Annuity

Before you rely on it

What to check

Find out which convention the quote assumed before comparing two products.

The common error

Where people go wrong with annuity

Comparing a quote built on one convention against a calculator set to the other. The products look different when only the timing assumption is.

Worked through

Annuity in plain numbers

Save $1,000 at the end of each year for five years at 5%; the first deposit grows for four years, the last for none, and the total comes to $5,525.63. Now save $1,000 at the start of each year instead. Every deposit earns one more year of growth, so the total is 5,525.63 × 1.05, which is $5,801.91. Same payments, same rate, $276.28 more, purely because of timing, and read a quote for an annuity and one of the first things to find is whether it assumes payments at the end of the period or the start.

Easily confused

Annuity and its neighbours

An annuity is a stream of equal payments, and the word is used for two different products. In finance it is any regular series of payments, such as loan installments or lease rent. In insurance it is a contract you buy with a lump sum in exchange for income, sometimes for life; the math of the first underlies the second. An annuity is also not a perpetuity, which never ends, or a lump sum. Fixed, variable and indexed contracts differ a lot in cost and risk, so the shared name should not suggest shared terms.

In real decisions

Where annuity turns up

Loans are annuities in reverse: you receive a lump sum and repay a stream. Pension payments, structured settlements and lease agreements are annuities too; retirees weigh buying a lifetime annuity against drawing down savings; planners use annuity formulas to work out how much to save monthly to reach a target, or how long a nest egg lasts at a given withdrawal. The present value of an annuity is how a lender decides how much a payment stream is worth today.

Know the edges

Where annuity stops being reliable

The standard formulas assume a constant rate and level payments. Inflation erodes a fixed payment over time, and the rate you earn may not stay the same. Insurance annuities add fees, surrender charges and the credit risk of the insurer, and the formulas also assume you know how long payments last, which is uncertain for anything tied to a lifetime; use calculators for the arithmetic, and read the contract for the terms that no formula captures.

Quick answers

What people ask about annuity

Is an annuity a good way to get retirement income? It can be, for people who value certainty. A lifetime annuity trades a lump sum for payments that continue however long you live, at the cost of flexibility and, often, inflation protection. Compare fees, the insurer's strength and alternatives before buying.

What is the difference between an annuity due and an ordinary annuity? Timing. An ordinary annuity pays at the end of each period, an annuity due at the start. Because each payment earns one more period of interest, an annuity due is worth more.