This article was originally published on Nov.r 8, 2015. It was updated on May 10, 2017.

For most of us, the hope of one day collecting a pension has faded as pensions have largely been phased out in the U.S. As we figure out how to generate the income we'll need to support ourselves in retirement, one appealing option is an annuity. So how does an annuity work?

There are lots of different kinds of annuities. For example:

  • Immediate versus deferred (paying you immediately versus starting at some point when you're older)
  • Fixed versus variable (fixed payouts versus payouts tied to the performance of the market)
  • Lifetime versus fixed period (paying until death or paying for a certain span of time)

And the list goes on.

Immediate or deferred fixed annuities are smart options for many people who are in or near retirement. But some annuities, such as indexed annuities and many variable annuities, are more problematic and charge steep fees or carry restrictive terms.

Couple speaking with financial advisor

Image source: Getty Images.

In a nutshell

At its heart, an annuity is a contract -- generally between a buyer and an insurance company. You pay the company up front, and in return you receive regular payments -- either now or later. The payments are often monthly, but they can be quarterly or annual. The payments can last for a fixed number of years or for the rest of your life. Pay a little extra (or accept smaller checks), and your payouts can last for the rest of your spouse's life, too, and/or be adjusted to keep up with inflation over the years. And although it's less common, you can also opt to receive a lump sum payment down the road.As an example, $100,000 can buy a 70-year-old man about $635 per month, or $7,620 per year. A $300,000 purchase can generate nearly $23,000 annually. Women can generally expect lower payouts, because they tend to live longer than men.

An annuity works much like insurance, especially when it comes to fixed annuities. Some annuity holders will live a long time and thus receive a lot of money from the insurer, while others will pass at a younger age and thus cost the insurer less. By pooling these policies and using actuarial data, insurance companies can get an idea of how much they can expect to spend and, therefore, how much to charge for the annuities. 

Words of caution

An annuity is only guaranteed so long as the insurer remains solvent, so if you go annuity shopping, seek highly rated insurers. You can reduce your risk even more by dividing your annuity purchase among several insurers.

Annuities typically charge fees and commissions. So when shopping for one, compare several options and find the best deal. You can avoid commission charges by purchasing your annuities through companies that sell them directly, bypassing salespeople. Many major low-cost brokerages offer no-commission fixed annuities, as do insurance companies and other financial institutions.

One of the biggest drawbacks with an annuity is that once you buy it, you give up the principal for good (though with many annuities, you may be able to get some or much of your money back by paying a hefty "surrender" fee). It will no longer be growing in stocks and cannot easily be liquidated to meet some urgent need. It won't be left to be passed down to your heirs, either -- though some annuities allow beneficiaries to receive some payments if you should pass on before you've received a certain minimum amount (and, naturally, this feature comes at a price).

Know that the payments you sign up for today are lower than those people have received at other times because of our current environment of extremely low interest rates. Interest rates seem to be rising, though, so payouts should rise with them. In this environment, you might want to "ladder" your purchases, buying a third of the annuity income you want now, another third in a few years when rates are likely to be higher, and the last third even later. Or if you're not in a rush, just wait. 

What to do

The average Social Security retirement benefit is only about $1,366 per month, or about $16,000 per year. That won't be enough for many people to live on, so building additional income streams is a smart thing for most of us to do. All current and future retirees should learn more about annuities so that they can figure out whether buying one (or more) makes sense.