Variable Annuities: When They Make Sense (and When They Don't)

Variable annuities are sold more aggressively than almost any other retirement product — and criticized more harshly by fee-only advisers than almost any other financial instrument. Both reactions contain truth.

A variable annuity can genuinely solve a specific problem: providing guaranteed lifetime income while preserving some exposure to market growth. For a narrow set of retirees, that combination is worth paying for. For the majority of people who own variable annuities, the costs exceed the value they receive — often significantly.

The gap between those two groups comes down to understanding exactly what a variable annuity is, what it costs, and what alternatives exist. That is what this article covers.

What a Variable Annuity Is

A variable annuity is an insurance contract that invests your premium in sub-account mutual funds — equity, bond, or mixed — and provides a death benefit and, optionally, a guaranteed lifetime withdrawal benefit (GLWB) income rider.

The "variable" means your account value fluctuates with market performance, unlike a fixed annuity (fixed rate) or fixed index annuity (linked to an index with a floor). Variable annuities are securities — regulated by both the SEC and state insurance regulators — and can gain or lose value based on the sub-accounts you choose.

The insurance wrapper provides two things that a plain mutual fund does not: a death benefit guarantee (heirs receive at least the amount invested) and, with a rider, a guaranteed income floor that continues even if the account value drops to zero. Those guarantees are real. The question is what you pay for them.

The Full Fee Stack

Variable annuities layer multiple fees on top of each other. Each fee is expressed as an annual percentage of either the account value or the benefit base — and they compound annually.

The mandatory baseline includes three charges that apply to every VA regardless of options selected:

• Mortality & Expense (M&E) risk charge: 0.75%–1.35%/year. Covers the insurer's cost of providing the death benefit and guaranteeing contract expenses. This fee persists for the life of the contract and cannot be removed.
• Sub-account fund expense ratios: 0.50%–1.50%/year. The annual expense ratio of the mutual funds inside the VA. These are almost always more expensive than equivalent retail ETFs or index funds — the same fund can cost 3–4× more inside a VA wrapper than outside it.
• Administrative fee: 0.10%–0.30%/year (or a flat $30–$50/year on smaller contracts).

Add the most commonly elected optional rider:

• GLWB income rider: 0.60%–1.50%/year, typically charged on the benefit base (discussed below) rather than the account value.

A typical VA with an income rider costs 3.15%/year in total annual fees — versus 0.05%–0.10% for a diversified ETF portfolio. On a $200,000 investment at 7% gross return, that fee difference compounds into roughly $343,000 less in account value over 20 years — before taxes.

Then there are surrender charges: penalties of 7–10% in year one, declining to zero over 6–10 years, applied to withdrawals above the 10% annual free-withdrawal allowance. A $200,000 contract in year one has a $14,000–$20,000 exit cost. Commissions to the selling agent — typically 4–8% of premium — are embedded in the M&E structure and do not appear as a separate line item on any statement.

The GLWB Rider — Benefit Base vs. Account Value

The income rider is the central feature marketed in most VA sales — and the most frequently misunderstood.

A GLWB rider creates two separate values inside one contract:

The account value is your real money — the market value of your sub-account investments. This is what you can surrender, withdraw, or pass to heirs (subject to surrender charges). It rises and falls with the market and shrinks as annual fees are deducted.

The benefit base is a phantom accounting value that grows at the guaranteed rollup rate — typically 5–8% annually compounded — or steps up to the account value on anniversary dates if the account has grown. The benefit base determines your maximum annual withdrawal (typically 4–6% of the benefit base). It cannot be accessed as a lump sum. It cannot be inherited. It exists solely as an income calculation base.

The critical distortion: the GLWB fee is charged on the benefit base, not the account value. In a flat or declining market, the benefit base grows (the rollup continues), the fee on the inflated benefit base increases, and the actual account value shrinks under the weight of fees. A retiree who purchased a $200,000 VA in a flat market may watch their account value drop to $147,000 in year 10 while being told their "guaranteed value" is $393,000 — a number they cannot touch.

The benefit base reaches its purpose when the account value is depleted to zero. At that point, the insurer continues paying the guaranteed annual withdrawal from its own balance sheet for the rest of the annuitant's life. That is the genuine insurance value of the GLWB — and it only activates if you live long enough and markets perform poorly enough to exhaust the actual account.

When a VA Can Make Sense

Variable annuities are not inherently bad products — they are frequently sold to the wrong people at the wrong cost. There are genuine scenarios where the structure adds value.

Tax-deferred growth after maxing other accounts. A high earner who has fully funded their 401(k), Roth IRA, HSA, and any deferred compensation plan faces limited options for additional tax-deferred accumulation. A no-load or low-load VA (available from providers like Vanguard or Fidelity at significantly lower costs than broker-sold products) can provide marginal tax-deferral value. The breakeven timeline for a high-bracket investor is roughly 15–20 years, depending on the cost differential.

High risk aversion combined with the need for equity exposure. A retiree who would otherwise hold only bonds out of fear of market loss may actually benefit from a VA/GLWB: the income guarantee enables more equity allocation than the retiree would otherwise accept. For this narrow profile, the guarantee has real behavioral and financial value.

Very long life expectancy with poor market timing risk. The GLWB guarantee that payments continue after the account depletes has its highest value for someone who lives into their mid-90s through a prolonged period of poor market returns. The VA absorbs the sequence-of-returns risk that would otherwise deplete a self-managed portfolio.

Existing VA past the surrender period. If the surrender period has ended, the question is not whether you should have bought it — it is whether continuing to hold it makes sense given current fee structure and remaining guarantees. Sometimes it does; sometimes a 1035 exchange to a lower-cost product is the right move.

When a VA Is the Wrong Choice

The scenarios where a VA should not be purchased are broader and more common than the scenarios where it should.

Inside an IRA or 401(k). A variable annuity inside a traditional IRA is paying 2–3%/year for tax deferral the IRA already provides for free. This is arguably the most common and most costly variable annuity mis-sale — a meaningful percentage of VA assets sit inside tax-deferred accounts, paying insurance fees that add zero tax benefit.

When a SPIA would meet the same income need. If the goal is guaranteed lifetime income, a SPIA delivers more monthly income per dollar deployed — at roughly $1,463/month vs. $833/month on a $200,000 premium for a 65-year-old — with no ongoing fee drag and no benefit base confusion. The VA/GLWB only outpaces the SPIA if the sub-accounts significantly outperform over the deferral period.

When liquidity may be needed within the surrender period. Buying a VA with money that may be needed for healthcare costs, home repairs, or other large expenses is an expensive mistake. The 10% free-withdrawal provision is insufficient for major unexpected costs; exceeding it triggers surrender charges of 7–10%.

When the primary pitch is the rollup rate. "Your money is guaranteed to grow at 7%" describes the benefit base — not the account value. Any sales presentation that does not clearly distinguish between these two values and explain that the rollup is a phantom accounting number, not accessible cash, is incomplete at best and misleading at worst.

Lower-Cost Alternatives That Accomplish the Same Goals

For most VA buyers, simpler and cheaper alternatives serve the same purpose:

For tax-deferred growth: Max 401(k) contributions ($23,500 + $7,500 catch-up in 2026), Roth IRA, and HSA first. After-tax brokerage with low-cost index ETFs (0.05–0.08% total expense) grows significantly faster than a VA net of fees in virtually all scenarios above a 15-year horizon.

For guaranteed lifetime income: A SPIA delivers higher monthly income per dollar at far lower cost. A QLAC from an IRA addresses deep longevity protection at a fraction of the VA's ongoing annual fee. Neither imposes a surrender period.

For downside protection combined with growth: A bond ladder (Treasury or TIPS) floors essential income for a specified period. The remainder of the portfolio holds equity ETFs for growth. This combination replicates the floor-plus-upside structure of a VA/GLWB at roughly 1/30th of the annual fee.

If You Already Own a Variable Annuity

Do not surrender it without careful analysis. Surrender charges — potentially 7–10% in early years — plus ordinary income tax on gains make impulsive exits expensive.

Evaluate three things:

1. Is the surrender period over? If yes, all options are open at full liquidity.
2. What is the total annual fee and does the guarantee still apply? Some older contracts have rich GLWB terms that are worth keeping; others have deteriorating guarantees at high ongoing cost.
3. Is a 1035 exchange viable? A 1035 exchange transfers the VA to a new annuity contract (or, in some cases, a SPIA) without triggering ordinary income tax on the accumulated gain. If a lower-cost VA or a SPIA would better serve your current income goals, a 1035 exchange preserves the tax-deferred status during the transition.

Work with a fee-only fiduciary adviser who does not earn commissions on annuity products before making any changes to an existing contract.

Important Notes

• Variable annuities are securities — they must be sold with a prospectus. Read the fee table and surrender schedule in the prospectus, not just the summary brochure.
• "No-load" variable annuities exist — Vanguard, Fidelity, and a few other providers offer VAs with M&E charges below 0.25% and no surrender period. These are structurally different from broker-sold products.
• State guaranty associations provide coverage if an insurer fails — typically up to $250,000 per contract. Verify your state's limit at NOLHGA.org.
• FINRA's BrokerCheck tool can verify whether the person who sold you a VA has any regulatory history. Annuity salespeople are not required to act as fiduciaries under FINRA broker-dealer rules.
• This is education, not individualized financial, insurance, or tax advice. Variable annuity contracts are complex; review the full prospectus and consult a fee-only adviser before purchasing.

In ModernRetire

The Annuity Income Modeler under Strategy -> Income includes a VA analysis tool:

1. Enter your existing or proposed VA contract details — premium, current account value, benefit base, annual withdrawal percentage, and total fee — to see the net income, break-even analysis, and comparison against SPIA and self-managed portfolio alternatives.
2. Run the fee drag calculator: see how the total annual fee compounds against projected account growth and compare the after-fee account value trajectory against a low-cost ETF portfolio.
3. Model the 1035 exchange: enter the current contract terms and a target replacement product to compare projected income under each option, with estimated tax impact if a taxable surrender is taken instead.