An annuity is a regular payment that received in exchange for a lump sum of money invested with a financial institution (usually insurance companies) or an investment that is made over a period of time (usually many years). People purchase an annuity by entering into a contract and paying over a proportion of their income for a number of years, usually 10 years or more.
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When you have made all the payments that you are required to make under the contract that you have entered into with the financial company, you begin to receive regular payments (the contract becomes ‘annuitized’) or you receive a lump sum. This is called a deferred annuity, and people choose such annuities in order to take care of their financial needs when they retire, or to pay for their children’s college education etc.
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You need to know what your annuity is going to be worth in the future. There are several reasons for this. In order to make sure that there will be enough money to take care of future needs, careful financial planning needs to be carried out so that the amount of money required can be determined. How much will you need for your retirement, for the kid’s education etc.? Once you are satisfied that you know what you will need, you then need to set up an annuity which has a future value that will meet those needs.
Another reason you need to know the future value of an annuity is that you may decide to sell your annuity at some stage. You may decide that you want to get cash for some, or all, of your annuity so that you can make a better investment, or there may be some other financial emergency that arises (e.g. medical bills).
If you become the beneficiary of someone else’s annuity – you might inherit an annuity – you might also decide to sell it. The future value of the annuity will have an effect on its present value. It’s a bit like selling an asset such as a house; if the value of the house is expected to grow, this will affect its present value.
It is difficult to determine exactly what your annuity will be worth because of inflation and other factors, but it is possible to come up with a reasonable approximation. As you will see, there is a standard formula for establishing the value that is more or less universally agreed upon.
Inflation will affect the value of the money you receive, and in an effort to compensate for the loss of value inflation can cause, some people choose a variable annuity in place of the more secure fixed annuity. Variable annuities often yield a greater return, but there is some risk involved.
When determining the value of money in the future, we must take an economic principle called the time value of money into consideration. The value of money changes over time. If money is not invested it will lose its value due to inflation, but if you invest it, its value will grow or at least be maintained.
This simple example illustrates the principle: If you can get 6% interest on $100 and you invest it today for one year, in a year’s time your $100 will actually be worth $106 – $106 is the future value of $100 (this simple example does not take inflation into account, we will deal with that later). This calculation is also referred to as a capitalization.
Working out the future value of an annuity takes the time value of money into account, and it includes factors such as the number of deposits/contributions, the length of time contributions were made, and the interest rates. Economists have developed an algebraic formula for the calculation.
The formula FV = R x [(1+i)n - 1] / i is used to calculate the future value of an annuity. An additional factor - (1+i) is added to the formula where contributions are made at the beginning of periods. Thankfully you do not need to be a mathematician to work it out. There are many calculators which are made available online by various institutions, and all you have to do is enter your monthly contribution rate, the time length of the investment, and the real interest rate.
The real interest rate is the interest rate minus the inflation rate. Obviously these factors are variable, and that’s why is difficult to arrive at a very precise figure. In addition, you need to account for any fees to be paid, and of course, there is tax to take into consideration. The amount of tax depends on whether you used pre-tax income to buy the annuity or income that you had already paid tax on.
Nevertheless, it is possible to work out what the future value of your annuity is to a reasonable degree, and it is something that you must do in order to plan ahead and to make sound financial decisions. Why not visit the websites of Pacific Life, ING, Midland and others and use the calculators that they provide? Make an appointment with a financial advisor with expertise in this area too.
