The present value of an annuity is the current value of that plan if you take the money now, instead of allowing it to continue providing periodic payments, as originally intended. The amount will always be less than the original investment.
Would you take a lump-sum payment of $5,000 now or divide it into five yearly payments of $1,000?
Most people would take the money now. Why? Because money in your hand now can be invested and allowed to earn interest, while any stream of money received in future payments is subject to inflation.
The present value of your annuity is the future value with discounts applied to show its current value as if that amount existed today.
When it comes to selling annuity payments, having money in your pocket allows you to make large purchases now or reallocate finances that could possibly generate greater returns through other investment vehicles.
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Before you make a decision to sell your annuity, you should evaluate what your money is worth right now.
For example, a $5,000 annuity that provides you with five annual payments of $1,000 at 6 percent interest. The present value of that annuity would be $4,210.20.
Let’s take a few moments to go through the math in determining that amount. First, figure your cash flow period or dollar amount of payments received (C), interest rate (i) and number of periodic payments (n).
Next, use this formula to determine present value of your annuity:
Present Value of Annuity = C x [1-[1/(1+i)n]]/i
Present Value of Annuity = $1,000 x [1-[1/(1+0.06)5]]/0.06
=$1,000 x [1-[1/(1.338)]]/0.06
=$1,000 x [1-[0.7474]]/0.06
=$1,000 x [4.2102]
Present Value of Annuity = $4,210.20.
Looking at the present value of your annuity, you may notice that you are receiving less than you originally contributed.
While an annuity provides the guarantee of a specific payment amount, unless you figure interest adjustments in your annuity, you may lose the value on the money you invested as time goes by.
If your annuity payments stay the same throughout retirement, and you are relying solely on this income base in the future, it is likely the quality of your lifestyle will decline in retirement.
Are you planning to change your lifestyle if your future income makes regular living expenses or certain luxuries unaffordable? When facing the increased costs of medical care as you age, it will be necessary to adjust your regular budget.
No. The amount you receive for selling your annuity payments is based on factors such as how many of your payments you have left, how many payments you intend to sell, the amount you receive in each payment and the competitive market of purchasing annuity payments.
If you surrender your annuity to the insurance company that issued it, then you will be subjected to a fee based on the original contract.
The present value of your annuity just gives you an idea of what your annuity is worth in the future with today’s dollars.
Annuity valuation often comes into play when determining the suitability of court settlements, taxes on states lottery jackpots, ensuring pensions are equitable distributions, and looking at an annuity contract for estate tax purposes.
Present value calculations are helpful for mortgages, loans, sinking funds, bonds and other investments. When determining where to invest your money, the time value of money is a key determiner of worth.
For example, you can utilize principals of present value to determine whether or not you will accept your company’s pension or take a lump sum now.
It can also be applied in a lawsuit where a structured settlement was intended to resolve a case. The plaintiff will accept a settlement of a lower value in a lump sum using present and future values (how much you will have in the future with a given rate of return) to determine that payment is fair.
Keep in mind this accounting concept doesn’t just relate to structured settlements and single premium indexed annuities, but also any series of fixed regular payments over a specified time period.