Walk into a retail brokerage office, mention you’re nearing retirement, and there’s a non-trivial chance you’ll be steered toward a variable annuity. The product will be presented as a way to combine market growth with downside protection, lifetime income, and tax deferral. It sounds great. It is, in nearly every case I’ve examined, a terrible product.
Variable annuities survive because they’re profitable to sell, not because they’re useful to own. The fee structure alone is a small disaster.
The fee stack is brutal
A typical variable annuity layers several fees that most buyers don’t fully grasp. Mortality and expense (M&E) charges run 1.0% to 1.5% annually. The underlying subaccounts (essentially mutual funds) charge another 0.5% to 1.5% in expenses. Optional riders for guaranteed income or death benefits add another 0.5% to 1.5%. Add it all up and you’re looking at 2.5% to 4% in annual fees, sometimes higher.
For comparison, a low-cost index fund charges 0.03% to 0.10%. The fee differential compounds savagely over a 20-year retirement horizon. A 3% fee drag turns a hypothetical 7% market return into a 4% net return, and the difference between those two over two decades is enormous.
Surrender charges trap you
Most variable annuities come with surrender charge schedules that lock up your money for 5 to 10 years. Withdraw early and you’ll pay a penalty that often starts at 7% to 8% in year one and decreases over time. This isn’t a fee you pay if something goes wrong; it’s a fee that exists to prevent you from leaving once you realize the product isn’t what you thought.
Combined with the IRS 10% early withdrawal penalty if you’re under 59½, and ordinary income tax rates on gains (annuities don’t get capital gains treatment), the cost of getting out can easily exceed 20%. The trap is structural. Once you sign, you’ve effectively committed.
The riders rarely deliver what they promise
Guaranteed lifetime income riders are the headline feature. They sound like a guaranteed return on your investment, but they’re not. The “guaranteed” amount is typically a withdrawal benefit that doesn’t represent your account value—it’s a notional figure used to calculate income. If you actually try to take a lump sum, you get the (usually lower) account value, not the guaranteed number.
The income guarantees are also calibrated to be roughly equivalent to what you’d get from a much cheaper immediate annuity, minus the fees you’ve been paying for years. The math is complicated specifically because complication is what allows the product to look better than it is.
Bottom line
If you want tax-deferred growth, max out your 401(k) and IRA. If you want guaranteed income in retirement, buy a single-premium immediate annuity from a low-cost provider when you actually need the income. If you want market exposure, buy index funds in a regular brokerage account. Variable annuities exist to combine these goals into a single product that pays high commissions to the agent who sold it. The combination is worse than the sum of its parts. There’s almost no scenario where a variable annuity is the right answer.
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