In
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
, an annuity is a series of payments made at equal intervals.
[Kellison, Stephen G. (1970). ''The Theory of Interest''. Homewood, Illinois: Richard D. Irwin, Inc. p. 45] Examples of annuities are regular deposits to a
savings account
A savings account is a bank account at a retail bank. Common features include a limited number of withdrawals, a lack of cheque and linked debit card facilities, limited transfer options and the inability to be overdrawn. Traditionally, transac ...
, monthly
home mortgage
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any pu ...
payments, monthly
insurance
Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...
payments and
pension
A pension (, from Latin ''pensiō'', "payment") is a fund into which a sum of money is added during an employee's employment years and from which payments are drawn to support the person's retirement from work in the form of periodic payments ...
payments. Annuities can be classified by the frequency of payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other regular interval of time. Annuities may be calculated by
mathematical functions
In mathematics, a function from a set to a set assigns to each element of exactly one element of .; the words map, mapping, transformation, correspondence, and operator are often used synonymously. The set is called the domain of the functi ...
known as "annuity functions".
An annuity which provides for payments for the remainder of a person's lifetime is a
life annuity.
Types
Annuities may be classified in several ways.
Timing of payments
Payments of an ''annuity-immediate'' are made at the end of payment periods, so that interest accrues between the issue of the annuity and the first payment. Payments of an ''annuity-due'' are made at the beginning of payment periods, so a payment is made immediately on issueter.
Contingency of payments
Annuities that provide payments that will be paid over a period known in advance are ''annuities certain'' or ''guaranteed annuities.'' Annuities paid only under certain circumstances are ''contingent annuities''. A common example is a
life annuity, which is paid over the remaining lifetime of the annuitant. ''Certain and life annuities'' are guaranteed to be paid for a number of years and then become contingent on the annuitant being alive.
Variability of payments
*Fixed annuities – These are annuities with fixed payments. If provided by an insurance company, the company guarantees a fixed return on the initial investment. Fixed annuities are not regulated by the
Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
.
*Variable annuities – Registered products that are regulated by the
SEC in the United States of America. They allow direct investment into various funds that are specially created for Variable annuities. Typically, the insurance company guarantees a certain death benefit or lifetime withdrawal benefits.
*
Equity-indexed annuities – Annuities with payments linked to an index. Typically, the minimum payment will be 0% and the maximum will be predetermined. The performance of an index determines whether the minimum, the maximum or something in between is credited to the customer.
Deferral of payments
An annuity that begins payments only after a period is a ''deferred annuity'' (usually after retirement). An annuity that begins payments as soon as the customer has paid, without a deferral period is an ''immediate annuity''.
Valuation
Valuation of an annuity entails calculation of the
present value
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is usually less than the future value because money has inte ...
of the future annuity payments. The valuation of an annuity entails concepts such as
time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The t ...
,
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
, and
future value
Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is ...
.
[.]
Annuity-certain
If the number of payments is known in advance, the annuity is an ''annuity certain'' or ''guaranteed annuity''. Valuation of annuities certain may be calculated using formulas depending on the timing of payments.
Annuity-immediate
If the payments are made at the end of the time periods, so that interest is accumulated before the payment, the annuity is called an ''annuity-immediate'', or ''ordinary annuity''. Mortgage payments are annuity-immediate, interest is earned before being paid.
What is Annuity Due?
Annuity due refers to a series of equal payments made at the same interval at the beginning of each period. Periods can be monthly, quarterly, semi-annually, annually, or any other defined period. Examples of annuity due payments include rentals, leases, and insurance payments, which are made to cover services provided in the period following the payment.
The ''present value'' of an annuity is the value of a stream of payments, discounted by the interest rate to account for the fact that payments are being made at various moments in the future. The present value is given in
actuarial notation
Actuarial notation is a shorthand method to allow actuaries to record mathematical formulas that deal with interest rates and life tables.
Traditional notation uses a halo system where symbols are placed as superscript or subscript before or ...
by:
:
where
is the number of terms and
is the per period interest rate. Present value is linear in the amount of payments, therefore the present value for payments, or ''rent''
is:
:
In practice, often loans are stated per annum while interest is compounded and payments are made monthly. In this case, the interest
is stated as a
nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees
# An adjustment for inflation(in contrast with ...
, and
.
The ''future value'' of an annuity is the accumulated amount, including payments and interest, of a stream of payments made to an interest-bearing account. For an annuity-immediate, it is the value immediately after the n-th payment. The future value is given by:
:
where
is the number of terms and
is the per period interest rate. Future value is linear in the amount of payments, therefore the future value for payments, or ''rent''
is:
:
Example: The present value of a 5-year annuity with a nominal annual interest rate of 12% and monthly payments of $100 is:
:
The rent is understood as either the amount paid at the end of each period in return for an amount PV borrowed at time zero, the ''principal'' of the loan, or the amount paid out by an interest-bearing account at the end of each period when the amount PV is invested at time zero, and the account becomes zero with the n-th withdrawal.
Future and present values are related since:
:
and
:
= Proof of annuity-immediate formula
=
To calculate present value, the ''k''-th payment must be discounted to the present by dividing by the interest, compounded by ''k'' terms. Hence the contribution of the ''k''-th payment ''R'' would be
. Just considering ''R'' to be 1, then:
:
which gives us the result as required.
Similarly, we can prove the formula for the future value. The payment made at the end of the last year would accumulate no interest and the payment made at the end of the first year would accumulate interest for a total of (''n'' − 1) years. Therefore,
:
Annuity-due
An ''annuity-due'' is an annuity whose payments are made at the beginning of each period.
Deposits in savings, rent or lease payments, and insurance premiums are examples of annuities due.
Each annuity payment is allowed to compound for one extra period. Thus, the present and future values of an annuity-due can be calculated.
:
:
where
is the number of terms,
is the per-term interest rate, and
is the
effective rate of discount given by
.
The future and present values for annuities due are related since:
:
:
Example: The final value of a 7-year annuity-due with a nominal annual interest rate of 9% and monthly payments of $100 can be calculated by:
:
In Excel, the PV and FV functions take on optional fifth argument which selects from annuity-immediate or annuity-due.
An annuity-due with ''n'' payments is the sum of one annuity payment now and an ordinary annuity with one payment less, and also equal, with a time shift, to an ordinary annuity. Thus we have:
:
. The value at the time of the first of ''n'' payments of 1.
:
. The value one period after the time of the last of ''n'' payments of 1.
Perpetuity
A ''perpetuity'' is an annuity for which the payments continue forever. Observe that
:
Therefore a
perpetuity
A perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few actual perpetuities in existence. For example, the United Kingdom (UK) government issued them in the past; these were known as conso ...
has a finite present value when there is a non-zero discount rate. The formulae for a perpetuity are
:
where
is the interest rate and
is the effective discount rate.
Life annuities
Valuation of
life annuities may be performed by calculating the
actuarial present value The actuarial present value (APV) is the expected value of the present value of a contingent cash flow stream (i.e. a series of payments which may or may not be made). Actuarial present values are typically calculated for the benefit-payment or seri ...
of the future life contingent payments.
Life table
In actuarial science and demography, a life table (also called a mortality table or actuarial table) is a table which shows, for each age, what the probability is that a person of that age will die before their next birthday ("probability of deat ...
s are used to calculate the
probability
Probability is the branch of mathematics concerning numerical descriptions of how likely an Event (probability theory), event is to occur, or how likely it is that a proposition is true. The probability of an event is a number between 0 and ...
that the annuitant lives to each future payment period. Valuation of life annuities also depends on the timing of payments just as with annuities certain, however life annuities may not be calculated with similar formulas because actuarial present value accounts for the probability of death at each age.
Amortization calculations
If an annuity is for repaying a debt ''P'' with interest, the amount owed after ''n'' payments is
:
Because the scheme is equivalent with borrowing the amount
to create a perpetuity with coupon
, and putting
of that borrowed amount in the bank to grow with interest
.
Also, this can be thought of as the present value of the remaining payments
:
See also
fixed rate mortgage
A fixed-rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float". As a result, payment amounts and the duration of th ...
.
Example calculations
Formula for finding the periodic payment ''R'', given ''A'':
:
Examples:
# Find the periodic payment of an annuity due of $70,000, payable annually for 3 years at 15% compounded annually.
#* ''R'' = 70,000/(1+〖(1-(1+((.15)/1) )〗^(-(3-1))/((.15)/1))
#* R = 70,000/2.625708885
#* R = $26659.46724
Find PVOA factor as.
1) find ''r'' as, (1 ÷ 1.15)= 0.8695652174
2) find ''r'' × (''r''
''n'' − 1) ÷ (''r'' − 1)
08695652174 × (−0.3424837676)÷ (−1304347826) = 2.2832251175
70000÷ 2.2832251175= $30658.3873 is the correct value
# Find the periodic payment of an annuity due of $250,700, payable quarterly for 8 years at 5% compounded quarterly.
#* R= 250,700/(1+〖(1-(1+((.05)/4) )〗^(-(32-1))/((.05)/4))
#* R = 250,700/26.5692901
#* R = $9,435.71
Finding the Periodic Payment(R), Given S:
R = S\,/((〖((1+(j/m) )〗^(n+1)-1)/(j/m)-1)
Examples:
# Find the periodic payment of an accumulated value of $55,000, payable monthly for 3 years at 15% compounded monthly.
#* R=55,000/((〖((1+((.15)/12) )〗^(36+1)-1)/((.15)/12)-1)
#* R = 55,000/45.67944932
#* R = $1,204.04
# Find the periodic payment of an accumulated value of $1,600,000, payable annually for 3 years at 9% compounded annually.
#* R=1,600,000/((〖((1+((.09)/1) )〗^(3+1)-1)/((.09)/1)-1)
#* R = 1,600,000/3.573129
#* R = $447,786.80
Legal regimes
*
Annuities under American law
In the United States, an annuity is a financial product which offers tax-deferred growth and which usually offers benefits such as an income for life. Typically these are offered as structured (insurance) products that each state approves and r ...
*
Annuities under European law
Under European Union law, an annuity is a financial contract which provides an income stream in return for an initial payment with specific parameters. It is the opposite of a settlement funding. A Swiss annuity is not considered a European a ...
*
Annuities under Swiss law
A Swiss annuity simply refers to a fixed or variable annuity marketed from Switzerland or issued by a Swiss based life insurance company but has no legal definition. Insurance brokers promoting annuity contracts issued by insurance companies domi ...
See also
*
Amortization calculator
An amortization calculator is used to determine the periodic payment amount due on a loan (typically a mortgage), based on the amortization process.
The amortization repayment model factors varying amounts of both interest and principal into eve ...
*
Fixed rate mortgage
A fixed-rate mortgage (FRM) is a mortgage loan where the interest rate on the note remains the same through the term of the loan, as opposed to loans where the interest rate may adjust or "float". As a result, payment amounts and the duration of th ...
*
Life annuity
*
Perpetuity
A perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few actual perpetuities in existence. For example, the United Kingdom (UK) government issued them in the past; these were known as conso ...
*
Time value of money
The time value of money is the widely accepted conjecture that there is greater benefit to receiving a sum of money now rather than an identical sum later. It may be seen as an implication of the later-developed concept of time preference.
The t ...
References
*
*
{{DEFAULTSORT:Annuity (Finance Theory)
Finance theories