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Present Value vs. Future Value: Annuities

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present value vs future value

Annuities can provide you with an additional stream of income in retirement. These insurance contracts allow you to collect payments at a future date in exchange for an upfront premium. In addition to using annuities to fund retirement, you might also annuitize payments if you find yourself holding a winning lottery ticket. One key concept to understand when purchasing an annuity contract is the difference between present value vs. future value.

For help adding annuities to your portfolio, consider working with a financial advisor.

Annuity Definition

An annuity is a contract that you can purchase from an insurance company. When you buy an annuity, you make one or more premium payments to the insurer. In exchange, the insurance company agrees to make payments back to you beginning at some later date.

Immediate annuities typically allow you to start receiving payouts within one year. Deferred annuities, on the other hand, allow you to put off receiving payments for several years if necessary.

An annuity can be used to generate income for retirement and depending on how it’s structured, you may be able to pass that income on to your spouse after you pass away. Seniors may choose to set up an annuity to supplement Social Security benefits, 401(k) withdrawals or other retirement savings.

Present Value vs. Future Value of an Annuity

Present value and future value are two terms you’ll hear used when discussing annuities. In simple terms, the present value of an annuity represents what it’s worth today.

If you own an annuity, then the present value is what you’d get out of it, less any surrender charges or taxes, should you decide to cash it in. If you don’t own an annuity yet, present value is your out-of-pocket cost to purchase an annuity contract.

The present value of an annuity is based on a concept known as the time value of money. This concept suggests that the money you have now is worth more than the money that you’re promised tomorrow. Future value, on the other hand, represents what an annuity will be worth later and it accounts for the power of compounding interest.

How to Calculate Present and Future Value for an Annuity

present value vs future value

Present value calculations can be helpful if you’re considering cashing out or selling your annuity. To find the present value of an annuity, you’ll need to know three things:

  • Amount of each annuity payment
  • Number of payments remaining in the annuity contract
  • Discount rate

If you have that information, you can apply the formula for calculating the present value of an annuity. The formula looks like this:

P = PMT x ((1 – (1 / (1 + r) ^ – n )) / r)

Here’s what each part of the formula stands for:

  • P = Present value
  • PMT = Amount of each annuity payment in dollars
  • r = Interest or discount rate
  • n = Number of payments left in the contract

Calculating present value can get a little tricky and there are online calculators you can use to simplify the process.

There’s a similar but separate formula you can use to calculate the future value of an annuity. That formula looks like this:

F = PV x (1 +r)n

Here’s what each part of the formula stands for:

  • F = Future value
  • PV = Present value
  • r = Interest or discount rate
  • n = Number of years

When you calculate the future value of an annuity, you’re trying to figure out how much future payments from the annuity will be worth. You might perform this calculation if you’re trying to determine whether an annuity is a good investment or what returns you might be giving up should you decide to sell or cash out.

Present Value vs. Future Value: Key Differences

Present and future value offer two very different perspectives on annuities and there are several things that set them apart.

Each calculation has a distinct purpose, in terms of when you might apply it. With present value, you’re concerned with estimating value now, while future value looks ahead to see what an annuity might be worth. Present value can take inflation into account, while future value typically does not.

Present value can be useful to know if you’re considering buying an annuity or selling one that you already own. Future value, meanwhile, can be a helpful tool for retirement planning.

If you’re able to estimate how much future annuity payments will be worth, that can make it easier to coordinate other streams of income. For example, you might opt to delay taking Social Security benefits or withdrawing money from a Roth IRA, depending on what you expect to get from an annuity.

Should You Use an Annuity?

present value vs future value

Present value and future value can both come in handy when helping you to gauge what an annuity might be worth to you. It’s important, however, to consider whether an annuity is a good fit for your financial plan based on the pros and cons.

On the pro side, annuities can provide you with reliable income for retirement. There are different annuity options you can choose from, based on your risk tolerance and goals. Annuities also allow for tax-deferred growth, which is another plus.

However, annuities are not necessarily right for everyone. For one thing, they can be highly complex insurance products. If you’re not working with a trusted annuity expert or financial advisor, purchasing the right product may be more challenging.

Annuities can also come with high fees, including surrender charges should you decide to sell your annuity or cash it out early. Should you find yourself in a situation where you need to access funds quickly, withdrawing money from an annuity could cost you.

While some annuities can offer higher returns, those are usually accompanied by a higher degree of risk. It’s also possible that an annuity might fall short of your expectations where returns are concerned. Talking to your financial advisor can help you to decide if an annuity is a good option for your needs.

The Bottom Line

Present value and future value are relatively simple concepts but it’s important to understand what they mean if you’re weighing an annuity as part of your retirement plans. Performing these calculations can help you to better understand what you’ll need to invest in an annuity to reach your goals so you can decide if that’s something that makes sense.

Insurance Planning Tips

  • Consider talking to a financial advisor about annuities, how they work and how you might benefit from purchasing one. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Annuities are not all alike and it’s important to understand exactly what you’re getting should you decide to buy one. Fixed annuities, for example, can provide you with predictable returns. Indexed annuities attempt to match the performance of an underlying benchmark or index. Variable annuities, meanwhile, generate returns based on underlying investments in the mark. Getting to know the risk/reward profile of each type of annuity can help you to decide which one makes the most sense.

Photo credit: ©iStock.com/Chaay_Tee, ©iStock.com/tdub303, ©iStock.com/dusanpetkovic

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