Time Value of Money
The following paper will explain how annuities affect TVM (Time Value of Money) problems and investigate outcomes. Starting with annuities, it came to light that annuities work best when based on longevity since the principal investment is broken down and distributed over the term of the annuity.
An annuity is a series of regular periodic payments comprising principal and interest. In the case of retirement, an annuity is usually purchased from an insurance company who then pays the purchaser a monthly amount while still alive. Annuities may have more complicated features such as indexing, guarantee periods and benefits payable to a spouse or other beneficiary after death. (Agents, 2006)
Annuities are used to preserve a cash investment and there are a few types of annuities which include CD, fixed, equity, and immediate. (Annuity Advantage, 2006) Since annuities are a safe place to keep money they offer a lower return than some of the more risky investment avenues such as stocks. When an individual purchases an annuity, they usually pay a lump sum to an insurer. The insurer then takes this (premium) and divides by an annuity factor based on mortality, current interest rates and payment features.
In this case the interest is the amount paid to the individual by the insurance company for the privilege of using the individual's money. Interest is usually calculated as a percentage of the principal balance of the loan, and the security comes from the interest rate being fixed. Regular savings accounts have an adjustable interest rate. However, a savings account compounds the interest and annuities do not. Compounded interest is interest that is paid on both the principal balance of the loan and on any accrued interest.
When looking at annuities compared to traditional stocks it is important to understand the present value of the payment received and the future value of the investment. The present value of a future payment is calculated by first determining how many years until the payment is received, and then using the interest rate to establish how much you would be paid on the money if you invested it from now until the future payment is received. That amount is deducted from the principal.
So, let's say that you inherited $100,000 and had the choice of collecting all of the money now, or all of the money in three years. Ignoring the obvious that you would want your money now, let's look at the present value of the future payment received. If we take the first option and invest it for three years, at an interest rate of 5%, after the first year the $100,000 would be worth $105,000. After the second year you would have $110,250 and at the end of the third year you would have $115,762.50. So working the numbers backward, if you waited three years for the $100,000 it would be the same as getting $84,237.50 right now. So the difference in three years is huge, and knowing this before you come into some cash is a huge advantage. I hear so many people say that if they won the lottery they would take the 20 year payment plan, and so many others say that they would take the lump sum. By looking at it with the scenario described above it is easier to make an educated decision about your money.
Now since we just invested the $100,000 for three years at 5% we may wonder if this investment was our best option. Opportunity cost is the value of the best alternative use of a resource (BioSociety, 2006); in this case the best alternative use of our $100,000. This basically means, how much could and would we have made if we had not invested the $100,000 the way we did which we know gave us $X in return.
Considering a three year term we may have made more money by investing in an annuity, but if it were a three year term the annuity would expire in three years and we would have to deal with the $100,000 again if we had not spent it. If the annuity paid us 36 payments with all things being equal, we would have reeled in 36 payments of about $3,216. That amount would be pretty easy to spend and at the end of three years we might have nothing. Whereas the $100,000 in our other investment (wherever we put it earning the 5%) would still be there in three years. Life expectancy plays a big role in how we invest, and I guess if the doctor gave you three years to live it might be better to go with the annuity.
So let's say that I want to retire in 20 years and we want to use the $100,000 as my retirement fund. We would want to see if the $100,000 would be enough when we retire and one way to figure our sum is to use the rule of 72. The rule of 72 says that to find the number of years required to double your money at a given interest rate; you just divide the interest rate into 72 (MoneyChimp, 2006). For example, if you want to know how long it will take to double your money at eight percent interest, divide 8 into 72 and get 9 years. The rule of 72 is an approximation, but pretty accurate. So using our 5% interest rate from above we can determine that in 14.4 years the $100,000 will double. If we think we can make it on a little more than $200,000 when we retire in 20 years from now then this is a good route. Personally I think it would be best to find an interest rate that would double the money in 10 years or less, and then take the entire amount and double it again in 10 to 14 years. I would follow an aggressive investment strategy now with things tapering toward a more conservative strategy as I near retirement.
Annuities are more of a cash management tool (in my opinion) and less of an investment. Focusing on the time value of money it just makes more sense to invest money with the goal of growing rather than losing the principal.
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Agents, Fiscal (2006). Fiscal Agents Financial Glossary. Retrieved 04/29/06, from Fiscal Agents Financial Services Group Web site: http://www.fiscalagents.com/newsletter/gloss/Glossary/a.shtml
Annuity Advantage, (2006). Annuity Advantage. Retrieved 04/29/2006, from Research and Compare over 300 Fixed and CD-Type Annuities Ranked by Highest Yield to Surrender Web site: http://www.annuityadvantage.com/
BioSociety, B (2006). Bio-Glossary. Retrieved 04/29/06, from BioSociety Research on-line Web site: http://europa.eu.int/comm/research/biosociety/library/glossarylist_en.cfm?Init=O
MoneyChimp, M (2006). Money Chimp. Retrieved 04/29/2006, from Rule of 72 Web site: http://www.moneychimp.com/features/rule72.htm