You Don’t Need to Be Genius to Understand the Annuity Formula

Annuity FormulaOkay.  I’m a big financial nerd.

(As if you couldn’t guess – I own a financial blog).

There are things about financial planning that I just HAVE to know.  And one of those things is this: I like knowing how the things I invest in actually work.

So the other day I an article about annuities caught my eye and I decided I wanted to look into it more.  All the article did was slam annuities for being so confusing.  But then in the same text it said that annuities have been around since the time of Romans.  So what gives?

I think the secret to the whole thing is in understanding the annuity formula.  In case you don’t know what that is, it’s the method of calculating income that is derived from an annuity plan over the term of the contract. In short, if you want to know how much money you can expect to receive on your investments over time, you need to know the formula that allows you to arrive at that number.

Looking at the actual annuity formula can cause even a professional financial wizard’s eyes to glaze over. It’s a combination of letters that represent fund amount, annual annuity, interest rate, term and payout. The reason it looks so complicated is because it uses a geometric series that only math geniuses really understand. Fortunately, you don’t have to be a genius to know what your income stream will be at the end of your annuity’s term. There are tools available to you that can help you get the information you need without the brain damage that comes with trying to calculate the annuity formula on your own.

 

Understanding the Formula Behind Annuities:

While you do not need to know the actual formula to know how much you can expect to get from your annuity, it is helpful to know what investment experts are actually doing when they come up with your number. Essentially, an annuity plan pays out money to you at regular intervals.

The annuity formula provides you with an estimate of what the future value of an annuity will be. Knowing this amount will help you with your financial planning by giving you an idea of how much money you will have to work with in the future.

When using this formula, you are basically determining the value of your money over time. You know that when you make a deposit into an interest-bearing account today, it will be worth more in the future. This is because the interest accrues over time, compounding your initial investment.

The formula takes into account the present value (PV) of your investment and the future value (FV) of that same investment. When you subtract the PV from the FV, you get your return on investment (ROI), which is the only number that really matters when it comes to what you want to know.

 

Example of the Annuity Formula at Work:

The pieces of information you need to have before you can use the annuity formula are the present value, the interest rate on the annuity and the length of time your money will be held in the account (term). Pretend you are depositing $100 into your annuity account. If your annuity has an interest rate of five percent that compounds annually and you are keeping your investment for five years, the present value of your investment is $105 or $100 plus five percent interest.

To find the expected value of this investment at the end of the five-year term, you must take the present value and multiply it by 1 + 5% to the power of 5. This gives you your future value. In this case, the calculation would look like this:

$100(1 + .05)= FV

Your initial $100 investment will be worth $127.63 in five years. By leaving your money alone, you will have not only the principle amount you invested, but $27.63 of free money to use in the future. Imagine how much money you could have if you invested a lot more money in an account that has a higher interest rate!

 

No Need for Complicated Math Skills:

Fortunately, in this day of technology, you don’t have to calculate the annuity formula yourself. There are numerous annuity formula calculators on the Internet that can perform the complicated math for you. You just need to know how much the present value of your annuities are, how much interest they are earning and how long they will be earning that amount of interest. This will give you an estimate of your future value.

You can also ask an expert what your future value will be if you invest in a specific annuity. All financial professionals know how to work the annuity formula if they are worth their fees. In fact, if you are looking to partner with a financial advisor but don’t know how to determine the best one for you, ask the candidates to calculate your future value of one of their annuities. If they can do this, you have a good reason to work with them. If not, you probably want to pass.

 

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Comments

  1. says

    Nice post! I am also a financial nerd (and also run a finance blog haha), but I think it’s very important, like you said, to understand what you invest in. Whether I make gains or losses, I want to know why.

    I think this is a great explanation of annuities and I love how you incorporated the formula. I don’t think annuities have to be as scary as some people believe.

  2. says

    I enjoyed the explanation of how annuities work. I really don’t know a whole lot about annuities or when they make sense to purchase. I don’t think I know of anyone who has invested in an annuity before.

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