Annuities

If a fixed amount of money earns interest that is compounded periodically,

by now, we know how to find its future value. The truth is most people and financial institutions do not deposit money and then sit back, and watch it grow.

Money is usually, invested in small amounts at periodic time intervals. Some examples are: Life insurance premiums

Regular deposits in a bank

installment loan payments

Definition: An annuity is a sequence of

equal periodic payments.

When the payments are made at the same time the interest is credited, i.e. at the end of the time interval, the annuity is called an ordinary

annuity.

We consider only such annuities in this course.

The future value of an annuity is the sum of all payments made plus all interest earned.

Example
Equal annual deposits of $100 are made into an account that pays 10% interest compounded annually. Find the future value of this annuity after 4 years.

One way of solving this problem is to use the

Compound Interest Formula

We find the value of each of the four deposits at the end of the 4-year period. The first deposit, made at the end of the first year, will accumulate interest for 3 years. Its value will be

v1 100 1 .10 133 .10 .

3

The second deposit, made at the end of the second year, will accumulate interest for 2 years.
Its value will be

v2 100 1 .10 121 .00 .

2

The third deposit, made at the end of the third year, will accumulate interest for 1 year. Its value will be

v3 100 1 .10 110 .00 .

The fourth deposit, made at the end of the fourth year, will earn no interest. Its value will be

v4 100 .

The value of the annuity after 4 years is obtained by adding the accumulated amounts. Its value will be 133.10 121.00 110.00 100 $464.10

There is another way of solving this problem: using the TVM

Solver

Example
Equal annual deposits of $100 are made into an account that pays 10% interest compounded annually.
Find the value of this annuity after 4 years.

We need to know FV, the future value. Since interest is compounded annually, C/Y=1 and P/Y=1. Over the 4-year period, there will 4 times 1 compounding periods, so N=4. There was no investment at the beginning of the 4-year period, so PV= 0. The annual rate of interest is 10%, so I=10. Each annual deposit, payment to the account, is of $100, therefore, PMT= -100.
Note that we enter a negative number for cash outflow.

We now proceed to find FV. Set FV=0. Place the cursor in FV=0.
Press the ALPHA key (underneath the 2nd key), then the SOLVE key (same as the Enter key) You should see on your screen: FV= 464.1

The positive sign indicates that the investor will receive $464.10 at the end of the 4 years.

We just solved the same problem in two different ways. Which method do you prefer? Many would choose the TVM solver. With this in mind, we will not use a number of formulas to study annuities. we will use the financial capabilities of our calculators.

Some of the advantages of this approach are:

more problems can be done in less time, the effects of small changes in investments can be quickly explored, and we are equipped for the real-world, where one uses computers with financial calculators to make financial statements in virtually no time.

Example
Jenny decides to put aside $100 every month in an insurance fund that pays 8% compounded monthly. After making 8 deposits, how much money does she have? How much of this amount is interest?

We need to know FV, the future value. Interest is compounded monthly, so C/Y=12 and P/Y=12. She makes a total of 8 payments, so N=8. There was no investment at the beginning, so PV= 0. The annual rate of interest is 8%, so I=8. Each monthly deposit, payment to the account, is of $100, therefore, PMT= -100.
Note that we enter a negative number for cash outflow.

We now proceed to find FV. Set FV=0. Place the cursor in FV=0.
Press the ALPHA key (underneath the 2nd key), then the SOLVE key (same as the Enter key) You should see on your screen: FV= 818.92

The positive sign indicates that Jenny will receive $818.92 from her investment. Since she invests only $800, she earns $18.92 in interest.

Example
Harry, age 35, decides to invest in an Individual Retirement Account (IRA). He will put aside $2000 per year until he reaches age 65. a) How much will he have at age 65 if his annual rate of return is assumed to be 10% compounded annually? b) What would his IRA be worth if Harry had begun it at age 25?

a) We need to know FV, the future value, after 30 years. Interest is compounded yearly, so C/Y=1 and P/Y=1. He makes a total of 30 payments, so N=30. There was no investment at the beginning, so PV= 0. The annual rate of interest is 10%, so I=10. Each annual deposit, payment to the account, is of $2,000, therefore, PMT= -2000.
Note that we enter a negative number for cash outflow.

We now proceed to find FV. You should see on your screen: FV= 328988.05

So Harry will have $328, 988.05 in his IRA at age 65.

b) We need to know FV, the future value, after 40 years. The values of the TVM variables remain the same as in part a) except N which is now 40. We now proceed to find FV. FV= 885,185.11

So Harry would have $885,185.11 in his IRA at age 65.

What a difference! By investing just 10 years sooner, Harry could have earned three times the interest he will earn from his investment started at age 35.

This example shows that it is not only important to save but to start doing so early.

Definition
The account established for accumulating funds to meet a future obligation is referred to as a Sinking Fund. A company may want to reach a certain savings goal. A person with a debt may decide to accumulate sufficient funds to pay off the debt.

Such goals may be achieved by agreeing to set aside enough money each month (or quarter, or year, and so on)

Example
How many years will it take to save $1,000,000 if a small company places $1000 per month in an account that earns 8.915% compounded monthly?

We need to know N, from which we can find the number of years. Interest is compounded monthly, so C/Y=12 and P/Y=12. The annual rate of interest is 8.915%, so I=8.195. There was no investment at the beginning, so PV= 0. The future value is $1,000,000, so FV=1000000. Each monthly deposit, payment to the account, is of $1,000, therefore, PMT= -1000.
Note that we enter a negative number for cash outflow.

We now proceed to find N. N= 288 Dividing by 12, we obtain 24 years. This is how long it would the company to achieve its goal.

We can easily find the total interest earned over a certain period of time. But sometimes we need to know, say for tax purposes, the interest earned over each compounding period.

Example
$2,000 is deposited at the end of each quarter for 2 years into an ordinary annuity earning 7.9% compounded quarterly. Construct a balance sheet showing the interest earned each quarter and the balance at the end of each quarter.

8 deposits are made over the 2-year period. The values of the TVM variables are: I=7.9 PV=0 PMT= -2000 P/Y=4 C/Y=4 We determine the balance after each quarter by finding the future value, FV, when N takes the values from 1 through 8. Well find the interest earned for each quarter by subtracting the previous balance as well as the current payment from the balance for that quarter.

When N=1, FV=2000. End of quarter # 1 Payment 2,000 Balance 2,000 Interest 0

i.e. the first deposit, made at the end of the first quarter, earns no interest at that time.

When N=2, FV=4039.50 End of quarter # Payment Balance Interest

2,000

4,039.50

39.50

i.e. when the second deposit is made at the end of the second quarter, the first deposit earns interest at that time.

Continuing this way, we obtain: