Variable Annuity: Definition and How It Works, Vs. Fixed Annuity

What Is a Variable Annuity?

A variable annuity is a type of annuity contract, the value of which can vary based on the performance of an underlying portfolio of sub accounts. Sub accounts and mutual funds are conceptually identical, but sub accounts don't have ticker symbols that investors can easily type into a fund tracker for research purposes. Among annuities, variable annuities differ from fixed annuities, which provide a specific and guaranteed return.

Key Takeaways

  • The value of a variable annuity is based on the performance of an underlying portfolio of sub accounts selected by the annuity owner.
  • Fixed annuities, on the other hand, provide a guaranteed return.
  • Variable annuities offer the possibility of higher returns and greater income than fixed annuities, but there’s also a risk that the account will fall in value.

Understanding Variable Annuities

There are two elements that contribute to the value of a variable annuity: the principal, which is the amount of money you pay into the annuity, and the returns that your annuity’s underlying investments deliver on that principal over the course of time.

The most popular type of variable annuity is a deferred annuity. Often used for retirement planning purposes, it is meant to provide a regular (monthly, quarterly, annual) income stream, starting at some point in the future. There are also immediate annuities, which begin paying income right away.


Variable Annuity Basics

You can buy an annuity with either a lump sum or a series of payments, and the account’s value will grow accordingly. In the case of deferred annuities, this is often referred to as the accumulation phase. The second phase is triggered when the annuity owner asks the insurer to start the flow of income, often referred to as the payout phase. Most annuities will not allow you to withdraw additional funds from the account once the payout phase has begun.

Variable annuities should be considered long-term investments due to the limitations on withdrawals. Typically, they allow one withdrawal each year during the accumulation phase. However, if you take a withdrawal during the contract’s surrender period, which can be as long as 15 years, you’ll generally have to pay a surrender fee. As with most retirement account options, withdrawals before the age of 59½ will result in a 10% tax penalty.

Variable Annuities vs. Fixed Annuities

Variable annuities were introduced in the 1950s as an alternative to fixed annuities, which offer a guaranteed—but often low—payout during the annuitization phase. (The exception is the fixed income annuity, which has a moderate to high payout that rises as the annuitant ages).

Variable annuities gave buyers a chance to benefit from rising markets by investing in a menu of mutual funds offered by the insurer. The upside was the possibility of higher returns during the accumulation phase and a larger income during the payout phase. The downside was that the buyer was exposed to market risk, which could result in losses. With a fixed annuity, by contrast, the insurance company assumes the risk of delivering whatever return it has promised.

Variable Annuity Advantages and Disadvantages

In deciding whether to put money into a variable annuity versus some other type of investment, it’s worth weighing these pros and cons.

  • Tax-deferred growth

  • Income stream tailored to your needs

  • Guaranteed death benefit

  • Funds off-limits to creditors

  • Riskier than fixed annuities

  • Surrender fees and penalties for early withdrawal

  • High fees

Below are some details for each side.


  1. Variable annuities grow tax-deferred, so you don’t have to pay taxes on any investment gains until you begin receiving income or make a withdrawal. This is also true of retirement accounts, such as traditional IRAs and 401(k)s.
  2. You can tailor the income stream to suit your needs.
  3. If you die before the payout phase, your beneficiaries may receive a guaranteed death benefit.
  4. The funds in an annuity are off-limits to creditors and other debt collectors. This is also generally true of retirement plans.


  1. Variable annuities are riskier than fixed annuities because the underlying investments may lose value.
  2. If you need to withdraw money from the account because of a financial emergency, you may face surrender fees. Any withdrawals you make prior to the age of 59½ may also be subject to a 10% tax penalty.
  3. The fees on variable annuities can be quite hefty.

What Is an Annuity?

An annuity is an insurance product that promises to pay out income at a future date based on invested funds. If one purchases an annuity for a set price, the issuing company would invest the funds and hold them until they are supposed to be disbursed, generally based on the owner's age. Annuities are similar to other forms of investing in that the owner invests money with the hope that it will gain in value, but annuities also come with higher fees than most mutual funds.

Which Earns More: Variable or Fixed Annuities?

There is no clear answer to this. While variable annuities have greater potential for earnings, since their interest rate rises and falls with their underlying investments, they can lose money. They are also riddled with fees, which can cut into profits. Fixed annuities typically earn at a lower, stable rate. Carefully look at your options when choosing an annuity.

Are Annuities FDIC-insured?

No, annuities are not FDIC-insured as they are not bank products. However, they are protected by state guaranty associations in the event that the insurance company providing the product goes out of business.

The Bottom Line

Before buying a variable annuity, investors should carefully read the prospectus to try to understand the expenses, risks, and formulas for calculating investment gains or losses. Annuities are complicated products, so that may be easier said than done.

Bear in mind that between the numerous fees—such as investment management fees, mortality fees, and administrative fees—and charges for any additional riders, a variable annuity’s expenses can quickly add up. That can adversely affect your returns over the long term, compared with other types of investments.

Article Sources
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  1. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Page 3.

  2. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Pages 6–7.

  3. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Page 10.

  4. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Page 3.

  5. U.S. Securities and Exchange Commission. "Variable Annuities: What You Should Know," Page 6.

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