Chapter 5

Annuities

We have focused our attention on calculation of the present or future value of different amounts or
payments which are due at different points in time. For many types of financial transactions, the
cashflows comprise a series of regular payments made at regular time intervals. Examples of these
types of contracts include

 Mortgages or home loans

 Insurance premiums
 Annuity or pension payments
 Savings vehicles
 Monthly rent

The payment amounts are usually of equal size, but can also increase in a regular, pre-defined way.

These series of payments are so common, that they have their own terminology, and are referred to
as annuities.

Definition of an Annuity and some terminology

An annuity is defined as a series of payments made at regular intervals for a given length of time
called the term.

 An annuity paid for a fixed term or number of payments is called an annuity certain
 An annuity where the regular payment are made at the end of each of the intervals is called
regular annuity or annuity in arrears
 An annuity where the regular payment are made at the start of each of the intervals is called
annuity due or annuity in advance
 An annuity where payment continues indefinitely is called a perpetuity
 An annuity where the first payment is only made at some later date is called a deferred
annuity

We will cover each of these types of annuities in this chapter.

Annuities certain paid in arrear

Present value of an annuity certain paid in arrear

Consider an annuity of n payments, each of amount 1, to be made at time intervals of 1 unit.

Annuity payments are in arrear which means that the first payment is at time 1.

This can be represented on a timeline as follows :

The present value, at time 0, of these annuity payments will then be the discounted value of each of
the payments. The present value of the annuity calculated using interest rate is denoted by the
symbol

This can also be written as “ at interest rate ”

Hence, as we can see from the timeline below, that at interest rate
It would take a lot of time to work out the present value of each term, and some annuities can be for
100 years or more. We can reduce this formula using the mathematics of series.

We know that the sum, of the geometric series :

is .

So substituting for , and 1 for , we get

So,

This formula can therefore be used to solve for the present value of any level annuity of amount
and of term periods, at an interest rate of per period.

The formula above can be obtained by general reasoning as follows:

If a R1 is invested at rate for a period of years it will provide a series of payments of p.a. for
periods. The R1 will also remain at the end of the period.

The present value of these sums it will produce is and 1. In other words,

This can be re-arranged to

Example 5.1

Calculate the present value of R500 paid at the end of every year, for 20 years at an interest rate of
3% p.a.

In this case,

The present value of the annuity is = R7 438.74

Future value of an annuity certain paid in arrear

Consider the same annuity of n payments, each of amount 1, to be made at time intervals of 1 unit.
Annuity payments are still in arrear which means that the first payment is at time 1.

The accumulated value, at time n, of this annuity is denoted by the Symbol

Hence at interest rate

This is shown in the timeline below:

Now we know that the sum, of the geometric series :

is .

So substituting for , and 1 for , we get

So,

This formula can therefore be used to solve for the accumulated value at time of any level annuity
of amount and of term periods, at an interest rate of per period.

Example 5.2

Calculate the accumulated value after 20 years of R500 paid at the end of every year, for 20 years at
an interest rate of 3% p.a.

In this case,

The accumulated value of the annuity is = R13 435.18

Annuities certain paid in advance

Present value of an annuity certain paid in advance

Consider, now, an annuity of n payments, each of amount 1, to be made at time intervals of 1 unit.
Annuity payments, however, are made in advance (at the start of each time period) which means
that the first payment is at time 0.

This can be represented on a timeline as follows :

The present value, at time 0, of this annuity is denoted by the Symbol

Hence as is seen in the timeline below.

Recall

So

---------------------------------------(i)

Also

----------------------------------------(ii)
Also

So

--------------------------------------(iii)

Relationships (i), (ii) and (iii) can be used to convert from annuities paid in arrear to annuities paid in
advance. These relationships should be memorized and you should be able to prove these in a test
or exam.

Example 5.3

Calculate the present value of R500 paid at the start of every year, for 20 years at an interest rate of
3% p.a.

In this case,

The present value of the annuity in arrear is = R7 438.74

Therefore the present value of the annuity in advance is = (1.03).(7 438.74) =

R7 661.22.

Future value of an annuity certain paid in advance

Consider, again, an annuity of n payments, each of amount 1, to be made at time intervals of 1 unit.
Annuity payments, however, are made in advance (at the start of each time period) which means
that the first payment is at time 0.

The accumulated value, at time 0, of this annuity is denoted by the Symbol

Hence as can be seen from the timeline below

Recall

So

---------------------------------------(iv)

Also

So

--------------------------------------(v)

Relationships (iv) and (v) can be used to convert from annuities paid in arrear to annuities paid in
advance. These relationships should be memorised and you should be able to prove these in a test
or exam.

Example 5.4

Calculate the accumulated value after 20 years of R500 paid at the start of every year, for 20 years at
an interest rate of 3% p.a.

In this case,
The accumulated value of the annuity is = R13 435.18

Therefor the accumulated value of the annuity paid in arrear is = (1.03).(13 435.18) =

R13 838.23

The annuity examples we have shown so far are all quite straightforward. More complex problems
will arise, particularly when the annuity payment period is not annual and furthermore when the
annuity payment period and the interest rate period do not coincide. In these cases the best solution
to this kind of problem is to convert the interest rate to one which corresponds to the same period
as the payment period using the relationships developed in Chapter 2.

Example 5.5

Find the corresponding single amount which must be invested immediately in order to provide the
same present value as that of an annuity of R1 700 per month for payable for 3 years at an interest
rate of 12% p.a. compounded monthly.

The present value of the annuity = at an interest rate of per month

Present value =

Note: where a problem does not specify that annuity is paid in advance, you should assume it is paid
in arrear

Example 5.6

An investor saves a regular amount of R1 700 per month at the start of every month for a period of 3
years. Find the accumulated value of the investment at an effective interest rate of 12% p.a.

The payment period of the annuity is monthly, therefore we first need to convert our interest rate to

an effective monthly rate using

So,
The accumulated value of the annuity is =
Deferred Annuities

We defined a deferred annuity as one where the first payment commences at some future date. An
annuity of R1 payable for n years at an annual interest rate of i p.a., which is deferred for m years is
denoted:

This can be shown on a timeline as follows:

The formula for can therefore simply be written as at interest rate

If the interest rate remain constant from time 0 to time n, then we can also use:

at interest rate i

It follows that the value of a deferred annuity due (paid in advance) can be calculated as

= or at interest rate

Example 5.7

Calculate the amount which needs to be set aside now, to be able to pay an annual pension in
arrears at age 65 to someone who is now aged 58. The pension amount is R 74 000 per annum, and
it is assumed the pension will live to age 89.

Any money invested to pay this annuity will earn a return of 8% p.a.

This is a deferred annuity with the following parameters:

m = 65-58 = 7

n = 89-65 = 24

the answer is therefore at

Amount which needs to be set aside now = R 460 757.20

Perpetuites

In certain circumstances, particularly during times of war, loans would be taken out with no
maturity. In other words interest is just payable on the loan indefinitely. This is equivalent to an
annuity of infinite term, where the annuity amount is just the interest on the loan. This type of
annuity is called a perpetuity.

The timeline below represents a perpetuity where the payment amount equals 1.

Now recall, the formula for a fixed rate annuity is

at interest rate

So,

So the present value of a perpetuity of amount paid in arrear at regular intervals, at an interest
rate of per interval is

Now since we can say that the present value of a perpetuity of amount paid in
advance (ie a perpetuity due) at regular intervals, at an interest rate of per interval is

=
Example 5.8

Suppose an irredeemable loan of R 1 000 000 is issued with at an interest rate of 5% p.a payable
monthly. Interest payments commence immediately. Calculate the value at issue date of this loan,
at an effective annual interest rate of 6% per annum.

Interest payment = per month

Now since the interest payment is payable monthly, we need the effectively monthly interest rate
that corresponds to 6% p.a.

This is per month

So the present value of the loan at 6% is