Future Value Annuity Vs. Annuity Due
Annuities are investment products you purchase through insurance companies. Earnings on an annuity grow tax deferred, treated as income when distributions are made after age 59 1/2. Part of an annuity contract is the annuity due date. This is different than the future value of the annuity. Understanding these terms will help you understand how income is derived from the contract.
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Terms
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When talking about annuities, there are many terms that get confused. A deferred annuity places money in the contract and defers the income (and taxes) until a later date. A deferred annuity is also referred to as an ordinary annuity where the value is being accumulated for later payments. An ordinary annuity may be converted to an annuity due annuity, meaning the payments have started. The future value of the annuity is the expected income based on accumulated cash values.
Identification
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You can identify the annuity due in one of two ways. Once an annuity begins regular income payments, the annuity due date has been reached. If you are looking at an annuity contract that is still in the accumulation period, on the contract term page is an "annuity due" date. This is the date that the annuity is required to start income payments if you have not already started them. When looking at an annuity due date in the future you may use the future value of an annuity to calculate what the amount of income would be based on existing earning parameters.
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Establishing Value
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You can use the formula for future value of an annuity to determine what the potential value will be when the annuity due date is reached. The formula for future value (FV) of the cash balance is: FV = PMT * [((1 + i)^n -1/ i]. PMT is the periodic payments made into the ordinary annuity, "i" is the interest rate and "n" is the number of payments. Once you have determined this, you compound the number one more time to get the projected annuity due amount.
Example
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Assume you contribute $5,000 per year into an annuity with a 4 percent interest rate. The annuity due date is in 10 years. The future value of the annuity would be: FV = $5,000 *[(( 1+ .04)^10 - 1) / .04] = $5,000[((1.04)^10 -1) /.04 = $5,000 [(1.48 -1) /.04 = $17,500. This is the future value of the ordinary annuity. You then need to compound this to convert it to the annuity due: FV * (1 +.04) = $17,5000(1.04) = $18,200.
Significance
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Annuities are long-term investments. The contracts alone may range from three to 15 years. Regardless of the contract, a person can own an annuity for his entire lifetime. With such long and different time frames, it is important for investors to be able to compute how the annuity will perform based on defined parameters.
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References
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