in diversified market options while deferring taxes on growth, the potential for higher returns than fixed annuities during strong markets, and optional riders that guarantee minimum income or death benefits regardless of market performance. These features make them attractive to investors seeking tax-sheltered growth with downside protection through guarantees.

However, the disadvantages are substantial: layered fees (M&E charges, sub-account expenses, rider costs) often total 2-4% annually, surrender charges can lock up funds for 7-10 years with early exit penalties of 7-10% of principal, and market downturns directly reduce your account value. Unlike CDs or fixed annuities, there