Analyzing the Future Value of an Annuity
An annuity is a capital investment that pays out a fixed sum at regular intervals over an agreed period. A simple calculation illustrates how the fund will grow over the specified term.
Typically, investors take out an annuity to fund future major expenses like college fees, or a retirement pension—so it's vital to know how the payments will appreciate over the years. Likewise a company will want to determine the future value of any fund to which they make regular payments, such as pension contributions.
Annuities take different forms, depending on how the fund accumulates, and how payments are distributed. Some of the most common include:
- Fixed—guaranteed payments of a set amount made until the end of an agreed term (usually the death of the recipient).
- Variable—generally based on stock or fund performance, which has potential for a greater return, but carries no guarantee.
- Deferred—payments are delayed until the recipient decides to take them.
- Hybrid or combination—includes features from both fixed and variable types.
The future value of an annuity can be worked out automatically using a spreadsheet or financial calculator. Manual calculations use a standard formula and a table of values ("future value of an annuity table") based on interest rates and the period in question:
Suppose a pension manager puts $1,000,000 at the end of every year into the company pension scheme, which earns interest at 7%. At the end of ten years (assuming no money is withdrawn in that time) the fund will be worth:
- The calculation assumes that no money is withdrawn until the end of the stated period.
- Interest must be expressed as an annual rate.
- Although annuities may not the highest performing investments, they are at the safer end of the spectrum and can provide a steady income stream over a specified period.
- Annuity payments can be made free of tax in the U.S., but there may be penalties for withdrawing early.
- For manual calculations using tables, it's important to use a "future value of an annuity table" not a "future value" table—they are not the same thing.
- Expressed mathematically, the values that appear in the table are: [(1 + i)n – 1] / I, where i is the interest rate, and n is the specified number of years.
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