Question

• What is an annuity?
• Explain the difference between an ordinary annuity and an annuity due.
• Explain the relationship between Table 2, Present Value of $1, and Table 4, Present Value of an Ordinary Annuity of $1.

Answer 1

What is an annuity?

Solution: An annuity is a long-term investment that is issued by an insurance company and is designed to help protect you from the risk of outliving your income. Through annuitization, your purchase payments (what you contribute) are converted into periodic payments that can last for life.

OR

An annuity is a contract between you and an insurance company in which you make a lump-sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future.

Explain the difference between an ordinary annuity and an annuity due?

Solution: The difference between an ordinary annuity and annuity due lies in when the payments occur – at the period's end for an ordinary annuity and at the period's beginning for an annuity due.

Annuity Due Overview

The classic example of an annuity due is rent. When you sign a lease for an apartment, you commit to pay rent on the first of each month. This qualifies as an annuity due because the payments occur at a regular interval (monthly) and at the beginning of each period.

Insurance premium payments are another common example of annuity due. Notice how annuity due is usually found in situations where you are paying out money.

Ordinary Annuity Overview

Ordinary annuities are seen in retirement accounts, where you receive a fixed or variable payment every month from an insurance company, based on the value built up in the annuity account. In a fixed annuity account, your monthly payment is based on a fixed interest rate applied to the account balance at the start of payments. Variable annuity account payments are based on the investment performance of your account.

Retirement annuities send you payments at the end of each period. That’s standard when you are the recipient of annuity payments rather than the payer.

Explain the relationship between Table 2, Present Value of $1, and Table 4, Present Value of an Ordinary Annuity of $1.

Solution: Table 2 lists the present value of $1 factors for various time periods and interest rates. The factors in Table 4 are simply the summation of the individual PV of $1 factors from Table 2.