An annuity can be a useful tool when planning for retirement. After you’ve stopped working, you’ll be relying on your savings and Social Security payments to support yourself and enjoy your golden years. Purchasing an annuity creates an additional income stream, which can make things easier. Many people work with a financial advisor to optimize a plan for their retirement goals. Let’s take a look at how the present value of your annuity is calculated and how it could impact your retirement.
Why the Present Value of Annuity Is Important
You may find yourself wondering about the present value of the annuity you’ve purchased. The present value of an annuity is the total cash value of all of your future annuity payments, given a determined rate of return or discount rate. Knowing the present value of an annuity can help you figure out exactly how much value you have left in the annuity you purchased. This makes it easier for you to plan for your future and make smart financial decisions.
Present Value of Annuity Defined
Before we cover the present value of an annuity, let’s first review what an annuity is exactly. An annuity is a contract you enter into with a financial company where you pay a premium in exchange for payments later on.
The present value of an annuity is the cash value of all of your future annuity payments. The rate of return or discount rate is part of the calculation. An annuity’s future payments are reduced based on the discount rate. Thus, the higher the discount rate, the lower the present value of the annuity is.
The present value of an annuity is based on the time value of money. You can invest money to make more money through interest and other return mechanisms, meaning that getting $5,000 right now is more valuable than being promised $5,000 in five years. The rate of return you’ll earn from investing that $5,000 means that by the time you would get the $5,000 in five years, the $5,000 you would get now would be worth more money.
With an annuity, you might be comparing the value of taking a lump sum versus the annuity payments. Calculating the present value of annuity lets you determine which is more valuable to you.
The Present Value of Annuity Formula
There is a formula to determine the present value of an annuity:
P = PMT x ((1 – (1 / (1 + r) ^ -n)) / r)
The variables in the equation represent the following:
- P = the present value of the annuity
- PMT = the amount in each annuity payment (in dollars)
- R= the interest or discount rate
- n= the number of payments left to receive
As you may have guessed from the number of variables in the formula, calculating the present value of an annuity can be tricky. Though there are online calculators available that can do the math for you, with the right formula and a regular annuity, it’s not impossible to figure out on your own. We explain in detail how to use the formula below.
Example of the Present Value of an Annuity
Using the above formula, you can determine the present value of an annuity and determine if taking a lump sum or an annuity payment is a more efficient option. Here is an example of how that can work. Note that this formula is for a regular annuity.
Let’s say you have the option of either a $25,000 annuity for 20 years or a lump sum of $300,000, with a discount rate of 5%. These numbers can be plugged into the formula as follows:
P = 25,000 x ((1 – (1 / (1 + .05) ^ -20)) / .05)
Doing the math, that comes out to $311,555. This means that for this particular annuity, the value of the annuity is worth more than the lump sum, and you’d be better off choosing to take the annuity payments rather than the lump sum.
When Is the Present Value of Annuity Calculated?
The present value of annuity is commonly used to figure out the cash value of recurring payments in court settlements, retirement funds and loans. It is also used to calculate whether a mortgage payment is above or below an expected value. These payments are sometimes called annuities.
An annuity is a financial contract you enter with an insurance company. You’ll pay a certain amount of money upfront or as part of a payment plan, and get a predetermined annual payment in return. You can receive annuity payments either indefinitely or for a predetermined length of time. Regular payments are one of the pros of annuities.
There are three types of annuity contracts:
- Fixed annuities: Offer guaranteed interest rates paid over a certain period of time.
- Variable annuities: Don’t have guaranteed payouts, meaning that you’ll have more freedom to invest your money in different ways, and thus your payments will be tied to those investments’ performance. This can result in higher returns, but also runs the risk of lower returns.
- Indexed annuities: Hybrid annuities that combine elements of their fixed and variable counterparts. An indexed annuity tracks a stock market index such as the S&P 500 or the Dow Jones Industrial Average and pays out a certain percentage of the index’s return.
Keep in mind that money spent on an annuity grows tax-deferred. That means that when you eventually start making withdrawals, the amount you contributed to the annuity is not taxed, although your earnings are taxed at your regular income tax rate.
Knowing the present value of an annuity can be helpful when planning your retirement and your financial future in general. If you have the option of picking an annuity or a lump-sum payment, you’ll want to know how much your remaining annuity payments are worth so you can choose. Even if you aren’t making that decision, knowing the present value of an annuity can give you a clearer picture of your finances.
Retirement Planning Tips
- If you’re thinking about buying an annuity, talking to a financial advisor may be a good choice. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted 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 aren’t the only retirement income option. If you have a 401(k), you’ll want to know the likely value of that account when you retire. Find out with SmartAsset’s 401(k) calculator.
- If you want to know how much money you will need to retire, SmartAsset’s retirement calculator can help you figure out how much you’ll need to stash away to live comfortably.
Photo credit: ©iStock.com/mapodile, ©iStock.com/SARINYAPINNGAM, ©iStock.com/shapecharge