Variable Annuities

What is a variable annuity

A variable annuity is a deferred annuity contract issued by a life insurance carrier and registered as a security with the Securities and Exchange Commission. The consumer pays a premium that is allocated among subaccount investment options. The contract value rises and falls with the subaccount performance.

Unlike a fixed or indexed annuity, the carrier does not guarantee principal in the base contract. The consumer bears the investment risk. Optional riders can add guarantees of lifetime income, enhanced death benefit, or principal protection, but those guarantees carry separate annual charges.

Subaccounts

Subaccounts are pooled investment options structured similarly to mutual funds. Each subaccount has a stated investment objective (large-cap equity, international, bond, money market, target-date) and a portfolio manager. The carrier offers a menu of subaccounts (typically 30 to 80) from which the consumer selects an allocation.

Subaccounts carry their own annual fund expense, expressed as a percentage of subaccount assets. This expense is in addition to the contract-level fees described below.

The fee stack

A variable annuity contract has multiple fee layers. The combined fee load is typically 1.5% to 4% per year depending on the contract and riders selected.

Mortality and expense (M&E) charge

The M&E charge funds the insurance features of the contract (death benefit, mortality guarantees) and the carrier's general administrative costs. Typical M&E charges range from 0.85% to 1.40% annually of contract value.

Administrative charge

A separate annual fee for record-keeping and contract administration. Often combined with M&E in product disclosures. Typically 0.10% to 0.25%.

Subaccount fund expense

Each subaccount's own annual expense ratio. Active equity subaccounts often run 0.70% to 1.20%. Passive (index) subaccounts may be lower, 0.20% to 0.50%. Money market and short-bond subaccounts are typically lower still.

Rider charges

Optional riders (GLWB, enhanced death benefit, long-term care) add 0.50% to 1.50% each. Charges are typically deducted from the contract value or the benefit base annually.

Surrender charges

A withdrawal beyond the free withdrawal allowance during the surrender period triggers a surrender charge. VA surrender schedules typically run 5 to 9 years, declining from 7% in year 1 to 0% at the end.

Income and death benefit riders

Guaranteed lifetime withdrawal benefit (GLWB)

A GLWB rider guarantees a stream of withdrawals for life, even if the contract value reaches zero. The rider tracks a "benefit base" that grows during the deferral period at a contractually defined rate. Once income begins, the carrier pays a percentage of the benefit base each year for life. Typical GLWB rider charge: 1.00% to 1.50% of the benefit base annually.

Guaranteed minimum income benefit (GMIB)

A GMIB rider guarantees a minimum lifetime income amount calculated as a percentage of the benefit base, available only when the consumer chooses to annuitize the contract (convert to a stream of payments). The annuitization rates are set by the rider and may be less favorable than current market SPIA rates.

Enhanced death benefit

The base contract typically pays the greater of (a) the contract value or (b) the original premium minus withdrawals to beneficiaries. An enhanced death benefit rider can lock in high-water-mark contract values or roll up a stated benefit base at a defined rate, increasing the death benefit. Charge is typically 0.25% to 0.75% annually.

Long-term care rider

Some VAs include a rider that increases the withdrawal allowance if the contract owner enters a qualifying long-term care situation. Conditions and waiting periods apply.

When the GLWB rider math works

A GLWB rider transfers longevity risk to the carrier in exchange for an annual fee. The economic outcome depends on three variables: how long the contract owner lives, how the subaccounts perform, and the rider charge level.

The rider is most economically efficient when:

• The contract owner lives substantially beyond the breakeven point (typically 20 to 30 years past the income start date).
• Subaccount returns are weak, causing the guaranteed income to exceed what an unguaranteed portfolio would have produced.
• The contract owner does not want to manage withdrawal-rate decisions themselves.

The rider is least economically efficient when:

• Subaccount returns are strong and the contract value never depletes.
• The contract owner lives only an average lifespan.
• The rider charge plus underlying fund expenses exceed 2.5% combined.

Surrender schedule

Variable annuities have surrender schedules similar to FIAs, though typically shorter. A common VA schedule: 7% year 1, declining by 1 point per year, reaching 0% at year 8. Most VAs allow a 10% free withdrawal each year beyond which the surrender charge applies.

Surrender charges are calculated on the contract value at the time of withdrawal, which can be lower than the original premium if subaccounts have underperformed.

Prospectus disclosure

Because variable annuities are registered securities, carriers must provide a prospectus disclosing all fees, subaccount investment objectives, performance history, and contract terms. The prospectus is typically a 200-400 page document. SEC rules require it to be delivered before purchase.

The summary prospectus is a shorter version (15-50 pages) that highlights material features. Reading the summary prospectus before purchase is the minimum due diligence for a variable annuity.

Tax treatment

Variable annuities are tax-deferred. Subaccount growth (interest, dividends, capital gains) is not taxed annually. Withdrawals are taxed as ordinary income, not as long-term capital gains, in LIFO order for non-qualified contracts. Withdrawals before age 59½ may be subject to a 10% federal tax penalty.

This tax treatment is less favorable than a direct mutual fund investment in a taxable account, where long-term capital gains are taxed at lower rates. For tax-deferred accounts (IRA, 401(k)), the annuity tax-deferral feature is redundant and adds no benefit beyond the rider guarantees.

When a variable annuity fits

• The consumer wants to combine market participation with a guaranteed lifetime income floor.
• The consumer is willing to pay 3% to 4% annually for that combination.
• The consumer is in a high tax bracket and tax deferral is genuinely valuable.
• The consumer has already maximized lower-cost retirement vehicles (IRA, 401(k), HSA).

When a variable annuity does not fit

• The contract is being sold for tax deferral alone inside an IRA or 401(k). The tax-deferral feature is wasted.
• The consumer's primary goal is market growth without guarantees. A diversified mutual fund portfolio at 0.10% to 0.30% expense ratio achieves the same growth at a fraction of the fee.
• The consumer cannot articulate why the rider guarantee is worth the rider charge.
• The consumer is being shown the variable annuity by a salesperson who emphasizes the bonus, the income rider, or the death benefit without disclosing total annual fees.

Frequently asked questions

Is a variable annuity the same as a mutual fund?

No. The subaccounts inside a VA are structured similarly to mutual funds but are not the same. Subaccounts are only available inside the VA contract. They have their own ticker symbols and prospectuses. The VA wrapper adds the contract-level fees (M&E, administrative, optional riders) on top of the subaccount fund expense.

What is the difference between a VA and an FIA?

A VA has direct market exposure through subaccounts. The contract value can lose principal. An FIA has no direct market exposure. The contract value cannot decline because of market loss. A VA can pay unlimited upside; an FIA caps the upside. A VA is a registered security; an FIA is a fixed insurance product.

Can I lose money in a variable annuity?

Yes. Without an optional rider, the contract value can decline because of subaccount losses. Even with a GLWB rider, the contract value can decline; the rider guarantees the income stream, not the contract balance.

What is the typical fee load?

With M&E, administrative, subaccount expense, and one rider, total annual fees commonly run 3.0% to 3.5% of contract value. This compounds against returns. A 7% subaccount gross return becomes a 3.5% to 4% net return after fees.

Can I exchange a VA for another annuity tax-free?

Yes, under IRC Section 1035. A variable annuity can be exchanged for another VA, an FIA, a fixed annuity, or some long-term care products without triggering tax on the gain at the time of exchange. Surrender charges from the original contract may still apply.

Sources

• SEC Investor Bulletin: Variable Annuities
• FINRA, Variable Annuities Resource Page
• NAIC Annuity Consumer Information
• Carrier prospectus filings (SEC EDGAR)
• A.M. Best Financial Strength Ratings

Related

• Fixed Indexed Annuities, the principal-protected alternative to a VA
• Annuity Fees Complete Guide
• Glossary: GLWB rider
• Glossary: GMIB rider
• Glossary: 1035 Exchange