Present Value of Annuity
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Updated date : 18 June 2020
The present value of an annuity can be described as a series of cash contributions that are made over a specific period of time. In a simple annuity plan, these payments are distributed to the annuitant in the form of annuities at the completion of the pay period. However, it is important to know that the money you invest in an annuity today, what is the value of that money now, and based on that how much you will be receiving as future payments?
The word ‘value’ refers to the financial limit that a sequence of payments can attain. The value of money that the individual invest in an annuity is known as the present value of an annuity. It is directly affected by the interest earned and payments made by the annuitant in the future.
To know the value of the money invested, the individuals can use the present value of the annuity formula. In simple terms, the money invested by an individual holds a great value than the same amount of money he/she will invest in the future. This is because the investment made by you now has a longer-term period to accumulate interest. Moreover, the value of money invested by an individual will be higher in the long-term because of its potential to gain interest.
The formula of Present Value of Annuity
PV= C x [1-(1+r)-n / r]
- C= cash flow perf period
- R= interest rate
- N= number of periods
Sometimes it can be seen that while discussing the present value, the term interest rate is also mentioned as a discount rate sometimes. While calculating the equation it is important to pay attention to the rate.
In an annuity plan, the payments of the annuity can be done at different frequencies. The policy can pay annuity in monthly, quarterly, half-yearly, or yearly modes. The frequency of interest rate used for computation should be the same as the number of payments made which is shown as variable n. If the individual has signed up for monthly annuity then they should use a monthly interest rate while calculating the present value of the annuity.
For example, if a person has signed up for monthly annuity and has an annual interest rate of 6% then he/she will have to use a monthly interest rate of 0.05% in the calculation.
It is important to keep in mind that in this formula the interest rate should remain the same throughout and the investment amount should be distributed equally. This formula will not be applicable if the interest rate decreases or increases or the distributed amount by annuity changes. In case, the annuity payments eventually increase at a specific rate then the annuitant will have to use the formula of the present value of growing annuity.
Analysis of Present Value of Annuity
Mostly, the objective behind calculating the present value of annuity is to make a foolproof retirement planning for a financially secure future. Individuals who are making financial planning for their retirement would want to know how much they need to invest today in order to receive the desired annuity after retirement. Annuities can be very attractive as it provides an opportunity to gain regular income after retirement.
Moreover, it comes with the advantage of a fixed interest rate and a dependable payment option. However, it is important to keep in mind that the individual will have to pay the applicable taxes on the amount received as an annuity.
While computing the present value of annuity, the individual will need to make the initial investment one period away from the start of annuity, or else, the value of payments made in the future will change. In case, the initial investment from the start of the annuity is more than one payment period away then the investor can use either the present value of the deferred annuity or present value of an annuity due formula.
Benefits of Present Value of Annuity
- The present value of annuity formula is an instrument, which helps us to plan how much we should invest now in order to avail the desired cash flow after retirement.
- Present value of annuity due is majorly used to assess how much a person will need to pay immediately into an immediate annuity plan in order to receive specific amount as immediate annuity.
- The annuity payments are made after the completion of the accumulation phase.
- The formula of present value of annuity identifies 3 variables i.e the interest rate, cash value of the payments made by the annuitant per period, the number of payments within the series.
- The PV of annuity is applicable with a fixed rate of interest and equal payment during the specific time period.
Wrapping it Up!
The annuity calculator helps the individuals to calculate an estimated amount that they will need as an annuity or regular cash flow after retirement. With the help of annuity calculator one can calculate the present value and future value of annuity and can create a strong financial planning for a secure future. However, while calculating the annuity make sure you pay equal attention to the factors which can have an impact on your annuity like income, demography, current savings, inflation rate, expected rate of return etc. By keeping these aspects in mind you can make a strong retirement planning for future and life a stress-free life after retirement.
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