Understanding Annuities: A Comprehensive Guide

An annuity is a financial product that provides certain cash flowsCash FlowCash Flow (CF) is the increase or decrease in the amount of money a business, institution, or individual has. In finance, the term is used to describe the amount of cash (currency) that is generated or consumed in a given time period. There are many types of CF at equal time intervals. Annuities are created by financial institutionsFinancial Institutions Group (FIG)Financial Institutions Group (FIG) is a group of professionals that provide advisory services to financial institutions. Some of the services that FIG offers include mergers and acquisitions, recapitalization, capital raising, financial restructuring, corporate valuations, expert financial opinions and other advisory services., primarily life insurance companies, to provide regular income to a client.

An annuity is a reasonable alternative to some other investments as a source of income since it provides guaranteed income to an individual. However, annuities are less liquid than investments in securitiesFixed Income SecuritiesFixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed, interest payments and repayments of the because the initially deposited lump sum cannot be withdrawn without penalties.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 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 amount of income, but the rate of return is generally higher relative to 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 financial instruments that grant perpetual cash flows to its holder are extremely rare.

The most notable example is a UK Government bond called consol. The first consols were issued in the middle of the 18^th 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.

Valuation of Annuities

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

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

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