Because annuities offer advantages like regular lifetime payments, premium protection, tax-deferred growth, unlimited contributions, and various investment options, they should be a part of your retirement plan. This is especially true if you want to supplement other retirement income streams, like Social Security. Or if you’re losing sleep over whether you’re going to outlive your savings or not.
There are, however, disadvantages with annuities that you should also be aware of. At the top of the list would be that annuities aren’t liquid. They also come with high fees and penalties, misleading high yield rates. And, overall, annuities are more complex than most other retirement vehicles.
Another drawback? Not always knowing what the total cash value of your future annuity payments will be. Knowing this in advance allows you to plan accordingly, like setting a retirement budget or knowing how much to save each month.
This isn’t the case with all annuities, though. Due, as an example, offers a 3% guaranteed interest rate on your money. As such, the Due Annuity Formula is straightforward depending on;
- If you’re making monthly contributions or a lump sum payment.
- The interest rate — 1% for Free Accounts, 3% for Pro Due Customers
- Current age
- The age you want to retire
There’s even a helpful annuity calculator to do the math for you. So, if you were 35 and contributed $500 a month, your payments would be $4,457.44 per month when you retire at 65. But, that’s not the case with all annuities, such as variable, fixed indexed, or multi-year guaranteed annuities. With these types of annuities, you’re going to have to find their present value.
Present Value of Annuity Defined
Before explaining how to find the present value of an annuity, we should first define the present value of an annuity. In simplest terms, this is the cash value of all your future annuity payments. Included in the calculator is the discount rate or rate of return. That’s important to be aware of since the discount rate can rescue an annuity’s future payments. To put that more succinctly, the higher the discount rate, the lower the annuity’s present value.
The present value of an annuity is based on a concept called the time value of money. For the uninformed, this is a widely accepted theory that it’s better to accept a lump sum of money today than waiting for an identical sum in the future. The reason being that future payments aren’t as valuable because of uncertain economic conditions.
For instance, let’s say that you have $10,000 to invest. While you can make money via interest and other return mechanisms, that rate of return you may get in five or ten years won’t be as much as the initial investment. In other words, that $10,000 today is worth more money than what you’re promised in the future.
If you’re considering buying an annuity, you’ll need to know its present value, as this will help you determine if you want to take a lump-sum payment or series of recurring payments.
What is the Formula for Calculating the Present Value of an Annuity?
Hopefully, you feel a little more comfortable with defining the present value of an annuity. Now, let’s discuss how you can find the present value of an annuity. After all, calculating the present value lets you know how much your annuity is worth. And, more important, it helps determine if you’re getting a fair deal or not if/when you sell your payments.
Thankfully, there is a formula that you can use to calculate the present value. It’s not terribly complicated as long as you have the right information. And, here is said formula;
P = PMT x ((1 – (1 / (1 + r) ^ -n)) / r)
The variables in this equation are as follows;
- P = the present value of an annuity
- PMT = the dollar amount in each annuity payment
- R= the interest or discount rate
- n= the number of remaining payments that you’ll receive
While not the most complex formula, it can still be tricky to calculate the present value of an annuity. You can thank the number of variables features in the formula for that. However, not all types of annuities are this complicated. And, there are also calendars the can do the math for you.
How to Calculate the Present Value of an Annuity
Whether you do this manually or with a calculator, figuring out the present value of an annuity can be extremely beneficial. Primarily, this can help you decide if you should take a lump sum or annuity payment. But, an example of how this works might illustrate which is the more efficient option.
Similar to winning the lottery, you have two options. In this scenario, you could take a lump sum or $300,000, with a 5% discount rate.
You’ll plug these numbers into the formula as follows:
P = 25,000 x ((1 – (1 / (1 + .05) ^ -20)) / .05)
Once you do a little math, you’ll find out that this will come out to $311,555. As you can tell, the value of the annuity is worth more than the $300,000 lump sum. So, in this case, it makes more financial sense to take the annuity payments.
Can You Use Calculators to Estimate the Present Value of an Annuity?
Suppose math isn’t your strong suit; no worries. You can easily find online calculators that can do the legwork for you. Most of these calculators use a time value of money formula. Specifically, this is used to measure the current worth of a stream of equal payments that will take place at a future period.
Of course, you’ll need the right information to input into the calculator, such as;
- Payment type
- The date of the next payment
- How much each payment is worth
- The number of payments you have left
- The frequency of payments
All of this information can be found in your annuity contract. And, once you have it in hand, it only takes a couple of minutes for the calculator to generate a quote that will indicate interest rates, market value, and the impact of time.
Just note that what quote the calculator displays isn’t set-in-stone. What’s more, most calculators do not provide accurate estimates if increasing payments or market value adjustments that are determined by fluctuating interest rates are a part of your annuity.
It does, however, give you a ballpark figure on what to expect. With that in mind, you may also want to look at other variables, especially if you’re a secondary market buyer.
- Fees and any other additional charges
- Current annuity market rates
- The annuity company’s specific guidelines
- How much money is left in your annuity
- When annuity payments started
If you want even more details regarding the present value of your payments, schedule an appointment with your financial advisor. They can review the estimate and give you more information and guidance.
Frequently Asked Questions About the Present Value of an Annuity
What is an annuity table?
Also known as a “present value table,” an annuity table is a tool that simplifies the calculation of the present value of an annuity. It’s also based on the time of the value of money. And, all you have to do is multiply the present value interest factor of an annuity with your recurring payment amount to get the present value of your annuity.
For this to work, though, you’ll need to know if you’ll be receiving payments at the beginning or end of the period. With traditional annuities, however, payments are distributed at the end. So you’ll also need to know your payment amount and discount rate.
While this is a simple and effective way to find the present value of an annuity, it’s not as effective as manual calculations or calculators.
When is the present value of an annuity calculated?
There’s no exact answer. But, in most cases, the present value of an annuity will be used to figure out the cash value of retirement funds like annuities, recurring payments in court settlements, and loans. It can also be used to calculate if a mortgage payment is either above or below its expected value.
Do discount rates affect present value?
Let’s say that you sell your annuity, or even a structured settlement, to a factoring company. This company will use discount rates to take into account market risks. This can include risks like inflation so that they can turn a small profit. And you’ll be granted early access to your payments. In turn, a discount rate will directly influence the value of an annuity and the amount you’ll receive from the purchasing company.
Discount rates will vary. But, standard discount rates can range between 8% and 15 percent. FYI, the lower the discount rate you receive, the higher the present value your annuity has. Also, low discount rates permit you to keep even more of your hard-earned money.
The Internal Revenue Service states that most states require factoring companies to disclose discount rates. The most also present value during the transaction process. To be on the safe side, always ask for these numbers before selling your payments.
One more thing, distant payments are usually less valuable to purchasing companies. As mentioned in the beginning, that’s because of economic factors. So, the sooner the payment, the more you’ll get. So, for example, an immediate annuity or when that being payouts in five years is worth more than an annuity that will make distributions in twenty years.
What’s the difference between annuity due and ordinary annuity?
Present value calculations are influenced by when payments will be disbursed. That means the payment will begin at the beginning or end of a period.
If payments are disbursed at the beginning of each period, then this type of annuity is called annuity due. A common example of an annuity due would be paying your landlord’s rent on the first of each month.
The other type is an ordinary annuity. This is what we’ll focus more on since this is associated with retirement accounts. In this case, you’ll receive either a fixed or variable payment at the end of each month or quarter. It will also be based on the value of your annuity contract.
The Bottom Line
Regardless of the method, measuring the value of an annuity will help you make the right investment decision for your retirement. While it may sound complex, doing a little math today can go a long way tomorrow. But, you should also work with a trusted financial advisor to ensure that you stay on the right track.