What is Annuity and Term Life Insurance? Basically these two are the same things but for different reasons. Annuity refers to any structured financial agreement that promises a fixed amount of income over a certain period. Once the person reaching the agreed upon age, the amount of money settled for will be paid directly to him/her without the need of any kind of financial institution or bank. This type of settlement is called an annuity and is usually managed by a financial advisor on behalf of the person who has signed the agreement.
However, there are some annuities that are paid on a direct basis. The present value formula is used to determine the amount of compensation to be paid out. The present value formula involves the use of certain factors like interest rates, carrier rates and life expectancy of the person who has mortgaged his/her annuity in the deal. This method of calculation is what is used in all kinds of insurance contracts where future payments are involved. If the carrier is expected to pay future payments the present value formula is used. There are various factors considered in this process of determining the value of future payment.
A carrier rate is a fluctuating economic indicator that is used to determine the present values of future payments in the annuity case. For example, if there is a long-term deferred annuity plan with a guaranteed return of 5% per year for the first five years and the remaining period is then at a steady rate of around 2%, the carrier rate will remain at that level for the next ten years. If however, after the ten years, the rate for the first five years has dropped to zero, then the present value is calculated as zero. This is due to the fact that the money that would have been received under the plan can now be invested in a completely different field with better returns.
The life expectancy of the person getting the annuity ensures that he/she receives the same present value on his/her annuity according to the present time. This concept is very important because it will ensure that the person who gets the payments scheduled gets the same amount regardless of his/her age at the time of signing the contract. However, there are certain factors that can cause a slight change in the actual present value. These include the amount of time left until the maturity of the annuity (which may vary depending on the carrier rates at the time), the amount of increase in premium and the amount of increase in death benefit over the time. These factors are usually ignored by most companies when calculating the present value.
It is therefore important to understand that the annuity purchasing company uses a discount rate for the calculation of the present value. This rate is a percentage that the purchasing company considers as being an average of all the premiums it charges for annuity policies. In simple terms, it is the average amount that you would get on your annuity if you were to purchase it at the current market price. There are two reasons why the present values used in discount rates are used instead of the actual present values. First of all, the rate allows a more accurate calculation of the present values by allowing for reasonable assumptions about future prices (for example, the cost of living increase over time).
The second reason is that the discounted value provides for a more conservative estimate of the future value than does the present value calculation. In other words, if a company has an annuity policy that has a discount rate of 10% and it predicts that in ten years’ time, it will have a higher present value, then the actual present value calculation would be too pessimistic. On the other hand, with a discount rate of zero percent, it will not be possible to calculate the present value. Therefore, the annuity purchasing company uses the discount rate to arrive at its estimates of the present values.