What is an Annuity? 

The series of payments or we can say lump sum payments which are done or bought through a contract with the buyer or the customer and seller or the insurance company while doing insurance which in return gives a promise to receive the money either as monthly income or by receiving the whole amount at some point of time in the later period. 

Different Types of Annuity 

There are three types of annuity that have their potentials of payout and levels of risk are as follows: 

  • Fixed annuity: In the fixed annuity, there is a guaranteed amount of payout. The disadvantage of the predictability of the fixed annuity is a relatively modest annual return. Certificates of deposit from a bank are usually a bit higher.  
  • Variables annuity: In the variables annuity, an opportunity is provided for potentials of higher return along with the higher level of risk. One can go to their personal “sub-account” by picking up from the list of the mutual funds.  
  • Indexed annuity: In the indexed annuity, when the indexed comes in the middle of the situation when potential reward and risk. A guaranteed minimum payout one will receive much as a segment of the return is inbound with the performance of a market index. 

Apart from the aforesaid varieties of the annuities there are also exist other varieties of annuities for instance ordinary annuity, annuity due, and deferred annuity. 

  • Ordinary annuity: In an ordinary annuity, the guaranteed fixed amount will be received and paid at the end of each period. 
  • Annuity due: In an annuity due, the guaranteed fixed amount will be received and paid at the beginning of each period. 
  • Deferred annuity: In the deferred annuity, the guaranteed fixed amount will be started after a fixed time period instead of immediately after the investment. 

Advantages and Disadvantages of an Annuity 

The advantages of an annuity are as follows

  • Regular payments will be received: This is the biggest that an individual will receive regular payments from the insurance company (from where he or she had done his or her insurance). 
  • Growing of tax-deferred from the contribution of the individual: Tax is exempted from the money which is given to the annuity in other words money contributed before the tax is paid.  
  • Guaranteed rates of return are offered by the fixed annuities. 
  • Availability of death benefits. 

The disadvantages of an annuity are as follows

  • Annuities can be costly: Annuities may be very costly. An individual who is going to start an annuity must take note of the fees that come with an annuity. 
  • Returns on investment may not match with the returns on annuity: In one year the stock market may make good gains and in some years it won't. A good gain in the stock market will be the money for the investments. This is one of the reasons for the difference in the growth of fees in the annuity.   
  • Difficulties on moving out of an annuity 

What is the Present Value?

The outflow of cash flow with a given specific rate of return or the current value of the upcoming sum of money is known as the present value. 

The formula for the present value of an ordinary annuity: 

Present Value=Annuity× 1 1+Interest Rate Time Period Interest Rate

The formula for the present value of an annuity due: 

Present Value=Annuity× 1 1+Interest Rate Time Period Interest Rate × 1+Interest Rate

Criticism of Present Value 

An assumption that over the rate of return can be earned on the funds involves the calculation of the present value. If there is a different rate of return on a series of projects, thus the present value of the company will be lower and there exists an unrealistic expected rate of return. It is crucial to make a note of those decisions in which there is no guarantee of the interest rate. Grinding down on the rate of return on investment is caused by inflation. 

What is Future Value? 

On assuming a rate of growth, the current asset of the future date is based. Financial planners and investors use the future value to estimate how much the environment is to be made so that it will be worth it in the future. The sound decisions which are done by the investors are based on their anticipated needs and are done by understanding the future value. Moreover, the future value of the asset gets resentfully affected by extraneous economic factors for instance inflation by grinding down its value. 

Types of Future Value

The different types of calculation of future value are as follows: 

  • Calculating future value by using simple annual interest: By assuming an uninterrupted rate of growth and for the duration of investment, a particular instinctive payment is left unharmed. Depending on the type of interest which is earned the feature can be calculated in two ways. The formula for calculating the future value by using simple annual interest is shown below:  

Future Value=Present Value× 1+ Interest Rate×Time Period

  • Calculating present value by using compound annual interest: When calculating the future value using simple interest, we assume that in initial investment, interest rates are brought in. To each cumulative account balance of each period a rate is applied while doing the compound interest. The formula for calculating the present value by using compound annual interest is shown below: 

Future Value=Present Value× 1+Interest Rate Time Period

The formula for the future value of an ordinary annuity: 

Future Value=Annuity× 1+Interest Rate Time Period 1 Interest Rate

The formula for the future value of an annuity due: 

Future Value=Annuity× 1+Interest Rate Time Period 1 Interest Rate × 1+Interest Rate

Difference Between the Present and Future Value of the Annuity: 

In annuity contracts, these terms present value and future value are commonly used. The sum which is invested at the present moment in order to get the desired return in the future is known as present value. On the other hand, the total amount of money that is received in the final period is known as future value.  

Context and Applications    

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for  

  • B.B.A in Finance  
  • M.B.A  

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