Annuities are investment vehicles used primarily in retirement planning for the purpose of creating some certainty in your future financial security. The degree of certainty you could have can only be based on your understanding of the value of your annuity at any time during both the accumulation stage and the income distribution stage. Annuities are contracts between an individual and a life insurance company that exchanges capital for a stream of income. They can also be used for accumulating capital prior to the need for the income. In both instances, the contract contains provisions and formulas that enable annuity owners to determine the value of their annuity at various stages.
Because annuities are based on a series of payments (received or paid in), a known interest rate, and a known amount of payment or deposit, it is generally fairly easy to calculate its value. But, there are two ways to value an annuity – in its present value or its future value – so you first need to know from which vantage you are looking.
Often times a person who is receiving a monthly payment, from a pension plan, a settlement, or an annuity, wants to know what the value of that future stream of income amounts to as a present value, in other words, what the future payments are worth today as an investment. People who have won a settlement of some sort, in which the reward is paid out in installments, will often seek to exchange the future payments for a lump sum payment. Sometimes a person who is receiving payments from an annuity may want to do the same because their circumstance have changed to where they would be better off with a lump sum of money instead of the future income. Present value calculations are also used by investors to determine if an investment in real estate or a business that produces income will meet their criteria for a profitable return of investment.
First, you should know that you can easily calculate the present value or future value of any investment by accessing a calculator online. They allow for the easy input of key variables and will produce a quick calculation. However, it would be important to understand what the variables are and what is entailed in the calculation so you can put it the right context. Also, the use of variables does create the possibility of error or broad extrapolation that can render the calculation meaningless. It is important to have an understanding and appreciation of the “time value of money” to know that a quarter of a percentage point difference over several years can affect the outcome of the calculation by huge measures.
The common factors used in all present and future value calculations are:
the interest earned on a lump sum annually, or applied to each payment annually.
Number of payment periods:
the number periods in which a payment is received from an annuity, or paid into an annuity for accumulation.
the dollar amount of the payment received from or paid into an annuity
To calculate the present value of a future stream of fixed payments, you would discount each payment by the amount of interest credited, multiplied by the payment number. So, each payment is discounted by the fixed interest rate, based on the period in which it is made or received. Each payment is calculated this way and then added to each other. The sum of the payments is the amount of lump sum investment required today to produce that stream of fixed payments. Sound complicated? It’s not really, but it could take a long time. Let’s look at how a slight change in the variables can impact the calculation:
An annuity is currently making payments at a rate of $2000 a month and is scheduled for another 240 payments (20 years). The current interest rate applied is 3%. The current or discounted value of the annuity is $66,600. By adjusting the interest rate up by just .5% , the result is $57,100, more than a 10% difference in the present value.
When calculating the future value of your annuity, the same factors are used except the math formula is reversed. So, for example, if you wanted to determine how much a lump sum of capital or periodic investments will be worth at some point in the future, either as a lump sum value or as an annuity payment, you would multiply each investment contribution by an interest factor based on the actual period in which it is invested. So, each investment contribution is calculated separately and then they are all added together to arrive at a future sum. Again, not mathematically complicated, but time consuming.
When you arrive at future lump sum value, you can then calculate the future stream of income by applying the same factors of the number of payment periods, the interest rate and the lump sum of capital. This will tell you what the amount of the fixed income payment will be over a specific period of time. If you want to calculate income payments for your lifetime, you would take your life expectancy age, based on current mortality tables, and subtract your current age, then multiply that by 12 to arrive at the number of monthly payments. Keep in mind, that, while a lifetime income annuity payment is based on the number of monthly payment periods in your life expectancy time frame, the income payments will continue even if you live beyond your life expectancy.
Using a future value calculator you would arrive at the following outcome based on an annual investment of $12,000 at a rate of 5% for 20 years:
Future lump sum amount: $416,600
Future stream of annual income from lump sum (20 year period): $33,400
Bear in mind, that all of these calculations are do not include any taxation. Of course taxes paid on income received would reduce the amount, but the accumulation within an annuity is tax deferred, so the calculations for accumulation would be accurate. The other thing to bear in mind, is that annuity payments are only partially taxable because a portion is actually a return of your principal. So, it is advisable to consult with a tax professional to determine the impact of taxes on all future values.