Variable annuities are often the wrong product for most retirees because they combine high ongoing fees (typically 2.5-3.5% per year between mortality charges, administrative fees, sub-account fees, and rider fees), complex contract terms, and long surrender periods (often 7-10 years), features that benefit the salesperson and insurance carrier more than the policyholder. Better outcomes for most retirement income needs are typically achieved through fixed indexed annuities, single premium immediate annuities, or low-cost index portfolios, depending on the goal.
Variable annuities are insurance contracts that hold investments in 'sub-accounts' that function like mutual funds. They were designed to combine the tax-deferred growth of an annuity with the upside of equity investing. The sales pitch typically emphasizes a 'living benefit rider' (like a Guaranteed Lifetime Withdrawal Benefit or GLWB) that promises income for life regardless of investment performance. The pitch is compelling, the math, much less so.
Total fees on a variable annuity with living benefit riders typically run 2.5-3.5% per year, sometimes higher. Compare this to a low-cost balanced portfolio (0.05-0.30% in fund fees, 0.50-1.0% in advisor fees), total cost typically under 1.3%. Over 20 years, the fee difference compounds dramatically. A $500K starting balance in a 2.5%-fee variable annuity vs a 1.0%-fee balanced portfolio, with the same gross returns, leaves the variable annuity holder roughly $200K worse off after 20 years, money that went to the carrier instead of the retiree.
Living benefit riders sound powerful but typically pay 4-5% lifetime income from the protected base. A fixed indexed annuity or competitive single premium immediate annuity (SPIA) often provides comparable or higher lifetime income at substantially lower internal cost, without the variable annuity's complexity. Many living benefit riders also have catch-22 conditions: the protected base only matters if investment performance is poor; if performance is good, the rider is irrelevant. The retiree pays high fees for protection that often doesn't activate.
Surrender charges create lock-in. Most variable annuities have 7-10 year surrender periods with declining surrender charges (often starting at 7-8% and reducing 1% per year). This means a retiree who buys a variable annuity and later realizes it's the wrong product pays significant penalties to exit. Combined with the tax cost of any taxable gain at exit, the practical reality is that variable annuities, once purchased, are difficult to escape, and the salesperson who collected the upfront commission has moved on to the next sale.
Key facts
- Typical variable annuity total fees: 2.5-3.5% annually
- Typical low-cost balanced portfolio total cost: under 1.3% annually
- Surrender charge period: typically 7-10 years with declining penalty
- Living benefit rider: typical 4-5% lifetime income from protected base, often with significant fees
- Salesperson commission: typically 5-7% of premium paid upfront (incentive to sell)
- Better alternatives for income: fixed indexed annuity with lifetime income rider, SPIA, low-cost portfolio with systematic withdrawals
Are variable annuities ever appropriate?
In limited situations: (1) for very high-income individuals who have maxed all other tax-deferred vehicles and want additional tax-deferred growth space; (2) for individuals with creditor protection concerns where state law provides annuity protection; (3) for specific estate planning structures using variable annuity death benefits. Even in these cases, low-cost variable annuity options (such as those from Vanguard or Fidelity) typically dominate commission-loaded products from traditional insurance carriers. For most retirees seeking lifetime income, a competitively-quoted SPIA or fixed indexed annuity provides equivalent or better outcomes at far lower internal cost.
I already own a variable annuity, should I keep it or surrender it?
Depends on the specifics: when surrender charges expire, current contract value vs cost basis (tax implications), strength of the carrier, and whether any guarantees on the contract remain valuable. A 1035 exchange to a lower-fee variable annuity (Vanguard, Fidelity) preserves tax deferral while reducing ongoing costs. Surrendering to take cash incurs ordinary income tax on any gain plus possibly a 10% penalty if before age 59½. We typically recommend an analysis of the existing contract before any action, sometimes the existing contract has guarantees worth keeping; often the right answer is a 1035 exchange to a low-cost alternative.
