Present value and future value are terms that are frequently used in annuity contracts. The present value of an annuity is the sum that must be invested now to guarantee a desired payment in the future, while its future value is the total that will be achieved over time.
What Is an Annuity?
An annuity is a financial investment that generates regular payments for a set time period. In modern times, an annuity is most often purchased through an insurance company or a financial services company.
- Present value is the sum of money that must be invested in order to achieve a specific future goal.
- Future value is the dollar amount that will accrue over time when that sum is invested.
- The present value is the amount you must invest in order to realize the future value.
This type of investment is often used by those preparing for retirement or for a period of planned unemployment. Depending on the investor's choices, an annuity may generate either fixed or variable returns.
When you purchase an annuity, the insurance company takes a lump sum of money upfront and invests it, minus the fees it charges. The investor, in return, will receive an agreed sum of money at regular intervals over a period of time.
There are a variety of arrangements that can be made. The payments can begin immediately or may be delayed to a future date when the investor is ready to retire.
Some pay until the death of the beneficiary, thus shifting the longevity risk from the beneficiary to the insurance company. Couples frequently arrange for the payments to continue through the lifetime of the surviving partner.
Present value and future value depend on many individual variables.
All of these decisions affect the precise amount that the beneficiary will receive in the monthly annuity payment.
The calculation of both present and future value assumes a regular annuity with a fixed growth rate. Many online calculators determine both the present and future value of an annuity, given its interest rate, payment amount, and duration.
Present Value of an Annuity
The present value of an annuity is the current value of all the income that will be generated by that investment in the future. In more practical terms, it is the amount of money that would need to be invested today to generate a specific income down the road.
Using the interest rate, desired payment amount, and the number of payments, the present value calculation discounts the value of future payments to determine the contribution necessary to achieve and maintain fixed payments for a set time period.
For example, the present-value formula would be used to determine how much to invest now if you want to guarantee monthly payments of $1,000 for 10 years. To achieve a $1,000 annuity payment for 10 years with interest rates at 8%, you'd need to invest $6,710.08 today.
Future Value of an Annuity
The future value of an annuity represents the total amount of money that will be accrued by making consistent investments over a set period, with compound interest.
Rather than planning for a guaranteed amount of income in the future by calculating how much must be invested now, this formula estimates the growth of savings, given a fixed rate of investment for a given amount of time.
The future-value calculation would be used to estimate the balance of an investment account, including interest growth, after making monthly $1,000 contributions for 10 years. In this case, assume interest rates are 8% (which is also the growth rate), after 10 years, the future value is $19,990.05.