401(k) Variable Annuities - 5 Reasons to Avoid Them

If your 401(k) plan is managed by an insurance company, your investments may not be in low-cost mutual funds as you think. Instead, they could be in variable annuities — and that can cost you big money. While variable annuities are often marketed as offering “guarantees” and “protection,” they come with one major downside: fees, fees, and more fees. 

These fees, often called "wrap fees," can be difficult to identify. They are often buried within expense ratios or insurance contracts, making them challenging to detect even for financially savvy participants. Over time, even a small extra fee can cost a participant tens or even hundreds of thousands of dollars. Let’s break down what a variable annuity is, how wrap fees work, and why you should reconsider having them in your 401(k) plan. 

What Is a Variable Annuity?

A variable annuity is a retirement investment product offered by insurance companies. They allow individuals to invest in "sub-accounts" tied to the performance of underlying investments – usually mutual funds. When you retire, you can annuitize your account balance, meaning you convert it into periodic payments. 

The benefits of a variable annuity include tax-deferred growth, guaranteed income in retirement, and a death benefit for beneficiaries. The downsides are complexity, layered fees, and withdrawal penalties. 

What is A Wrap Fee?

Wrap fees are the extra charges "wrapped" around the cost of an annuity’s underlying investments. These fees cover services provided by the insurance company and can significantly increase your total cost of investing. 

Wrap fees can include: 

• • Administrative Fees: Fees for plan administration, participant recordkeeping, and investment management. 

• • Mortality & Expense Risk Fees: Charges to cover the insurance company's risk of guaranteeing lifetime income. 

• • Rider Fees: Optional add-ons, like income guarantees, which come with additional costs. 

• • Surrender Charges: Penalties for withdrawing funds early during a "surrender period" (typically 7-10 years). 

5 Hidden Pitfalls of Variable Annuities in 401(k) Plans

Because 401(k) plans already offer tax-deferred growth and a death benefit for beneficiaries, the benefits of a variable annuity can be redundant inside a 401(k) plan, leaving participants to pay for "benefits" they don’t need — and those costs add up. Here are five pitfalls to watch for: 

1. Lack of Transparency

Wrap fees are notoriously hard to spot. While 401(k) providers must disclose direct fees, they can bury wrap fees within expense ratios or insurance contracts. This means even financially savvy participants may struggle to understand the true cost of their investment. 

2. Poor Risk-Reward Tradeoff

Variable annuities offer the option to convert your balance into guaranteed lifetime income. While guaranteed income may sound appealing, many participants do not need this type of insurance early in their savings journey. The irony is that most participants in 401(k) plans are years (if not decades) away from retirement, which means they are paying for benefits that will not be realized until much later — if at all. 

3. Conflicts of Interest

Insurance companies have a financial incentive to promote variable annuities over mutual funds. Why? Because it’s more profitable for them. Since they issue the annuity and administer the plan, they make money from both sides. 

This creates a conflict of interest where providers steer plan sponsors and participants toward high-fee annuities. The more fees you pay, the more revenue the insurer collects. 

4. Surrender Penalties

Once an annuity product is added to a 401(k), it’s hard to remove. Plan sponsors often face contractual penalties or surrender charges when switching providers or removing an annuity from the investment lineup. These charges are designed to lock plan sponsors (and participants) into long-term, high-fee arrangements. 

5. Losses that Compound

Wrap fees may seem small — maybe 1-2% annually — but they add up. Due to the power of compounding, a 1% fee drag can reduce total savings by up to 30% over a 30-year career. 

Example of the Impact of Variable Annuity Fees 

To illustrate how fees affect retirement savings, let’s compare two scenarios over 30 years with a starting balance of $100,000 and a 7% annual return before fees. 

The additional fees of the variable annuity cost Investor B nearly $286,905 over 30 years. This difference highlights the long-term impact of fees on retirement savings. 

Don’t Let Hidden Fees Steal Your Retirement 

When saving for retirement, fees matter. The difference between a 0.50% fee and a 2.5% 401(k) fee may seem small, but over time, it can cost you hundreds of thousands of dollars in retirement. 

Given the stakes, you want to know how much you’re paying as a 401(k) participant. Variable annuities can make this job impossible given their opaque and layered fees. Low-cost mutual funds that pay no revenue sharing are the better choice for most 401(k) participants. They are simpler, cheaper, and easier to understand.