MAT 371 - CHAPTER 3 - Page 1 of 12

Chapter 3: Basic Annuities

Section 3.1: Introduction

An annuity may be defined as a series of payments made at equal intervals of time.

An annuity-certain is an annuity such that payments are certain to be made for a fixed period of
time (the term of the annuity).

A contingent annuity is an annuity under which the payments are not certain. i.e. payments from
a pension plan for the life of a retiree.

The interval between annuity payments is called the payment period. This chapter considers annu-
ities where the payment period and the interest conversion period are equal and coincide.

Section 3.2: Annuity-Immediate

An annuity under which payments are made at the end of each payment period for n periods, where
n is a positive integer, is called an annuity-immediate or an ordinary annuity or just an annuity.

Consider the annuity where payments of $1 are made at the end of the period for n periods.

• The present value (PV) of the annuity is denoted by an or an i .

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• The accumulated value (FV) of the annuity is denoted by sn or sn i .

Relationship between sn and an

Geometric Progression/Geometric Series

n−1
a + ar + ar2 + ar3 + · · · + arn−1 = ark
P
k=0
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Example: David will receive payments of $50 at the end of each month for the next 8 years. Assume
i(12) = 9%
(a) Find the present value of this annuity.

(b) Find the accumulated value of this annuity.

Example: How much should be deposited at the end of each quarter so that at the end of 15 years
the account balance is $75,000? Assume an annual effective rate of interest of 6.14%.
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Example: Bob invests a $15,000 gift at nominal rate of 6% compounded quarterly. How much can be
withdrawn at the end of every quarter to use up the fund exactly at the end of 6 years of college?

Section 3.3: Annuity-Due

An annuity-due is an annuity for which payments are made at the beginning of the period.

• The present value (PV) of the annuity-due is denoted by än or än i .

• The accumulated value (FV) of the annuity-due is denoted by s̈n or s̈n i .

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Relationship between s̈n , än , sn , and an

Example: Sam wishes to accumulate $30,000 in an account in 7 years. He will make deposits semian-
nually with the first deposit at time 0 and the last deposit at time 6.5. How large should the deposit
be if the account earns a nominal rate of 8% compounded semianuualy.
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Section 3.4: Annuity Values on any Date

Example: Suppose 7 payments of 1 are made at the end of the 4th through 10th periods, inclusive.

Find the value of the annuity

(a) at the end of the 1st period.

Note: This in an example of a deferred annuity, since payments only commence after a deferred period.
Notation: m |an is n payments deffered after m periods.

(b) at the end of the 14th period.

(c) At the end of the 7th period.

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Section 3.5: Perpetuities

A perpetuity is an annuity whose payment continue forever. The term of the annuity is not finite.

• The present value of a perpetuity-immediate is denoted by a∞ .

• The present value of a perpetuity-due is denoted by ä∞ .

Note: Accumulated values do not exist since payments continue forever.

Example: Payments of $5000 are received at the end of each year for 10 years, after which payments of
$1000 are received at the end of each year forever. The annual effective interest rate is 9%. Determine
the present value of these payments.
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Example: Bob wishes to leave an inheritance to 3 charities in a series of level payments at the beginning
of each year, continuing in perpetuity. He wants Charity A and B to share the payments equally for
10 years, and then all payments revert to charity C. If the shares received by all three charities have
the same value at the time of bequest, find the annual effective interest rate i.

Section 3.6: Unknown Time

How do you interpret annuity symbols for non-integral terms?

Consider for n an integer and 0 < k < 1.

1 − v n+k 1 − v n + v n − v n+k 1 − v n v n − v n+k

an+k = = = +
i i i i

v n+k (v −k − 1)
an+k = an +
i

(1 + i)k − 1 n+k
an+k = an + v
i
(1 + i)k − 1
The above notation represent n payments of 1 and then a final payment at time n + k of .
i
In practice payments at non-integer periods are usually not done. Usually a balloon payment or a
drop payment is made.

• A balloon payment is a payment that combines the regular payment and a smaller additional
payment made at the same time as the last regular payment.

• A drop payment is a smaller additional payment that is made one period after the last regular
payment.
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Example: Bob has $180,000 in an account and plans to withdraw $20,000 at the end of each year for
as long as possible. If i = 6%, find how many regular payments can be made and find the amount of
the smaller payment.

(a) to be paid in addition to the last regular payment. What is the balloon payment?

(b) to be paid one year after the last regular payment. i.e. a drop payment.

(c) to be paid during the year following the last regular payment. i.e. paid during the next period
consistent with the fractional time.
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Example: A fund of $30,000 is to be accumulated by making deposits of $1500 at the end of every
year as long as necessary. If the fund earns an effective interest rate of 10%, find how many regular
deposits will be necessary and the size of the final deposit made one year after the last regular deposit.

Section 3.7: Unknown Rate of Interest

The best way to determine an unknown rate of interest for a basic annuity is to use a financial calcu-
lator.

Note: There are two approximation formulas for this in the book. Don’t worry about them.

Example: At what rate of interest convertible monthly is is $10,000 the present value of $300 paid at
the beginning of every month for 6 years?

Example: Find the rate of interest at which (a) s2 = 2.35, (b) s̈4 = 4.7.
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Section 3.8: Varying Interest

There are two common methods for varying interest rates for an annuity.

Portfolio Method: Assumes that the interest rate for any given period is the same for all payments
whose value is affected by interest during that period.
Yield Curve Method: Assumes that each payment has an associated interest rate which remains
level over the entire period for which present values(or accumulated values) are being computed.

Example: Find the accumulated value of an 8-year annuity-immediate of $200 per year if the effective
rate of interest is 4% for the first 5 years and 6% for the last three years.

(a) Use the portfolio method.

(b) Use the yield curve method.

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Let ik = the effective rate of interest for the k th period.

Find general formula for sn .

(a) portfolio method

(b) yield curve method

Find the general formula for an

(a) yield curve method.

(b) portfolio method