Variable Annuities: The Retirement Products with Hidden Costs

How Variable Annuity Fees Stack Up

Variable annuities come with multiple layers of fees that are rarely presented as a single total. Each fee sounds small in isolation. Together, they create a significant annual drag that most buyers do not fully understand until years after purchase. The first layer is the mortality and expense risk charge, commonly called the M&E fee. This is the insurance company's charge for providing the death benefit and the annuity payout guarantees. For most variable annuities, the M&E fee runs 1.25% to 1.50% of the account value annually. The second layer is the underlying sub-account expense ratios. Variable annuities invest your money in mutual fund-like sub-accounts, and those sub-accounts carry their own internal expense ratios. Unlike low-cost index funds in a standard brokerage account - which might charge 0.03% to 0.20% - variable annuity sub-accounts often run 0.50% to 1.50% annually. The third layer is rider fees. Most people buy variable annuities with income riders that guarantee a minimum withdrawal benefit, living benefit, or similar feature. These riders add another 0.50% to 1.25% per year on top of everything else. Add those layers together: 1.35% M&E plus 1.00% sub-account expenses plus 0.75% rider fee equals 3.10% total annual cost. Some variable annuities run higher than that. To put this in perspective: a variable annuity with 3.10% in annual fees needs to earn 10.10% gross just to deliver a 7% net return. A simple S&P 500 index fund earning the same 10.10% gross - with 0.03% in fees - delivers 10.07% net. Over 20 years, that difference is enormous.

The Surrender Charge Trap

Beyond annual fees, variable annuities typically impose surrender charges - penalties for withdrawing your money during the initial surrender period, which commonly runs 7 to 10 years. A typical surrender charge schedule starts at 7-8% in year one and decreases by 1% per year until it reaches zero. If you invest $200,000 and need to access $100,000 in year three, you could face a 5-6% surrender charge on that withdrawal - a penalty of $5,000 to $6,000 for accessing your own money. Surrender charges matter most in situations that are all too common in retirement planning: unexpected medical expenses, a better financial product becoming available, or simply realizing the annuity does not fit your situation as well as you thought. The surrender period effectively locks your money with that insurance company for nearly a decade. Some variable annuities allow annual penalty-free withdrawals of 10% of the account value. This provides some liquidity, but it is limited. And those penalty-free withdrawals are still subject to income tax - and a 10% federal penalty if you are under age 59.5. For someone who enters a variable annuity in their late 50s and finds themselves in a 7-year surrender period, the practical reality is that the money is largely inaccessible at a reasonable cost until their mid-60s. During those same years, more efficient alternatives - including direct investments or properly structured retirement accounts - remain fully accessible.

The Tax Disadvantage Most Buyers Miss

Variable annuities are often marketed with the phrase 'tax-deferred growth.' That is technically accurate but leaves out the critical second half of the story: when you take money out, all of the growth is taxed as ordinary income - not at the lower long-term capital gains rates that apply to growth in a regular brokerage account. Here is why that matters. If you hold an S&P 500 index fund in a taxable brokerage account for 10 years, the gains qualify as long-term capital gains. In 2026, married couples with taxable income below $94,050 pay 0% on those gains. Those with higher incomes pay 15% or 20% - rates significantly lower than ordinary income rates. In a variable annuity, all gains are taxed as ordinary income when distributed - regardless of how long the money was invested or how the underlying sub-accounts performed. If you are in the 22% or 24% bracket in retirement, you pay 22-24% on every dollar of annuity gains, not the 0-15% you would pay on the same growth held in a standard account. There is also no step-up in basis at death. With a direct investment account, heirs receive a stepped-up cost basis to the fair market value at the date of death - potentially eliminating capital gains tax on decades of appreciation. Variable annuities do not get this step-up. The taxable gain passes to heirs as ordinary income. For investors in the 22% bracket or higher, the tax disadvantage of variable annuity distributions can easily offset any tax-deferral benefit, particularly when combined with the annual fee drag.

When Variable Annuities Do and Do Not Make Sense

Variable annuities are not universally bad products - but they are frequently sold to people for whom they are a poor fit. Understanding the legitimate use case helps identify when they are appropriate versus when a simpler alternative serves better. The reasonable case for a variable annuity is narrow. They may make sense for a high-income investor who has already maxed out all tax-advantaged accounts (401(k), Roth IRA, HSA) and wants additional tax-deferred growth space. In that scenario, the tax deferral provides genuine value that can partially offset the fee drag. They may also make sense for someone with a specific need for guaranteed lifetime income who cannot achieve that through other means and who understands the fee structure fully before purchasing. They rarely make sense for: anyone who has not yet maxed out available tax-advantaged accounts, anyone in a lower tax bracket where the deferral benefit is minimal, anyone who may need liquidity during the surrender period, or anyone primarily motivated by the death benefit (term life insurance typically provides equivalent death benefit coverage at far lower cost). A 1035 exchange allows you to move money from one annuity to another without a taxable event - which means if you own a high-fee variable annuity, you may be able to exchange it into a lower-cost product. However, surrender charges at the current carrier may still apply, and the receiving product's surrender period resets. Understand the full cost of any exchange before executing it.