How to Calculate the Interest Rate of an Annuity

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By W D Adkins
eHow Contributing Writer

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An annuity is a form of retirement income in which you invest money (usually with an insurance company). During the "accumulation phase," your investment builds up. When you retire, the insurance company pays you a fixed sum each year, usually in monthly payments. Each payment includes part of the principal plus interest. Strictly speaking, you don't calculate the interest. The rate is set by the insurance company. However, you can calculate how much interest is required to produce the monthly income you want. This can be very useful when shopping for annuity plans.

Difficulty: Moderate

Instructions

Step 1

Determine the present value of the annuity or estimate the value in the future when you want payments to begin. To calculate the interest rate required to pay a specific amount for a period of time, decide how long you want the payouts to last (in years) and how large you want the annual payments to be.
Step 2

Find the PVOA (Present Value of Ordinary Annuity) factor. This is the ratio of the annual payment to the PVOA. Divide the PVOA by the desired annual payment. For example, if the value of the annuity is $10,000 and you want a payout of $1,200 per year for 10 years, the PVOA factor is $10,000/$1,200, or 8.33.
Step 3

Look up the PVOA factor closest to 8.33 for 10-year annuities using a PVOA interest table (see Resources). A PVOA factor of 8.33 falls almost exactly between the value for 3 percent interest (8.530) and for 4 percent (8.111). The interest rate you need is thus between 3 and 4 percent.

Tips & Warnings

In practice, you'll usually want to use an annuity calculator. There is a link to a free online annuity calculator in Resources. Don't confuse the interest an annuity earns during the time you are investing in it with the interest rate as it is amortized (paid out). Earnings during this accumulation phase depend on the market and/or the policy of the company where you buy the annuity. You can choose a fixed-term or open-term annuity. A fixed-term annuity pays for a predetermined period of time and then stops. Open-ended annuities are based on life expectancy. They pay for your lifetime, whether that is shorter or longer than the statistical expectation.

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