What is an annuity and how does it work?

Only 36% of Americans saving for retirement expect to have enough to be financially secure when they retire, according to an AARP survey from January 2024. The biggest risk with most retirement planning is outliving your savings.

"When you think about retirees of the past, many had pension plans from their employers and, through that, a guaranteed income stream," Elle Switzer, director of annuity product management with TruStage, told CNBC Select. "That doesn't exist for most of us anymore."

One way to help maintain a regular income in your golden years is by buying annuities. With an annuity, you pay a lump sum to an insurance company in return for a guaranteed income stream.

An annuity is a contract between you and a life insurance company in which you pay a lump sum or make a series of payments and the insurer invests the money in the market. In return, you receive a guaranteed monthly income. 

Banks, fintechs and brokerage firms also sell annuities. You can purchase one that starts paying you back immediately, but most annuities are deferred — meaning you have to leave the money untouched for a number of years or face stiff penalties.

There are annuities with minimum initial payments of $100,000 and some as low as $2,500. The more you deposit, typically, the larger your monthly payments will be.

There are three main types of annuities.

Fixed annuity

A fixed annuity has a flat rate of return, regardless of what happens with the market or inflation. Fixed annuities offer peace of mind and few or no fees, though they usually don't pay out as much as variable accounts.

Variable annuity

A variable annuity is invested in stock funds that typically keep pace with inflation. The payouts could be higher, but so is the risk – if the market drops, your payments decline. It could take decades for you to make back your initial investment.

"You're not going to run out of money but it can continue to go lower if the market continues to go lower," said Evan Potash, an executive wealth management advisor at TIAA. "If you look at markets over the long term, though, they tend to go up much more than they go down."

If you opt for a variable annuity, be sure you can still afford your expenses even if your payouts decrease.

Indexed annuity

An indexed annuity is invested in market indexes like the S&P 500 or the Dow Jones Industrial Average. Because these indexes include many of America's top companies, they generally reflect the shape of the economy as a whole. Like a variable annuity, an indexed annuity is designed to keep pace with inflation and secure your purchasing power for life.  

When shopping for an annuity provider, consider its size, financial stability and reputation for customer service. These companies all rank among the top 10 annuity sellers of 2023, according to the Life Insurance Marketing and Research Association (LIMRA), and have high customer satisfaction scores from J.D. Power.

• Best for fixed annuity: Athene
• Best for variable annuity: Nationwide
• Best customer service: F&G Annuities & Life
• Best for guaranteed income: MassMutual
• Best for low minimum: New York Life
• Best for shorter surrender period: Pacific Life

Best for fixed annuity

Athene sold 34.6 billion in fixed annuities in 2023, the most of any company reviewed by LIMBRA. Athene Agility annuities are guaranteed not to lose money and provide a guaranteed income stream with a death benefit rider at no additional charge. 

Best for variable annuity

Landing in the top 10 for annuity sales in 2023, Nationwide netted $4.7 billion in variable annuity premiums alone. It touts over 100 investment options, many of which come with low annual fees and the ability to withdraw up to 10% annually without incurring a penalty. 

Nationwide's New Heights® fixed indexed annuity can be linked to the S&P 500, MSCI EAFE, Morgan Stanley 3D or J.P. Morgan Mozaic II index and has optional riders for lifetime income and enhanced death benefits. 

Nationwide was third for customer service among major annuity providers, right behind F&G and  MassMutual. It also earned a commendable 90 COMDEX score. 

Best for customer service

F&G Annuities & Life was a top 10 seller of fixed annuities in 2023 and came in first place in J.D. Power's  2023 U.S. Individual Annuity Study. Its Performance Pro® Annuity is a fixed index-based account with a $10,000 minimum initial premium and an annual contract fee of just 0.1%.

F&G annuitants 75 and under earn a 15% bonus that vests over 10 years, while those 76 and older earn a 9% bonus.

Best for guaranteed income

Dating to 1851, MassMutual offers fixed, variable and index-based annuities, and both deferred and immediate options. It came in second for customer satisfaction with J.D. Power and has less than a third the volume of complaints than competitors of similar size, according to the National Association of Insurance Commissioners. 

Mass Mutual ranked second in fixed annuity sales in 2023, according to LIMRA, and second for total annuity sales. It also earned a near-perfect 98 COMDEX score and paid out more than $9 billion in annuity and life insurance benefits.

Best for low minimum

While minimums for some annuities can stretch to $100,000 or more, New York Life's floor is a modest $10,000. It sold $19.3 billion in premiums in 2023, mostly in fixed annuities, and received a perfect 100 on Comdex, an index that aggregates scores from A.M. Best, S&P, Moody's and Fitch. 

Available in all 50 states, Washington, DC, and Puerto Rico, New York Life scores well above average in customer satisfaction and receives a third of the number of complaints of other companies its size, according to NAIC.  

Best for shorter surrender period

Tying up your money in an annuity can be nerve-racking: Surrender periods can stretch to 10 years and penalties for withdrawals can be as high as 20% of your contributions. Pacific Life's Pacific Choice has a surrender period of just five years, though, coupled with more than 90 investment options and a low 1.20% fee.

Scoring well above average for customer service, Pacific Life is also a standout for financial stability, with a healthy 4.11% capital ratio and a 95 Comdex score.

The period after you purchase an annuity and it starts to earn interest is known as the accumulation phase. During the annuitization phase, you begin receiving payments.

Depending on the type of annuity you buy, your annuitization phase may begin immediately or there may be a surrender period, during which you can't access the funds without paying a penalty. 

Accounts that pay out right away are called immediate annuities. They can be a good choice if you're close to (or already in) retirement. Since they don't have as much time to accumulate interest, though, the payments are usually smaller.

Accounts with a surrender period, the most common kind, are called deferred annuities. Most deferred annuities have a surrender period of between two and eight years, but some can last 10 years or longer.

Even after the surrender period expires, if you make a withdrawal before age 59½ you'll be hit with a 10% IRS penalty. In fact, most financial advisors recommend leaving an annuity untouched until your late 60s or early 70s.

Once you reach your annuitization phase you'll start receiving monthly payments, like a paycheck or a Social Security. Interest earned on a deferred annuity isn't taxed until you make a withdrawal.

Annuity returns depend on several factors, including the type of account and the performance of the index it's attached to. Insurance companies also usually put caps on the interest rate that an annuity can earn. Since many guarantee no risk of losing money, the cap rate offsets their losses in downturn years by limiting the annuitant's upside in market years.

Most annuities have a 4% to 6% annual return, although some are as high as 8%.

Many also charge annual fees, typically between 1% and 3% of your account balance, to cover administrative costs, trading fees, commissions, premium taxes, surrender charges and other expenses. There is also often a mortality-and-expense (M&E) risk charge, which compensates the insurer if the customer lives longer than expected or expenses run higher than anticipated.

The more complicated an annuity, the more expensive the fees: A variable annuity, which requires more investor oversight, will have a higher charge than a simple fixed annuity.

Riders can also cut into your payouts, but they can help your annuity better withstand economic downturns. In general, the more value a rider adds, the more expensive it will be.

Annuity riders include:

• Guaranteed minimum income: Prevents your income from dropping below a certain threshold
• Guaranteed lifetime withdrawal: Lets you bypass the deferral period and use your annuity account as an emergency fund. 
• Enhanced death benefit: Ensures beneficiaries receive a lump sum or continuation of payments after you die, up to a predetermined amount or the remaining value of the contract. 
• Long-term care annuity: A deferred annuity that can be paid out as usual or to cover expenses relating to your care if you're diagnosed with a chronic or terminal illness.
• Cost-of-living rider: Automatically adjusts payments to keep up with inflation
• Impaired risk rider: Fast tracks payouts if you're diagnosed with a condition expected to shorten your lifespan.

As with any investment product, annuities have their benefits and drawbacks.

Pros

• Regular payments: Annuities are structured to offer continuous payments, sometimes for the remainder of your life. 
• Lifetime income: Outliving your savings is a major concern in retirement. Annuities can come with riders that ensure regular payments for the rest of your life.  
• Guaranteed rate of return: Fixed and indexed annuities can have guaranteed minimum rates of return, which can be reassuring.
• Tax advantages: Money in an annuity grows tax-deferred and only a portion of regular annuity payouts are taxed.   

Cons

• Higher fees: Fees and commissions for annuities can be more than other retirement products like IRAs or 401(k) plans.
• Restricted access: Deferred annuities have a surrender period, a number of years during which you can't access funds without paying a stiff penalty.
• Complex: Even savvy investors can find annuities complicated to understand
• Limits on returns: Your annuity may be guaranteed not to lose money but, in return, providers put a cap on the interest rate you can earn.

If you like the idea of steady payments and not having to monitor your investments closely, an annuity could be right for you. If you invest $100,000 into an annuity with a 7% return and leave it untouched for two decades, you could expect nearly $900 a month for 15 years.

It's important to remember, however, that you won't be able to touch those funds for years, which could leave you in a jam if there's a financial emergency. Potash recommends having about two-thirds of your savings in a guaranteed account, like an annuity, and another third as readily accessible cash.

And an annuity alone probably won't cover all your expenses in retirement. It's just one component of an entire retirement portfolio, said Switzer, along with a 401(k) plan, an IRA and other accounts.

"Annuities can really just be another investment vehicle," he said. "It's an investment that has some guarantees, which works very well for some people."

At CNBC Select, we work with experts who have specialized knowledge and authority based on relevant training and/or experience. For this story, we interviewed Elle Switzer, the director of annuity product management at TruStage, and Evan Potash, an executive wealth management advisor at TIAA.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed decisions with their money. Every investing article is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of financial products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics. See our methodology for more information on how we choose the best annuities.

To determine the best annuity companies, CNBC Select looked at various U.S.-based annuity providers, considering market share, fees, surrender periods, minimums and availability. We also used customer satisfaction and financial health data from A.M. Best, the National Association of Insurance Commissioners, the Life Insurance Marketing and Research Association and  J.D. Power's 2023 U.S. Individual Annuity Study.

Catch up on CNBC Select's in-depth coverage of credit cards, banking and money, and follow us on TikTok, Facebook, Instagram and Twitter to stay up to date.

Correction: This story has been corrected to reflect that F&G's Performance Pro® Annuity has an annual contract fee of 0.1% and that annuitants 75 and under earn a 15% bonus, while those 76 and older earn a 9% bonus.