This article is part of the Retirement Financial Life Equation (RFLE). It was initially published on July 31, 2019, and updated in January 2026.
In this, the third and final article in this series on annuities, I examine variable annuities.
The 2025 landscape: Although sales of fixed index annuities have significantly outpaced variable annuities in recent years, variable annuities remain popular among certain segments of annuity purchasers. Since you may be pitched one by your friendly insurance rep or financial advisor, it makes sense to take a closer look.
What is a variable annuity?
Like fixed index annuities, variable annuities can be confoundedly complex. One reason is that they are an “investment hotdog in an insurance bun.” Consequently, they exhibit characteristics of both an investment portfolio and an annuity contract.
One way to examine them is to compare them with their fixed-index cousins.
The performance of a fixed index annuity is tied to changes in the price of a stock market index (subject to minimum and maximum limits). But the performance of variable annuities is based on a set of underlying securities that you directly invest in (such as stock or bond mutual funds—known as “subaccounts”). How those investment assets perform directly determines how well your annuity does, but may also be limited by certain contract provisions.
Like fixed index annuities, variable annuities are intended to be set up as “deferred” payment annuities. During the accumulation phase, your principal grows based on how your investments perform, which will determine your payouts during the distribution phase.
You could purchase a variable annuity with a lump sum or with multiple smaller payments over time. That money is then invested in those underlying “subaccounts,” which are the investment options you’ve chosen from those made available to you by the insurance company.
These investment choices can range from shares in a single mutual fund, multiple funds, or a “fund of funds.” They can hold equities, bonds, or both. The funds can be actively-managed, index funds, or both—domestic and international.
The IRA problem
Because these are the same types of investments people hold in their Individual Retirement Accounts (IRAs), variable annuities are sometimes recommended for your IRA. However, as we saw in a previous article, this doesn’t make much sense, since you would be placing a tax-deferred insurance product into a tax-deferred retirement account.
That would be like putting a hot dog in a bun, and then putting the bun in another bun (like what Taco Bell famously does: putting a taco shell inside a flour tortilla to create a new product—which I have never tried, by the way).
Some of the insurance components of variable annuities are offered as “riders” (extra-cost policy options). These guarantees, which retirees find particularly attractive, are not available with basic mutual fund investments. They include things like principal protection, lifetime income, and death benefits.
What about returns?
The returns of variable annuities are highly unpredictable because they depend on the performance of the underlying investment subaccounts. However, they will never be less than the minimums that are in your annuity contract—typically a 0% floor.
However, as with fixed index annuities, calculating your returns is where things get much more complicated.
Variable annuities have limits on their upside potential. Although your investments are in a set of mutual funds, the growth of your principal will be based on complex performance calculations used by the insurer to determine what your actual earnings will be.
If you think about it, these earnings limitations are understandable. The insurance company must limit your performance; otherwise, it wouldn’t be able to assume the risk of poor performance. Nor would they be able to offer the level of downside protection they can at the cost they do.
Because the contract value depends on subaccount performance, the value of a variable annuity will fluctuate during the accumulation phase. Payout amounts may also vary during the distribution phase, depending on how the underlying portfolio continues to perform. (The exception would be in the case of “annuitization,” which we will look at in a moment.)
A significant implication is that the performance of the underlying investments must be good enough to offset the limitations and embedded costs. Otherwise, you will end up no better off than you would have with a basic fixed annuity of some kind.
Taking income from a Variable Annuity
When you reach the distribution phase, which could be at retirement age or beyond, you can start receiving annuity payouts. Assuming you are not subject to any contractual surrender charges, which is usually after five to ten years, you can begin taking withdrawals without penalty.
Some variable annuity contracts offer only fixed-income payouts. Others allow variable payouts or both variable and fixed payouts. In any case, you can (hopefully) continue to build your annuity assets by staying invested in the mutual fund subaccounts.
You can also manage risk by choosing a guaranteed rate of return or income riders (at an additional cost, of course) for at least some of your income payments. For example, if you require at least a 5% payout, you might elect to protect a portion of it by purchasing the appropriate riders.
2025 update on income riders: Guaranteed Lifetime Withdrawal Benefit (GLWB) riders now typically offer withdrawal rates of 3.5% to 6.75%, depending on your age and whether you choose single or joint life coverage. These riders cost approximately 0.30% to 2.5% annually.
The annuitization option
Another option is to fully annuitize the principal. This means you take it as a lump sum and then use it to purchase an immediate fixed-income annuity. The insurance company then returns it to you as a series of periodic payments for a guaranteed period (e.g., 5, 10, or 20 years) or for life—a “lifetime immediate fixed income annuity”.
The ability to annuitize is sometimes used as a selling feature of variable annuities. However, any lump-sum payment can be converted into an immediate annuity. You can take money out of a traditional or Roth IRA and purchase an immediate annuity at any time.
What do they cost?
One of the major issues with both fixed index and variable annuities is their cost. It’s no secret that the insurance companies don’t give away anything for free, nor should they. They are entitled to make a profit, just like all other companies.
The real issue is transparency (understanding what these products truly cost), and whether the benefits are worth the cost.
Types of costs in Variable Annuities
2019 baseline costs: According to 2012 Morningstar figures I cited in the original article, the average costs for a variable annuity were:
- Mortality & Expense (M&E): 1.25%
- Management fees (expense ratio): 0.97%
- Administrative fees: 0.28%
- Total base cost: 2.35%
- With living benefit rider: ~3.4%
2025 updated costs: Recent data from comprehensive industry analysis shows:
Base Costs (before riders):
- Mortality & Expense (M&E) charges: 1.15-1.35% annually
- Investment management fees (subaccounts): 0.60-3.00% (average ~0.94%)
- Administrative fees: 0.30% or $30-$100 flat fee
- Total base cost: 2.0-3.0% annually (average ~2.31%)
Optional Rider Costs:
- Guaranteed Minimum Death Benefit: 0.25-0.51%
- Guaranteed Lifetime Withdrawal Benefit (GLWB): 0.30-2.5% (average ~1.10%)
- Guaranteed Minimum Income Benefit: 0.50-1.50%
- Long-term care rider: 0.40-1.00%
- Cost of living adjustment rider: 0.25-0.75%
Total cost with popular riders: 3.0-4.5% annually
Other costs
Surrender charges: Typically 7-10% declining over 5-10 years. Some newer “L-share” products have shorter surrender periods (3-4 years) but may have other trade-offs.
Sales commissions: While not paid directly by you, they’re built into the product structure, typically 5-7% of your premium.
2025 improvement: Some companies now offer low-cost or commission-free variable annuities for fee-based advisors. For example, Schwab’s Genesis Variable Annuity has base fees 56-66% below the industry average with no surrender charges.
As I previously noted, some of the “cost” is embedded in the performance limits imposed by the insurance company’s crediting calculations. This mechanism ensures that they receive their share of the investment pie, which must be sufficient to cover contractual obligations and expenses and to generate a profit for their shareholders.
Should I (or you) purchase a Variable Annuity?
A deferred-income annuity—whether the fixed-index or variable variety—doesn’t seem to make much sense for someone like me who is already retired. Nor do I think it makes sense to purchase one inside an IRA either.
My Concerns Remain:
First: Complexity. It makes them challenging to understand and to compare with one another and with other annuity products. You might be surprised (or not) to learn how many people I have spoken with who didn’t fully understand what they had purchased.
I once worked with a couple who, after realizing what they had bought, paid the surrender charge to exit the contract and invested in a simple portfolio of low-cost index funds. I didn’t recommend that—they came to it on their own.
Second: The tax-deferral redundancy. If I move funds from my tax-deferred IRA account to a tax-deferred variable annuity, I am placing tax-deferred money into a tax-deferred account, which doesn’t make sense, at least in terms of the tax-deferral benefits.
That said, there may be certain estate-planning benefits of variable annuities that are not available with IRAs, mainly because, unlike IRAs, they can pass to a beneficiary outside probate. However, this only happens if you have a death benefit provision in place, which usually comes in the form of an optional rider.
Third: Limited investment choices and market risk. Unlike immediate annuities, there is an upside provided by the underlying investment funds. However, your fund choices are limited to those offered by the insurer. (But to be fair, the funds are sometimes very good ones that aren’t available to the general public.) I prefer the flexibility to invest in nearly any asset through my IRA brokerage account.
Plus, the value of your principal can rise and fall with the stock markets, and it could, theoretically, even go to zero. This is no different from what could happen when investing in a 401(k) or IRA with a traditional stock-and-bond fund portfolio.
Fourth: High costs. Although you can purchase a guaranteed income rider to ensure you would continue to receive income even if your principal does go to zero, it comes at a cost, which is usually in the 1% to 2.5% range. Add in the other expenses, and you could quickly reach 3-4% or even more, not to mention the high sales commissions paid for these products.
Fifth: Inflation risk remains. A drawback of most income riders is that they do not necessarily protect against inflation. Moreover, the guaranteed interest that they pay, which is separate from any stock market gains, is consistent with what you could earn for yourself by investing in safe, long-term corporate or government treasury bonds—but without the 3-4% annual fees.
When might a Variable Annuity make sense?
That said, it may be appropriate for the small number of people who:
- Are maxing out their retirement accounts and want to save even more in a non-qualified tax-deferred account (meaning that they fund it with after-tax dollars and only the earnings are taxable as ordinary income)
- Have extremely high net worth and are looking for specific estate-related (wealth transfer) benefits
- Want guaranteed lifetime income protection, but are willing to pay high fees for it
- Are working with a fee-based advisor and can access low-cost, no-surrender-charge products
However, for most of us, they don’t make much sense.
If not an annuity, then what?
This brings us back to where we started. At this point in my life, if I were to purchase an annuity, it would probably be a low-cost, immediate, inflation-adjusted, fixed-income annuity with a survivor benefit. I would use it to secure a “floor” of guaranteed income to make up the difference between what we receive from Social Security and our essential living expenses.
My plan: I am considering this again when I am approximately age 75-80, before I am subject to Required Minimum Distributions (RMDs) from my IRA.
2025 RMD update: Under the SECURE 2.0 Act:
- Born 1951-1959: RMD age is 73
- Born 1960 or later: RMD age is 75
- First RMD can be delayed until April 1 of the year following the year you reach RMD age
- Penalty for missing RMD: 25% (reduced to 10% if corrected within 2 years)
- QCDs (Qualified Charitable Distributions) can satisfy RMDs: up to $108,000 for 2025
For the remainder of our retirement income, I will continue to rely on a relatively safe withdrawal rate from my income-oriented stock-and-bond portfolio and a cash reserve. I recognize I am taking some risk, but since my focus is on income (in the form of stock dividends and bond interest) and I maintain a cash reserve, I am not overly concerned with the day-to-day fluctuations in the markets.
Of course, a prolonged market crash would be highly damaging to almost any risk-based portfolio, and that is where Social Security and a fixed-income annuity come in.
Other options
In lieu of a traditional stock/bond portfolio, I could also consider things like:
- A CD or bond ladder
- A TIPS (Treasury Inflation-Protected Securities) ladder
- Money market funds (currently yielding 4-5% in 2025)
There is another option that I haven’t discussed. It was suggested to me by a reader (via email). It involves using dividends from paid-up whole life insurance to fund retirement. It is discussed in depth in R. Nelson Nash’s Becoming Your Own Banker, as part of a broader financial life strategy of self-funding through policy equity accumulation and borrowing—hence the “be your own banker” concept.
I can say now, however, that I would likely view this as a means to supplement income from savings (IRAs, 401(k) s, etc.), rather than as a replacement for it.
The autopilot factor
There is one other reason for considering an annuity at some point, which I haven’t touched on much. It’s the ability to put a portion of our retirement income on “autopilot.” This becomes increasingly important as we age, particularly if we experience cognitive decline in the future.
As we age, our ability to manage complex financial decisions may decline. Having a portion of income guaranteed and automatic—like Social Security plus an annuity—can provide significant peace of mind and reduce the burden on spouses or family members who may need to step in to help.
This is a factor that shouldn’t be dismissed, even if the fees seem high when we’re younger and sharper. The simplification and automation may be worth the cost in our later years.