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Variable annuities are tied to market performance, making them somewhat riskier than fixed annuities. They offer tax-deferred growth, meaning you only pay taxes on your earnings once you start withdrawals. This feature could help your investments grow faster over time.
Read on to determine whether this annuity type is the right investment strategy for you.
What’s a variable annuity?
A variable annuity is a contract with an insurance company where the insurer agrees to provide periodic payments immediately or in the future (depending on your contract). You fund your annuity with either a lump sum at the start or a series of payments.
Variable annuities combine two benefits: Insurance companies protect your money while allowing you to invest in the stock market. As a result, you have a safety net and the potential for higher returns.
This annuity style contrasts fixed annuities, which offer a guaranteed rate of return, no matter how the market is performing. So if your fixed annuity guarantees 5% growth each year, you get it, even if the market plummets. It also means that if the market performs well, you are still only gaining 5% growth.
Exploring the mechanics of variable annuities
Here’s more on how the variable annuity process works.
Investment choices
Variable annuities offer diverse investment options through subaccounts. These typically include:
- Stock market funds
- Bond funds
- Money market funds
- Balanced funds combining stocks and bonds
- International investment options
Your annuity’s value changes based on how these investments perform, giving you a higher return — and risk — potential than fixed annuities.
Subaccounts
Subaccounts work like mutual funds within your annuity. Each has its own:
- Investment strategy
- Risk level
- Management team
- Performance history
For example, a stock market growth subaccount might have an aggressive investment strategy with a high risk level. Managed by a team specializing in large-cap stocks, this subaccount could aim for maximum capital appreciation.
You can move money between subaccounts without triggering taxes, helping you adjust your strategy over time.
Accumulation phase vs. payout phase
During the accumulation phase, you build your investment by making payments — as a lump sum or through regular contributions. Your money grows tax-deferred while you invest in various subaccounts, similar to mutual funds.
The payout phase begins when you're ready to receive income. You can choose regular payments for a specific period or lifetime income. The amount varies based on investment performance — unlike fixed annuities, which provide steady, predetermined payments.
Payout structure
You can choose from several payout options, including:
- Life income (payments until death)
- Period certain (payments for a specific timeframe)
- Life with period certain (combining both features)
- Joint and survivor (continuing payments to your spouse)
Withdrawal rules
Variable annuities typically include the following fees and limitations:
- A surrender period (usually 6–8 years) with penalties for early withdrawals
- A required minimum age (usually 59½) to avoid IRS penalties
- Optional withdrawal features for emergencies or healthcare needs
- Annual withdrawal limits to maintain guarantees
Variable annuity pros and cons
Explore the pros and cons to determine whether this annuity type supports your financial goals.
Variable annuity pros
Tax-deferred growth
Your investments grow tax-free until withdrawal, potentially building wealth faster than taxable accounts. This tax advantage means your earnings compound over time without annual tax payments slowing their growth.
Income for life
Variable annuities can provide guaranteed lifetime income via a rider, which reduces the worry of outliving your savings. You can choose payments that continue for your life, your spouse's life, or both. This offers valuable retirement security.
Principal protection
While market fluctuations can impact your growth potential, many variable annuities include features that protect your initial investment. Typically, the insurance company guarantees you’ll receive a policy-specified minimum payment.
Potential for higher returns
Unlike fixed annuities, variable annuities let you participate in market gains. Your investments can grow substantially during strong market periods, potentially providing better long-term returns than more conservative options.
Variable annuity cons
Market risk
While you’ll never lose your initial investment, your account value and future income can fluctuate based on investment performance.
For instance, if you invest $100,000, that amount is guaranteed — only the earnings above vary. Your account could potentially grow to $120,000 on good days while ensuring that your initial investment of $100,000 is protected during downturns.
Fees
Variable annuities often come with investment management fees, insurance charges, administrative expenses, and rider fees for additional features. These costs typically range from 2% to 3% of the account value, affecting returns.
That said, digital annuity platforms like Gainbridge® remove the middleman, eliminating administrative, maintenance, and commission fees. So you have options if you want to keep more money in your pocket.
Surrender charges and penalties
If you withdraw money early, you'll face a surrender charge (typically 6–8% that gradually decreases over 6–8 years until there are no surrender charges). And if you're under 59½, the IRS takes a 10% cut as a penalty. Plus, you'll need to pay taxes on your earnings, and you might lose some of those guaranteed benefits you signed up for.
Some insurance providers let you withdraw a set amount each year penalty-free (typically 10%), without a surrender penalty.
Variable annuity vs. fixed annuity
Choosing between a fixed or variable annuity depends on your financial goals, risk tolerance, and growth preferences. Here’s more on each type — and why it might suit your needs.
Variable annuity
Variable annuities are great for long-term retirement planning. A deferred variable annuity, for instance, allows you to invest $100,000 today and let it grow tax-deferred through various investment options before making payments in retirement.
These annuities often appeal to investors who:
- Have a longer time frame before retirement
- Feel comfortable with market fluctuations
- Seek potential for higher long-term returns
- Want to combat inflation through growth potential
- Desire flexibility in investment choices
Fixed annuity
Fixed annuities provide steady, predictable growth through guaranteed interest rates. They work much like certificates of deposit, offering peace of mind through consistent returns.
The insurance company guarantees both your principal and a minimum interest rate. This predictability makes budgeting easier since you'll know exactly how much income to expect.
These annuities typically attract investors who:
- Prefer guaranteed returns over growth potential
- Want protection from market volatility
- Need predictable retirement income
- Are closer to retirement
- Value stability over growth opportunity
Variable annuities offer a higher earnings potential, and fixed annuities provide more stability. Your decision ultimately depends on your retirement timeline, comfort with risk, and income requirements. You could also combine both types to balance your savings strategy.
5 things to consider when choosing a variable annuity provider
Your annuity is only as successful as the provider you choose. Here are some factors to consider when selecting one.
1. Find low or no fee options
Every dollar paid in fees reduces your potential returns. Look for annuities with competitive cost structures by comparing:
- Mortality and expense charges (typically 1–1.5%)
- Administrative fees (usually 0.15–0.3%)
- Investment management fees (varying by subaccount)
- Rider costs (if applicable)
The most competitive providers often offer total fees below 2%.
2. Evaluate investment flexibility
Variable annuities provide diverse investment choices that let you:
- Select from a broad range of asset classes
- Adjust your strategy as markets change
- Access well-known fund families
- Maintain appropriate risk levels throughout retirement
Look for providers offering 15–20 quality subaccounts covering major market sectors and investment styles.
3. Verify financial strength
Prioritize insurers with:
- Strong ratings from A.M. best
- Strong scores from Moody's and S&P
- Established track records in the annuity market
- Substantial financial reserves
4. Consider available features
Many providers offer optional benefits worth exploring, like:
- Guaranteed minimum income benefits
- Enhanced death benefit options
- Living benefit riders
- Free withdrawal provisions
5. Examine service quality
Outstanding customer support is invaluable during long-term investment relationships. Choose a provider that offers:
- Clear, accessible documentation
- Robust online account management
- Knowledgeable service representatives
- Educational resources and tools
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All guarantees are based on the financial strength and claims-paying ability of the issuing insurance company.
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