Calculating the present and future value of an annuity can help you decide whether to buy an annuity or what to do with the one you already have. The present value is handy to know if you want to compare the windfall from selling an annuity against its expected payments in the future. The future value lets you know what your account will be worth after a period of contributions and growth before annuitization. Keep reading to learn how to calculate each value and how to use this knowledge to secure your future.
How Annuities Work
An annuity is an insurance product that provides guaranteed payments starting at a certain date in exchange for a lump sum payment or premiums paid over time. Your contributions grow in the annuity account at an interest rate that’s either guaranteed by the insurance company or tied to market indexes and funds. The longer your money grows in an annuity account, the more you benefit.
Different annuities offer different advantages and considerations. With a fixed annuity, your contributions grow at an interest rate set by the insurance company. With a variable annuity, your account follows the ups and downs of the market with the benefit of guaranteed income when the contract matures. An indexed annuity is tied to an index like the S&P 500 and it grows with the market while offering a guaranteed minimum rate of return as well as protection of principal if the market performs poorly. Because there is a minimum floor, there is also a cap on growth.
After it matures, an annuity contract can pay you a fixed income amount for the rest of your life or a set number of years, whichever you decide. If you choose lifetime income, payments stop upon your death in most scenarios.
Why Calculate Present and Future Value?
Present value (PV) and future value (FV) calculations hinge on the time value of money. This concept states that a sum of money in the future is worth less than the same amount today because it could have been invested.
You can calculate the present value to see what you’d need to invest today to earn a specific payment amount in the future. Or, you can compare the future and present values of an annuity to decide if you want to sell a mature annuity for extra cash flow.
How To Calculate Your Annuity’s Present Value
The present value of an annuity is the value of all future payments taken together. It’s helpful if you’re deciding, for example, whether to take a lump sum from your pension or 401(k) plan or start an annuity. It’s also helpful to know if you want to sell an annuity for cash. The present value can tell you how much you have to invest in an immediate annuity to get payouts of a certain amount, too.
Let’s say you want to buy an immediate annuity and get a payment of $10,000 per year for 10 years. The annuity has a 4% interest rate and annual payments start the next calendar year. You get the same payout in year one as in year ten, but by that time, the $10,000 payment is worth slightly less than in today’s dollars.
Now, the price for the immediate annuity will be less than the total payout of $100,000 to take this into account. This is because of the discount rate. The interest rate is called a discount in this equation because it represents the value lost when set payments aren’t increasing with the market. It’s what makes the $10,000 payment in year one worth more than the $10,000 payment in year 10.
Here’s the present value annuity formula:
PMT x [(1 – [1 / (1 + r)^n]) / r] = The Present Value of the Annuity
And here’s what each variable means:
- PMT: The amount the annuity pays you per period
- r: The interest rate per period
- n: The number of expected payment periods
Annuity Present Value Formula Example
So, let’s figure out a simple example with the present value calculation. This assumes payments start immediately. The payment is $10,000 per year, the interest is 4% (or 0.04 written as a decimal) and the number of expected payments is 10:
$10,000 x [(1 – [1 / (1 + 0.04)^10]) / 0.04] = $81,109
You can see that the total value is not $100,000 but $81,109. The difference accounts for any interest lost as each periodic payment lowers the account’s principal. So, an immediate annuity that pays $10,000 per year for 10 years should cost about $81,109 with a rate of 4%.
Keep in mind that the formulas in this article assume a fixed rate of return. For indexed and variable annuities, the interest rate would be an estimate based on expectations in the market.
Should You Sell Your Annuity?
Many companies buy annuities so annuity holders can get cash now instead of payments later. These companies will calculate the present value and they may charge fees on top of that. So, is it worth it to take a lump sum of $81,000 today instead of $100,000 in payments over time? It could be if you invest it in higher-yield options and can get a good interest rate. But if you need to spread your income out over the years, it might not be the best option.
How To Calculate Your Annuity’s Future Value
The future value of an ordinary annuity tells you how much your account would be worth after an accumulation phase when you make contributions. In this case, you’re investing money to receive the benefit of compounding interest. Each year after the first year, you get an interest payment from the annuity. The interest that is generated on annuities is tax-deferred, so there is no tax due on the growth until the time of withdrawal. And each year’s interest payment builds on the previous one.
The future value lets you visualize the growth in your account over time. This is helpful if you’re thinking about purchasing a deferred annuity. Here’s the formula to calculate future value:
PMT x [ ([1 + r]^n – 1) / r]
And here’s what each variable means:
- PMT: The payment you make into the annuity account
- r: The expected rate of return
- n: The number of payments expected
Annuity Future Value Formula Example
Let’s take a different look at the previous example. Say you plan to contribute to a fixed annuity with a 4% rate of return for 10 years, and you’ll make contributions of $10,000 each year. You will have paid $100,000 in total, but the account will be worth more than that considering compounding interest.
$10,000 x [ ([1 + 0.04]^10 – 1) / 0.04]
= $120,061
While the PMT variable is used in both equations, it represents the payments you receive from an annuity for present value but the payments you make during accumulation for future value.
Comparing Present and Future Values
As we covered above, an annuity can have different values depending on how you look at it. Here’s a quick reference on when to use present or future value:
| Use Present Value | Use Future Value |
| To compare taking a lump sum from a pension or other source, or to opt for a series of annuity payments | To see how an annuity account can grow over time |
| To see how much to invest in an annuity for a certain payout | To plan how to best allocate funds between retirement accounts |
| Compare the value of different annuity payment options or payment schedules. | |
| When considering selling an annuity for cash |
Factors That Impact Your Annuity’s Value
A few factors that affect your annuity’s value include the interest rate, payment amount, payment period, and fees.
- Discount rate: The discount rate is the rate of return that discounts future cash payments. It’s synonymous with the interest rate of an annuity. When you calculate the total value of multiple fixed payments over time, this rate decreases the total in relation to today’s money, so it’s called a discount. The higher the discount rate, the lower the present value of the annuity, because the future payments are discounted more heavily. Conversely, a higher discount rate results in a greater future value for an annuity, because that means the annuity is earning more interest.
- Payment amount: A higher premium payment increases future value when building up an annuity account. If you’re calculating present value, a higher income payment received from the annuity increases value.
- Payment periods: Having more payment periods gives more time for interest to compound.
- Fees: Fees aren’t included in quick calculations for future or present values, but they can affect your selling options or how much interest your account receives.
- Taxes: Keep in mind the impact of income taxes if, for example, you’re trying to determine whether to take a lump sum now or payments at a later date. A lump sum payment from an annuity will incur a higher tax obligation than an annual payment, especially if the lump sum is large enough to move you into a higher tax bracket.
How Do These Values Impact Your Retirement Plan?
Between annuities, pensions, IRAs, and 401(k) plans, there’s a lot to think about when planning for your retirement. An annuity can be a great way to get income for life or supplement other investments. The value of an annuity at different points in time can present you with different opportunities.
It’s true that $100,000 in your pocket today is worth more than 10 payments of $10,000 over 10 years. However, this assumes you’ll invest the $100,000 and let it grow for 10 years. If you’re retiring soon, that might not be realistic.
Plus, it takes good money management skills to make $100,000 last and grow. Using a lump sum from a pension or 401(k) to buy an annuity provides security that payments will last for a specified period or even for the rest of your life.
Gain Clarity With an Annuity Agent
As you can see, calculating present and future value is a complex task. It’s even more complicated if you’re dealing with an indexed or variable annuity. An expert can help you look at present and future value while taking into account all the variables in your situation. Reach out to one of our trusted annuity experts today.
Disclaimer: All guarantees are subject to the claims-paying ability of the insurer.
