When I sit down with families who are exploring retirement income strategies, one question comes up more often than almost any other: “Should I consider a variable annuity?” It’s a fair question—variable annuities are everywhere in the financial world, and they’re often positioned as the answer to retirement income concerns. But like any financial strategy, the pros and cons of a variable annuity deserve a thorough examination before you make any decisions.
For a complete overview, see how annuities work.
In my experience helping families navigate retirement planning, I’ve seen variable annuities work well for some people and create problems for others. The difference usually comes down to understanding exactly what you’re getting into—both the benefits and the drawbacks—and whether those features align with your specific situation and goals.
Let me walk you through what I’ve learned about variable annuities over the years, so you can make an informed decision about whether they belong in your retirement strategy.
What Is a Variable Annuity?
Before we dive into the pros and cons, let’s make sure we’re on the same page about what a variable annuity actually is.
A variable annuity is a contract with an insurance company that combines elements of insurance and securities. You make premium payments (either a lump sum or over time), and that money gets allocated to investment options called sub-accounts—basically mutual funds within the annuity. The “variable” part means your account value fluctuates based on how those investments perform.
Unlike fixed annuities, where you earn a guaranteed rate, or indexed annuities, where your returns are linked to market indices with downside protection, variable annuities put your money directly at market risk. Your account can go up when the markets do well, but it can also go down when they don’t.
Most variable annuities also offer optional riders—additional features you can purchase—like guaranteed income benefits, death benefits, or principal protection.
The Pros of Variable Annuities
Let’s start with the potential benefits. Variable annuities do offer some features that can be attractive for certain situations.
Tax-Deferred Growth
One of the biggest advantages of variable annuities is tax deferral. Your money grows without being taxed on gains each year, similar to a 401(k) or IRA. This can be particularly valuable if you’ve already maxed out other tax-advantaged accounts and are looking for additional tax-deferred growth opportunities.
Unlike taxable investment accounts where you pay taxes on dividends, capital gains distributions, and realized gains each year, everything inside a variable annuity compounds without current taxation.
No Contribution Limits
Unlike 401(k)s and IRAs, variable annuities don’t have annual contribution limits. If you have a large sum of money—maybe from a business sale, inheritance, or other windfall—you can put the entire amount into a variable annuity for tax-deferred growth.
This can be appealing for high earners who want to defer more income than retirement account limits allow.
Professional Money Management
Variable annuities typically offer a range of professionally managed sub-accounts covering different asset classes and investment styles. This can be helpful if you don’t want to manage your own investments or prefer to have institutional-quality money management.
Optional Income Guarantees
Many variable annuities offer optional guaranteed income riders. These features can provide a guaranteed income stream in retirement regardless of how the underlying investments perform. While these riders come at additional cost, they can provide peace of mind for people worried about market volatility affecting their retirement income.
Death Benefits
Variable annuities typically include death benefit features that can protect beneficiaries if the account holder dies when the account value is below the premium payments made. Some offer enhanced death benefits that lock in gains or provide guaranteed growth rates for beneficiaries.
The Cons of Variable Annuities
Now let’s talk about the downsides—and there are several significant ones that you need to understand.
High Fees
This is the big one. Variable annuities are notorious for having multiple layers of fees that can significantly impact your returns over time. You’ll typically see:
- Management fees for the underlying investments (usually 0.5% to 2% annually)
- Insurance charges for the death benefit and other features (often 1% to 1.5% annually)
- Administrative fees for record-keeping and other services
- Rider fees for optional benefits like guaranteed income (typically 0.5% to 1.5% annually)
It’s not uncommon for total annual fees to reach 2% to 3% or even higher. Over time, these fees can seriously erode your returns. If your investments earn 7% but you’re paying 2.5% in fees, your net return is only 4.5%.
Surrender Charges
Variable annuities typically come with surrender periods—often 6 to 8 years or longer—during which you’ll pay significant penalties if you withdraw more than a small percentage of your account value. These surrender charges can be 7% to 10% or higher in early years.
This lack of liquidity can be a real problem if you need access to your money for emergencies or opportunities.
Ordinary Income Tax Treatment
While the tax deferral is nice, when you eventually withdraw money from a variable annuity, it’s taxed as ordinary income—not capital gains. This means you could pay higher tax rates than if you had invested the same money in a taxable account and held investments for more than a year.
In a taxable account, long-term capital gains are taxed at preferential rates (0%, 15%, or 20% for most people), while ordinary income can be taxed at rates up to 37%.
Complexity
Variable annuities can be incredibly complex products with dozens of features, options, and provisions. Many people don’t fully understand what they’re buying, which can lead to disappointment later when the product doesn’t perform as expected or when they discover limitations they weren’t aware of.
Limited Investment Options
While variable annuities offer professional management, you’re limited to the investment options available within that particular contract. You can’t buy individual stocks, bonds, or other investments that might be available in a regular brokerage account.
No Step-Up in Basis
Unlike assets held in taxable accounts, variable annuities don’t receive a “step-up in basis” when you die. This means your beneficiaries will owe ordinary income taxes on any gains, whereas they might inherit other assets with favorable tax treatment.
Who Might Benefit from Variable Annuities?
Despite the drawbacks, variable annuities can make sense for certain people in specific situations:
High earners who have maxed out other retirement accounts and want additional tax-deferred growth opportunities might find variable annuities useful, especially if they can tolerate the fees and complexity.
People who want guaranteed income features and are willing to pay for them might appreciate the optional riders that provide income guarantees, even though these come at significant cost.
Individuals who lack investment discipline might benefit from the professional management and restricted access that comes with variable annuities, though there are usually better and cheaper ways to address these issues.
Who Should Probably Avoid Variable Annuities?
In my experience, variable annuities are often not the best choice for:
Most people who haven’t maximized other retirement accounts should probably focus on 401(k)s, IRAs, and other options first, since these typically offer better tax advantages and lower fees.
Anyone who might need access to their money within the surrender period should be very cautious about variable annuities due to the high early withdrawal penalties.
Cost-conscious investors who are comfortable managing their own investments can usually achieve better net returns by avoiding the high fee structure of variable annuities.
My Honest Assessment
After years of helping families with retirement planning, I’ve come to see variable annuities as products that work for a small percentage of people in very specific situations. The high fees and complexity mean they’re rarely the optimal choice, even when the basic concept of tax-deferred growth makes sense.
Most of the time, when someone thinks they want a variable annuity, there are better alternatives available. If you want tax-deferred growth, maxing out 401(k)s and IRAs usually makes more sense. If you want guaranteed income, there are often simpler and cheaper ways to achieve that goal.
The challenge with variable annuities is that they try to be everything to everyone—tax deferral, investment growth, income guarantees, death benefits—but they don’t excel at any one thing. You often end up paying high fees for a product that’s mediocre at several things rather than excellent at one thing.
That said, I have seen situations where variable annuities made sense, particularly for very high earners who had truly exhausted other options and were specifically looking for the combination of features that variable annuities provide.
Questions to Ask Yourself
If you’re considering a variable annuity, here are the key questions I’d encourage you to think through:
Have you maximized other tax-advantaged accounts first? If not, start there.
Do you understand all the fees involved? Can you calculate what your net return would be after all costs?
How important is liquidity to you? Can you truly commit to not needing this money during the surrender period?
Are you comfortable with market risk? Variable annuities offer no downside protection unless you pay extra for it.
Do you really need the complexity? Could simpler alternatives achieve your goals more efficiently?
- Understand that variable annuities combine insurance and investment features, putting your money directly at market risk unlike fixed annuities that offer guaranteed returns.
- Consider variable annuities primarily if you’ve maxed out other retirement accounts, since they offer tax-deferred growth with no contribution limits.
- Evaluate whether the tax deferral benefit justifies the typically higher fees and complexity compared to direct mutual fund investing.
- Recognize that optional riders like guaranteed income benefits come at additional costs that can significantly impact your overall returns.
- Assess your risk tolerance carefully since variable annuities can lose value when markets decline, making them unsuitable for conservative investors near retirement.
The Bottom Line
The pros and cons of a variable annuity ultimately come down to your specific situation, goals, and priorities. While these products do offer legitimate benefits like tax deferral and optional guarantees, they come with significant costs and complexity that make them inappropriate for most people.
If you’re exploring variable annuities, I’d encourage you to also look at alternatives like maximizing other retirement accounts, considering different types of annuities with lower fees, or exploring properly designed life insurance strategies that can provide tax-advantaged growth with more flexibility.
The retirement planning landscape offers many options, and variable annuities are just one tool in a much larger toolkit. The key is finding the combination of strategies that works best for your unique circumstances.
Retirement planning decisions are too important to make in isolation. I work with families to explore all their options—from traditional retirement accounts to annuities to life insurance strategies—so they can build retirement income plans that actually make sense for their situations.
Want to explore your retirement income options? Reach out for a consultation and let’s discuss what might work best for your specific goals and circumstances.
