What it means
A variable annuity has two phases. During the accumulation phase you pay in and the money grows or shrinks with the sub-accounts you have chosen, and during the payout phase the contract converts into an income stream or is withdrawn as a lump sum.
The main attractions are tax deferral and the option to convert savings into income you cannot outlive. That makes them most relevant to people who have already filled up their standard retirement accounts and want another tax-deferred container.
Costs are the defining feature and the most misunderstood part. A typical contract carries a mortality and expense charge, an administration fee, the underlying fund expenses, and any optional rider fees, which together often reach 2% to 3% a year.
Surrender charges are the other trap. Many contracts impose a declining penalty for withdrawals in the first six to eight years, so money that might be needed sooner does not belong inside one.
Riders are where the product gets complicated. A guaranteed minimum withdrawal benefit promises a floor on the income you can draw regardless of market performance, but it is priced as insurance and it reduces the growth you keep.
In practice
Real-world examples.
Example
A dentist aged 52 has already maximised her pension and workplace plan contributions and still wants to shelter another $150,000 from tax. Her adviser recommends a low-cost variable annuity with total charges of 0.9%, specifically because the tax deferral only pays off if the fees stay modest.
Example
A retiring couple worries about outliving their savings. They move $300,000 of a $900,000 portfolio into a variable annuity with a guaranteed withdrawal rider that promises at least $15,000 a year for life, accepting the extra 1.1% rider charge as the price of certainty.
Example
A financial planner reviews a client's inherited contract and finds a 6% surrender charge still applies for two more years. She advises waiting rather than switching, because exiting early would cost $9,600 on a $160,000 balance.
Think of it
“Variable annuity has payments that change-depends on how investments perform.
Formula
Calculation
Contract value grows at the gross return of the chosen sub-accounts minus all annual charges:
Ending value = Starting value x (1 + Gross return - Total annual charges)
An investor places $200,000 into a variable annuity. The sub-accounts return 7% gross, and the contract charges a 1.25% mortality and expense fee plus 0.75% in underlying fund expenses, a total of 2.00%.
Net return = 7.00% - 2.00% = 5.00%
Value after one year = $200,000 x 1.05 = $210,000
Compounded over ten years the difference is stark. At the net 5% the contract grows to $200,000 x 1.05 to the power of 10 = $325,779, while the same 7% gross return with no charges would have produced $393,430, a gap of $67,651.Case study
Seen in the real world.
The following is an illustrative and fictional account. Deryn Hollowell, an invented 58-year-old operations manager, was sold a variable annuity for $250,000 without a clear explanation of the charging structure.
Six years later she compared her statement with a plain index fund and found her contract had grown to $312,000 while the equivalent index investment would have reached $381,000. The gap came almost entirely from a 2.6% total annual charge that included two riders she did not need, since she had a defined benefit pension already covering her essential spending.
She switched into a lower-cost contract using a tax-free exchange between annuity contracts, cutting total charges to 1.0%. The illustrative lesson is not that variable annuities are bad but that the guarantees inside them are only worth buying when you actually need the guarantee.
Watch out
Common mistakes.
- Treating the tax deferral as automatically worthwhile. High annual charges can easily cost more than the tax saved, especially for someone whose tax rate in retirement will be similar to today's.
- Buying riders without pricing them. A guaranteed income floor sounds free because it is deducted from the account rather than billed, but it can consume more than a full percentage point of return every year.
- Confusing the guaranteed income base with the account value. The rider base used to calculate income is often larger than the money you could actually withdraw, and the two are not interchangeable.
Questions
People also ask.
How is a variable annuity taxed on withdrawal?
Growth is normally taxed as ordinary income rather than at capital gains rates, and withdrawals before age 59 and a half can attract an additional penalty.
What is the difference from a fixed annuity?
A fixed annuity pays a rate the insurer guarantees, while a variable annuity passes market gains and losses straight through to you.
Can I move to a cheaper contract without a tax bill?
Usually yes, through a like-for-like exchange between annuity contracts, but check whether surrender charges on the existing contract still apply first.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%