Variable annuities: read the disadvantages first

A variable annuity puts your money into market subaccounts inside a tax-deferred insurance wrapper. It offers the most growth potential of any annuity, the most risk, and usually the most fees. Say the first thing plainly: in a variable annuity, you can lose principal. We lead with the downsides on purpose, because the sales brochures never do.

A variable annuity is a sports car with a roll cage. Real speed is on the table, and so is a real crash. The cage helps if things go wrong, but it is heavy, it is expensive, and it does not make the car crash-proof. Plenty of drivers would be happier, and richer, in a sensible sedan.

Introduction

No annuity generates more heat than the variable annuity. Regulators write bulletins about it, financial columnists dunk on it, and insurers keep selling billions of dollars of it a year. If you have been offered one, you have probably heard both extremes: a miracle of market growth plus guarantees, or a fee-riddled trap. As usual, the truth is duller and more useful. A variable annuity is a specific tool that fits a narrow garage, and the way to judge it is to understand exactly what you are buying.

Here is the deal in plain English. You hand an insurance company money, and instead of promising you a rate, the company lets you invest it in market subaccounts that look and behave like mutual funds. Your balance rises and falls with those investments, with no buffer and no floor. Around that engine, the insurer wraps tax deferral, a death benefit, and a menu of optional guarantees, and charges a distinct fee for each layer of the wrapping. Speed, cage, and a sticker price for every part. This guide takes the whole car apart.

What Is a Variable Annuity?

A variable annuity is an insurance contract and a registered security at the same time. Because your money is genuinely invested in the market and can be lost, the SEC requires a prospectus and the seller needs a securities license. That is the same regulatory signal you see on a RILA, and it means the same thing here, only more so: there is no market protection on your principal at all unless you pay extra for a rider that adds some.

Since safety is the first thing most annuity shoppers ask about, let us settle it early. A variable annuity is not FDIC insured, and unlike a fixed annuity, it does not even promise your principal back. The insurance guarantees that do exist inside it, the death benefit and any optional riders, are backed by the issuing insurer's claims-paying ability. The market risk, though, is entirely yours. A few terms unlock the rest of the machinery.

How Does a Variable Annuity Work?

A variable annuity works in two phases: you fund the contract and invest in market subaccounts, then take the money as withdrawals or lifetime income. What changes from other annuities is who carries the market risk at each step: you do.

• You fund the contract. A lump sum or ongoing contributions, with no IRS cap on non-qualified contributions, which is part of the appeal for high savers who have filled their other accounts.
• You allocate across subaccounts. You choose the investment mix, and you can usually change it later without triggering taxes.
• Your balance floats with the market. Good years compound tax-deferred. Bad years subtract directly from your principal. There is no cap on the upside and no buffer on the downside.
• Fees come out continuously. Insurance charges, fund expenses, and any rider costs are deducted from the account every year, in up markets and down ones alike.
• You choose how to take the money. Withdraw it, annuitize it into lifetime income, or exchange it for another annuity tax-free under Section 1035. Our annuity tax guide walks each door.

Because the account rides the market with no protection, time is the only cushion you have. A variable annuity bought five years before you need income is a very different bet from the same contract bought twenty years out. Before weighing anything else, locate yourself on that clock.

What Fees Does a Variable Annuity Charge?

Every product on this site charges something. What sets the variable annuity apart is that it charges several somethings at once, each reasonable-sounding alone, stacking into a drag that can quietly claim a large share of your returns. Exact numbers vary widely by contract, so treat the table as a map of what to hunt for in the prospectus, not a quote.

Add the layers for a contract with a popular income rider and an all-in annual cost in the neighborhood of 3 percent is not unusual, though some modern low-cost contracts run far leaner. At that level the math turns stark: the market has to earn 3 percent a year before your balance grows a dime. Never judge the layers separately. Ask for the single all-in number, in dollars, and read our fees and costs guide for how to find each piece in the paperwork.

What Are Living-Benefit Riders on a Variable Annuity?

Living-benefit riders are optional guarantees, bought for an annual fee, that promise income or withdrawals even if the market wrecks your account value. They are the cage around the car: most variable annuities are sold on the cage, not the engine. The flagship is the guaranteed lifetime withdrawal benefit, which tracks a separate income base alongside your real account value and guarantees withdrawals for life against that base, even if the account itself runs dry. In a genuine worst case, that promise pays. Retirees who held guaranteed riders through the 2008 crash collected income from accounts the market had gutted.

The honest print is the same as everywhere else in rider country. The income base is not cash you can walk away with, the fee runs every year whether the guarantee is ever needed, and withdrawal rules must be followed exactly or the guarantee can shrink. If the rider is the reason you want the product, read our full riders guide first, then ask the harder question: if what you really want is guaranteed lifetime income, would a plain income annuity deliver it with fewer moving parts and lower cost? Sometimes the answer is no and the rider earns its keep. It should have to argue its case.

What Are the Benefits of a Variable Annuity?

After that much cold water, credit where it is due, because the variable annuity does hold real advantages no other annuity matches. It is the only family member with uncapped market upside: no cap, no participation rate, no spread, just your subaccounts' actual performance. It accepts unlimited non-qualified contributions after your 401(k) and IRA are full, which makes it one of the few tax-deferred spaces left for a high saver. Rebalancing inside it triggers no taxes. The death benefit puts a floor under what your heirs receive even when the market does not cooperate. And the optional riders, at their real price, can bolt a lifetime income guarantee onto a growth engine, a combination nothing else on this site offers in one contract.

That is a genuine list. Notice, though, what every item has in common: each matters most to someone who has already maxed the simpler tax-advantaged accounts, has decades or a specific guarantee need in view, and can pay the fees without flinching. That someone exists. The question is whether it is you.

What Are the Disadvantages of a Variable Annuity?

The main disadvantages of a variable annuity are principal risk, stacked fees, ordinary-income taxation, double exit penalties, complexity, and unfriendly tax treatment for heirs. These are not edge cases. They are the ordinary experience of the product, and any one of them can outweigh the benefits for the wrong buyer.

• You can lose principal, full stop. No buffer, no floor, no reset. A 30 percent market drop is a 30 percent hit to your subaccounts, minus nothing, and the fees still come out that year.
• The fee stack is a permanent headwind. Every layer compounds against you for decades. High all-in costs can consume a startling share of lifetime returns compared to low-cost investing in a plain brokerage or IRA.
• Gains convert to ordinary income. Inside the wrapper, growth that would have enjoyed lower long-term capital gains rates outside it is taxed at your ordinary income rate on withdrawal. For some savers, tax deferral bought at that price is a bad trade. Details in our tax guide.
• Early exits are punished twice. Surrender charges during the schedule, and a possible 10 percent IRS penalty on the taxable portion before age 59 and a half. This is committed money.
• Complexity hides problems. Prospectuses run long, riders interact, and mis-selling has a documented history here; regulators flag variable annuities for exactly that reason. If you cannot explain it, do not own it, and see our guide to red flags before any pressured decision.
• Heir taxes are unfriendly. Unlike many taxable investments, annuity gains get no step-up at death; beneficiaries owe ordinary income tax on the growth.

Who Should Buy a Variable Annuity?

A variable annuity fits a saver who has filled the cheaper tax shelters, has a long runway or a real guarantee need, and can stomach losses. Weigh yourself against all four of these, not just the flattering ones.

And if what you are really weighing is the head-to-head most shoppers start with, fixed versus variable, here are the two ends of the annuity spectrum side by side.

Moving forward: choose the car for the driving you do

Back to the driveway. A sports car with a roll cage is not a scam; it is a machine for a specific driver on a specific road, and it is a poor commuter for everyone else. The variable annuity is the same. If you are seeking safety first, a fixed annuity or fixed index annuity does that job with no market risk to principal and a fraction of the cost. If you want more upside with a defined loss limit, a RILA splits the difference. The variable annuity belongs to the saver who has filled every simpler account, wants uncapped growth or a bolt-on income guarantee, and has priced the whole machine with clear eyes.

If that describes you, make the seller earn it: every fee in dollars, every rider justified against a cheaper route, every guarantee read from the prospectus rather than the brochure. And if you want help kicking the tires, we can match you with a Certified Annuity Advisor for a no-pressure read, with how we get paid published in plain sight. Fast cars are fine. Just know what the speed costs before you drive it home.

Pros and cons at a glance

Every product has trade-offs. Here is the honest ledger for this one, side by side.

Questions to ask before you buy

Bring these to any advisor. A good one will welcome them.

• What is the true all-in annual cost, in dollars, with every layer added?
• Have I actually filled my 401(k), IRA, and other cheaper tax shelters first?
• Do I need the living-benefit rider, and would a plain income annuity beat it?
• Am I prepared, in writing, for a year when the account falls hard?
• Why am I being offered this inside an IRA, if I am?
• Could a simpler annuity or a low-cost index fund meet the same goal?

Frequently asked questions