Understanding the Present Value of an Annuity: Formula & Calculation

The annuity formula used to calculate an annuity’s total value is the present value of an annuity. An annuity is essentially a continuous stream of payments, made at specific time intervals and for a set time horizon. Because of inflation and of assumptions based on market reinvestment rates, calculating the total value of an annuity involves more than simply adding up all of the cash flows. The PV formula effectively discounts each cash flow by its timing in relation to the discount rate. A cash flow coming later in the life of the annuity is worth less in present value terms than an identical cash flow due next period.

The Difference between Variable and Fixed Annuities

The primary difference between fixed and variable annuities relates to the different interest rates used in calculating annual cash payments. A fixed annuity maintains the same interest rate for every payment over the life of the annuity, and investors receive a total annual cash payment of this fixed percentage rate multiplied by the total amount originally invested in the annuity. The interest rate of variable annuities is usually tied to the performance of riskier assets, such as an equity index. Years of high market growth in this case will result in higher payments.