Lecture 4: Annuities

Lecturer: Trần Minh Hoàng

Financial Mathematics

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Table of Contents

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 Varying Annuities

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Arithmetic annuities

Definition
We call an annuity where payment at time t is exactly t for t = 1, 2, 3, ..., n an
n-period arithmetic increasing annuity-immediate. Its present value and
accumulated value at time n are denoted by (Ia) n and (Is) n respectively.

Definition
We call an annuity where payment at time t is exactly t + 1 for t = 0, 1, 2, ..., n − 1
an n-period arithmetic increasing annuity-due. Its present value and accumulated
value at time n are denoted by (I ä) n and (I s̈) n respectively.

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Formulae for arithmetic increasing annuities

Proposition

ä n − nv n
(Ia) n = ,
i
s̈ n − n
(Is) n = ,
i
(1 + i)( ä n − nv n )
(I ä) n = (1 + i)(Ia) n = ,
i
(1 + i)(s̈ n − n)
(I s̈) n = (1 + i)(Is) n = .
i

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Example
You invest $1000 at the beginning of each year for 20 years. The investment
makes interest payments to you at the end of each year at the rate of 7%. You
invest the interest payments in a fund that pays 6% annually. What is your total
accumulation at the end of the 20 years?

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Example
Eric makes deposits into a retirement fund earning an annual effective rate of 7%.
The first deposit of $1,000 is made on his 38th birthday and the last deposit is
made on his 64th birthday. Every year his deposit increases by 3%. When he
attains age 65, he will withdraw all the money in the retirement fund to purchase
an annuity-immediate which provides him with monthly payment for 25 years. The
nominal rate of interest on the annuity is convertible monthly at 6%. Find the
amount of each monthly payment.

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Arithmetic decreasing annuities

Definition
We call an annuity where payment at time t is exactly n + 1 − t for t = 1, 2, 3, ..., n
an n-period arithmetic decreasing annuity-immediate. Its present value and
accumulated value at time n are denoted by (Da) n and (Ds) n respectively.

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Formulae for arithmetic decreasing annuities

Proposition

n − an
(Da) n = ,
i
n(1 + i)n − s n
(Ds) n = .
i

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Proof: It is easy to see that

(Da) n + (Ia) n = (n + 1)a n .

Therefore,

(Da) n = (n + 1)a n − (Ia) n

(n + 1)(1 − v n ) ä n − nv n
= −
i i
n + 1 − v n − ä n
=
i
n + i a n − (1 + i)a n
=
i
n − an
= .
i
Finally,
n(1 + i)n − s n
(Ds) n = (1 + i)n × (Da) n = .
i

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Geometric annuities

Consider an annuity-immediate with n payments.

Suppose payments of this annuity has been modified to follow a geometric
progression, i.e., payment at time t is given by αt for t = 1, 2, ..n.

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Formulae for geometric annuities

Proposition
The present and accumulated values at time n of this cash flow can be calculated
as follows
n
X 1 − (αv )n
PV = αk v k =
iα
k=1
(1 + i)n − (α)n
AV = (1 + i)n PV =
iα

where iα = (αv )−1 − 1.

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Example
A 20-year annuity immediate with annual payments earns 6.2%. The first payment
is 500 and each subsequent payment is increased by 4% over the previous one.
Find the present value of this annuity.

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Continuous annuities with linear step payments

Consider a continuous cash flow over [0, n] with unit jumps at unit intervals.
The amount paid in (t − 1, t] is t for t = 1, . . . n, but it is paid continuously
at the constant rate of t per time unit in each of these unit intervals.
In other words, the payment rate is the following step function


 1 for t ∈ (0, 1]
2 for t ∈ (1, 2]

ρ(t) =

 ... ...
n for t ∈ (n − 1, n].


The present and accumulated values of this cash flow are denoted by (I ā) n
and (I s̄) n respectively.

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Formulae for continuous annuities with linear step
payments

Proposition

ä n − nv n
(I ā) n = ,
δ
s̈ n − n
(I s̄) n = .
δ

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Continuous annuities with continuous payments

Consider a continuous cash flow over [0, n] with payment rate at time t is
equal to t.
¯ n
The present and accumulated values of this cash flow are denoted by (Ia)
¯ n respectively.
and (Is)

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Formulae for continuous annuities with continuous
payments

Proposition

¯ n = ā n − nv n
(Ia) ,
δ
¯ n = s̄ n − n .
(Is)
δ

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Example
Dontrelle earns $2,000 at the end of each month during the first year of his
employment. His monthly rate of compensation increases by $400 for each year of
his employment. Therefore, it is $2,400 in the second year, $2,800 in the third
year, and $2,000 + $400(20 - 1) = $9,600 in the twentieth year. If Dontrelle is
employed for exactly twenty years, what level monthly rate of compensation has
the same present value if the present values are computed at an annual effective
interest rate of 5%?

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Example
Martin deposits $12,000 in a savings account with a discount rate of 10%
convertible quarterly. He leaves his money in this account to accumulate for
fifteen years, then moves it to a fund that is accumulating at 8% per annum
convertible continuously. If, starting at time 15 when he invests in the new fund,
money is withdrawn continuously at a rate of $6,000 per annum, how long will
Martin’s money last?

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Example
A man makes fixed end of year payments into a fund that earns at an annual rate
of r . He determines that the accumulation at the end of 20 years will be triple the
accumulation at the end of 10 years. Find r .

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 Term of Annuity

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Non-integral term of annuity

Given the rate of interest, the sizes of the annuity payments, the present or
the future values of the annuity, we can calculate the term of the annuity
using the formulae derived earlier.
Sometimes, the term of the annuity found is not an integer.
In such case, we may need to modify the last payment of the annuity
depending on the question.

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As an example, suppose we need to pay off a fixed liability L by scheduling a
stream of cash flow similar to an annuity-immediate with fixed payment per
period P and fixed effective interest rate i.
We can set up the equation of value

P(1 − v x )
L = P ax = ,
i
where x is the term of annuity.
Solving for x yields
ln 1 − Li


P
x= .
ln(v )
Suppose x is not an integer. How do we schedule the payments ?

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We write x = n + k where n is an integer and 0 < k < 1.
We have the following formula

a n+k = a n + n| a k
= an + v n ak
= a n + v n+k s k
= a n + v n+1 ä k ,

where a k , a k and a k are given by the usual formula as if k were an integer.

That means we can schedule the payments as follows:
I Make the payments of P at times 1, 2, ..., n − 1 and P(1 + a k ) at time n.
I Make the payments of P at times 1, 2, ..., n and P s k at time n + k.
I Make the payments of P at times 1, 2, ..., n and P ä k at time n + 1.

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Example
A principal of $5,000 generates income of $500 at the end of every year at an
effective rate of interest of 4.5% for as long as possible. Calculate the term of the
annuity and discuss the possibilities of settling the last payment.

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Homework

Textbook questions:
Chapter 2: 34,35,36,38,43,45,46,49,52.

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