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.
You may find yourself wondering, though, 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 your future and make smart financial decisions.
What Is an Annuity?
An annuity is a financial contract you enter with an insurance company. You’ll pay a certain amount of money, either up front or as part of a payment plan. You 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.
Two types of annuities exist: fixed annuities and variable annuities. Fixed annuities offer guaranteed interest rates paid over a certain period of time. Variable annuities, on the other hand, don’t have guaranteed payouts. 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.
Present Value of Annuity Defined
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 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.
How to Calculate 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.
The Bottom Line
Knowing the present value of an annuity can be a 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, finding a financial advisor may be a good choice. You want to find the right financial advisor, though, and SmartAsset can help with our free financial advisor matching service. Here’s how it works: you answer a few questions about your financial situation and goals. Our system then matches you with up to three financial advisors in your area. We fully vet them and make sure they are free of disclosures. Each of your advisor matches will then reach out to you to discuss working together.
- 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 as well. Find out with SmartAsset’s 401(k) calculator.
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