The annuity factor formula is used to calculate how much this financial product will be worth in the future.
Definition of Annuity
The word "annuity" simply means a series of payments made to an individual. A person may choose to buy a life annuity from an insurance company to provide a source of retirement income.
How Annuities Work
Annuities can work in two ways:
Single Premium Immediate Annuity: With this option, a person would make one payment to the insurance company. In return, the insurer will provide the annuitant with a monthly payment for life. The advantage of buying this type of investment product is that the recipient will not outlive their retirement funds. However, if the annuitant dies within a short time after buying the annuity, then the insurer has made the better deal, since the company keeps the principal amount deposited.
Single Premium Deferred Annuity: Some people choose to give a lump sum to the insurance company but delay receiving payments until a later time. When the maturity date for the annuity arrives, they can receive the funds as a lump-sum payment or buy an annuity that will provide them with monthly payments for life at that point.
Time Value of Money
The concept of the time value of money is a relatively simple one. If you were to make a $1.00 deposit today in an interest-bearing account, the amount of money in the account will be worth more in the future than it is today.
The dollar invested today has a present value (PV) and a future value (FV). The difference between the FV and the PV is the return on investment (ROI).
Making Calculations Using the Annuity Factor Formula
In order to calculate the future value of a sum of money, you need to know the following information:
- Present Value
- Interest rate the annuity will be earning
- Number of years the funds will be on deposit
The annuity factor reads as follows:
Future Value = Present Value (1 + Interest Rate) to the power of n
Here's an example: A person invests $100 for five years at an interest rate of five percent, compounded annually. The Present Value is $1.05 ($1.00 + 5 percent interest). When you calculate this sum to the fifth power, you get 1.2763. The future value of that $100.00 investment in five years is $127.63.
If you have questions about whether buying an annuity makes good financial sense for your situation, please contact an insurance agent who can provide you with the information you need to make an informed decision.