What is an Annuity?
An annuity is a fixed sum of money paid at regular intervals. “Annuity” comes from the Latin for “year”. In the context of life insurance, it is a contract between you and an insurance company under which the insurance company pays you money for a stipulated period — often for life. The payments are frequently monthly. The person receiving the payments is referred to as an “annuitant.”
Types of Annuity purchase options in India
a. Deferred annuity
Deferred annuity means annuity payment commence after a certain deferment period which may be a fixed term or after attaining a certain age. You pay a fixed sum over a pre determined period (3 to 25 years) and thus build a corpus. At the end of the payment the corpus continues to grow. Then at a pre-determined age, the annuity payment starts. This option is taken at a young age (around 30 years). The payout starts at a later age. Say at 60. The payout continues as per the payout option chosen by the insured. The premium (or part of it) is tax deductible. The tax advantage makes this very attractive. But the annuity payouts are taxable in your hand. But since the other income may be less, this may not matter too many.
b. Immediate annuity
In immediate annuity the annuity payment commence immediately (from 1st of next month) after sum deposited for the insurance.You pay out a lump sum and purchase the annuity.
How to determine how much money an annuity would generate yearly?
If you select a fixed annuity, then it would be fairly simple to determine how much money your annuity would generate yearly by simply applying the guaranteed interest rate for the period. You must remember, though, that interest is compounded. Over time, the original fund grows as you apply interest not just on the original fund but also on the interest earnings it has earned for the previous periods.
With the help of mathematics formula, you can determine how much money an annuity would generate at a given year, provided that the interest rate remains constant throughout that time. All you need to know is :
1- How much money is invested annually?
2- How much interest will be applied annually?
3- The number of compounding periods (how many times the fund was applied compounded interest within a given period?). In most cases, the interest is compounded annually.
Future value of Annuity Formula
N = (P/r)( (1 + r)n – 1)
P = Sum deposited at the end of each year (beginning one year from when the annuity “starts”)
r = Interest rate, as a decimal (5%, for example, is r = 0.05)
n = Number of years the annuity has run
N = Total amount accumulated at the end of n years.
If you invested Rs.5,000 at a guaranteed interest of 5% for 20 years, then annuity would be –
N = (5000/0.05)( (1 + 0.05)20 -1)
= 100,000(2.6533 -1)
Calculate Annuity using MS Excel
Enter details of P, r, n and use FV formula of excel –