Annuity

An annuity is a series of payments made at fixed intervals of time. Examples of

annuities are regular deposits to a savings account, monthly home mortgage
payments, monthly insurance payments and pension payments. Annuities are
classified by the frequency of payment dates. The payments (deposits) may be
made weekly, monthly, quarterly, yearly, or at any other interval of time.

In a financial point of view, annuity is a financial plan characterized by periodic

payments/deposits. We can view an annuity as a savings plan in which the
regular payments are contributions to the account, or we can also view an
annuity as a payment plan in which regular payments are made from an
account. Distinct formulas can be used to calculate the different types of
annuities.

Definition of Terms
Accumulation period: The time during which your fund builds up for a
deferred annuity.
Annuitant: The person during whose life the annuity is payable, usually the
person who is to receive the annuity.
Annuity: A contract that provides a fixed sum at periodic intervals for life or
certain number of years.
Deferred Annuity: An annuity which payments begin at some future date.
Fixed Annuity: An annuity which the amount paid out is fixed sum and is
usually guaranteed.
Loads: The fees or charges paid when you purchase an annuity. Includes sales
commissions.
Owner: The person who purchases the annuity.
Payout Phase: The period when income is received from the annuity.

Principal: The amount paid into the annuity (basis) as distinguished from the
interest or growth inside the annuity.
Qualified Annuity: An annuity sold as part of a tax-qualified Keogh plan or,
retirement plan
Straight Life or Single Life Annuity: An annuity that pays a predetermined
amount periodically (usually monthly) but ceases when you die.
Variable Annuity: An annuity which has security investment options for
investment of the principal and where the periodic payments will vary based
upon the performance of the stock or other investments.

Terms to be used:
A = Annuity
P = Present Worth / Value
F = Final Worth / Value
i = Interest Rate per period
n = No. of periods / years

Different Types of Annuity

Ordinary Annuity
Ordinary annuity is that equal payments are made at the end of each
compounding period starting from the first compounding period

Characteristics of Ordinary Annuity

All payments are in the same amount (such as a series of payments of

$1,000).
All payments are made at the same intervals of time (such as once a
month or quarter, over a period of a year).
All payments are made at the end of each period (such as payments
being made only the last day of the month).

Usually, payments made under the ordinary annuity concept are made at the
end of each month, quarter, or year, though other payment intervals are
possible (such as weekly or even daily). Examples of ordinary annuity
payments are:

Semi-annual interest payments on bonds

Quarterly or annual dividend payments

Because payments are made sooner under an annuity due (where payments
are made at the beginning of each period) than under an ordinary annuity, an
annuity due has a higher present value than an ordinary annuity.
When interest rates rise, the value of an ordinary annuity is reduced. When
interest rates decline, the value of an ordinary annuity is increased. The reason
for these variations is that the present value of a stream of future cash
payments is dependent on the interest rate used in the present value formula.
As the time value of money changes, so does the annuity valuation.
Present Value of an Ordinary Annuity

To calculate the present value of an ordinary annuity the following formula is

used:
1( 1+i )n
P= A [
]
i

Future Value of an Ordinary Annuity

To calculate the future value of an ordinary annuity the following formula is
used:
F=A [

( 1+i )n1
]
i

Annuity if Present Value is given:

A=P [

i
]
1( 1+i )n

Annuity is Future Value is given:

A=F [

i
]
( 1+i )n1

Annuity Due
The equal payments are made at the beginning of each compounding
period starting from the first period.

Characteristics of Annuity Due:

All payments are in the same amount (such as a series of payments of

$500).
All payments are made at the same intervals of time (such as once a
quarter or year).
All payments are made at the beginning of each period (such as
payments being made only on the first day of the month).

Because payments are made sooner under an annuity due than under
an ordinary annuity (where payments are made at the end of each period), an
annuity due has a higher present value than an ordinary annuity.
Several examples of an annuity due:

A company acquires a copier through a lease that requires a payment of

$250 at the beginning of each month for three years. Since all payments
are in the same amount ($250), they are made at regular intervals
(monthly), and the payments are made at the beginning of each period,
the payments are an annuity due.
A company enters into an office lease, under which the lessor requires
the company to make monthly payments of $12,000 for the next 24
months, no later than the beginning of the month to which each payment
applies. Since all payments are in the same amount ($12,000), they are
made at regular intervals (monthly), and the payments are made at the
beginning of each period, the payments are an annuity due.

The annuity due concept is less common than the ordinary annuity concept,
since most payments are made at the end of a period, not the beginning.
Present Value of an Annuity Due
To calculate the present value of an annuity due the following formula is used:
P= A [

1( 1+i )1n
+1]
i

Future Value of an Ordinary Annuity

To calculate the future value of an ordinary annuity the following formula is
used:
F=A [

( 1+i )n+1 1
1]
i

Annuity if Present Value is given:

A=P [

i
]
1( 1+i )n

Annuity is Future Value is given:

A=F [

i
]
( 1+i )n1

Deferred Annuity
Characteristics of Deferred Annuity

The first payment is deferred a certain number of compounding periods

after the first.
Annuities that are computed on different present year and/or future year

In deferred annuity, after the base year, money does not initially flow. The
first payment is deferred or scheduled for some time before it is actually
paid

Present amount of deferred annuity

P= A

1( 1+i )
i

( 1+i )k

Future amount of deferred annuity

( 1+i )n1
F=
i
Perpetuity
Perpetuity is an annuity where the payment period extends forever,
which means that the periodic payments continue indefinitely

The value of the perpetuity is finite because receipts that are anticipated far in
the future have extremely low present value (present value of the future cash
flows). Unlike a typical bond, because the principal is never repaid, there is no
present value for the principal. Assuming that payments begin at the end of the
current period, the price of a perpetuity is simply the coupon amount over the
appropriate discount rate or yield.

Present Value for Perpetuity

P=

A
i

References:
http://www.uwyo.edu/uwe/passiton/passingitonchapter7g-annuities.pdf
Samuel A. Broverman (2010). Mathematics of Investment and Credit, 5th
Edition. ACTEX Academic Series. ACTEX Publications. ISBN 978-1-56698-7677.
http://www.epcc.edu/OfficeofStudentSuccess/tutorialservices/tutorialsupport
servicesvv/Documents/Annuities.pdf
http://www.accountingtools.com/questions-and-answers/what-is-an-ordinaryannuity.html
http://www.investopedia.com/terms/p/perpetuity.asp