Financial Terms Part 4 – Annuity
An Annuity is a regular stream of cash flow or equal payments made regularly, usually every year or every month. An annuity investment product is sold by insurance companies and sometime banks.
There are several ways it works:-
- You pay a lump sum now and the insurance company pays back a regular sum for X number of year
- You pay in over a period of time, say Y number of years and then the insurance company pays back a regular sum for X number of years
The annuity can be immediate, which mean you start to receive the payments immediately or deferred. Deferred means you, the investor will receive payments at some later date, perhaps 5 years or 10 years from the time you purchase the annuity.
Why do you want an annuity? After all, money now is better than money later, right? Some people buy an annuity with a lump sum of cash because they are concerned that they will out live the retirement sum. That’s the key reason why people buy annuities.
Annuities can be looked at as life insurance reversed. When you buy a life insurance policy, the insurance company is betting that you will live long enough and surrender the policy so that they don’t pay out the death benefit. For an annuity, the insurance company is betting that you won’t live so long as to receive all the income stream that is due to you.
The formula to calculate the value of an annuity is as follows
- PV(A) is the value of the annuity at time=0
- A is the value of the individual payments in each compounding period
- i equals the interest rate that would be compounded for each period of time
- n is the number of payment periods.
A much simpler way is off course to use a financial calculator. Let’s use an example. Let’s say you retired and have a lump sum of 500,000. Some one came to you to sell you an annuity that pays you 40,000 a year for the next 20 years. Is is a good deal or not?
Let’s assume inflation rate is 4% and you live long enough to collect the full 20 years payment. Using the formula above,
enter n = 20, i = 0.04, A = 40,000, you get PV = $543,513
which is more than the 500,000 you paid for it. So it looks like you have gotten a good deal.
