Annuities in detail

An annuity is a series of equal payments made at equal intervals during a period of time. In other words, it’s a system of making or receiving  payments where the payment amount and time period between payments is equal.

Annuities are created by financial institutions, primarily life insurance companies, to provide regular income to a client. Since, annuities provide guaranteed income to an individual, it is a good alternative to some other types of investments . Annuities are primarily bought by individuals who want to receive stable retirement income.

When an annuity is issued , the individual has to pay a lump sum amount to the issuer of the annuity (financial institution ). This lump sum amount is held by the issuer for a certain period also known as accumulation period . After this period , fixed payments are made by the issuer to the individual according to the predetermined time intervals .

An annuity that begins paying out immediately is referred to as an immediate annuity, while one that starts at a predetermined date in the future is called a deferred annuity.

TYPES OF ANNUITIES :-

Annuities are classified according to their frequency and types of payments .  The primary types of annuities are:

  • Annuity Due :- Annuity due is an annuity whose payment is due immediately at the beginning of each period.A common example of an annuity due payment is rent, as landlords often require payment upon the start of a new month as opposed to collecting it after the renter has enjoyed the benefits of the apartment for an entire month.

 

  • Ordinary Annuity :- An ordinary annuity is a series of regular payments made at the end of each period over a fixed length of time . While the payments in an ordinary annuity can be made as frequently as every week, in practice they are generally made monthly, quarterly, semi-annually, or annually.The basic example of ordinary annuity is interest payment from bonds which are generally made semiannually .

VALUATION OF ANNUITIES :-

Formula for annuity valuation = P [1-(1+r) ^(-n) ] /r

Where:

  • P = Fixed payment
  • r = Interest rate
  • n = Total number of periods of annuity payments

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