Someone at work mentions a “variable annuity” and makes it sound like a magic box that only goes up. Someone else says annuities are a rip-off with sky-high fees. Both can’t be fully right, and the truth is more interesting than either claim. A variable annuity is a real financial tool with real benefits and real costs, and once you see how the pieces fit together, it stops feeling like a mystery.
This guide walks through exactly what a variable annuity is, how it grows (or shrinks), the three benefits insurance companies actually deliver, the fees that come with them, and a worked example straight from real numbers so you can see the math for yourself. By the end, you’ll know enough to have an informed conversation instead of just a gut feeling.
What Is a Variable Annuity, Anyway?
Think of a variable annuity as a mutual fund wearing an insurance company’s costume. Underneath, your money is invested in the market, just like it would be in an IRA or a 401(k). It rises and falls with the market, and there is no guarantee that stops you from losing money on the investment portion. That part is exactly like any other investment account you already understand.
The costume is what makes it different. Because an insurance company is involved, a variable annuity can offer extra features a plain brokerage account cannot, like tax deferral, a death benefit floor, and guaranteed lifetime income options. Those features are valuable to some people and unnecessary for others, so understanding them is the whole game here.
How the Investments Inside Actually Work
Here’s a detail most people never hear: the investments inside a variable annuity are not actual mutual funds or index funds. They’re called “sub-accounts,” and a sub-account is basically a clone of a mutual fund. It mimics that mutual fund’s strategy closely, but it isn’t the identical fund, so its performance and fees can differ a bit from the original.
On average, sub-accounts cost a little more than owning the real fund elsewhere. There’s also a quieter difference: because sub-accounts are clones, they don’t pass dividends directly to you the way a mutual fund does inside a regular IRA. If you own a mutual fund privately through an IRA, you’re credited that dividend every year. Inside a variable annuity, that isn’t automatically the case. It’s a small detail, but it’s exactly the kind of thing that surprises people later, so it’s worth knowing going in.
The 3 Real Benefits of a Variable Annuity
Variable annuities aren’t sold on their investment performance alone. Insurance companies build in three specific benefits that a regular brokerage account simply cannot offer. Here’s what each one actually does.
Benefit 1: Tax Deferral
Money you put into a variable annuity grows tax-deferred, similar to an IRA or 401(k). You don’t pay taxes year to year on the growth; you pay when you eventually withdraw it. This matters most for “non-qualified” money, which is just a fancy way of saying money that isn’t already in a tax-advantaged account, like funds sitting in a regular brokerage account, a CD, or a money market account.
Here’s the catch worth knowing before you move money in: all gains inside an annuity are eventually taxed at ordinary income tax rates, not the lower long-term capital gains rates you’d typically pay in a regular brokerage account. So tax deferral can help your money grow faster along the way, but you need to weigh that against a potentially higher tax bill when you finally take the money out.
Benefit 2: A Death Benefit Floor
This is one of the most tangible benefits, so let’s use real numbers. Say you put $100,000 into a variable annuity, and you never withdraw a dime. Then the market has a rough stretch, and your account value drops to $70,000. If you were to pass away at that point, your beneficiaries wouldn’t just get the $70,000 that’s left. Most variable annuities guarantee a death benefit equal to at least what you originally put in, so your family would receive the full $100,000 back.
A regular investment account can’t promise that. If the market is down when you pass away, your heirs simply get whatever the account is worth that day. The table below lines the two scenarios up side by side.
| Detail | Regular Brokerage Account | Variable Annuity |
|---|---|---|
| Amount originally invested | $100,000 | $100,000 |
| Account value when you pass away | $70,000 | $70,000 |
| What your beneficiaries actually receive | $70,000 | $100,000 (guaranteed minimum death benefit) |
That guarantee only applies as long as you haven’t been withdrawing money along the way, since withdrawals reduce the guaranteed amount too. But as a pure “what if the market is down when I die” protection, it’s a real, concrete benefit you won’t find in a plain investment account.
Benefit 3: The Option for Lifetime Income
The third benefit is the option to turn your annuity into guaranteed income for the rest of your life. You can get there two ways: by adding an income rider that guarantees income while keeping some flexibility, or through “annuitization,” where you formally convert the contract into a stream of payments. You can annuitize at any time, but there may be setup charges if you do it too early, so it usually pays to wait until you’re older, when the payout tends to be larger.
The Fees Nobody Explains Very Well
This is where most of the media horror stories come from, and honestly, some of it is deserved confusion. Let’s break down exactly what you pay for a bare-bones variable annuity, with no extra add-ons.
First, there’s the M&E fee, short for “mortality and expense” charge. This is what the insurance company charges just for you to be inside the annuity structure, typically between 1% and 1.5% per year. Second, there’s the sub-account fee for the investments themselves, similar to a fund’s expense ratio, usually running around 1%. Add those together, and a plain-vanilla variable annuity, invested for growth with no extra features, typically costs somewhere between 2% and 2.5% per year.
But most variable annuities aren’t sold bare-bones. They’re usually pitched alongside an optional “rider,” which is an add-on that gives you extra guarantees, like the income benefits described above. Riders typically cost another 1% to 2.5% each, and most people only add one. So once you add a rider, total fees commonly land somewhere between 3% and 4% per year. The table below summarizes the pieces.
| Fee Type | Typical Annual Cost | What It Pays For |
|---|---|---|
| M&E fee | 1% – 1.5% | Cost of being inside the insurance/annuity structure |
| Sub-account fee | ~1% | Managing the underlying “clone” investments |
| Optional rider (e.g., income guarantee) | 1% – 2.5% | Guaranteed lifetime income or extra death benefit |
| Bare-bones total (no rider) | 2% – 2.5% | Growth-only annuity, no extra guarantees |
| Typical total with one rider | 3% – 4% | Growth plus one guaranteed benefit |
So when you hear a headline claiming annuities charge “six or seven percent” in fees, that number usually comes from someone adding up every possible rider as if you’d stack them all at once, which almost never happens in practice. The real, honest range for most people is 2% to 4% a year. That’s still meaningfully higher than a low-cost index fund, and it needs to be judged against what you’re actually getting for it: tax deferral, a death benefit floor, or guaranteed income.
Independent research from Morningstar has looked at exactly this tradeoff, using a real-world example with fees of 3.34% a year. Compared side by side against the market with no fees dragging on it, the fee-laden version fell dramatically behind over time. Fees don’t just nibble at your returns; compounded over 10 or 20 years, they can be the difference between your money lasting through retirement and running out early.
A Real Example: What Happens When You Start Taking Income
Here’s where variable annuities get genuinely confusing, so let’s walk through an example using real figures from an actual annuity illustration. Someone puts in $200,000. That cash is invested in the market, so it rises and falls just like any other investment, the same way your 401(k) balance moves around from month to month.
Alongside that real cash value, there’s a separate number called the “income base,” which is what you’re paying that extra 1% rider fee for. The income base grows on a guaranteed schedule and never goes down, even in years when the market falls. If the market does better than the guaranteed growth rate in a given year, the income base jumps up to match it. Eventually, you decide to start taking income, and at that point, the income base stops growing and locks in place.
Your actual withdrawals are calculated as a percentage of that locked-in income base, not the real account value. So even as your real cash value declines over time, drained by both your withdrawals and the ongoing fees, your withdrawal amount stays level, because it’s tied to the guaranteed income base instead. Eventually, the real cash value can hit zero. That’s when “annuitization” kicks in for real, and the insurance company keeps paying you that same income for the rest of your life, even though your actual account has nothing left in it.
That last part is genuinely valuable if you’re worried about outliving your savings. But there’s a real caution here too: if you have a bad year where the market drops 20%, you’re also paying 4% in fees, and you withdraw another 4% or 5%, your real account value could fall by close to 30% in a single year. Run out of money earlier than planned, and your eventual guaranteed income payment could end up smaller than you expected.
The Downsides: Liquidity and Surrender Charges
Variable annuities are not liquid. You can’t just withdraw money whenever you feel like it without consequences. The same rules that apply to other retirement accounts apply here: money withdrawn before you turn 59½ is generally hit with a 10% IRS penalty on top of any regular taxes owed.
On top of that, annuities come with their own “surrender schedule,” a set period of time where pulling out more than the allowed amount triggers a surrender charge from the insurance company itself, separate from the IRS penalty. Surrender periods typically run somewhere between five and ten years, though some contracts run longer. Because of this, a variable annuity should only hold money you’re confident you won’t need for a good while.
So, Is a Variable Annuity Right for You?
A variable annuity makes the most sense for someone who has already maxed out other tax-advantaged accounts, wants a guaranteed floor under a market-based investment, or specifically values guaranteed lifetime income and is willing to pay 2% to 4% a year for it. It makes less sense for money you might need soon, or if you’re simply chasing tax deferral without weighing the higher ordinary-income tax bill waiting at the end.
There’s no one-size-fits-all answer here, and the right decision depends heavily on your full financial picture: your age, your other accounts, your income needs, and your comfort with market ups and downs. If you’d like to walk through your specific numbers with someone rather than guess, you can schedule a personal meeting to go over your options one on one.
Frequently Asked Questions
Are variable annuities really as expensive as people say?
Usually not as bad as the scariest headlines claim. A bare-bones variable annuity typically runs 2% to 2.5% a year, and adding one income rider brings it to roughly 3% to 4%. Claims of 6% or 7% in fees usually come from stacking every possible rider at once, which most people never actually do.
Can I lose money in a variable annuity?
Yes, on the underlying investment. Your cash value rises and falls with the market, just like an IRA, and there’s no guarantee against that. The guarantees you’re paying for, like the death benefit or income base, are separate protections layered on top, not a promise that your account value itself can’t drop.
What’s the difference between a sub-account and a mutual fund?
A sub-account is a clone version of a mutual fund built specifically for use inside an annuity. It aims to mimic the original fund’s strategy, but performance and fees can differ slightly, and sub-accounts typically don’t pass dividends through to you the way owning the fund directly would.
How long is money typically locked up in a variable annuity?
Most surrender schedules run five to ten years, though some run longer depending on the contract. Withdrawing more than the allowed amount during that window triggers a surrender charge from the insurance company, in addition to any IRS penalty for early withdrawals before age 59½.
Is the death benefit the same thing as the account value?
No. The account value is what your investments are actually worth today, and it moves with the market. The death benefit is a separate guaranteed floor, often equal to what you originally put in, that protects your beneficiaries if you pass away while the market happens to be down.
P.S. If you already own a variable annuity, or you’re weighing whether one belongs in your retirement plan, you don’t have to sort through the fine print alone. Come learn alongside other Washington State employees who are asking the same questions.
