Annuity

An annuity is a series of equal payments made at equal intervals of time. Financial activities like
installment payments, monthly rentals, life-insurance premium, monthly retirement benefits, are familiar
examples of annuity.

Annuity can be certain or uncertain. In annuity certain, the specific amount of payments are set to begin
and end at a specific length of time. A good example of annuity certain is the monthly payments of a car
loan where the amount and number of payments are known. In annuity uncertain, the annuitant may be
paid according to certain event. Example of annuity uncertain is life and accident insurance. In this
example, the start of payment is not known and the amount of payment is dependent to which event.

Annuity certain can be classified into two, simple annuity and general annuity. In simple annuity, the
payment period is the same as the interest period, which means that if the payment is made monthly
the conversion of money also occurs monthly. In general annuity, the payment period is not the same as
the interest period. There are many situations where the payment for example is made quarterly but the
money compounds in another period, say monthly. To deal with general annuity, we can convert it to
simple annuity by making the payment period the same as the compounding period by the concept of
effective rates.

Elements of Annuity

A = amount of periodic payment

P = present amount of all periodic payments

F = future worth of all periodic payments after the last payment is made

i = interest rate per compounding period

n = total number of payments

m = nominal rate (see compounded interest)

t = number of years

Types of Annuities

Types of Simple Annuities

In engineering economy, annuities are classified into four categories. These are: (1) ordinary annuity, (2)
annuity due, (3) deferred annuity, and (4) perpetuity.

1. Ordinary Annuity

In ordinary annuity, the equal payments are made at the end of each compounding period starting from
the first compounding period.

Future amount of ordinary annuity, F

F=A[(1+i)n−1]i

The factor (1+i)n−1i is called equal-payment-series compound-amount factor and is denoted by

(F/A,i,n).
Present amount of ordinary annuity, P

P=F(1+i)n=A[(1+i)n−1](1+i)ni

The factor (1+i)n−1(1+i)ni is called equal-payment-series present-worth factor and is denoted by

(P/A,i,n).

Periodic payment of annuity, A

Value of A if F is known:

A=Fi(1+i)n−1

The factor i(1+i)n−1 is called equal-payment-series sinking-fund factor and is denoted by (A/F,i,n).

Value of A if P is known:

A=P(1+i)ni(1+i)n−1

The factor (1+i)ni(1+i)n−1 is called equal-payment-series capital-recovery factor and is denoted by

(A/P,i,n).

2. Annuity Due

In annuity due, the equal payments are made at the beginning of each compounding period starting
from the first period. The diagram below shows the cash flow in annuity due.

Future amount of annuity due, F

F=F1(1+i)=A[(1+i)n−1]i(1+i)

Present amount of annuity due, P

P=F(1+i)n=A[(1+i)n−1](1+i)ni(1+i)

3. Deferred Annuity

In deferred annuity the first payment is deferred a certain number of compounding periods after the
first. In the diagram below, the first payment was made at the end of the kth period and n number of
payments was made. The n payments form an ordinary annuity as indicated in the figure.

Future amount of deferred annuity, F

F=A[(1+i)n−1]i
Present amount of deferred annuity, P

P=F(1+i)k+n=A[(1+i)n−1](1+i)k+ni

4. Perpetuity

Perpetuity is an annuity where the payment period extends forever, which means that the periodic
payments continue indefinitely.

There is no definite future in perpetuity, thus, there is no formula for the future amount.

Present amount of perpetuity, P

From the present amount of ordinary annuity:

P=A[(1+i)n−1](1+i)ni

P=A(1+i)n(1+i)ni−A(1+i)ni

P=Ai−A(1+i)ni

When n→∞, A(1+i)ni→0. Thus,

P=Ai