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Annuities are investment options that trade present-day deposits for a series of future payouts. Money deposited into an annuity grows over time based on a variety of factors, including the type of annuity you have and the rate of interest that the annuity earns.
Financial experts generally use two figures to describe an annuity’s growth — present value and future value. Understanding these terms can help you make the most of your annuity, both now and in years to come.
Annuities are offered by insurance companies, banks and other financial institutions as a way to secure extra cash during retirement.
When you sign an annuity contract, you’ll contribute money, either in a large lump sum or as smaller monthly payments, called premiums. Once invested, your money grows on a tax-deferred basis, which allows you to take advantage of compound interest. When it comes time to withdraw your funds, you may owe taxes on either the full withdrawal amount or any interest accrued, depending on the type of annuity you have.
Annuities come in many forms. For instance, you can choose between annuities with fixed or variable interest rates, or between annuities that offer immediate or deferred payouts.
The present value of an annuity describes the current total worth of all future payouts, based on the annuity’s fixed rate of growth.
Present value calculations are most commonly used if you’re considering cashing out or selling your annuity. It’s important to understand how much the annuity is worth, so you can feel confident that the purchasing company is offering you a fair rate.
When calculating the present value of an annuity, you will need to know several variables:
It’s also important to note that your calculations will vary depending on when your annuity payments are due.
The present value formula for an ordinary annuity (where payments occur at the end of a period) is:
PMT x [(1 – [1 / (1 + r)^n]) / r]
The present value formula for an annuity due (also known as an annuity in arrears, where payments occur at the beginning of a period) is:
(PMT x [(1 – [1 / (1 + r)^n]) / r]) x (1 + r)
The future value of your annuity estimates how much your annuity might be worth in years to come, based on your planned contributions and a fixed rate of growth.
The future value calculation helps you visualize how your annuity might grow by taking compound interest into consideration. Compound interest occurs when the amount of money you earn in interest is periodically added back into the principal. In simpler terms, it’s the interest you earn on your annuity’s principal plus interest.
When calculating the future value of an annuity, you will need to know these variables:
Future value calculations will also vary slightly depending on when payments are made.
The future value formula for an ordinary annuity (where payments occur at the end of a period) is:
PMT x [ ([1 + r]^n – 1) / r]
The future value formula for an annuity due (also known as an annuity in arrears, where payments occur at the beginning of a period) is:
PMT x [ ([1 + r]^n – 1) x (1 + r) / r]
Calculations for the present and future values of annuities are typically used in different circumstances. These calculations also reveal different aspects of a potential investment.
Present value calculations estimate an annuity’s current value.
For a real-world example, say you’re trying to calculate the worth of a fixed annuity with a guaranteed 5% interest rate. This annuity offers $5,000 payouts over 15 annual periods. We’ll also assume this is an ordinary annuity, where payments occur at the end of each period.
Your ordinary annuity’s present value calculation looks like this:
Present value = 5,000 x [(1 - [1 / (1 + .05)^15]) / .05]
Present value = $51,898.29
Future value calculations, on the other hand, estimate how much the annuity might be worth in the future.
Consider the same ordinary annuity’s future value. Say you pay an annual $5,000 premium for a period of 15 years, with a fixed interest rate of 5%. Your future value calculation for this annuity looks like this:
Future value = 5,000 x [([1 + .05]^15 – 1) / .05]
Future value = 107,892.82
As you can see, the future value shows how much this annuity will be worth in the future. That’s because it accounts for growth — specifically, compound interest — over time.
Both present and future value calculations are important planning tools for annuity owners. With the present and future values of your annuity in hand, you can feel more confident working toward a comfortable retirement.
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