- Annuities are contracts with insurance companies that can be part of anyone’s investment strategy.
- They can be used to provide a lifetime of steady income during retirement or to limit losses from a volatile stock market.
- However, they can be complicated, costly and opaque so it’s best to fully understand how they’re valued and used in a portfolio.
There are many investment options available for your retirement. One less common option is the annuity. Annuities are contracts with an insurance company and can provide guaranteed lifetime income that mitigates risks of outliving your assets or sets a floor to losses in volatile markets. All of this, though, comes with costs whether they are in fees, capped gains in times financial markets are rallying or inflation that can eat away at your steady income during retirement.
Inside this article
What's an annuity?
An annuity is a long-term contract with insurance companies that make periodic payments to you, starting immediately or at some future time. You buy annuities from insurance companies in a single payment or a regular series of payments called premiums.
Many people use annuities as part of their retirement planning because they can provide a lifetime of steady payouts to mitigate risks of outliving your assets or limit your losses in volatile markets. However, they can be costly and complicated so it’s important to understand how they’re valued so you can appropriately compare them to other investments.
There are three main types of annuities: fixed, variable and indexed. Indexed annuities are a hybrid of the fixed and variable versions.[1,2]
Understanding present value of an annuity
The present value of an annuity is the cash value of all future annuity payments, given the annuity’s rate of return or discount rate.
It’s based on the time value of money concept. That means future payments are worth less today because of uncertain economic conditions and inflation, but current payments have more value because they can be invested in the meantime.
Let’s say you have an annuity that pays you $1,000 each year for 10 years. But let’s say you need a larger payment to cover some unexpected expenses. The company offers to buy five years of annual payments with a 10% discount.
With this information, you can use an online calculator and find that the present value of five $1,000 structured settlement payments is worth roughly $3,790.75.
Tell me about future value (FV) and its importance
The future value of annuity payments is a calculation that tells you how much a series of fixed payments earning a specific interest rate would be worth at a specific date in the future.
It’s an important tool to help you compare different types of investments and plan for your future. Retirement planning requires you to predict where your finances will be in the future
Ordinary annuity vs annuity due
The difference between ordinary annuity and annuity due is when the payment is made.
An ordinary annuity means you receive a fixed or variable payment at the end of each month or quarter from an insurance company based on the value of your annuity contract. These are typically used in retirement accounts.
Annuity due means payments are made regularly at the beginning of each period. A classic example is rent that is due at the start of each month.
What’s the formula for the present value of an ordinary annuity?
The formula for calculating the present value of an annuity due (where payments occur at the beginning of a period) is:
P = (PMT [(1 - (1 / (1 + r)n)) / r]) x (1+r)
P = The present value of the annuity stream to be paid in the future
PMT = The amount of each annuity payment
r = The interest rate
n = The number of periods over which payments are made
What is an annuity?
It’s an insurance contract in which the insurer offers the policyholder a stream of payments over a specified timeframe in exchange for premium payments collected and invested on their behalf.
What are some pros?
They can promise a lifetime of income that can mitigate the risks of outliving your retirement assets. Some limit the downside potential attached to securities by setting a floor on losses while others can guarantee you a minimum return.
What are some cons?
They can be expensive, complicated, opaque and future fixed payments can be susceptible to inflation.