ANNUITY

Definition
A sequence of payments made at equal intervals of time
A sum of money or an investment that is paid at regular intervals
Is described as a stream of fixed cash flows, i.e. payments or
receipts, that occurs periodically, over time.
Is an account earning compound interest from which periodic
withdrawals are made
Is a contract between you and an insurance company in which you
make a lump sum payment or series of payments and, in return,
obtain regular disbursements beginning either immediately or at
some point in the future
Examples of annuity
Saving money for
a vacation, or
fees for your baby’s college education
Payment of
housing loan,
life insurance premium,
Monthly rent, etc.
Monthly salary
 Types of Annuity
Fixed annuity
This type of annuity accumulates interest on the funds deposited
into the annuity on a fixed rate basis.
Every fixed annuity has a current interest rate and a minimum
guaranteed interest rate.
The current interest rate will always be equal to or higher than the
minimum guaranteed interest rate.
Although this varies from company to company and contract to
contract, the current interest rate is declared on an annual basis,
usually after an initial guarantee period. With a fixed annuity, the
insurance company assumes the risk of paying at least the minimum
guaranteed interest rate
Variable annuity
Different than a fixed annuity, a variable annuity pays varying
rates of interest on the funds placed inside the annuity based upon
the investment options chosen by the annuity owner.
If the investment choices do well, the annuity will do well. If the
investment choices do poorly, the annuity will not grow as well or
even could lose value.
Because the growth of a variable annuity is not guaranteed by the
insurance company, the contract holder assumes the risk.
Immediate annuity
This type of annuity begins paying a benefit very soon, usually within
30 days to one year after it is purchased, and usually requires a lump
sum payment.
Deferred Annuity
An annuity which payments begin at some future date.
Fixed -Indexed annuity (new type of annuity)
 Indexed annuities pay an interest rate that is tied to the performance of a
common or well-known index such as the S&P 500, the Russell 1000 or the S&P
100.
The growth of an indexed annuity is based upon the participation rate of the index
it is tied to.
For example, if an indexed annuity has a defined participation rate of 70 percent
and the index it follows goes up by 10 percent, the annuity’s accumulation value
will increase by 7 percent (10 percent increase times the 70 percent participation
rate).
On the downside, most indexed annuities specify a “floor” that the annuity growth
rate cannot go below or offer a minimum interest rate ranging from 1% to 3%.
CALCULATING THE AMOUNT OF ANNUITY
There are two types of annuity formula

Ordinary Annuity

 Annuity Due
Differences between ordinary annuity and annuity due
based on timing
BASIS FOR COMPARISON ORDINARY ANNUITY ANNUITY DUE
Meaning Ordinary annuity is one in Annuity due is described as
which the inflow or outflow of the series of cash flows
cash fall due for payment at occurring at the beginning of
the end of each period. each period.

Payment Belongs to the period Belongs to the period

preceding its date. following its date.

Appropriate for Payments Receipts

Example Housing loan, payment of Rental lease payments, life

mortgage, coupon bearing insurance premium, etc.
bonds, etc.
 ORDINARY ANNUITY

 Defined as a series of regular payments or receipts; that occurs at

regular intervals over a specified number of periods (also known as
annuity regular or deferred annuity).
Ordinary annuity payments are made at the end of each period and
the frequency of the payments is the same as the frequency of the
compound the interest
Note
ordinary annuity payment is made on a monthly, quarterly, semi-
annual or annual basis
FUTURE VALUE OF ORDINARY ANNUITY
• 

Where,
PMT = Period cash payment (the amount of money that has been
deposited )
r = interest per period (Written in decimal)
n = total number of Compounded periods (number of times the account
will compound in one year)
• t = time taken(years) the account is active
 = Future value of the Ordinary annuity (the money in the account at
the end of a time or period or in the future)

Compounding periods n
Annually 1
Semi-Annually 2
Quarterly 4
 Monthly 12
Daily 365
Weekly 52
Bi-Weekly 26
•Example1
 
Find the future value of an ordinary annuity with a term of 25 years,
payment period is monthly with payment size of $50. Annual
interest is 6%.
Solution
Given t = 25 years, n(monthly) = 12, rate, r = 6% = 0.06, PMT =
$50

Using the formula

•We
  have

Interpretation
• We put only $50 each month for One year will have $600 and after 25
years we will have deposited $600x25 years = $15,000 thus the
interest will be $19,649.7
Example 2
You have travel enthusiasm and curious to visit Asia but cannot afford
the lump sum amount of $800. Currently, from your salary, you can save
only $150 per month and you are searching for a source which would
provide you the sum after 5 years to enjoy a trip to Asia. For this, you
consider buying an annuity contract with 7% interest rate annually.
Solution
Given:
t = 5 years,
n = annually = 1,
r = 7% = 0.07,
PMT = $150
• 
From

We have

=
=
Example 3
Suppose $1500 is deposited at the end of each year for the next 6
years in an account paying 8% interest compounded annually. Find
the ordinary future value of annuity
Solution
Given
t = 6 years
n = annually = 1,
r = 8% = 0.08,
PMT = $1500
•From
 

We have,
=
PRESENT VALUE OF ORDINARY ANNUITY
•Present
  value for ordinary annuity is given by

Where,
PMT is cash payment during specific period of time
r is interest rate during a period
n is a total number of periods
•Example
  1
You have inherited $20,000 from your father and you wish to purchase a
contract that will provide you a steady income for next 10 year. Currently,
banks are paying 12% compound interest on the annual basis. How much
would you be able to receive on yearly basis?

Solution
Givens:
Time, t = 10 years
 n = annually = 1,
rate, r = 12% = 0.12,
PMT = ?,
$20,000
•From
 

Thus,
=

Then, you would receive

•Example
  2
Ms. Smith buys a car Costing $20300.She agrees to make payment at
the end of each monthly period for 6 years. she pays 9.65% interests
compounded monthly. What is the amount of each payment, Find
the total Interest?
Solution
Givens:
Time, t = 6 years
n =Monthly = 12,
rate, r = 9.65% = 0.0965,
PMT = ?,
$20,300
• 
From
,
We have

=
• Then, you would receive

Total interest =
=
=

 Thus Ms. Smith will pay a total Interest of = $6520.10

Test your understanding
•Problem
  1. (Three different ways of asking the same question)
Find the present value of ordinary annuity which has payments of $200 per month
for 5 years at 4.1% Compounded monthly
Find the amount necessary to fund the given withdrawals monthly of $200 for 5
years interest rate is 4.1% Compounded monthly
Find the lump sum deposit today that will yield the same total amount as payment
of $200 at the end of each month for 5 years at the interest rate of 4.1%
Compounded monthly
(Answer

Problem 2
Find the PV of an ordinary annuity which has deposited of $10279 semiannually for 5
years at 7.6% Compounded semiannually
(Answer