What Is a Variable Annuity? How It Works, Risks & Payout Options

A variable annuity is a retirement contract issued by an insurance company that allows you to invest premiums in market-based subaccounts (like mutual funds) with the potential for higher returns, but also exposes you to market risk and typically includes surrender charges that can exceed 10% of your account value in the early years. Unlike fixed annuities, your returns depend on the performance of the underlying investment options, and you pay both investment fees and insurance charges that can total 2% to 4% annually or more.

What Agents Don’t Tell You About Variable Annuity Fees and Surrender Costs

When considering variable annuities, many investors remain unaware of how significantly the fee structure can degrade their long-term growth. While the focus is often on the potential for higher returns from market-based subaccounts, the reality is that you face a complex layer of costs that aggregate to between 2% and 4% annually or even more. The average variable annuity holder pays roughly 2.3% in total annual fees, which includes administrative costs, mortality and expense charges, and investment management fees. When you combine these with the added expense of optional riders, which can cost an additional 0.5% to 1.5% each year, the erosion of your account value is substantial compared to low-cost index funds that average only 0.06%. Furthermore, these fees are deducted from your account daily, meaning they reduce your net returns regardless of whether the market experiences gains or losses. Beyond these ongoing annual costs, you must also contend with the risk of surrender charges. These penalties typically start at 7% to 10% in the first year and decrease by 1% annually over a 7- to 10-year period. Since the average variable annuity holder surrenders their contract within just six years, many investors end up incurring these substantial charges, which can significantly surprise them when calculating their net surrender value.

Before purchasing any annuity product, request a variable annuity surrender calculator estimate to understand potential surrender charges and net surrender value based on your specific contract terms and holding period.

How Does a Variable Annuity Work?

A variable annuity has two phases: accumulation (where you pay premiums and choose investment options) and distribution (where you receive income payments or lump sums).

What happens during the accumulation phase?

During accumulation, your premiums are allocated to subaccounts (similar to mutual funds) whose value fluctuates with market performance.

You choose from a menu of investment options typically including stock, bond, and money market funds. The insurance company deducts administrative fees, mortality and expense (M&E) charges, and investment management fees from your account value daily. These fees reduce your net returns regardless of market performance. For example, a 2% annual fee on a $100,000 account reduces your balance by $2,000 each year even if the market gains 5%.

• Average M&E charge: 1.25%
• Average administrative fee: 0.15%
• Average investment management fee: 0.80%

What happens during the distribution phase?

During distribution, you can choose systematic withdrawals, lump-sum payments, or annuitization for guaranteed lifetime income.

Annuitization converts your account value into a series of payments based on life expectancy tables and current interest rates. However, once you annuitize, you typically lose access to your principal. Systematic withdrawals let you retain control but expose you to market risk and sequence of returns risk. The IRS treats earnings as ordinary income upon withdrawal, not capital gains.

What fees reduce your actual returns?

Variable annuities typically layer investment fees, insurance charges, and rider costs, often totaling 2% to 4%+ annually.

Beyond the base M&E and administrative fees, optional riders (like guaranteed minimum income benefits or death benefits) add 0.5% to 1.5% annually. Investment subaccounts carry their own expense ratios (averaging 0.50% to 1.50%). A 2023 study by the Center for Retirement Research at Boston College found the average variable annuity investor pays 2.32% in total annual fees, significantly eroding long-term compounding compared to low-cost index funds averaging 0.06%.

What Are the Risks and Downsides of Variable Annuities?

Variable annuities carry market risk, high fees, surrender charges, tax inefficiency, and complex surrender value calculations that often surprise owners.

How do surrender charges work?

Surrender charges typically start at 7% to 10% of your account value in year one and decrease by 1% annually over a 7- to 10-year period.

These charges apply if you withdraw more than the annual free withdrawal amount (usually 10%) during the surrender period. For example, a $100,000 annuity with an 8% year-one surrender charge would cost you $8,000 to surrender fully in the first year. Many contracts also apply a market value adjustment (MVA) that can increase or decrease your surrender value based on interest rate changes.

• Average surrender period: 8 years
• Average initial surrender charge: 8.5%
• Average MWA impact: ±2% to 5% of account value

Why are variable annuities tax-inefficient for heirs?

Unlike mutual funds, variable annuities do not get a step-up in basis at death, meaning heirs pay ordinary income tax on all gains.

If you leave a mutual fund to your heirs, they receive a step-up in basis to the market value at your death, eliminating capital gains tax on appreciation. With a variable annuity, the entire gain is taxed as ordinary income to your beneficiary. For example, a $100,000 gain in a mutual fund might save heirs $20,000 in taxes (assuming 15% capital gains rate), while the same gain in an annuity could cost them $24,000+ in federal income tax (assuming 24% bracket).

How does market risk affect your retirement income?

Market downturns during early retirement can severely impact your account value, especially if you’re taking withdrawals, increasing the risk of outliving your money.

Sequence of returns risk means that poor market returns early in retirement, combined with withdrawals, can deplete your account faster than average returns would suggest. A 20% market drop in year one of retirement, combined with a 5% withdrawal rate, requires a 30% return in year two just to break even—a significant hurdle.

What Are the Alternatives to Variable Annuities?

For most investors, maxing out 401(k)s and IRAs, then investing in low-cost index funds, provides better growth potential with lower fees and greater flexibility than variable annuities.

How do low-cost index funds compare?

A portfolio of low-cost index funds averages 0.06% in fees versus 2.32% for variable annuities, potentially adding hundreds of thousands to your retirement savings over 30 years.

Assuming a 6% annual return before fees, a $10,000 initial investment growing for 30 years would reach approximately $57,435 in index funds (0.06% fees) versus only $32,071 in a variable annuity (2.32% fees)—a difference of over $25,000. This gap widens with larger balances and longer time horizons.

When might a variable annuity make sense?

Consider a variable annuity only if you’ve maxed out tax-advantaged accounts, need a death benefit, and want lifetime income protection you cannot obtain elsewhere.

For example, if you’re concerned about outliving savings and have exhausted your 401(k) and IRA options, a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB) rider might provide peace of mind. However, compare the cost of that rider (often 0.80% to 1.20% annually) against purchasing a standalone immediate annuity or using a systematic withdrawal plan from a diversified portfolio.

• Average GLWB rider cost: 1.00%
• Average immediate annuity payout for 65-year-old male: 5.5% to 6.5%
• Average variable annuity GLWB payout: 4.5% to 5.5%

What about fixed indexed annuities?

Fixed indexed annuities offer principal protection with limited upside, typically averaging 2% to 4% annual returns after fees—often lower than a balanced portfolio’s historical returns.

While they avoid market losses, their returns are capped by participation rates (often 50% to 90%) and caps (often 4% to 6%). Over the past 20 years, the S&P 500 averaged approximately 9.8% annually before fees, while the average fixed indexed annuity returned about 3.2% annually after fees according to a 2023 study by the Insured Retirement Institute.

What Are the Tax Implications of Variable Annuity Withdrawals?

Withdrawals from variable annuities are taxed as ordinary income on earnings first, then return of principal, and early withdrawals before 59½ incur a 10% IRS penalty.

How does the exclusion ratio work?

The exclusion ratio determines what portion of each annuity payment is a tax-free return of your principal versus taxable earnings.

For example, if you invested $100,000 and your expected return is $200,000 over your lifetime, the exclusion ratio is 50%—meaning half of each payment is tax-free return of principal and half is taxable earnings. However, this calculation assumes you live to your life expectancy; if you live longer, 100% of payments beyond your life expectancy are taxable.

Are there exceptions to the 10% early withdrawal penalty?

Exceptions to the 10% IRS penalty include death, disability, substantially equal periodic payments (SEPP), and certain medical expenses—but not for general retirement income needs.

Note that even if you qualify for an exception, the earnings portion of your withdrawal is still taxed as ordinary income. For example, a $10,000 withdrawal at age 50 with $6,000 in earnings would incur a $600 penalty (10% of $6,000) plus income tax on the $6,000 earnings.

How are annuity inheritances taxed?

Non-spouse beneficiaries must withdraw the entire account within 10 years and pay ordinary income tax on all earnings, with no step-up in basis.

Spousal beneficiaries can typically assume the contract and continue tax-deferred growth. However, non-spouse beneficiaries (like children) must empty the account within 10 years of the owner’s death under the SECURE Act, potentially pushing them into higher tax brackets during those withdrawal years.

What Should You Ask Before Buying a Variable Annuity?

Ask about total annual fees, surrender charge schedule, market value adjustment policy, rider costs and benefits, and how the product compares to low-cost investment alternatives for your specific goals.

What is the total annual expense ratio?

Request a detailed breakdown of all fees: mortality and expense risk charge, administrative fees, investment management fees, and any rider costs.

Ask for the prospectus and specifically the “fees and expenses” section. A 2022 study by the Securities and Exchange Commission