You are on page 1of 9

9.

4 Annuities
Objectives
1. Calculate the future value of an ordinary annuity.
2. Perform calculations regarding sinking funds.

Somewhere over the rainbow . . . skies are blue, . . . and the dreams that
you dare to dream . . . really do come true. —Lyman Frank Baum
(Author of The Wizard of Oz)
What are your financial dreams? Do you dream about owning a beautiful house? Visiting
some exotic far-away place? Providing a college education for your children? Retiring
happily in comfortable surroundings? If you have any long-term plans such as these, to
achieve your dreams you will need to have a large sum of money in the future.
In this section, we will discuss how you can do just that by making a series of regular
payments over many years to accumulate the money that you will need. This type of
investment is called an annuity.

Copyright © 2010 Pearson Education, Inc.


9.4 y Annuities 423

KEY POINT Annuities


We make regular payments An annuity is an interest-bearing account into which we make a series of payments of the
into an annuity. same size. If one payment is made at the end of every compounding period, the annuity is
called an ordinary annuity. The future value of an annuity is the amount in the account,
including interest, after making all payments.
To illustrate the future value of an annuity, suppose that in January you begin making
payments of $100 at the end of each month into an account paying 12% yearly interest
compounded monthly. How much money will be in this account for a summer vacation
beginning on July 1?
This problem is different from those in Section 9.2. In the earlier problems, we
deposited a lump sum that earned a stated interest rate for an entire period. In this problem,
we are depositing a series of payments, and each payment earns interest for a different
number of periods.
The January deposit earns interest for February, March, April, May, and June. Using
the formula for compound interest, this deposit will grow to
100(1 + 0.01)5 = $105.10.
However, the May deposit earns interest for only 1 month and therefore grows to only
100(1 + 0.01)1 = $101.
The June deposit earns no interest at all. We illustrate this pattern with the timeline in
Figure 9.3.

January February March April May June July

$100

$100

Earns
$100 interest.

$100

$100

Earns no
$100
interest.

F I G U R E 9 . 3 Timeline for ordinary annuity with deposits at end of


January, . . . , June.

If we compute how much each deposit contributes to the account and sum these
amounts, we will have the value of the annuity on July 1.

January 100(1.01)5 = $105.10


February 100(1.01)4 = $104.06
March 100(1.01)3 = $103.03
April 100(1.01)2 = $102.01
May 100(1.01)1 = $101.00
June 100(1.01)0 = $100.00
Total = $615.20

We can express the value of this annuity as


100(1.01)5 + 100(1.01)4 + 100(1.01)3 + 100(1.01)2 + 100(1.01)1 + 100.

Copyright © 2010 Pearson Education, Inc.


424 CHAPTER 9 y Consumer Mathematics

By factoring out the 100, we can write the value of the annuity in the form
100[(1.01)5 + (1.01)4 + (1.01)3 + (1.01)2 + (1.01)1 + 1]. (1)
Notice that although you deposited $100 at the end of each month for six months, the first
deposit earned interest for five months, the second deposit earned interest for four months,
and so on.
Following this pattern, it is clear that if you had deposited the $100 in a vacation savings
account at the end of each month for 10 months, the value of the annuity would have been
100[(1.01)9 + (1.01)8 + . . . + (1.01)2 + (1.01)1 + 1]. (2)
Notice that in equation (1) we have an expression of the form x5 + x4 + x3 + x2 + x1 + 1,
and in equation (2) we have an expression of the form x9 + x8 + . . . + x2 + x1 + 1. Fortu-
nately, there is a way to write these lengthy expressions in a simpler form.

EXAMPLE 1 Simplifying Annuity Computations


x6 - 1
Show that x 5 + x 4 + x 3 + x 2 + x 1 + 1 = .
x-1
SOLUTION: To show this relationship, we multiply the polynomials x5 + x4 + x3 + x2 + x1 + 1
and x - 1 in the usual way.
x5 + x4 + x3 + x2 + x1 + 1
*x-1
Quiz Yourself 14 x6+ + + + + x1
x5 x4 x3 x2
- x5 - x4 - x3 - x2 - x1 - 1
Write x3 + x2 + x1 + 1 as a
quotient of two polynomials. x6 -1
(Do computations that are This result shows that (x5 + x4 + x3 + x2 + x1 + 1)(x - 1) = x6 - 1. Dividing this equa-
similar to those we did in tion by x - 1, we obtain our desired relationship.
Example 1.)
Now try Exercises 3 to 4. ] 14

Following the pattern of Example 1, we can prove that


n +1
x -1
x n + x n -1 + x n-2 + Á + x 2 + x 1 + 1 = . (3)
x-1
Returning to our vacation savings account example, we can think of 1.01 as x in equation (1).
Then we can use equation (3) to simplify our calculations. Because
(1.01)5 + (1.01)4 + (1.01)3 + (1.01)2 + (1.01)1 + 1
(1.01)6 - 1 1.061520151 - 1 0.061520151
= = = L 6.1520,
1.01 - 1 1.01 - 1 0.01
we can write
100[(1.01)5 + (1.01)4 + (1.01)3 + (1.01)2 + (1.01)1 + 1] L 100(6.1520) = $615.20.
This is the same amount that we found earlier.
Doing similar computations, we find that the 10-month vacation savings account annu-
ity has a value of
KEY POINT 100[(1.01)9 + (1.01)8 + Á + (1.01)2 + (1.01)1 + 1]
The future value of an (1.01)10 - 1
annuity depends on the size = 100 c d L 100(10.4622) = $1,046.22.
1.01 - 1
of the payment, the interest
rate, and the number of We can generalize the patterns that we have just seen in a formula for finding the future
payments. value of an annuity.

Copyright © 2010 Pearson Education, Inc.


9.4 y Annuities 425

F O R M U L A F O R F I N D I N G T H E F U T U R E VA LU E O F A N O R D I NA RY
A N N U I T Y Assume that we are making n regular payments, R, into an ordinary
annuity. The interest is being compounded m times a year and deposits are made at
the end of each compounding period. The future value (or amount), A, of this annuity
at the end of the n periods is given by the equation
r n
a1 + b -1
m
A=R .
r
m

To calculate this expression, you should do the following steps:


1st: Find mr and add 1.
2nd: Raise 1 + mr to the n power and then subtract 1.
3rd: Divide the amount that you found in step 2 by mr .
4th: Multiply the quantity that you found in step 3 by R.

EXAMPLE 2 Finding the Future Value


of an Ordinary Annuity
Assume that we make a payment of $50 at the end of each month into an account paying a
6% annual interest rate, compounded monthly. How much will be in that account after
3 years?
r
SOLUTION: This account is an ordinary annuity. The payment R is 50, the monthly rate m
6% 0.06
is =
12 = 0.005, and the number of payments n is 3 * 12 = 36. Using the formula for
12
finding the future value of an ordinary annuity, we get
r
1+ n
TI-83 screen verifies calculations in m

   50 1.19668053 
Example 2. (1.005)  1
36
1
A  50
0.005 0.005
R r
m
Quiz Yourself 15

Redo Example 2, except now


 50  0.19668053
0.005 
assume that you are depositing  50(39.336105)  $1,966.81.*
$75 per month for 2 years.
Now try Exercises 7 to 16. ] 15

If you make regular payments into an annuity for many years, the value of the annuity
can become enormous due to the compounding of interest. Figure 9.4 shows that if the an-
nual interest rate is 6.6%, then in roughly 19 years, the amount of interest that the annuity
has earned exceeds the amount of the deposits. The fact that the interest curve is rising so
rapidly indicates that the future value of your account is also growing rapidly.

KEY POINT Sinking Funds


With a sinking fund, we make You may want to save regularly to have a fixed amount available in the future. For exam-
payments to save a specified ple, you may want to save $1,800 to travel to Jamaica in 2 years. The question is, how
amount.
much should you save each month to accomplish this? The account that you establish for

*When using your calculator, you should hold off on rounding your answers as long as possible. If you round off
too soon, your answers will differ slightly from the answers in this text.

Copyright © 2010 Pearson Education, Inc.


426 CHAPTER 9 y Consumer Mathematics

¶ ¶ ¶ HIGHLIGHT
Between the Numbers—Whom Do You “Trust”?
The “trust” that we are referring to is the Social Security U.S. workers. If we think of this as a ratio, every person on
trust fund. When you first started working, you may have Social Security is supported by 4 workers. In 1950, the ratio
been dismayed to see a deduction from your first paycheck was 16 workers for every Social Security beneficiary. It is
labeled FICA, which is an acronym for the Federal Insur- projected that by 2030, the ratio will be 2 workers for every
ance Contributions Act. This law mandates that workers beneficiary and the fund will be in trouble. So what can you
must contribute a certain amount of their wages to the Social do to protect your retirement?
Security trust fund. The government has been encouraging people to make
When you contribute to Social Security, you are not actu- plans for their retirement by establishing tax-deferred annu-
ally saving your money for your retirement, but your taxes are ities to guarantee that when they retire they will have money
paying for someone else’s retirement. The idea is that when to supplement Social Security benefits. Tax deferred means
you retire, younger workers will then pay for your retirement. that the money you set aside in the annuity is not taxed
However, some see a huge problem with this. Right now, now but at a later date when you start withdrawing from the
roughly 50 million Americans receive Social Security benefits annuity. As you will see in the exercises, there can be a huge
with contributions supported by approximately 200 million financial benefit to saving this way.

250
Thousands of dollars

200
Interest
150

100
Interest exceeds
deposits Deposits
50

0
100 200 300 400
Months
FIGURE 9.4 At an annual rate of 6.6%, the amount of
interest earned in an ordinary annuity exceeds the amount of
deposits in about 230 months.

your deposits is called a sinking fund. You could estimate the amount to save each month
by simply dividing 1,800 by 24 months to get 1,800
24 = $75 per month. Because your estimate
ignores the interest that your deposits will generate, the actual amount you would need to
put aside each month is somewhat less. Knowing exactly how much you need to save each
month could be important if you were on a tight budget.
Because a sinking fund is a special type of annuity, it is not necessary to find a new
formula to answer this question. We can use the formula for calculating the future value of
an ordinary annuity that we have stated earlier. In this case, we know the value of A and we
want to find R.*

EXAMPLE 3 Calculating Payments for a Sinking Fund


Assume that you wish to save $1,800 in a sinking fund in 2 years. The account pays 6%
compounded quarterly and you will also make payments quarterly. What should be your
monthly payment?

*In making payments into a sinking fund, we will always round the payment up to the next cent.

Copyright © 2010 Pearson Education, Inc.


9.4 y Annuities 427

SOLUTION: Recall the formula for finding the future value of an ordinary annuity:
r n
a1 + b -1
m
A=R . (4)
r
m
We want the value A of the annuity to be $1,800, the monthly rate mr is 6% 0.06
4 = 4 = 0.015,
and the number of payments n is 2 * 4 = 8. Substituting these values in equation (4), we get
TI-83 screen verifies calculations in
Example 3. 11 + 0.01528 - 1
1,800 = R = R(8.432839106).
0.015
Quiz Yourself 16
Dividing both sides of the equation by 8.432839106, we get the monthly payment
What payments must you make 1,800
to a sinking fund that pays 9%
R= L $213.46.
8.43289106
yearly interest compounded
monthly if you want to save Now try Exercises 17 to 20. ] 16

$2,500 in 2 years?

› Some Good Advice


You may be tempted to memorize a new formula to solve sinking fund problems. This is not
necessary, because once you have learned to solve annuity problems, you can use the same
formula (and a little bit of algebra) to solve sinking fund problems.

KEY POINT Sometimes in working with annuities, we want to know how long it will take to save a
We use the log function to certain amount. That is, in the annuity formula we want to find n. This problem is a little
find how long it takes for an more complicated than those we have solved so far. To solve such problems, we will use
annuity to accumulate a the exponent property for the log function, which we introduced in Section 9.3. We will
specified value. show you how to use this property in Example 4.

EXAMPLE 4 Finding the Time Required to


Accumulate $1,000,000
Suppose you have decided to retire as soon as you have saved $1,000,000. Your plan is to
put $200 each month into an ordinary annuity that pays an annual interest rate of 8%. In
how many years will you be able to retire?
S O LU T I O N : We can use the future value formula for an ordinary annuity to solve this
problem:
r n
a1 + b -1
m
A=R
r
m
Here, A is the future value of $1,000,000, mr is the monthly interest rate of 0.08
12 L 0.00667,
and R is 200. We must find n, the number of months for which you will be making
deposits. Therefore, we must solve for n in the following equation:
r
m

 
(1  0.00667)n  1
1,000,000  200
0.00667
A R r
m

We begin by multiplying both sides of the equation by 0.00667:


6,670 = 200[(1 + 0.00667)n - 1].

Copyright © 2010 Pearson Education, Inc.


428 CHAPTER 9 y Consumer Mathematics

Next, we divide both sides of the equation by 200 and then add 1 to both sides of the equation:
34.35 = (1.00667) n.
Then we take the log of both sides:
log 34.35 = log(1.00667) n.
Now we use the exponent property of the log function to simplify the equation:
Quiz Yourself 17 log 34.35 = n log 1.00667.
We divide by log 1.00667 and use a calculator to find n:
If you put $150 per month into
an ordinary annuity that pays log 34.35
n= = 531.991532 L 532.
an annual interest rate of 9%, log 1.00667
how long will it take for the This tells how many months it will take you to save $1,000,000. Dividing 532 by 12 gives
annuity to have a value of us 532
12 = 44.33 years until your retirement.
$100,000?
Now try Exercises 29 to 34. ] 17

Exercises 9.4 9. Amount, $400; monthly; 9%; 4 years


Looking Back*
10. Amount, $350; monthly; 10%; 10 years
These exercises follow the general outline of the topics presented in
this section and will give you a good overview of the material that 11. Amount, $600; monthly; 9.5%; 8 years
you have just studied. 12. Amount, $500; monthly; 7.5%; 12 years
1. To calculate the future value of the annuity in Example 2, we 13. Amount, $500; quarterly; 8%; 5 years
used the expression 14. Amount, $750; quarterly; 9%; 3 years
r n
a1 + b - 1 15. Amount, $280; quarterly; 3.6%; 6 years
m r
R . What is the meaning of ? What is the 16. Amount, $250; quarterly; 4.8%; 18 years
r m
m
meaning of m? What is R? In Exercises 17–20, find the monthly payment R needed to have a
sinking fund accumulate the future value A. The yearly interest rate r
2. What implications do you see of the situation presented in the
and the time t is given. Interest is compounded monthly. Round your
Highlight regarding the Social Security trust fund?
answer up to the next cent.
Sharpening Your Skills 17. A = $2,000; r = 6%; t = 1
In Exercises 3 and 4, simplify each algebraic expression, as in 18. A = $10,000; r = 12%; t = 5
Example 1. 19. A = $5,000; r = 7.5%; t = 2
3. x7 + x6 + . . . + x2 + x1 + 1 20. A = $8,000; r = 4.5%; t = 3
4. x8 + x7 + . . . + x2 + x1 + 1 Solve each equation for x.
Exercises 5 and 6 are based on the vacation account example at the 21. 3x = 20 22. 5x = 15
beginning of this section. Assume that, beginning in January, you
23. 8x = 10 24. 20x = 100
make payments at the end of each month into an account paying the
specified yearly interest. Interest is compounded monthly. How much 8x - 5 4x + 6
25. = 20 26. = 10
will you have available for your vacation by the specified date? 6 3
5. Monthly payment, $100; yearly interest rate, 6%; August 1 8x + 2 5x - 8
27. = 12 28. = 14
6. Monthly payment, $200; yearly interest rate, 3%; May 1 5 10

In Exercises 7 and –16, find the value of each ordinary annuity at In Exercises 29–34, use the formula for finding the future value of
the end of the indicated time period. The payment R, frequency of an ordinary annuity,
deposits m (which is the same as the frequency of compounding), r n
a1 + b -1
annual interest rate r, and the time t are given. m
A=R ,
7. Amount, $200; monthly; 3%; 8 years r
8. Amount, $450; monthly; 2.4%; 10 years m

*Before doing these exercises, you may find it useful to review the note How to Succeed at Mathematics
on page xix.

Copyright © 2010 Pearson Education, Inc.


9.4 y Exercises 429

to solve for n. You are given A, R, and r. Assume that payments are 42. Saving to start a business. Victory is making monthly
made monthly and that the interest rate is an annual rate. payments into an annuity that pays 0.8% monthly interest to
29. A = $10,000; R = 200; r = 9% save enough for a down payment to start her own business. If
she wants to save $10,000 in 5 years, what should her monthly
30. A = $12,000; R = 400; r = 8%
payments be?
31. A = $5,000; R = 150; r = 6%
43. Saving for consumer goods. Sandra Lee is making monthly
32. A = $8,000; R = 400; r = 5%
payments into an annuity. She wants to have $600 in the fund
33. A = $6,000; R = 250; r = 7.5% to buy a new convection range in 6 months, and the account
34. A = $7,500; R = 100; r = 8.5% pays 8.2% annual interest. What are her monthly payments to
the account?
Applying What You’ve Learned 44. Saving for consumer goods. Lennox is making monthly
In Exercises 35–40, assume that the compounding is being done payments into an annuity. He wishes to have $1,150 in 10 months
monthly. to buy exercise equipment. His account pays 9% annual interest.
35. Saving for a scooter. Matt is saving to buy a new Vespa. If he What are his monthly payments to the account?
deposits $75 at the end of each month in an account that pays Tax-deferred annuities work like this: If, for example, you plan to set
an annual interest rate of 6.5%, how much will he have saved aside $400 per month for your retirement in 30 years in a tax-
in 30 months? deferred plan, the $400 is not taxed now, so all of the $400 is
36. Saving for a trip. Angelina wants to save for an African safari. invested each month. In a nondeferred plan, the $400 is first taxed
She is putting $200 each month in an ordinary annuity that pays and then the remainder is invested. So, if your tax bracket is 25%,
an annual interest rate of 9%. If she makes payments for 2 years, after you pay taxes, you would have only 75% of the $400 to invest
how much will she have saved for her trip? each month. However, in the tax-deferred plan, all of your money is
taxed when you withdraw the money. In the nondeferred plan, only
the interest that you have earned is taxed.
In Exercises 45–50, we give the amount you are setting aside each
month, your current tax rate, the number of years you will contribute to
the annuity, and your tax rate when you begin withdrawing from the
annuity. Answer the following questions for each situation:
a) Find the value of the tax-deferred and the nondeferred accounts.
b) Calculate the interest that was earned in both accounts. This
will be the value of the account minus the payments you made.
c) If you withdraw all money from each account and pay the
relevant taxes, which account is better and by how much?

37. Saving for a car. Kristy Joe deposits $150 each month in an Number Annual Current Future
ordinary annuity to save for a new car. If the annuity pays a Monthly of Interest Tax Tax
monthly interest rate of 0.85%, how much will she be able to Payment Years Rate Rate Rate
save in 3 years? 45. $300 30 6% 25% 18%
38. Saving for retirement. Cohutta is saving for his retirement in 46. $400 25 4.5% 25% 15%
10 years by putting $500 each month into an ordinary annuity.
47. $400 20 4% 30% 30%
If the annuity has an annual interest rate of 9.35%, how much
will he have when he retires? 48. $600 30 4.6% 25% 25%

39. Saving for a vacation home. Wendy has set up an ordinary 49. $500 35 3.4% 25% 30%
annuity to save for a retirement home in Florida in 15 years. If 50. $500 30 4.8% 18% 25%
her monthly payments are $400 and the annuity has an annual
interest rate of 6.5%, what will be the value of the annuity In Exercises 51–54, assume that monthly deposits are being placed
when she retires? in an ordinary annuity and interest is compounded monthly.
40. Saving for retirement. Thiep has set up an ordinary annuity to 51. Saving for a fire truck. The Reliance Volunteer Fire Company
save for his retirement in 20 years. If his monthly payments are wants to take advantage of a state program to save money to
$350 and the annuity has an annual interest rate of 7.5%, what purchase a new fire truck. The truck will cost $400,000, and
will be the value of the annuity when he retires? members of the finance committee estimate that with commu-
41. Saving for a condominium. Kanye wants to save $14,000 in nity and state contributions, they can save $5,000 per month in
8 years by making monthly payments into an ordinary annuity an account paying 10.8% annual interest. How long will it take
for a down payment on a condominium at the shore. If the to save for the truck?
annuity pays 0.7% monthly interest, what will his monthly 52. Saving for new equipment. BioCon, a bioengineering company,
payment be? must replace its water treatment equipment within 2 years. The

Copyright © 2010 Pearson Education, Inc.


430 CHAPTER 9 y Consumer Mathematics

new equipment will cost $80,000, and the company will transfer For Extra Credit
$3,800 per month into a special account that pays 9.2% interest.
59. Saving for retirement. Reconsider Exercise 38. Suppose that
How long will it take to save for this new equipment?
Cohutta had started his annuity 10 years earlier. What would
53. Saving for a condominium. Kirsten wants to save $30,000 his monthly payments have been to accumulate the same future
for a down payment on a condominium at a ski resort. She value in his annuity as you found in Exercise 38?
feels that she can save $550 per month in an account that has a
60. Saving for retirement. Reconsider Exercise 40. Suppose
7.8% annual interest rate. How long will it take to acquire her
that Thiep had started his annuity 10 years earlier. What
down payment?
would his monthly payments have been to accumulate
54. Saving for a business. Leo needs to save $25,000 for a down the same future value in his annuity as you found in
payment to start a photo restoration business. He intends to Exercise 40?
save $300 per month in an account that pays an annual interest
61. Saving for retirement. Carlos began to save for his retirement
rate of 6%. How long will it take for him to save for the down
at age 25, and for 10 years he put $200 per month into an
payment?
ordinary annuity at an annual interest rate of 6%. After the
Communicating Mathematics 10 years, he could no longer make payments, so he placed the
value of the annuity into another account that paid 6% annual
55. What property of the log function would you use to solve an
interest compounded monthly. He left the money in this
equation of the form y = ax for x?
account for 30 years until he was ready to retire. How much
56. What is similar about the problem of finding the future value of did he have for retirement?
an annuity and finding the payments to make into a sinking
62. Saving for retirement. If Carlos had waited until age 45 to
fund? How are the two problems related?
think about retirement and then decided to put money into an
ordinary annuity for 20 years, what would his monthly pay-
Using Technology to Investigate
ments have to be to accumulate the same amount for retirement
Mathematics as you found in Exercise 61? (We assume that the interest rate
57. See your instructor for tutorials for the TI-83 to do financial for the annuity is the same.)
calculations. Use your calculator to reproduce some of the 63. Saving for retirement. Examine your solutions to Exercises 61
examples in this section.* and 62. What do you notice? Explain why this is so.
58. You can find many interactive annuity calculators on the Inter- 64. Comparing annuities. The difference between an annuity
net. Some implement the calculations that you have learned in due and an ordinary annuity is that with an annuity due, the
this section and others implement other types of annuity prob- payment is made at the beginning of the month rather than at
lems. Find some interesting annuity calculators, experiment the end of the month. This means that each payment generates
with them, and report on your findings. one more month of interest than with an ordinary annuity.
a. How does this change the formula for finding the future
value of an annuity?
b. Use this formula to find the value of the annuity in Example 2,
assuming that the annuity is an annuity due.

Copyright © 2010 Pearson Education, Inc.

You might also like