What is Annuity?

An annuity is an investment that you make, either in a single lump sum or through installments paid over a certain number of years, in return for which you receive back a specific sum every year, every half-year or every month, either for life or for a fixed number of years. After the death of the annuitant or after the fixed annuity period expires for annuity payments, the invested annuity fund is refunded, perhaps along with a small addition, calculated at that time. Annuities differ from all the other forms of life insurance discussed so far in one fundamental way - an annuity does not provide any life insurance cover but, instead, offers a guaranteed income either for life or a certain period. Typically annuities are bought to generate income during ones retired life, which is why they are also called pension plans. Annuity premiums and payments are fixed with reference to the duration of human life. Annuities are an investment, which can offer an income you cannot outlive and provide a solution to one of the biggest financial insecurities of old age; namely, of outliving ones income. Definition 1 A contract sold by an insurance company designed to provide payments to the holder at specified intervals, usually after retirement. The holder is taxed only when they start taking distributions or if they withdraw funds from the account. All annuities are taxdeferred, meaning that the earnings from investments in these accounts grow tax-deferred until withdrawal. Annuity earnings are also tax-deferred so they cannot be withdrawn without penalty until a certain specified age. Fixed annuities guarantee a certain payment amount, while variable annuities do not, but do have the potential for greater returns. Both are relatively safe, low-yielding investments. An annuity has a death benefit equivalent to the higher of the current value of the annuity or the amount the buyer has paid into it. If the owner dies during the accumulation phase, his or her heirs will receive

The term annuity is used in finance theory to refer to any terminating stream of fixed payments over a specified period of time. This usage is most commonly seen in discussions of finance, usually in connection with the valuation of the stream of payments, taking into account time value of money concepts such as interest rate and future value.[1] Examples of annuities are regular deposits to a savings account, monthly home mortgage payments and monthly insurance payments. Annuities are classified by payment dates. The payments (deposits) may be made weekly, monthly, quarterly, yearly, or at any other interval of time.

Ordinary annuity
An ordinary annuity (also referred as annuity-immediate) is an annuity whose payments are made at the end of each period (e.g. a month, a year). The values of an ordinary annuity can be calculated through the following:[2] Let: r = the yearly nominal interest rate. t = the number of years. m = the number of periods per year. i = the interest rate per period. n = the number of periods. Note:

n = tm Also let: P = the principal (or present value). S = the future value of an annuity. R = the periodic payment in an annuity (the amortized payment). (annuity notation) Also:

Clearly, in the limit as n increases,

Thus, even an infinite series of finite payments (perpetuity) with a non-zero discount rate has a finite present value.

Proof

The next payment is to be paid in one period. Thus, the present value is computed to be:

. We notice that the second term is a geometric progression of scale factor 1 and of common ratio . We can write

. Finally, after simplifications, we obtain

. 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 (n1) years. Therefore,

. Hence:

Additional formula
If an annuity is for repaying a debt P with interest, the amount owed after n payments is:

because the scheme is equivalent with lending an amount amount

and putting part of that, an

, in the bank to grow due to interest. See also fixed rate mortgage.

Annuity-due
An annuity-due is an annuity whose payments are made at the beginning of each period. [3] Deposits in savings, rent payments, and insurance premiums are examples of annuities due. Because each annuity payment is allowed to compound for one extra period, the value of an annuity-due is equal to the value of the corresponding ordinary annuity multiplied by (1+i). Thus, the future value of an annuity-due can be calculated through the formula (variables named as above):[4]

(annuity notation) It can also be written as

(1 + i) 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 with one payment more, minus the last payment. Thus we have: (Value at the time of the first of n payments of 1) (Value one period after the time of the last of n payments of 1)

Other types
Fixed annuities These are annuities with fixed payments. They are primarily used for low risk investments like government securities or corporate bonds. Fixed annuities offer a fixed rate but are not regulated by the Securities and Exchange Commission.

Variable annuities Unlike fixed annuities, these are regulated by the SEC. They allow you to invest in portions of money markets. Equity-indexed annuities Lump sum payments are made to an insurance company.

Annuity due is useful for lease payment calculations 1 the accumulated amount in the annuity. This money is subject to ordinary income taxes in addition to estate taxes. Types of Annuities Annuities are available in several forms and types, and different annuities have different properties and costs. The properties and costs of annuities are very important factors that require to be considered properly as business owners put together their retirement investment portfolio. Here are a few common types of annuities defined below. As the name suggests, an immediate annuity begins providing payouts immediately. The payouts may run either for a specific period or for life, depending on the contract terms. The immediate annuities that are generally bought with a one-time deposit, with a minimum of around $10,000 are not very common. This class of immediate annuities normally appeals to people who wish to roll over a lump-sum amount from a pension or inheritance and start drawing income from it. People prefer immediate annuities to regular bank accounts because the principal grows more quickly through annuity investment and because the amount and duration of payouts are guaranteed by contract. On the other hand, a deferred annuity delays payouts until a specific future date. In deferred annuity the principal amount is invested and allowed to grow tax-deferred over time. Deferred annuities are more common that immediate annuities. Deferred annuities appeal to people who want a tax-deferred investment vehicle in order to save for retirement. A fixed annuity offers a guaranteed interest rate over a certain period, usually between one and five years. Fixed annuities are comparable to certificates of deposit (CDs) and bonds, with the main benefit that the sponsor guarantees the return of the principal. Fixed annuities generally offer a slightly higher interest rate than CDs and bonds, while the risk is also slightly higher. Additionally, in fixed annuities also the principal is allowed to grow tax-deferred until it is withdrawn. On the other side, a variable annuity offers an interest rate, which changes based on the value of the underlying investment. Variable annuities are more popular that fixed annuities. The buyers of variable annuities can usually choose from a range of

stock, bond, and money market funds for investment purposes in order to diversify their portfolios and manage risk. The minimum investment in variable annuities usually ranges from $500 to $5,000. Variable annuities usually feature varying levels of risk, from aggressive growth to conservative fixed income. In most cases, the annuity principal can be shifted from one investment to another without being subject to taxation. The variable annuities are subject to market fluctuations, however, and investors also must accept a slight risk of losing their principal if the sponsor company encounters financial difficulties.

Annuity Types? What Investment Types Are Available? 1. Fixed Annuities Fixed annuities are invested primarily in high-grade corporate bonds and government securities. This type offers a guaranteed rate of return, usually in one to ten years. Types: A. Market Value Adjustment: The annuity works much like the Guaranteed Return Annuity, below, except there is no guarantee of funds if rates rise and you end or surrender your contract. B. The Guaranteed Return: This annuity is a fixed annuity that offers a guarantee that you will not receive less than 100% of your investment funds. There are no fluctuations in the interest rate and the market can deplete your initial investment should you surrender your contract. 2. Variable Annuities Variable annuities enable you to invest in specific funds, into sub-accounts. These subaccounts are tied to the current market's rate. Types: Conservative Type:

Money market guaranteed fixed accounts government bonds

Aggressive Type:

small cap markets funds mid cap markets funds large cap markets funds capital appreciation aggressive growth emerging markets funds growth markets funds

Special type:

Living benefit annuity

3. Bonus Annuities: This annuity plan has penalties for early withdrawal but it will also give you a signing bonus up front of 3 to 5%. It's easy to get your money out. The broker simply needs to agree and reduce their commission in return for you receiving the bonus. This annuity will need to mature for at least seven years. Annuity Pay Out Timing: The next thing to figure out is if you need an immediate or deferred annuity: A. Deferred Annuities: In a deferred annuity, you receive payments starting at retirement. With a deferred annuity you can invest either a lump sum all at once, or make payments over a specified length of time. With Deferred annuities you can invest in either fixed or variable type accounts. These funds grow tax-deferred until youre ready to begin receiving funds. Deferred annuities are the most popular type in the US. B. Immediate Annuities: This is where the investor will start to receive payments immediately upon vesting in the annuity. This annuity is for persons who need immediate income from an annuity. You can also choose between a fixed payment that doesnt change or a variable payment that is based on the annuity's performance. Types of Variable Annuities

Nonqualified
Nonqualified annuities are purchased with after-tax dollars. This means that when you are ready to take annuity income payments, you won't owe tax on the portion that's considered return of purchase payments. You only pay taxes on earnings. There are no government-imposed limits to the amount of money you can contribute to your nonqualified variable annuity. Your contract will state a date by which you must begin to receive annuity income payments, but you may start sooner. Typically, it's a specific age, usually around age 95 or 100.

Qualified
Annuities funding IRAs and qualified plans are typically purchased with pre-tax dollars. Qualified plans are generally set up by employers for employees under the Internal Revenue Code for example, 401(k) plans. It's important to know that these plans, as well as IRAs, are already tax deferred. Therefore, an annuity contract should be used to fund an IRA or qualified plan to benefit from the annuity's features other than tax deferral. The other benefits of using a variable annuity to fund a qualified plan or an IRA include the lifetime income options, guaranteed living and death benefit options and the ability to transfer among investment options without sales or withdrawal charges. In fact, Congress has recognized the use of annuity contracts, particularly with respect to funding IRAs, in the Internal Revenue Code (Section 408(b)). With a qualified contract or an IRA, when you are ready to retire and take money out, you will owe taxes on both the amount you invested pre-tax and the earnings. In addition, qualified contracts and IRAs are subject to IRS contribution limits and other restrictions. A fixed annuity is an insurance contract in which the issuing company promises to make fixed dollar payments to the contract holder, the annuitant, for a pre-determined length of time. In return for payment of the contract premium, the issuing company also guarantees both the earnings on the account and the principal balance. In this article, we're first going to review the fundamental concepts of an annuity. Then we're going to talk about the pros and cons of investing in an annuity. Next, we're going to discuss how fixed annuities work. Finally, we're going to explain some of the features you might find in an annuity contract, including payment terms as well as fees.

Buying Annuities
Most annuities are written contracts issued by life insurance companies. In exchange for payments of the contract premiums, the contract holder (annuitant) can expect to receive a series of regularly scheduled payments. Buying an annuity should not be confused with purchasing life insurance. It's also not a savings account, and it is typically used to supply long-term retirement income. And because the insurance company guarantees both earnings and principal, the investment is as safe as the financial strength of the insurance company.

Pros and Cons of Annuities

Some of the benefits of annuities are listed below:

Security - Annuities are considered very safe investments - payments received aren't subject to the volatility of the stock market. Straightforward - After you've bought an annuity, the entire process is simple. Your payment of premiums will guarantee a future source of income. Stability - Since the contract holder is receiving a fixed monthly payment, it's easier to create a retirement plan or budget.

Some of the disadvantages of purchasing an annuity include:

Control - You're paying premiums to the insurance company in exchange for a future income stream, so you're losing some of the control you'd have if you were investing the money. Cost - We'll talk more about this later, but under certain conditions, you may not recover the full benefit of the annuity.

Income Taxes
Annuities offer contract holders the benefit of tax-deferred growth on their money. For example, the earnings on the money placed in an annuity grow on a tax-deferred basis until withdrawn. By deferring taxes, the contract holder may be able to accumulate more retirement funds over a shorter period, ultimately providing more retirement income. However, if an annuity contract is surrendered (redeemed), then a tax penalty may apply on surrender.

Fixed Annuity Contracts

When a fixed annuity contract is in its accumulation period, the investment will earn a rate of interest as specified by the insurance company. The contract will usually show both a minimum, or guaranteed, interest rate in addition to a current, or declared interest rate. The guaranteed interest rate is just that - a minimum rate of interest the contract holder will earn on their investment that is guaranteed by the insurance company. The current, or declared, interest rate is used by the insurance company to calculate income payments in the current period. As is the case with variable annuities, fixed annuities will typically offer the contract holder options for the way benefits are received, as well as how the premiums are paid. For example, there are:

Immediate or Deferred Annuities, and Single or Installment Premiums

Each of these concepts is explained in the sections below.

Immediate versus Deferred Annuities

There are two ways the benefits, or payments, are received from an annuity. With an immediate annuity, payments begin shortly after the premium is paid. With a deferred annuity, the income stream is received at a future point in time. Immediate annuities are used when the contract holder is looking to obtain a steady source of income immediately. This type of annuity is usually purchased by an individual looking for a stable source of retirement income. If the investor is looking for a way to amass money on a tax-deferred basis, then a deferred annuity is chosen. This type of contract allows the annuitant to defer the payment of income tax until the income is needed at a future point in time.

Annuity Premium Payments

Contract holders usually have two options when it comes to making premium payments on an annuity - single premiums or installment payments. With a single premium contract, the annuitant is expected to pay the insurance company one premium. Installment premiums tend to be associated with more flexible annuity contracts. The contract holder might be obligated to make certain minimum payments on a loosely defined schedule. On the other hand, an installment premium might also be defined as a very specific series of payments that are due on a predetermined schedule. As is the case with any competitive marketplace, different insurance companies will offer fixed annuities at a variety of costs. That being said, the following factors typically determine the premiums paid on an annuity:

The contract holder's age and gender The payment option selected The size or amount of the annuity purchased The features included in the annuity such as payment guarantees

Features of Fixed Annuity Contracts

The value of any fixed annuity can be calculated by using premiums paid, subtracting contract fees or charges, then adding back interest credited to the account. Using this relatively simple formula, the insurance company can determine the benefits received by the contract holder.

Charges or Fees
There are many different charges, or fees, a company may impose as part of the fixed annuity contract. Some annuities are sold with front-loads (which require fees to be paid

at the start of the contract), while others are back-loaded (which require fees to be paid later). Finally, a contract might also spread the fees evenly over the life of the annuity. Buying an annuity is an important decision, so it's vital to understand all of the charges or fees that could affect the premium payments / income benefit. Fixed annuity contracts may include the following fees / charges:

Percentage of Premium Charge - This charge effectively reduces the value of the premiums paid and is usually referred to as a "load." This percentage or premium charge may diminish over time. Percentage of Net Assets Charge - Usually associated with variable annuities, the percentage of net assets charge is deducted from the current value of your annuity. These deductions occur on a predetermined schedule and may occur as frequently as daily. Contract Fee - A flat dollar amount that is either a one-time charge or it is collected as an annual fee. Transaction Fee - A fixed fee that is paid following each transaction conducted, or premium payment.

Surrender Rights
Most annuity contracts allow the contract holder to surrender the contract if income benefits have not yet been received. A contact is terminated when surrendered, and the money received for the contract is its present value less the surrender fees. Under certain conditions, the amount received at surrender could be less than the amount paid into the annuity.

Surrender Charges
The surrender charge is normally stated as a percentage of the contract's value. In some cases, this percentage will reduce over time and / or as the account's balance grows. The surrender charge could also be stated as a reduction in the interest rate.

Annuity Benefits
The last topic we're going to cover is perhaps the most important - the benefits paid by a fixed annuity. The income payments are normally received on a monthly basis, although it is possible to find payment terms of varying frequencies. As mentioned earlier, the amount received will depend on factors such as age, gender, contract features, as well as the contract's value. The annuity contract itself will contain a table of both guaranteed rates and current rates. These interest rates can be modified by the insurance company at any time. The guaranteed interest rate will serve as a floor rate - the rate cannot go lower than this level. Generally, there are four types of fixed annuities in the marketplace:

Life Annuities - Straight life annuities are paid as long as the contract holder is alive. Payments are no longer received after the contract holder passes away. Term Certain Annuities - With a term-certain annuity, payments are received until a predetermined date or term. If the annuitant passes away before the term is over, then the insurance company keeps the remaining value of the annuity. Life With Term Certain Annuities - With this type of annuity, payments are received as long as the annuitant is alive. However, if the annuitant should pass away before a "certain period" or term, then a beneficiary will receive payment for the remaining term. Joint and Survivor Annuities - With a joint and survivor annuity, payments are received as long as either person named in the annuity is alive.

Free Look Provisions

Laws exist in many states that allow the buyer of an annuity a certain number of days to evaluate the annuity after purchase. If the buyer decides they do not want to keep the annuity, then they can return the contract and receive a full refund. This type of arrangement is called a "right to return" or "free look" period. If the law allows for this free look period, then this feature will be prominently described in the contract. This is just another reason why it's so important to understand all the features of an annuity before a decision is made to buy a contract. An Annuity is a bunch of structured payments or equal payments made regularly, like every month or every week. You win the lottery. The lottery guy comes to your house and says you have to choose between getting $ 1,000,000 now in one lump sum, or getting structured payments of $ 50,000 a year for the next 22 years. Which do you take?? Or, similarly, let's say you were injured on the job or whatever and were awarded an annuity of structured payments of $50,000 a year for the next 22 years. Perhaps you want to sell your annuity (the payments) to someone and get a lump sum of cash today. Is it worth $1,000,000?First you have to choose an interest rate. Money is generally worth less in the future, right? So that $50,000 payment you get in 22 years is not going to be worth as much as it is today? You know, stuff will be more expensive then, right? So guess an interest rate, in this case, the rate of inflation for the next 22 years. Lets say 4%. Now, you have to figure out what is the present value of the $50,000 times 22 years discounted by 4% and then compare it with the million bucks. There are basically 2 ways to do this.

Use a financial calculator. Use an annuity table.

Use a financial calculator - The PV of an Annuity.

1. Enter n (the number of compounding periods - in this case the number of years). Press 22 and then push the N button. 2. Enter i (the interest rate per period - in this case the number of years). Press 4 and then push the i button. 3. Enter FV (the future value). It is zero. You want to know the Present Value, not the future value, right? Push 0 and then push the FV button. 4. Enter PMT (the payment). You are not making a payment, you are getting one. So you have to show a negative number. Press 50000, then the CHS (change sign button), then push the PMT button. 5. Push the PV (present value) button. 6. Answer = $722,555. This means 22 annual structured payments of 50,000 each is worth only $722,555 of today's dollars. So you should take the million bucks from the lottery guy in one lump sum. Use an annuity table - The PV of an Annuity. Somewhere in your book, I bet there is a table that looks something like this: 1% 1 2 3 4 5 6 7 8 9 2% 3% 4%

00.9901 00.9804 00.9703 00.9615 01.9704 01.9416 01.9135 01.8861 02.9410 02.8839 02.8286 02.7751 03.9020 03.8077 03.7171 03.6299 04.8534 04.7135 04.5797 04.4518 05.7955 05.6014 05.4172 05.2421 06.7282 06.4720 06.2302 06.0021 07.6517 07.3255 07.0197 06.7327 08.5660 08.1622 07.7861 07.4353

10 09.4713 08.9826 08.5302 08.1109 11 10.3676 09.7868 09.2526 08.7605 12 11.2551 10.5753 09.9450 09.3851 13 12.1337 11.3484 10.6350 09.9856 14 13.0037 12.1062 11.2961 10.5631 15 13.8651 12.8493 11.9379 11.1184 16 14.7179 13.5777 12.5611 11.6523 17 15.5623 14.2919 13.1661 12.1657 18 16.3983 14.9920 13.7535 12.6593 19 17.2260 15.6785 14.3238 13.1339

20 18.0456 16.3541 14.8775 13.5903 21 18.8570 17.0112 15.4150 14.0292 22 19.6604 17.6580 15.9369 14.4511 1. 2. 3. 4. 5. 6. Find this table. On the left, find the number of compounding periods (in this case years) - 22 On the top, find the interest rate - 4% Find below where they meet. It says 14.4511 Multiply 14.4511 times the Payment - $50,000 Answer = $722,555. This means 22 annual structured payments of 50,000 each is worth only $722,555 of today's dollars. So you should take the million bucks from the lottery guy in one lump sum.

Each payment of an ordinary annuity belongs to the payment period preceding its date, while the payment of an annuity-due refers to a payment period following its date. The meaning of the above statement may not be immediately obvious until we look at it graphically...

A more simplistic way of expressing the distinction is to say that payments made under an ordinary annuity occur at the end of the period while payments made under an annuity due occur at the beginning of the period. A third possibility is to define an annuity due in terms of an ordinary annuity: an annuity-due is an ordinary annuity that has its term beginning and ending one period earlier than an ordinary annuity. This definition is useful because this is how we will compute an annuity due; i.e., in relation to an ordinary annuity (discussed further in "Calculating the Value of an Annuity Due" below). Most annuities are ordinary annuities. Installment loans and coupon bearing bonds are examples of ordinary annuities. Rent payments, which are typically due on the day commencing with the rental period, are an example of an annuity-due. Note that an ordinary annuity is sometimes referred to as an immediate annuity, which is unfortunate because it implies that the payments are made immediately (i.e., at the beginning of the period, which would be the case with an annuity-due). However, ordinary annuity is the more widely used term.

2. Calculating the Value of an Annuity Due An annuity due is calculated in reference to an ordinary annuity. In other words, to calculate either the present value (PV) or future value (FV) of an annuity-due, we simply calculate the value of the comparable ordinary annuity and multiply the result by a factor of (1 + i) as shown below... Annuity Due = Annuity Ordinary x (1 + i) This makes sense because if we go back to our earlier definitions we see that the difference between the ordinary annuity and the annuity due is one compounding period. Note also that the above formula implies that both the PV and the FV of an annuity due will be greater than their comparable ordinary annuity values. This is illustrated graphically in the section that follows, "Visual Comparison of Cash Flows." It can also be clearly seen in the discount and accumulation schedules constructed in the "Excel" section. The following examples illustrate the mechanics of the ordinary annuity calculation and subsequent annuity due calculation. a. Present Value of an Annuity Using the example problem from the Present Value of an Annuity page, we calculate the PV of an ordinary annuity of $50 per year over 3 years at 7% as...

...and the present value of an annuity due under the same terms is calculated as...

...and just as we thought, the PV of the annuity due is greater than the PV of the ordinary annuity; by 9.18 in this example. b. Future Value of an Annuity Using the example problem from the Future Value of an Annuity page, we calculate the FV of an ordinary annuity of $25 per year over 3 years at 9% as...

...and the future value of an annuity due under the same terms is calculated as...

...and again the FV of the annuity due is greater than the FV of the ordinary annuity; in this example by 7.38. 3. Visual Comparison of Cash Flows The distinction between an ordinary annuity and an annuity-due can be easily grasped by visualizing the timing of the payments. a. Present Value of an Annuity: Ordinary Annuity. Continuing with the same example from the Present Value of an Annuity page, the following illustration shows how payments are applied in the case of

an ordinary an

nuity:

Annuity-Due. With an annuity-due the payments are made at the beginning rather than the end of the period...

Note that the PV of the ordinary annuity is 131.22 and the PV of the annuity-due is 140.40 (calculated as 131.22 x 1.07). The fact that the value of the annuity-due is greater makes sense because all the payments are being shifted back (closer to the start) by one period. This means the PV should be larger under the annuity due because all the payments are made earlier. In other words, they are all closer to the "present" so they are subject to less discounting. Note that there is no need to discount the first payment under the annuity due at all; since it is made at the very outset, its PV is its face value. b. Future Value of an Annuity: Continuing with the same example from the Future Value of an Annuity page, the following illustration shows how payments are applied in the case of an ordinary annuity...

Annuity-Due. With an annuity-due the payments are made at the beginning rather than the end of the period.

Note that the FV of the ordinary annuity is 81.95 and the FV of the annuity-due is 89.33 (calculated as 81.95 x 1.09). The fact that the value of the annuity-due is greater makes sense because all the payments are being shifted back (closer to the start) by one period. Moving the payments back means there is an additional period available for compounding. Note the under the annuity due the first payment compounds for 3 periods while under the ordinary annuity

it compounds for only 2 periods. Likewise for the second and third payments; they all have an additional compounding period under the annuity due. The additional compounding generates a larger FV. 4. Example Problems The following solved problems illustrate the distinction between an ordinary annuity and an annuity due. QID 7. At 5% annual interest, what is the difference in the present value of $100 paid at the end of each year for 10 years and $100 paid at the beginning of each year? This problem calculates the difference between the present value (PV) of an ordinary annuity and an annuity due. The timing difference in the payments is illustrated in an Excel schedule.

QID 32. You plan to deposit $100 into a savings account at the end of each month for the next 5 years. a) At 3% compounded monthly, how much will you have accumulated at the end of 5 years? b) How much difference would it make if the payments were made at the beginning of the month rather than at the end? This problem calculates the amount to which a monthly payment will grow over time (i.e., the FV) assuming payments are made 1) at the end of each month; and 2) the beginning of each month. The discussion includes an Excel accumulation schedule and graphics showing how the annuity due calculation is specified in the Excel FV function and the HP-12C calculator ([g][BEG]).