Understanding Annuity Formulas

Due annuity agreement

So at first glance, annuities should be relatively straightforward. Each month, you pay money into the annuity. At the end of the accumulation phase, the money comes back to you. You get a way to supplement your pension. You can choose to take that money over a set number of years. Or you can ask to receive it for the rest of your life. Live a long time and the decision will be financially wise.

You may also get tax benefits for putting your money away now and only using it after you’ve retired when your income is lower.

But the math is horribly complicated. The world of annuities is filled with complex formulas. Those formulas are needed to show you how much your annuity is worth now and how much it will be worth in the future. If you’re not used to crunching numbers and making calculations though, using them is far from simple.

To make using annuity formulas easier there are a couple of options.

The easiest is to put your trust in someone else. The purchase of an annuity is usually done with the help of an insurance agent or a financial advisor. You’re less likely to be surfing the Web and comparing offers. You’re more likely to be sitting with an insurance agent you trust and fielding suggestions.

This is where understanding the formulas becomes so important. It’s also why you need to know the difference between the different kinds of annuity and ways of paying for them. Even if you don’t want to work your way through the annuity formulas yourself, you should know what they mean. It will help you to ask the right questions.

Understanding Annuity Formulas

There are a number of questions you need to ask an insurance agent before you buy an annuity but when it comes to the formulas used to calculate the values of annuities, a few stand out:

  1. Will I be paying on an annuity due or an ordinary annuity basis?

You can expect to be paying on an ordinary annuity basis. But you should always know how the insurance company is taking your payment. As we’ve seen, the difference between those two forms of payment will affect the value of your annuity.

If you’re paying on an ordinary annuity basis then use that knowledge to make sure that your savings are invested. You don’t want to leave the money just sitting in your current account.

  1. How much will my annuity be worth each year?

One reason you want to be able to calculate the current value of your annuity is that you should know the rate of accumulation. You might find, for example, that you want to stop investing before you reach the payout phase. In that case you should know how much you’ve built up. And you should know how much those funds will give you in the future.

The insurance agent won’t need to break out the annuity formulas to make those calculations. They should be able to use an annuity table, especially if you’re buying a fixed rate annuity. The table will reveal exactly how much the annuity is worth at each stage of the accumulation phase.

  1. How will those values change if the market declines?

If you’re buying a variable rate annuity, you’ll also want to know the worst case scenario. You’ll want to know what the value of your annuity will be if the market falls.

Bear in mind that even if you don’t put your funds in that annuity, you will be putting them somewhere else. Those funds could fall too. But you should know the degree of risk you’ll be taking.