The present value of an annuity is the sum that must be invested now to guarantee a desired payment in the future, while the future value of an annuity is the amount to which current investments will grow over time.
What Is an Annuity?
Though often associated with a specific insurance-related product, an annuity is any asset that generates regular payments for a set time period. This type of investment is often used by those preparing for retirement or for a period of planned unemployment. Depending on the types of investments used, annuities may generate either fixed or variable returns.
Annuities purchased by retirees are often sold by insurance companies. The insurance company takes a lump sum of money up front then invests it, minus fees. The company then pays out smaller sums of money over a period of time back to the beneficiary. There are several arrangements that can be made, and some annuities pay until the death of the beneficiary, thus shifting the longevity risk from the beneficiary to the insurance company. For insurance companies, this the income and payment stream model complements their other business lines nicely. With an annuity, insurance companies take in a lump sum up front, paying out a little at a time in a predictable stream, compared to other lines of insurance where small amounts are taken in over time in the form of premiums, then lump sums are paid out at unpredictable intervals.
Both the present and future value calculations assume a regular annuity with a fixed growth rate. Many online calculators determine both the present and future value of an annuity, given the interest rate, payment amount and duration.
Present Value of an Annuity
The present value of an annuity is simply the current value of all the income generated by that investment in the future – or, in more practical terms, the amount of money that would need to be invested today to generate consistent income down the road. Using the interest rate, desired payment amount and 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 the next 10 years.
Future Value of an Annuity
The future value of an annuity represents the amount of money that will be accrued by making consistent investments over a set period, assuming 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.