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Annuity

A financial product that provides specific cash flows at equal time intervals

What is an Annuity?

An annuity is a financial product that provides certain cash flows at equal time intervals. Annuities are created by financial institutions, primarily by life insurance companies, to provide regular income to a client.

 

Annuity

 

An annuity is a reasonable alternative to the investments as a source of income since it provides guaranteed income to an individual. However, annuities are less liquid than investments in securities because the initially deposited lump sum cannot be withdrawn without penalties.

Upon the issuance of an annuity, an individual pays a lump sum to the issuer of the annuity (financial institution). Then, the issuer holds the amount for a certain period (called an accumulation period). After the accumulation period, the issuer must make fixed payments to the individual according to predetermined time intervals.

Annuities are primarily bought by individuals who want to receive stable retirement income.

 

Types of Annuities

There are several types of annuities that are classified according to frequency and types of payments. For example, the cash flows of annuities can be paid at different time intervals; the payments can be made weekly, biweekly, or monthly. The primary types of annuities are:

 

1. Fixed annuities

Annuities that provide the fixed payments. The payments are guaranteed, but the rate of return is usually minimal.

 

2. Variable annuities

Annuities that allow an individual to choose a selection of investments that will pay an income based on the performance of the selected investments. Variable annuities do not guarantee the income, but the rate of return is generally higher relative to the fixed annuities.

 

3. Life annuities

Life annuities provide fixed payments to their holders until his/her death.

 

4. Perpetuity

An annuity that provides perpetual cash flows with no end date. Examples of the financial instruments that grant the perpetual cash flows to its holders are extremely rare.

The most notable example is a UK Government bond called consol. The first consols were issued in the middle of the 18th century. The bonds did not specify an explicit end date and were redeemable at the option of the Parliament. However, the UK Government redeemed all consols in 2015.

 

Types of Annuities

 

Valuation of Annuities

Annuities are valued by discounting the future cash flows of annuities and finding the present value of the cash flows. The general formula for annuity valuation is:

 

Annuity Valuation Formula

 

Where:

  • PV = Present value of the annuity
  • P = Fixed payment
  • r = Interest rate
  • n = Total number of periods of annuity payments

 

The valuation of perpetuity is different because it does not include a specified end date. Therefore, the value of the perpetuity is found using the following formula:

PV = P / r

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Commercial Insurance Broker
  • Federal Deposit Insurance Corporation (FDIC)
  • Financial Intermediary
  • Key Players in the Capital Markets

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