Annuities are an insurance product. Image source: Getty Images.

Annuities can be difficult to understand, especially because so many annuities are full of complex provisions that almost seemed designed to obscure how they work. Immediate annuities, however, are easy to understand, and they can be extremely useful in fighting the one threat that most other investments don't address: the risk of outliving your money. Below, we'll look at immediate annuities in more detail to give you a sense of how they work, and we'll offer some pros and cons of the annuities compared to other ways to invest your money.

What is an immediate annuity?

Immediate annuities offer investors a way to trade money now for money later. You pay an up-front lump-sum amount, known as the premium, to the insurance company in order to buy the annuity. In exchange, the insurance company selling you the annuity agrees to make fixed payments back to you.

Typically, annuities are structured so that the payments you receive continue throughout your lifetime. Different options are also available, and one popular one involves making annuity payments not only while you're still alive but also for the life of a spouse or other loved one.

Advantages of immediate annuities

The most valuable thing about the immediate annuity is that it takes away the longevity risk of outliving your money. With most investments, any reasonable strategy for spending down an account in retirement always runs the risk that you'll tap your financial resources too soon. Especially as life expectancies have risen over time, the threat of longevity risk has grown, and it has become more important to lock in guaranteed income that will last a lifetime. The ability to structure immediate annuities to include a spouse or other family member in the mix only adds to their value.

In addition, immediate annuities offer a fair amount of stability. The obligation is guaranteed by the insurance company, so if you pick a highly rated issuer, then you can expect to receive the payments you're due for the rest of your life. In addition, most states offer a guaranty fund that protects annuity holders in the event that the issuing insurance company fails.

Downsides of immediate annuities

Immediate annuities aren't perfect, however. Typically, the amount of the monthly payment you'll receive is based on prevailing interest rates in the market, because that's what helps determine how much the issuing insurance company will be able to earn by investing your up-front premium for the long haul. With interest rates as low as they have been lately, immediate annuity payments are lower than they were in the past, and that can make it expensive to buy the income stream that you need to make ends meet in retirement.

The other big problem with immediate annuities is that you can end up losing money if you pass away shortly after buying an annuity. If you die after receiving just one monthly payment, then your heirs won't be entitled to get any of the upfront premium you paid back unless you choose special provisions in the particular contract. Those provisions can make sure you leave something for your loved ones, but they can also result in lower monthly payments during your lifetime. With immediate annuities, most features involve trade-offs like this.

Finally, it's important to look at the costs of immediate annuities. Typically, those costs will be built into the monthly payment you receive back, and so it takes some work to determine exactly what expenses you're responsible for paying. It's worth the extra effort to see whether you're getting a good deal or whether the insurance company is trying to take advantage of the situation.

Are immediate annuities right for you?

Immediate annuities can be helpful to let you plan for your retirement by knowing in advance exactly how much income you'll have available to you each month. However, given the downsides involved, it typically makes more sense to invest just a portion of your retirement assets in an immediate annuity after you retire. That way, you can get the monthly income you rely on but also have some other assets invested in more lucrative investment vehicles. With a simple mix involving an immediate annuity, you can produce the stronger overall returns you'll need to help your money grow.