Annuities are a fantastic financial vehicle for gaining a steady income later in life. And there are plenty of options, so you can customize your contract to suit your financial goals.
Ordinary annuities are one such annuity type, and they’re best for those who want payouts at the end of periodic intervals, like monthly or yearly — rather than right away or at the start of these intervals.
Read on to find out whether an ordinary annuity is the right fit for you.
An annuity is a financial product where you contribute money in a lump sum or via various deposits. After the account’s maturity, you receive periodic payments (similar to a regular income).
An ordinary annuity disperses these payments at the end of periodic intervals — monthly, quarterly, or annually. This contrasts with an annuity due contract, which provides payments at the beginning of each payment period.
So if you purchase an ordinary annuity that pays $1,000 monthly for 10 years (or 120 annuity payments), you’ll receive your payments at the end of each month until the contract is complete.
As with any annuity, the first step is to deposit money into the account via a lump sum or a series of small payments. Throughout the term, your money grows. Your annuity may have a fixed interest rate, a fixed index rate (tied to an index like the S&P 500®), or a variable interest rate. When your annuity contract reaches maturity, you receive payments.
With an annuity due contract, the payment starts immediately after the maturity period. And with an ordinary annuity, you receive your payments at the end of each period.
Consider two fixed 5% 10-year annuities that both mature on January 1 and pay $500 monthly payments:
So why would you wait a month to get your first $500 installment? Because, since an ordinary annuity allows the provider to hold the money for an additional period, they usually offer a discount rate on the purchase price.
A good way of understanding how ordinary and annuity due contracts differ is via the present value calculation. The present value (PV) is what a series of guaranteed future payments is worth today. It’s the opposite of future value (FV), which is what the annuity will be worth at some future date.
Individuals and institutions invest money with the expectation of a greater return in the future. For example, a $100,000 investment today may yield $120,000 in five years. Without this expectation of gains, there’s no incentive to give up immediate and free access to the funds.
Here’s the formula financial institutions use to calculate the present time value of an ordinary annuity:
PVord = pmt × (1 - ( 1 + r )-n ) / r
Where:
Consider an ordinary annuity with the following variables:
For simplicity, the example uses years instead of months. This annuity pays $1,000 annually for 10 years, starting on the 11th year. There’s a 5% compound interest rate annually. Using the present value formula, we can calculate the present value (PV) of the ordinary annuity:
PVord = 1000 × (1 − ( 1 + 0.05)−10) / .05 = $7,722
As a purchaser, you may have to pay a little more than the present value for this annuity to cover fees and commissions, but the PV calculation gives you a starting point to determine the appropriate price.
An annuity due works almost identically to ordinary annuities, but you receive your first payment immediately after your investment reaches maturity. For that reason, the present value calculation is different (same shorthand here except due means annuity due):
PVdue = (pmt × (1 − ( 1 + r )−n ) / r) × (1 + r)
The PVord and PVdue formulas are similar, but to calculate PVdue you multiply it by one period of interest (1 + r), which increases the present value.
Here’s an example of how the difference in calculations affects the present value of an annuity due versus an ordinary annuity:
PVord = 1000 × (1 − ( 1 + 0.05)−10) / .05 = $7,722
PVdue = 1000 × (1 − ( 1 + 0.05)−10) / .05 × 1.05 = PVord × 1.05 = $8,108
The annuity due’s present value is $386 more than the ordinary annuity’s. So you, as the purchaser, should pay less for the ordinary annuity.
Before purchasing an ordinary annuity, first consider these important elements and determine whether this contract type’s features align with your goals.
When choosing between a front-paying annuity due and an ordinary annuity, make sure the products are the same types of annuities with similar parameters. Say an insurance company is offering an annuity due and an ordinary annuity. Both pay $1,000 per year at a fixed annual interest rate of 5% for 10 years.
You know from the calculations in the previous section that the present value of the ordinary annuity is $7,722, and the present value of the annuity due is $8,108. If the price for the annuities is $7,800 and $8,200, respectively, you would know that the ordinary annuity is a slightly better deal since it’s only $78 over the present value as opposed to $92 in the case of the annuity due.
You can make this argument because both contracts have the same payment amount, interest rate, and number of payment periods. However, it isn’t easy to compare the ordinary annuity in this example with a variable 5-year annuity due because they’re two different products.
Going back to the previous section’s example of an ordinary annuity versus annuity due, the ordinary annuity’s present value is almost $400 less than the annuity due’s present value. Assuming the insurance company’s pricing reflects the difference, is it worth saving a few hundred dollars at the time of investment if it means delaying payments for a year? The answer to that question depends on your retirement plan and whether you feel that you’ll be able to afford to delay your annuity payments.
This communication is for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice.
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