The Present Value Formula Explained
An annuity is usually a legally binding contract between an individual who has sold an annuity and an insurance company. When an individual receives payments in an annuity, they are receiving a lump sum which is the entire face value of the annuity, less any pre-determined fees. The amount of money in an annuity is typically determined by how much of a lump sum to the insured will receive upon retirement. In order to better understand how annuities work, it is important to first look at how annuities actually work.
Annuities are payouts which are based on the present values of future payments. The present value of an annuity can be thought of as a stream of money that continues to increase with inflation until it is depleted. The future payment value of a structured settlement is essentially the same amount, depending on how long it will take the settlement funds to accumulate. The higher the discount rate, which can be anywhere from zero to about 5%, the lower the annuity’s present value.
Life annuities are one of two types: guaranteed or variable. With a guaranteed annuity the entire end date of the plan is set at the time of purchase; however, with a variable annuity payments can be altered at any time. Guaranteed life annuities include benefit payments, variable universal life annuities (VULA), and variable universal life (UVLA) plans. As for life insurance payouts, most people receive their payments in monthly installments called premiums.
A fixed annuity pays a fixed amount every month for the agreed period of time. The annuitant can choose to make additional payments which are applied to their principle or paid directly to the fund. These annuity payments are guaranteed regardless of the performance of the stock market or other factors. However, these payments are not without risks as there is no guarantee that the payer will live to the end.
A lump sum is included in the calculation of the present value of an annuity. The lump sum is equal to the present value multiplied by the number of years stated in the agreement. In order to determine the present value is subtracted from the amount of money the payer expected to receive. If the expected amount of money changes, the lump sum is adjusted accordingly. One disadvantage to lump sum payments is that the value may be affected by inflation. In order to adjust for inflation, most annuities are adjusted periodically.
Many financial institutions use a combination of present value formula and discount rates to calculate the initial value of retirement annuities. Present value is defined as the present cost less the future cost, while discount rates are used to determine the risk-adjusted initial payment amount. It is recommended to speak with a financial representative before purchasing an annuity. They can advise a person on the best annuity options available. While there are a number of reputable companies that offer annuity products, there are also many Factoring Companies that are known for low quality annuities.