Question

annuities and sinking funds, What do these two instruments accomplish? How can you use these to your personal advantage?

Answer 1

Annuity is an investment option which promises to pay the investor a specific period sum of cash flow for a length of time while sinking fund is in a way opposite of annuity, where in, one invests periodically a specific amount for a length of time to receive lump sum at a later date. We can understand this with an example:

Annuity: X invests $ 100 today to receive $10 every year forever at 10%. Annuity can be perpetual like in this case or with specific maturity date. Annuities are quite useful in cases (like retirement planning) where one would require periodic cash flows are regular intervals

Sinking fund: X plans to purchase $100 item after 5 years and hence X invests $16.4 every year at 10% for 5 years. After 5 years this stream would have increased to $100. Sinking fund is useful when one is planning for a known repayment or outflow and it is a disciplined way of putting aside specific cash flows (basis interest rates and time due) for the known liability or purchase.

Some of the ways these can be used for personal advantage:

Retirement Planning is the most obvious one where one can save every month (create a sinking fund) during the working life and then on retirement use the sinking fund to get annuity for retirement period.

Children education fund: Parents can create a sinking fund and save regularly for reaching the funding goal of their children education. They can work backwards basis the current inflation, interest rate, time due and funds required to arrive at how much periodic (like monthly or quarterly) investments should be made to reach the funding goal