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The present value of an annuity is based on a concept called the time value of money. Payments scheduled decades in the future are worth less today because of uncertain economic conditions. In contrast, current payments have more value because they can be invested in the meantime.
That’s why $10,000 in your hand today is worth more than $10,000 over the next 10 years.
If you own an annuity or receive money from a structured settlement, you may choose to sell future payments to a purchasing company for immediate cash. Getting early access to these funds can help you eliminate debt, make car repairs, or put a down payment on a home.
Companies that purchase annuities use the present value formula — along with other variables — to calculate the worth of future payments in today’s dollars.
What Is the Formula for Calculating the Present Value of an Annuity?
Calculating present value is part of determining how much your annuity is worth — and whether you are getting a fair deal when you sell your payments.
In order to understand and use this formula, you will need specific information, including the discount rate offered to you by a purchasing company.
- Dollar amount of each fixed payment
- Number of payments you want to sell
- Discount rate
Discount Rates Affect Present Value
Factoring companies, or companies that will buy your annuity or structured settlement, use discount rates to account for market risks such as inflation and to make a small profit for granting you early access to your payments. A discount rate directly affects the value of an annuity and how much money you receive from a purchasing company.
Standard discount rates range between 8 percent and 15 percent. They can be higher, but they usually fall somewhere in the middle. The lower the discount rate, the higher the present value. Low discount rates allow you to keep more of your money.
According to the Internal Revenue Service, most states require factoring companies to disclose discount rates and present value during the transaction process. Always ask for these numbers before you agree to sell payments.
It’s also important to note that the value of distant payments is less to purchasing companies due to economic factors. The sooner a payment is owed to you, the more money you’ll get for that payment. For example, payments scheduled to arrive in the next five years are worth more than payments scheduled 25 years in the future. Keep this in mind during the selling process.
Ordinary Annuity vs. Annuity Due
Present value calculations are influenced by when annuity payments are disbursed — either at the beginning or the end of a period.
Annuity due refers to payments that occur regularly at the beginning of each period. Rent is a classic example of an annuity due because it’s paid at the beginning of each month.
An ordinary annuity is typical for retirement accounts, from which you receive a fixed or variable payment at the end of each month or quarter from an insurance company based on the value of your annuity contract.
Present Value of an Annuity Example
Let’s say your structured settlement pays you $1,000 a year for 10 years.
If you keep all your payments, you will eventually receive $10,000.
But what if you lose your job and need more than $1,000 a year to cover your expenses?
Let’s assume you want to sell five years’ worth of payments, or $5,000, and the factoring company applies a 10 percent discount rate.
In this example,
r= 10 percent, represented as 0.10
n= 5 (one payment each year for five years)
Therefore, the present value of five $1,000 structured settlement payments is worth roughly $3,790.75 when a 10 percent discount rate is applied.
If you simply subtracted 10 percent from $5,000, you would expect to receive $4,500. However, this does not account for the time value of money, which says payments are worth less and less the further into the future they exist. That’s why the present value of an annuity formula is a useful tool.
How Good Are Annuity Calculators for Estimating Present Value?
Many websites, including Annuity.org, offer online calculators to help you find the present value of your annuity or structured settlement payments. These calculators use a time value of money formula to measure the current worth of a stream of equal payments at the end of future periods.
Simply enter data found in your annuity contract to get started. In just a few minutes, you’ll have a quote that reflects the impact of time, interest rates and market value.
- Payment type
- Date of next payment
- How much each payment is worth
- Number of payments remaining
- How frequently you receive payments
This estimate is a great first step. It gives you an idea of how much you may receive for selling future periodic payments.
However, it isn’t perfect.
Learning the true market value of your annuity begins with recognizing that secondary market buyers use a combination of variables unique to each customer.
That’s why an estimate from an online calculator will likely differ somewhat from the result of the present value formula discussed earlier.
- Fees and extra charges
- Current annuity market rates
- Specific company guidelines
- Amount of money left in your annuity
- When annuity payments began
Use your estimate as a starting point for conversation with a financial professional. Discuss your quote with one of our trusted partners, who can explain the present value of your payments in more detail.
It’s also important to keep in mind that our online calculator cannot give an accurate quote if your annuity includes increasing payments or a market value adjustment based on fluctuating interest rates.
Email or call our representatives to find the worth of these more complex annuity payment types.
7 Cited Research Articles
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- Alanis Business Academy. (2012, October 7). How to Calculate the Present Value of an Annuity. Retrieved from https://www.youtube.com/watch?v=9L6eQUM23Ng
- Cooper, D., Franklin, M. & Graybeal, P. (2019, February 14). Principles of Accounting Volume Two: Managerial Accounting. Retrieved from https://openstax.org/books/principles-managerial-accounting/pages/11-3-explain-the-time-value-of-money-and-calculate-present-and-future-values-of-lump-sums-and-annuities
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