ANNUITY AND ITS TYPES
What is an annuity?
It is a series of equal payments that occurs at equal time intervals - usually
monthly, quarterly, semi-annually, or annually. The annuity formula is used to
find the present and future value of an amount.
An annuity is a fixed amount of income that is given annually or at regular
intervals. The present value of an annuity is the current value of future
payments from an annuity, given a specified rate of return, or discount rate. The
higher the discount rate, the lower the present value of the annuity.
Examples of annuities are as follows: Regular deposits to a savings account,
monthly home mortgage payments, monthly insurance payments, and pension
payments.
Formula:
Problem
1) A person pays ₹ 64,000 per annum for 12 years at the rate of 10% per
year. Find the annuity [(1.1)12=3.3184]
Solution :
Types of Annuity
There are five types of annuities which are as follows
1) Fixed annuities
2) Variable annuities
3) Fixed-indexed annuities
4) Immediate annuities
5) Deferred annuities.
FIXED ANNUITY
A fixed annuity is a type of annuity contract that provides a guaranteed, fixed
rate of return on the invested funds for a specified period.
EXAMPLE
An annuity is a financial product offered by insurance companies, and it is
designed to provide a steady stream of income for the annuitant (the person who
owns the annuity)
FORMULA-
VARIABLE ANNUITY
DEFINITION:
A variable annuity is a type of annuity contract, the value of which can vary
based on the performance of an underlying portfolio of sub-accounts. Sub
accounts and mutual funds are conceptually identical, but sub accounts don’t
have ticker symbols that investors can easily type into a fund tracker for
research purposes.
FORMULA
The future value of an annuity is FVn = PV(1+r)n
The present value of an annuity is PV = FVn (1+r)-n
EXAMPLES:
FUTURE VALUE
PV = 5,000
FVN =?
r =7%
N=10
⇒FV n = PV(1+r)n = 5000(1+0.07) 10 = 9,835.7568
PRESENT VALUE
FV=100,000
r=6%
N=8
PV=?
So,
⇒ PV=FVn (1+r)-n = 100,000(1.06)-8=62,741.237
IMMEDIATE ANNUITY
DEFINITION:
An immediate annuity is a financial contract where an individual makes a lump
sum payment to an insurance company, and in return, the insurance company
provides a regular stream of income payments, typically starting within a month
or a year of the initial investment. It is designed to provide a steady and
predictable source of income for a specified period or for the annuitant's
lifetime.
FORMULA:
Income payment = Initial investment / (Number of payments per year * number
of years)
EXAMPLES:
#1
● Initial Investment: $50,000
● Number of Payments per Year: 12 (monthly payments)
● Number of Years: 10
Income payment = $50,000/(12*10) = $416.67
#2
● Initial Investment: $75,000
● Number of Payments per Year: 4 (quarterly payments)
● Number of Years: 15
Income payment = $75,000/(4*15) = $1,250
INDEXED ANNUITY
An indexed annuity is a type of annuity contract that pays an interest rate based
on the performance of a specified market index, such as the S&P 500. It differs
from fixed annuities, which pay a fixed rate of interest, and variable annuities,
which base their interest rate on a portfolio of securities chosen by the annuity
owner. Indexed annuities are sometimes referred to as equity-indexed or fixed-
indexed annuities.
Example is as follows
if the market went up 6% and the annuity's participation rate was 70%, a 4.2%
return (70% of the gain) would be credited. Many indexed annuities that have a
participation rate also have a cap, which in this example would limit the
credited return to 3% instead of 4.2%.
It is calculated as
The rate on an indexed annuity is calculated based on the year-over-year gain in
the index or its average monthly gain over a 12-month period.
A common formula used to calculate the interest credited to an indexed annuity
is as follows:
Indexed Interest Credit = (Index Gain/Index Starting Value) × Participation Rate
Question 1:
You have an indexed annuity with a participation rate of 80%. The chosen
market index has an index gain of 30 points during the crediting period, and the
index starting value is 2000. Calculate the indexed interest credit for this
annuity.
Solution 1: Indexed Interest Credit = (Index Gain/Index Starting Value) ×
Participation Rate
Indexed Interest Credit = (30/2000) × 80%
Indexed Interest Credit= (0.015) × 0.80
Indexed Interest Credit ≈ 0.012 or 1.2%
Question 2:
You are considering an indexed annuity with a cap rate of 10%. The chosen
market index shows an index gain of 12% during the crediting period, and the
index starting value is $3,000. Calculate the indexed interest credit for this
annuity, considering the cap rate.
Solution 2:
Indexed Interest Credit = min (Cap Rate, (Index Gain/Index Starting Value) ×
Participation Rate)
Indexed Interest Credit= min(0.1,( 12/3000) × 100 %)
Indexed Interest Credit = min(0.1,0.004 × 1)
Indexed Interest Credit=min(0.05,0.004)
Indexed Interest Credit=0.004
So, in this case, the cap rate limits the indexed interest credit to 0.4% (since
0.004 is less than 0.05).
DEFFERED ANNUITY
A deferred annuity is a financial product that provides a stream of income
payments at a future date.
Unlike immediate annuities, where payments typically begin soon after the
annuity is purchased, deferred annuities have a waiting or accumulation period
during which the invested funds grow tax-deferred.
The annuitant (the person who owns the annuity) can choose to receive regular
payments at a later date, usually during retirement.
FORMULA-
