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Annuity Meaning
An annuity is an insurance contract that pays a series of fixed payments to a policyholder at fixed intervals. Annuities provide a steady stream of income in retirement, which can help protect retirees from outliving their savings. Annuities are also used as a way to save for retirement. There are two main types of annuities: immediate and deferred. An immediate annuity begins making payments to the policyholder immediately, while a deferred annuity does not begin making payments until a later date.
Types of Annuities
There are five types of annuities: immediate, deferred, fixed, variable, and indexed.
- An immediate annuity starts payments immediately,
- while a deferred annuity starts payments at some point in the future.
- A fixed annuity pays a set amount each month, while a variable annuity pays out a percentage of the account balance each month.
- With a variable annuity, the investment risk is taken by the annuity holder, while a fixed annuity removes the risk.
- An indexed annuity pays out a percentage of the account balance, but the payments are tied to an index, such as the Consumer Price Index, to protect the holder from market volatility.
How to Calculate Annuities
There are three ways to calculate annuities: the future value method, the present value method, and the amortization method.
The future value method calculates the future value of an annuity using the following formula:
FV = PV(1+i)^n
where FV is the future value, PV is the present value, i is the interest rate, and n is the number of periods.
The present value method calculates the present value of an annuity using the following formula:
PV = FV/(1+i)^n
where PV is the present value, FV is the future value, i is the interest rate, and n is the number of periods.
The amortization method calculates the amount of interest and principal that is paid over the life of an annuity using the following formula:
A = P*(1-i)^n/i
where A is the amortization amount, P is the principal, i is the interest rate, and n is the number of periods.
Formula to Calculate Present Value Annuities
The present value of an annuity is the sum of the present values of each of the payments in the annuity. The present value of an annuity can be calculated using the following formula:
PV = C[1/(1+r)^n]
Where:
PV = Present value
C = Payment amount
r = Annual interest rate
n = Number of payments
Formula to Calculate Future Value Annuities
The future value annuity calculation equation is:
FVA = C[(1 + r)^n – 1]/r
Where:
FVA = future value annuity
C = initial investment
r = annual interest rate
n = number of years
