What It Measures
The value to which a series of fixed-amount payments made at regular intervals will grow over the specified period of time.
Why It Is Important
The calculation enables companies to determine the future value of a fund receiving regular payments, such as a pension fund to which contributions are made. Individuals in companies may find the calculation equally useful if they want to establish a fund to pay the cost of future college education: they will know what their annual payments will grow to in a given number of years.
How It Works in Practice
There are several types of annuity. They vary both in the ways they accumulate funds and in the ways they dispense earnings. The following are some examples:
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A fixed annuity guarantees fixed payments to the individual receiving it for the term of the contract, usually until death.
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A variable annuity offers no guarantee but has potential for a greater return, usually based on the performance of a stock or mutual fund.
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A deferred annuity delays payments until the individual chooses to receive them.
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A hybrid annuity, also called a combination annuity, combines features of both the fixed and variable annuity.
Financial calculators and spreadsheet programs will compute annuity calculations automatically. Manual calculations require a future-value-of-annuity table that contains figures based on the interest rate and period in question. The basic formula is:
Future value = Amount invested × Table value [interest, period]
If, for example, a pension manager puts $1,000,000 at the end of every year into his company’s pension fund, the fund earns 8% interest, and there are no withdrawals, at the end of five years it will be worth:
$1,000,000 × 5.867 [table value] = $5,867,000
Tricks of the Trade
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The formula assumes that payments are made at the end of a given period.
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If a stated interest rate is not an annual rate, it must be adjusted to reflect an annual rate.
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Although their yields are low, annuities are relatively safe investments that provide level streams of cash flow for fixed periods of time.
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In the United States, annuities are tax-deferred, but also often carry an early withdrawal penalty.
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If you are calculating manually, be sure to use the designated future value of an annuity table, and not the future value table; there is a significant difference.
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The mathematical expression for the numbers appearing on a future value of an annuity table is [(1 + i)n – 1] ÷ i; i is the interest rate, and n is the number of years in question.
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