The Real Costs and Limits of Variable Annuities

Variable annuities charge more than most other retirement investments

The biggest disadvantage of a variable annuity is its cost structure. Variable annuities typically charge between 1% and 3% per year in fees, compared to 0.05% to 0.20% for a low-cost index fund or exchange-traded fund. Those percentage points compound over decades and can reduce your final balance by hundreds of thousands of dollars.

These fees come from several places at once. You pay an annual management fee for the insurance company to oversee your account. You also pay mortality and expense (M&E) charges, which cover the insurance guarantees built into the contract. On top of that, if you choose investment options within the annuity (called subaccounts), you pay the expense ratios of those funds themselves. A variable annuity might charge 1.5% in M&E fees plus 0.75% in subaccount expenses, totaling 2.25% annually before you earn a single dollar of investment returns.

Key Takeaways

• Variable annuities charge 1% to 3% annually in combined fees, which can reduce your retirement balance by hundreds of thousands of dollars over time.
• Your money is locked in a contract for 5 to 10 years, and withdrawing more than a small amount before that period ends triggers a surrender charge that can be 5% to 10% of your withdrawal.
• The insurance guarantees that make variable annuities appealing only protect you if the insurance company stays solvent, and they do not protect you from poor investment choices within the annuity.
• Variable annuities are complex contracts with dozens of pages of terms, making it difficult to compare them to simpler retirement savings options like IRAs or 401(k)s.
• Your heirs receive only the death benefit amount, not any investment gains above that, which means the annuity can cost your estate money compared to leaving them a regular investment account.

Surrender charges trap your money for years

When you buy a variable annuity, you enter a contract that typically lasts 5 to 10 years. If you need to withdraw more than a small amount (often 10% per year) before that period ends, the insurance company charges a surrender fee. These fees usually start at 5% to 10% of your withdrawal amount and decline by 1% each year until the contract period ends.

This means if you buy a $100,000 variable annuity with a 7-year surrender period and a 7% initial surrender charge, withdrawing $50,000 in year two would cost you $3,500 in surrender fees alone. You would receive only $46,500 of your own money back. Even if you face a genuine financial emergency, the surrender charge penalizes you for accessing your own funds.

The surrender period is separate from any tax penalties. If you are under 59½, the IRS also charges a 10% early withdrawal penalty on earnings, which stacks on top of the surrender charge. A withdrawal that looks necessary in the moment can cost far more than you expected.

Guarantees only work if the insurance company survives

Variable annuities often advertise guarantees: a minimum death benefit, a may provide income floor, or protection against market losses. These guarantees sound reassuring, but they are only as good as the insurance company backing them. If the company fails, your may provide disappears, and you become a creditor in bankruptcy court along with thousands of other policyholders.

State insurance guaranty funds exist to protect annuity owners, but coverage limits vary by state and typically cap protection at $250,000 per contract. If your annuity is worth more than that and the company fails, you lose the excess. Additionally, guaranty funds do not cover investment losses — they only cover the insurance company's failure to pay what it promised.

The guarantees also do not protect you from making poor investment choices within the annuity. If you choose subaccounts that perform badly, the insurance company is not responsible. You bear the full investment risk while still paying the full fee for the may provide you did not use.

Complexity makes it hard to compare to simpler options

A variable annuity contract is typically 50 to 100 pages long, filled with definitions, conditions, and exceptions. Most people cannot read through it and understand what they own. This complexity makes it nearly impossible to compare a variable annuity to a straightforward alternative like a traditional IRA, Roth IRA, or 401(k).

When you own an IRA or 401(k), you know exactly what you own: specific funds or stocks. You can see the expense ratio of each holding. You can move your money to a different provider if fees rise or service declines. With a variable annuity, you are locked into the insurance company's subaccount options, and switching providers means paying surrender charges.

The complexity also works in the insurance company's favor during sales. A salesperson can emphasize the guarantees and downplay the fees because most buyers will not read the full contract. By the time you understand what you own, you are already locked in.

Tax treatment can work against you in inheritance

Variable annuities receive unfavorable tax treatment when passed to heirs. If you die with a $500,000 annuity that has grown to $700,000, your heirs receive the full $700,000 but must pay income tax on the $200,000 gain. With a regular investment account, your heirs would receive the $700,000 with a "stepped-up basis," meaning they owe no tax on the $200,000 gain.

Additionally, if your variable annuity includes a death benefit may provide (for example, a may provide that your heirs receive at least what you paid in), that may provide only pays the may provide amount, not the full account value. If your account grew to $700,000 but the may provide was $500,000, your heirs get $500,000 — and the insurance company keeps the extra $200,000.

Limited investment options within the annuity

Inside a variable annuity, you can only invest in the subaccounts the insurance company offers. You cannot buy individual stocks, bonds, or funds outside the annuity's approved list. This restriction limits your ability to build a diversified portfolio tailored to your goals and risk tolerance.

The subaccounts themselves often charge higher expense ratios than the same funds would cost if you bought them directly. An index fund might cost 0.05% per year on its own but 0.75% per year inside a variable annuity because the insurance company marks up the price.

Frequently Asked Questions

Is a variable annuity ever worth buying?

For some people in specific situations, yes. If you have a very large portfolio, are in a high tax bracket, and want may provide lifetime income, a variable annuity's guarantees might justify the cost. However, you should explore simpler alternatives first, such as a deferred income annuity (which costs less) or a combination of low-cost index funds and a separate when ready annuity for income.

Can I get out of a variable annuity if I change my mind?

Most states allow a "free look" period of 10 to 30 days after purchase, during which you can return the annuity without penalty. After that period ends, you are subject to surrender charges. Some people have successfully challenged variable annuity sales through arbitration if they can show the salesperson misrepresented the product, but this is expensive and uncertain.

What happens to my variable annuity if I do not withdraw money?

The contract continues, and you keep paying fees. Your money remains invested in the subaccounts you chose. The surrender period eventually ends, and you can withdraw without penalty, but fees continue for as long as you own the annuity. Some people keep variable annuities specifically for the may provide income rider, which requires paying fees indefinitely.

How do variable annuity fees compare to 401(k) fees?

A typical 401(k) charges 0.5% to 1% annually in combined fees. A variable annuity charges 1% to 3%. The difference compounds significantly over 20 or 30 years. On a $100,000 investment growing at 7% annually, the extra 1% to 2% in annuity fees could cost you $100,000 to $300,000 by retirement.

Should I avoid variable annuities completely?

Not necessarily, but you should understand the full cost and compare it to simpler alternatives before buying. A fee-only financial advisor (one who charges you directly rather than earning commission from the sale) can help you determine whether a variable annuity makes sense for your specific situation. Many people find that lower-cost options meet their goals without the complexity and surrender charges.