There are multiple ways to classify annuities. You may hear about a life annuity where payments are handed out for the rest of the purchaser's (annuitant) life. Since this kind of annuity is only paid under particular circ*mstances, it is called a contingent annuity (i.e., it is contingent on how long the annuitant lives for). If the contract specifies the period in advance, we call it a certain or guaranteed annuity.
Annuities are also distinguished according to the variability of payments. There are fixed annuities, where the payments are constant, but there are also variable annuities that allow you to accumulate the payments and then invest them on a tax-deferred basis. There are also equity-indexed annuities where payments are linked to an index.
The most important way to differentiate annuities from the view of the present calculator is the timing of the payments.
In this context, there are two types of annuities:
Ordinary annuity (or deferred annuity): payments are made at the ends of the periods – mortgages, car loans, and student loans are conventionally ordinary annuities.
Annuity due: Payments are made at the beginning of each period – rental lease payments, life insurance premiums, and lottery payoffs (if you have the fortune to win one!)
The easiest way to understand the difference between these types of annuities is to consider a simple example. Let's assume that you deposit 100 dollars annually for three years, and the interest rate is 5 percent; thus, you have a $100, 3-year, 5% annuity.
Payment Amount = 100 dollars
Interest Rate = 5%
Annuity Term = 3 years
The graph below shows the timelines of the two types of annuity with their future values. As you can see, in the case of an annuity due, each payment occurs a year before the payment at the ordinary annuity. The advanced payments immediately affect the future value of the annuity as the money stays in your bank for longer and therefore earns interest for one additional period. Therefore with the annuity due, the future value of the annuity is higher than with the ordinary annuity.
The graph also visually explains how an annuity's future value is calculated: it is merely the sum of compounded cash flows estimated in each year. How to compute these individual payments? Look at our example for the ordinary annuity. The first payment earns interest for two periods, the second for one period, and the third earns no interest because it is made at the end of the annuity's life. This is an example of compound interest, a common feature in finance where interest is calculated on the interest.
This approach may sound straightforward, but the computation may become burdensome if the annuity covers an extended interval. Besides, other factors that need to be taken into consideration may appear and complicate the estimation even further. In the following section, you can learn how to apply our future value annuity calculator to any scenario, no matter how complex.
I'm well-versed in annuities, drawing from both theoretical knowledge and practical application. Annuities are financial products that involve a stream of payments over a specified period. There are various classifications, such as life annuities contingent upon the annuitant's lifespan or fixed versus variable annuities, offering different payment structures and investment opportunities.
In the context of the article you provided, here's a breakdown of the concepts mentioned:
- Life Annuity: Payments are made for the rest of the annuitant's life.
- Contingent Annuity: Payments are contingent on the annuitant's lifespan.
- Certain or Guaranteed Annuity: Payments are predetermined for a specified period.
- Fixed Annuity: Payments remain constant.
- Variable Annuity: Payments vary based on investment performance.
- Equity-Indexed Annuity: Payments are tied to an index's performance.
- Ordinary Annuity: Payments occur at the end of each period.
- Annuity Due: Payments occur at the beginning of each period.
The article also explains the implications of these classifications on future value calculations, highlighting the differences in timelines and how they impact the total value of an annuity.
It further delves into the concept of compound interest, showcasing how future values are computed by compounding cash flows over the annuity's duration. The practical example of a $100, 3-year, 5% annuity helps illustrate this calculation. Moreover, it discusses the complexities that may arise in computation for extended annuity periods and the necessity of considering additional factors.
Finally, it teases the use of a future value annuity calculator to simplify complex calculations for various annuity scenarios.
Understanding these concepts is crucial for making informed financial decisions involving annuities, especially regarding payment structures, timing, and the implications on accrued value over time.
