Thursday, June 7, 2007

Defining Investing Terms - What is an Annuity?

One thing that I've noticed from people is that many don't know some of the basic terms of investing - such as how does a mutual fund work? What are short term and long term capital gains? What is a JTWROS? (ok maybe that isn't a common one) etc. Well, here on the Trading Post I will try to break down, define and analyze some of these seemingly complex money ideas. I hope this will be useful to everyone.

What is an annuity? An annuity is a way to turn a present amount money into a specific number of future payments. To put it simply, if you give me $1000, and I promised you $100 for ten years, that would be an annuity. However, the present value of money is worth more than promised future streams of money, so in reality, you would want me to promise to give you perhaps an annuity of $110.

Pensions are really a form of an annuity, and mortgages are really (in a simplistic sense) the opposite of an annuity. Annuities can also be structured to change too - such as, for example above, $50 the first year, $75 the second year $150 the third year, $125 the fourth year and so on. This could be tied to various measures, such as how well the stock market is doing, or the profitability of a business. Insurance companies also provide a huge assortment of annuity products which can sometimes seem overwhelming. If all the criteria was the same, such as a guaranteed annuity for 20 years fixed, then it would be easy to choose - you would just pick the annuity that was highest (it would be giving you the highest effective rate of return) But there are all sorts of twists, such as continuing for only as long as the annuitant lives, or one that would continue to pay out to a spouse. The length of time can be different too. These all can make it very difficult to compare - and turns what at first appear a financial decision into one very much dependent on ones subjective tolerance to risk.

Excel and other spreadsheets and financial tools have functions that will tell you the equivalent interest rate for a specified present value and annuity value.

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