How Variable Annuities Work and What You Pay For

A variable annuity lets you control how your money is invested, but your payments and the value of your account rise and fall with market performance

A variable annuity is an insurance contract where you give money to an insurance company, and they invest it in options you choose — usually mutual funds or similar portfolios. Unlike a fixed annuity, which pays you a set amount each month, a variable annuity's payment amount depends on how well those investments perform. If your investments gain value, your payments may increase. If they lose value, your payments may decrease.

You can buy a variable annuity with a lump sum or add money over time during an accumulation phase. When you're ready to receive income — either when ready or years later — the insurance company converts your account balance into regular payments. The length of those payments depends on the payout option you choose: for life, for a set number of years, or until the money runs out.

Key Takeaways

• Variable annuities tie your payment amount to investment performance, so your income can go up or down depending on market results.
• You choose how your money is invested from a menu of options provided by the insurance company, typically mutual funds or similar portfolios.
• Variable annuities charge multiple layers of fees — insurance charges, investment management fees, and often surrender charges if you withdraw money early.
• The insurance company guarantees to convert your account balance into income payments, but does not may provide the payment amount will stay the same.
• Variable annuities are complex contracts with long terms, so reading the prospectus and understanding all fees before buying is essential.

How your money grows during the accumulation phase

When you first buy a variable annuity, your money enters an accumulation phase where it sits invested in the options you selected. The value of your account grows or shrinks based on how those investments perform — you own the upside and the downside. Unlike a savings account or money market fund, there is no may provide minimum return.

During this phase, you typically pay an annual insurance charge (sometimes called a mortality and expense fee or M&E fee), which covers the insurance company's cost of guaranteeing to pay you later. You also pay investment management fees charged by whoever manages the mutual funds or portfolios you chose. Some variable annuities let you add a may provide minimum income benefit (GMIB) or similar rider for an extra fee — this guarantees a minimum payment amount when you start receiving income, even if your investments have lost value.

You can usually withdraw money during accumulation, but many contracts charge a surrender charge if you withdraw more than a small amount (often 10 percent per year) in the first 5 to 10 years. The surrender charge percentage typically decreases each year. After the surrender period ends, you can usually withdraw your full balance without penalty, though you may still owe income tax on gains.

What happens when you start receiving payments

When you reach the payout phase, the insurance company converts your account balance into income. The amount of each payment depends on three things: your account balance at that time, your age, and which payout option you chose. If your account balance is higher because investments performed well, your payments will be higher. If your balance is lower because of market losses, your payments will be lower.

Common payout options include: payments for your lifetime (the insurance company takes the risk you live a long time); payments for a set period like 10 or 20 years (payments stop after that time, even if you're still alive); or a joint-and-survivor option (payments continue to a spouse or beneficiary after you die). Each option produces a different payment amount — lifetime payments are usually highest because the insurance company is taking on longevity risk.

Once you start receiving payments, you cannot change the payout option or go back to accumulation. This is a permanent decision, so understanding your choices before you convert is important.

Fees and costs you will encounter

Variable annuities are expensive compared to other retirement savings vehicles. A typical variable annuity charges:

• Mortality and expense (M&E) fee: Usually 0.5 to 1.5 percent per year, paid to the insurance company for the may provide to pay you later.
• Investment management fees: Usually 0.5 to 2 percent per year, depending on which mutual funds or portfolios you choose. These vary widely.
• Administrative fees: Some contracts charge a flat annual fee ($25 to $100 or more) for record-keeping and account maintenance.
• Rider fees: If you add a may provide income benefit or other rider, you pay an extra fee — often 0.5 to 1 percent per year or a flat amount.
• Surrender charges: If you withdraw more than the allowed amount during the surrender period, you pay a percentage of the withdrawal — often 5 to 10 percent in year one, declining each year.

These fees are deducted from your account automatically. Combined, they often total 2 to 4 percent per year or more, which significantly reduces how much your money can grow. Before buying, ask the insurance company for a written breakdown of all fees and charges, and compare the total cost to simpler alternatives like index funds or target-date funds in an IRA or 401(k).

Variable annuities versus fixed annuities

The main difference is who bears the investment risk. With a fixed annuity, the insurance company invests your money and guarantees you a set payment amount — the company takes the risk if investments perform poorly. With a variable annuity, you choose the investments and bear the risk yourself — if markets fall, your account value and future payments fall too.

Fixed annuities offer predictability and safety but typically lower returns. Variable annuities offer the potential for higher returns if markets perform well, but also the risk of lower returns or losses. Fixed annuities also have lower fees because the insurance company is managing the investments and taking the risk. Variable annuities have higher fees because you are managing the investment choices and the insurance company is only guaranteeing to convert your balance into income.

Some people buy a variable annuity hoping to get both the upside of market growth and the safety of a may provide income. Riders that add guarantees (like a may provide minimum income benefit) can provide this, but they cost extra and reduce your overall returns.

Tax treatment of variable annuities

Money inside a variable annuity grows tax-deferred, meaning you do not pay income tax on investment gains each year — only when you withdraw money or start receiving payments. This is similar to a traditional IRA or 401(k). However, variable annuities are not retirement accounts themselves; they are insurance contracts that can be held inside or outside a retirement account.

When you withdraw money during accumulation or start receiving payments, you owe ordinary income tax on any gains (the difference between what you put in and what your account is worth). This is true even if the gains came from long-term capital appreciation, which normally gets preferential tax treatment in regular investment accounts. If you withdraw before age 59½, you may also owe a 10 percent early withdrawal penalty on the gains portion (not the portion you contributed).

If you own a variable annuity inside a traditional IRA or 401(k), the tax treatment is the same as the retirement account — you pay tax when you withdraw. If you own one outside a retirement account, you pay tax on gains when you take money out. The tax-deferred growth can be valuable, but it is not unique to annuities; IRAs and 401(k)s offer the same benefit without the high fees.

Who variable annuities may fit and who they may not

Variable annuities may make sense for someone who wants professional investment management within an insurance contract, has a large amount of money to invest, and plans to hold the contract for many years (to avoid surrender charges). They may also fit someone who wants a may provide income stream in retirement and is willing to pay for riders that provide that may provide.

Variable annuities are usually not a good fit for someone who needs access to their money in the near term (surrender charges explore), someone who is uncomfortable with market risk (a fixed annuity or bonds might be better), or someone who wants low-cost investing (index funds in an IRA cost far less). They are also not necessary for tax-deferred growth — a traditional IRA or 401(k) offers the same benefit at a fraction of the cost.

Before buying a variable annuity, compare the total cost (all fees combined) to the cost of holding the same investments in a regular brokerage account or retirement account. The insurance company should provide a prospectus that lists all fees, investment options, and terms. Read it carefully or have a financial professional review it with you.

Frequently Asked Questions

Can I lose money in a variable annuity?

Yes. Your account value can fall if the investments you chose perform poorly. The insurance company guarantees to convert whatever balance remains into income payments, but does not may provide the balance will stay the same or grow. If you add a rider that guarantees a minimum income amount, that may provide applies only to your future payments, not to your account value during accumulation.

What happens to my variable annuity if I die?

If you die during accumulation (before you start receiving payments), your beneficiary receives the account balance or a may provide minimum amount, whichever is higher. This is one of the insurance features of the contract. If you die after you start receiving payments, what happens depends on the payout option you chose — if you chose lifetime payments with no survivor benefit, payments stop and your beneficiary receives nothing; if you chose a joint-and-survivor option, payments continue to your spouse or other beneficiary.

Can I change my investment choices after I buy a variable annuity?

Yes, most variable annuities let you move money between investment options without triggering a surrender charge, though you may pay a small transaction fee. However, you cannot change your payout option once you start receiving payments — that choice is permanent.

What is the difference between a variable annuity and a mutual fund?

A mutual fund is an investment only — you own shares and receive no insurance guarantees. A variable annuity is an insurance contract that invests in mutual funds or similar options. You pay extra for the insurance features (the may provide to convert your balance into income), which is why variable annuities cost more. If you only want investment growth, a mutual fund in a regular account or IRA is usually cheaper.

Do I have to buy a variable annuity through an insurance agent?

Most variable annuities are sold through insurance agents or brokers who earn a commission. Some are available directly from insurance companies. Commissions are typically 5 to 10 percent of your initial investment and are built into the contract price, so you do not pay them separately — but they do reduce how much of your money actually goes into investments. Ask what commission the agent is receiving before you buy.