Can You Lose Money in a Variable Annuity?

A variable annuity is a contract between an individual and an insurance company, offering potential investment growth and a guaranteed income stream in retirement. Its value is directly linked to the performance of underlying investment options, called subaccounts, meaning its value can fluctuate. This structure allows for market participation and growth, but also introduces factors that can lead to a decline in an investor’s principal or a reduction in their overall financial return.

Investment Performance and Market Volatility

Variable annuities invest capital into subaccounts, which function like mutual funds. These subaccounts hold diverse assets, such as stocks, bonds, or money market instruments, aligned with different investment objectives. The annuity’s cash value is directly tied to the performance of these subaccounts, exposing the investment to market fluctuations.

If subaccount assets decline due to market downturns, the annuity’s cash value decreases. Periods of market volatility, with rapid price swings, can lead to substantial reductions in the account balance. Unlike fixed annuities, variable annuities offer no inherent guarantee of principal preservation based on investment performance. A sustained market decline, like those during economic recessions, can cause subaccounts to lose significant value, directly translating into a loss of principal for the annuity holder.

Market volatility poses a risk to the principal. For example, a prolonged bear market erodes the value of equity-focused subaccounts. If a portfolio is heavily weighted towards growth stocks, values could fall sharply during an economic contraction. Rising interest rates can also negatively impact bond subaccounts, as existing bonds with lower coupon rates become less attractive.

Specific investment choices within subaccounts also impact potential for loss. Selecting subaccounts that consistently underperform their benchmarks, such as the S&P 500 for an equity fund, can lead to diminished returns or losses. Underperformance can stem from poor management, excessive trading costs, or an ill-suited investment strategy. Even in stable markets, poor subaccount selection can prevent growth or result in principal decline.

Investors also risk concentration if subaccounts are not diversified across asset classes, industries, or geographies. For instance, heavy concentration in a single sector, like technology, could lead to significant losses if that sector declines. Diversification across various subaccounts, including different equity styles, fixed income, and international markets, can help mitigate loss but not eliminate risk.

An investor’s risk tolerance and objectives are crucial for mitigating losses. Selecting overly aggressive subaccounts might lead to panic selling during market dips, locking in losses. Conversely, choosing overly conservative subaccounts might result in insufficient growth to offset annuity fees, leading to a net loss of purchasing power due to inflation and charges. Aligning subaccount choices with financial goals and risk profile is paramount.

The lack of a principal guarantee differentiates variable annuities from fixed annuities. In a variable annuity, investment risk rests with the contract holder, meaning capital depreciation is a direct consequence of market exposure. The investment component carries the same market risks as direct investments in mutual funds or exchange-traded funds. Therefore, the cash value can fall below the amount initially invested, particularly if market conditions are unfavorable or investment selections are ineffective.

Fees and Charges

Variable annuities carry multiple layers of fees that can significantly erode investment returns and contribute to a decline in account value, even during periods of modest growth. These charges can also exacerbate losses during market downturns, making it harder for the annuity’s value to recover.

One primary fee is the Mortality and Expense (M&E) Risk Charge, paid to the insurance company. This charge compensates the insurer for guarantees like the death benefit and lifetime income. It also covers administrative costs and mortality risk. M&E charges are typically an annual percentage of the annuity’s account value, often ranging from 0.50% to 1.50% per year.

Administrative fees cover operational expenses such as record-keeping, transaction processing, and customer service. These fees can be a flat annual charge (e.g., $30-$50) or a small percentage of the account value (e.g., 0.10%-0.25% annually). These deductions reduce the money available for investment growth.

Underlying investment options, or subaccounts, also incur expenses similar to mutual funds. These cover portfolio management, trading costs, and other operational expenses. Embedded within the subaccount’s net asset value, they range from 0.25% to over 1.00% annually, depending on the strategy. These costs reduce the overall return generated by the subaccounts before any annuity-specific fees.

Many variable annuities offer optional riders or benefits with distinct charges. These are for enhanced guarantees like Guaranteed Minimum Withdrawal Benefits (GMWB), Guaranteed Minimum Income Benefits (GMIB), or enhanced death benefits. For example, a GMWB rider, which guarantees a certain percentage of the initial investment can be withdrawn annually, might add 0.50% to 1.50% or more to annual fees. While these riders offer protection, their costs can significantly increase the total expense ratio.

The cumulative effect of these fees can be substantial, often totaling 2.00% to 4.00% or higher per year of the annuity’s account value. For an annuity to break even, its underlying investments must generate returns high enough to cover all combined charges. If an annuity has 3.00% in annual fees, subaccounts need at least a 3.00% return just to maintain principal. If returns fall below this, the account value will decline.

During market stagnation or decline, these fees rapidly deplete the annuity’s value. If subaccounts experience a negative return, fixed and percentage-based fees continue to be deducted, accelerating capital erosion. This can lead to the account value falling significantly below the initial contribution, even with potential future market recovery. The persistent drag of these charges can turn modest gains into net losses, or deepen actual losses.

Surrender Charges and Tax Implications

Withdrawing money from a variable annuity or canceling the contract within a specific timeframe can trigger substantial surrender charges, directly reducing the investor’s principal. These charges are typically imposed during an initial “surrender period,” commonly ranging from five to ten years. These fees help the insurance company recover upfront costs and agent commissions.

Surrender charges are usually a declining percentage of the amount withdrawn or initial premium. For example, a contract might impose a 7% charge in the first year, declining by 1% annually until it reaches 0% after seven years. If an investor accesses funds during this period beyond the “free withdrawal” provision (often 10% annually), they incur this penalty. This direct deduction can cause an immediate loss of principal, especially if investments haven’t performed well enough to offset the charge.

Beyond surrender charges, tax implications of withdrawals can diminish an investor’s net return. Earnings accumulated within a non-qualified variable annuity (funded with after-tax dollars) are taxed as ordinary income upon withdrawal, not at lower long-term capital gains rates. This means gains are subject to an individual’s marginal income tax bracket, which can be significantly higher.

The IRS applies a “Last-In, First-Out” (LIFO) tax treatment to non-qualified annuity withdrawals. This rule considers earnings withdrawn first, making them fully taxable as ordinary income until all accumulated gains are exhausted. Only after all earnings are withdrawn does the investor receive their tax-free return of principal. This LIFO treatment can result in a larger immediate tax burden compared to investments where principal is returned proportionally with gains.

Withdrawals made before age 59½ are generally subject to an additional 10% IRS penalty tax on the taxable portion. This penalty is imposed on top of ordinary income tax, significantly reducing the net amount received. For instance, a $5,000 taxable withdrawal would incur standard income tax plus a $500 penalty. This combined tax burden and penalty can substantially diminish the investment’s value, leading to a financial loss in terms of available capital, even if the annuity experienced some growth.

Understanding Optional Guarantees

Many variable annuities offer optional riders or guarantees to protect against market downturns or ensure a minimum income stream. Features like Guaranteed Minimum Withdrawal Benefits (GMWB) or Guaranteed Minimum Income Benefits (GMIB) provide assurances but do not prevent underlying subaccounts from losing market value. For example, a GMWB might guarantee annual withdrawals from a protected base even if the cash value drops, while a GMIB ensures a minimum lifetime income.

These guarantees offer a safety net, but the annuity’s actual cash value, based on subaccount performance, can still decline significantly. A key consideration is the additional fees these optional guarantees incur. These rider charges are typically an annual percentage of the annuity’s “benefit base” or account value, ranging from 0.50% to over 1.50% per year. These charges are deducted directly from the annuity’s cash value, reducing the amount available for investment and growth.

The imposition of these fees means that even if guarantees are not utilized or the market performs well, the overall investment return is reduced. For instance, if underlying investments gain 5% in a year but optional riders cost 1.00%, the net return is effectively 4%. This consistent drag from rider fees can significantly diminish the overall financial outcome, potentially leading to a loss of potential growth compared to lower-cost investments.

While these optional guarantees provide a valuable floor for income or accumulation, they carry a substantial cost that can diminish the overall financial outcome. The cumulative cost can reduce the net account value, after all fees, to less than what was initially invested, or significantly less than what could have been achieved in alternative, lower-cost investments. The perceived security of the guarantee must always be weighed against its ongoing expense.