CHAPTER 3: ANNUITIES

CHAPTER OUTLINE

3.1 Noatation and Types of Annuities

3.2 FV and PV of an Ordinary Simple and General Annuity
3.3 FV and PV of a Simple and General Annuity Due
3.4 Calculating Periodic Payment (PMT), Number of Payments (n), Time
Period (t), Periodic Interest Rate (i) and Nominal Interest Rate (j)
3.5 Other Types of Annuities
INTRODUCTION

• Many financial transactions involve investing or borrowing fixed

amounts of money at regular intervals for a fixed period of time.
• Businesses and governments also save for future expansion projects
by making regular deposits into investment funds. These regular
payments and investments are called annuities.
• An annuity is a series of payments, usually equal in size, made at
regular intervals for a fixed period of time.
3.1 NOTATION AND TYPES OF ANNUITIES

• t is the term of an annuity. It is equal to the time from the beginning of the first payment interval to
the end of the last payment interval
• PMT is the amount of the periodic payment of an annuity
• n is the total number of payments during the term of an annuity. It is equal to the number of
payments per year x time period in years
• j is the nominal interest rate
• m is the compounding frequency (or number of compounding periods per year)
• i is the periodic interest rate (or interest rate per compounding period)
• Payment interval (or payment period) is the time between two successive payments
• FV is the accumulated value or future value of an annuity. It is the equivalent value of the series of
payments at the end of the term
• PV is the discounted value or present value of an annuity. It is the equivalent value of the series of
payments at the beginning of the term
EXAMPLES

Calculate the number of payments during the term for the following
annuities:
1. $50 deposited at the end of every three months for seven years
2. $70 deposited at the end of every six months for 3 years and 6
months
3. $100 received at the end of every month for the first five years and
thereafter, $150 received at the end of every month for the next two
years
TYPES OF ANNUITIES BASED ON PAYMENT DATES

• When the payments are made at the end of each payment period, the
annuity is referred to as an ordinary annuity
• When the payments are made at the beginning of each payment
period, the annuity is referred to as an annuity due
EXAMPLE

Magda saves $750 in a bank account at the end of every month for one
year. She also pays rent of $1200 at the beginning of every month for
one year for her house. Identify the type of each of the annuity
payments
TYPES OF ANNUITIES BASED ON COMPOUNDING PERIODS

• When the payment period (or payment interval) and the interest
compounding period (or compounding frequency) are the same (or
equal), then the annuity is referred to as a simple annuity
• When the payment period (or payment interval) and the interest
compounding period (or compounding frequency) are not the same (or
not equal), then the annuity is referred to as a general annuity
EXAMPLES

Identify the following types of annuities:

a. Payments of $500 at the end of every month for ten years at 9%
compounded monthly.
b. Payments of $500 at the end of every month for ten years at 9%
compounded quarterly.
c. Payments of $500 at the beginning of every month for ten years at
9% compounded monthly.
d. Payments of $500 at the beginning of every month for ten years at
9% compounded quarterly.
3.2 FV AND PV OF AN ORDINARY SIMPLE AND GENERAL ANNUITY

(1 + 𝑖)! −1
𝐹𝑉 = 𝑃𝑀𝑇
𝑖
EXAMPLES

1. Rita invested $200 at the end of every month for 20 years into an RRSP. Assume that
the interest rate was constant at 6% compounded monthly over the entire term
a. What was the accumulated value of the investment at the end of the term?
b. What was the total investment over the term?
c. What was the amount of interest earned?
2. Jack deposited $1500 into an account every three months for a period of four years. He
then let the money grow for another six years without investing any more money into
the account. The interest rate on the account was 6% compounded quarterly for the
first four years and 9% compounded quarterly for the next six years.
a. Calculate the accumulated amount of money in the account at the end of the ten-
year period
b. Calculate the total interest earned
3. Grace saved $500 at the end of every month in an RRSP for five years and thereafter,
$600 at the end of every month for the next three years. If the investment was growing
at 3% compounded monthly, calculate the maturity value of her RRSP at the end of
eight years.
3.2 FV AND PV OF AN ORDINARY SIMPLE AND GENERAL ANNUITY

1 − (1 + 𝑖)"!
𝑃𝑉 = 𝑃𝑀𝑇
𝑖
EXAMPLES

1. Indrajit purchased an annuity that provided him with payments of $1000 every month
for 25 years at 5.4% compounded monthly.
a. How much did he pay for the annuity?
b. What was the total amount received from the annuity and how much of this amount
was the interest earned?
2. Andrew paid $20,000 as a down payment towards the purchase of a machine and
received a loan for the balance amount at an interest rate of 3% compounded monthly.
He settled the loan in ten years by paying $1500 at the end of every month.
a. What was the purchase price of the machine?
b. What was the total amount paid to settle the loan and what was the amount of
interest charged?
3. How much should Halifax Steel Inc. invest today in a fund to be able to withdraw
$15,000 at the end of every three months for a period of six years? The money in the
fund is expected to grow at 4.8% compounded quarterly for the first two years and
5.6% compounded quarterly for the next four years.
3.2 FV AND PV OF AN ORDINARY SIMPLE AND GENERAL ANNUITY

• In an ordinary general annuity, payments are made at the end of each

payment period and the compounding period is not equal to the
payment period
• We calculate the equivalent periodic rate, i2, that matches the payment
period => using this equivalent periodic rate to calculate the future
value and present value
• Equivalent periodic interest rate per payment period
𝑖! = (1 + 𝑖)" −1
• Number of compounding periods per payment period
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝑐=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
3.2 FV AND PV OF AN ORDINARY SIMPLE AND GENERAL ANNUITY

• FV of an ordinary general annuity

(1 + 𝑖! )# −1
𝐹𝑉 = 𝑃𝑀𝑇
𝑖!

• PV of an ordinary general annuity

1 − (1 + 𝑖! )$#
𝑃𝑉 = 𝑃𝑀𝑇
𝑖!
EXAMPLES

1. Rachel would like to save $100 every month for the next four years
in a saving account at 2.92% compounded daily
a. What would be the accumulated value of the investments at the end of four
years
b. What would be the amount of interest earned?
2. Nadir borrowed money from a bank at 6% compounded annually. He
settled the loan by repaying $500 at the end of every month for 6
years
a. What was the loan amount received?
b. What was the amount of interest charged?
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE

• Comparing the two equations in the preceding two diagrams:

𝐹𝑉-./ = 𝑃𝑀𝑇(1 + 𝑖)0+𝑃𝑀𝑇(1 + 𝑖)1+𝑃𝑀𝑇(1 + 𝑖)2+𝑃𝑀𝑇(1 + 𝑖)3+𝑃𝑀𝑇(1 + 𝑖)
𝐹𝑉 = 𝑃𝑀𝑇(1 + 𝑖)1+𝑃𝑀𝑇(1 + 𝑖)2+𝑃𝑀𝑇(1 + 𝑖)3+𝑃𝑀𝑇(1 + 𝑖)4+𝑃𝑀𝑇

=> notice that each term in FVDue is the multiple of the corresponding
term in FV by a factor of (1+i)

• FV of a simple annuity due

1+𝑖 5−1
𝐹𝑉-./ = 𝑃𝑀𝑇 (1 + 𝑖)
𝑖
EXAMPLES

1. Madison makes contribution of $500 at the beginning of 6 months

for 10 years towards an RRSP. If the RRSP earns 5% compounded
semi-annully, what would be the value of her RRSP at the end of the
time period?
2. Indu makes regular deposits of $200 at the beginning of every month
into a saving account that earns 3% compounded monthly. After 1
year of deposits, the interest rate drops to 2.7% compounded
monthly. How much money has accumulated in the saving account
after 5 years of deposits?
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE

• Comparing the two equations in the preceding two diagrams:

𝑃𝑉-./ = 𝑃𝑀𝑇(1 + 𝑖)6+𝑃𝑀𝑇(1 + 𝑖)74+𝑃𝑀𝑇(1 + 𝑖)73+𝑃𝑀𝑇(1 + 𝑖)72+𝑃𝑀𝑇(1 + 𝑖)71
𝑃𝑉 = 𝑃𝑀𝑇(1 + 𝑖)74+𝑃𝑀𝑇(1 + 𝑖)73+𝑃𝑀𝑇(1 + 𝑖)72+𝑃𝑀𝑇(1 + 𝑖)71+𝑃𝑀𝑇(1 + 𝑖)70

=> notice that each term in PVDue is the multiple of the corresponding
term in PV by a factor of (1+i)

• PV of a simple annuity due

1− 1+𝑖 75
𝑃𝑉-./ = 𝑃𝑀𝑇 (1 + 𝑖)
𝑖
LEASES

• A lease presents an alternative to obtaining a loan to purchase an asset

• With a lease, the lessee makes regular payments to essentially borrow an asset
from the lessor (bank, company, etc.) throughout the term of the lease; the lessee
does not own the asset during or after the term - the ownership remains with the
lessor
• The down payment is a lump sum payment made at the start of a lease
• The residual value is the expected value of the asset at the end of the lease term.
At the end of a lease term, the lessee often has the option to purchase the asset
for the residual value or return the asset to the lessor
• The lease amount is the value of the asset at the beginning of the lease term
𝐿𝑒𝑎𝑠𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 = 𝐷𝑜𝑤𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑃𝑉8/9:/ <=>: + 𝑃𝑉?/:@A.9B
EXAMPLES

1. Louis purchases kitchen appliances for his new home. He sets up a payment plan
where he pays $300 at the beginning of every 3 months for 8 years, at a rate of
4% compounded quarterly. What is the cost of the kitchen appliances?
2. A car dealership provided Akari with the following 2 options to buy or lease a
vehicle:
Buy option: Pay $21,500 immediately to own the vehicle
Lease option: Make a down payment of $2000 and lease payments of $230 at
the beginning of every month for 4 years. At the end of 4 years, she has the
option to buy the vehicle for the residual value of $10,000
The cost of borrowing is 3% compounded monthly
a. Which option is economically better for Akari?
b. In the lease option, what will be the buyback value of the vehicle at the end
of 3 years?
3.3 FV AND PV OF A SIMPLE AND GENERAL ANNUITY DUE

• In a general annuity due, payments are made at the beginning of each

payment period, and the compounding period is not equal to the
payment period
• FV of a general annuity due:
1 + 𝑖! # − 1
𝐹𝑉%&' = 𝑃𝑀𝑇 1 + 𝑖!
𝑖!
• PV of a general annuity due:
$#
1 − 1 + 𝑖!
𝑃𝑉%&' = 𝑃𝑀𝑇 (1 + 𝑖! )
𝑖!
EXAMPLES

1. Tao invested $5000 in a fund at the beginning of every 3 months for 5 years. The fund was earning
5% compounded monthly.
a. What was the accumulated value of the investment?
b. What was the interest earned over the period?
c. If Tao kept the money in the fund for another 2 years at the same interest rate, what would be
the final amount?
2. Noor inherited money that was invested in an account which provided her with $4500 at the
beginning of every month for 30 years. If the interest rate on the savings account was 4%
compounded semi-annually, what was the amount of the inheritance?
3. Ariana contributed $100 from her paycheque at the beginning of every month from age 18 to 65 into
an RRSP account (no contribution in the month of her 65th birthday). Macy contributed $4000 at the
beginning of every year from age 35 to 55 into a similar RRSP account, then left the money in the
fund to accumulate for another 10 years (no contribution in the year of her 55th birthday). Money
earned 4.8% compounded daily in both RRSP accounts.
a. Who had a greater accumulated value, and by how much, when they retired at age 65?
b. Calculate how much interest both Ariana and Macy earned in their RRSP accounts, respectively
3.4.1 CALCULATING PERIODIC PAYMENT, NUMBER OF PAYMENTS, AND TIME PERIOD

1. Hugo received a $35,000 home improvement loan from his bank at an interest
rate of 6% compounded monthly.
a. How much would he need to pay every month to settle the loan in ten years?
b. What was the amount of interest charged?
2. What quarterly payments should Ben make in order to save $60,000 in ten years
if money can earn 8% compounded semi-annually?
3. An amount of $10,000 is deposited into an account earning 4% compounded
annually. What is the largest withdrawal that can be made at the beginning of
each month from this account for the next five years?
4. A car with a manufacturer's suggested retail price (MSRP) of $38,000 is
estimated to have a residual value of $15,960 in four years. If the car is leased
for four years at the MSRP, with a down payment of 10%, what is the size of
each of the beginning-of-month lease payments? Assume an interest rate of
3.6% compounded monthly.
3.4.1 CALCULATING PERIODIC PAYMENT, NUMBER OF PAYMENTS, AND TIME PERIOD

1. Steve was planning for retirement and invested $5000 at the end of every year
into an RRSP that was earning 6% compounded monthly. How long will it take
for his RRSP fund to grow to $500,000?
2. Trent won a lottery of $50,000 and he deposited the money in an investment
fund earning 6% compounded semi-annually. If he withdraws $5000 at the end
of every three months, how long will the money last?
3. Rami plans to save $250,000 in his RRSP that is growing at 3.5% compounded
semi-annually. He deposits $2500 into this fund at the beginning of every
month. How long will it take for him to save this amount?
4. Kayla saved $100,000 in a retirement investment fund earning 4% compounded
quarterly. She plans to withdraw $2000 at the beginning of every three months.
a. After how many withdrawals will the fund be depleted?
b. How long will it take for the fund to be depleted?
3.4.2 CALCULATING PERIODIC INTEREST RATE AND NOMINAL INTERST RATE

1. What is the nominal interest rate compounded monthly and the periodic interest rate per
month of a $25,000 loan that can be settled by making payments of $240 at the end of
every month for ten years?
2. At what nominal interest rate compounded quarterly would payments of $1500 towards an
RRSP at the beginning of every 6 months result in a maturity value of $50,000 in 12 years?
Also, determine the corresponding periodic interest rate per quarter
3. Camila wishes to renovate her home and is comparing two loan options. Bank A is offering a
loan of $30,000, to be settled with payments of $12,000 at the end of every year for three
years. Bank B is offering a loan of $30,000, to be settled with payments of $1150 at the end
of every month for two-and-a-half years. By calculating the effective interest rate of both
options, determine which bank is offering Camila a more economical rate.
4. Niraj leases a new car by making a down payment of $2000 and beginning-of-month
payments of $275 for four years. If the lease amount of the car is $23,500 and Niraj has the
option of buying it for $11,250 at the end of the lease, what nominal interest rate
compounded monthly is he paying?
3.5 OTHER TYPES OF ANNUITIES

• Deferred Annuities

• Perpetuities

• Constant-Growth Annuities

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DEFERRED ANNUITIES

• A deferred annuity is an annuity in which the first periodic payment is

made after an interval that is not equal to the payment period. This
interval is known as the deferral period. The deferral period is the time
interval from 'now' to the beginning of the annuity period.
• 2 types of deferred annuities:
• Ordinary Deferred Annuity: If the deferral period ends one payment interval
before the first periodic payment, then it is an ordinary deferred annuity.
• Deferred Annuity Due: If the deferral period ends at the beginning of the first
periodic payment, then it is a deferred annuity due

34
DEFERRED ANNUITIES

35
DEFERRED ANNUITIES

• A deferred annuity due can be modified to become an ordinary

deferred annuity by shortening the deferral period by one payment
period
• The payments made at the beginning of each payment period can be
accommodated by making them into payments made at the end of
each payment period

36
EXAMPLE

Payments of $1000 are made at the beginning of each year for ten years
with the first payment being made three years from now.
a. Assuming the annuity is a deferred annuity due, identify the deferral
period and the annuity period.
b. Assuming the annuity is an ordinary deferred annuity, identify the
deferral period and the annuity period.

37
EXAMPLE

a.
• Deferral period ends at the first periodic payment
• Payments start 3 years from now
• The deferral period is 3 years
• The annuity period is 10 years

38
EXAMPLE

b.
• Deferral period ends one payment interval before the first periodic
payment
• Payments start 3years from now
• The deferral period is 2 years
• The annuity period is 10 years

39
CALCULATING FV AND PV OF A DEFFERED ANNUITY

• The future value of a deferred annuity is the accumulated value of the

stream of payments at the end of the annuity period. This is the same
procedure as calculating the future value of any annuity
• The present value of a deferred annuity is the discounted value of the
stream of payments at the beginning of the deferral period
Example: What amount should you invest now if you want to receive
payments of $1000 every year for ten years with the first payment to be
received three years from now? Assume that money earns 5%
compounded annually.
a. Treating the annuity as an ordinary deferred annuity
b. Treating the annuity as a deferred annuity due

40
NOTE

• Whenever the periodic payment is specified to occur at the end of the

payment interval, we will treat the annuity as an ordinary deferred
annuity
• Whenever the periodic payment is specified to occur at the beginning
of the payment interval, we will treat the annuity as a deferred annuity
due
• However, any deferred annuity can be treated as either an ordinary
deferred annuity or a deferred annuity due.

41
EXAMPLES

• Calculate the amount of money an investment banker would have to deposit in an

investment fund that will provide him with $1000 at the beginning of each month
for 11 years. He will receive his first payment two years from now and the interest
rate is 6% compounded semi-annually.
• The owner of a business borrowed $7500 to purchase a new machine for his
factory. The interest rate charged on the loan is 4% compounded semi-annually
and he is required to settle the loan by making equal monthly payments at the end
of each month for 5 years, with the first payment to be made 1 year and 1 month
from now. Calculate the size of the monthly payments that are required to settle
the loan.
• Third Eye Glassware Corporation invested its annual net profits of $500,000 in a
fixed deposit at 8% compounded quarterly. It wants to withdraw $90,000 at the
beginning of every year, with the first withdrawal to be made 3 years from now.
Calculate the time period of the annuity. Round your answer up to the next
payment period
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PERPETUITIES

• A perpetuity is an annuity in which the periodic payments begin on a

fixed date and continue indefinitely. Therefore, it is not possible to
calculate its future value
• However, there is a definite present value for a perpetuity.

43
CALCULATING THE PV OF A PERPETUITIES

• The formula for the present value of an ordinary perpetuity:

1 − (1 + 𝑖)$#
𝑃𝑉 = 𝑃𝑀𝑇×
𝑖
• As the number of payments, n, in an annuity increases, the value of
(1+i)-n becomes smaller. Therefore, as n approaches infinity, as in the
case of a perpetuity, the value of (1+i)-n approaches 0

𝑃𝑀𝑇
𝑃𝑉(')( =
𝑖

44
PERPETUITY DUE

• Similar to annuities, perpetuities can be classified as:

• Ordinary perpetuity or perpetuity due
• Ordinary deferred perpetuity or deferred perpetuity due
• PV of a Perpetuity Due:
𝑃𝑀𝑇
𝑃𝑉(')( +&' = (1 + 𝑖)
𝑖
• A few examples of perpetuities include:
• Continuous interest payments from a lump sum of money invested at a fixed
interest rate
• A scholarship to students paid from an endowment fund on a perpetual basis
• A charity fund established to provide regular payments indefinitely to needy
children

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EXAMPLES

• A college wants to provide students with a perpetual scholarship of $10,000 at the

end of every 3 months. How large should its endowment fund be if the money is
growing at 8% compounded quarterly?
• A wealthy donor sponsors an endowment fund that provides a hospital with $5000
at the beginning of every month in perpetuity. What is the sponsorship amount if
the fund is growing at 8% compounded quarterly?
• A large telecommunications company purchases a perpetual bond at $500,000
that earns interest of 5.75% compounded monthly. Calculate the end-of-quarter
payments that will be received from the bond.
• Green Splash Publishers wants to invest a lump sum amount in a fund growing at
6% compounded monthly. It plans to withdraw $2000 at the beginning of every
month from the fund with the first withdrawal to be made two years from now.
How much should it invest in the fund?

46
CONSTANT-GROWTH ANNUITIES

• A constant-growth annuity is an annuity where the periodic payment

amount (PMT) increases by a constant rate (g) over the preceding
payment amount.
• A few examples of constant-growth annuities include:
• Retirement annuity contracts
• Insurance policies
• Leases
• Installment purchases

47
EXAMPLE

You plan to deposit regular payments at the end of every month for 3
years, starting with an initial investment of $100, and increasing the
amount by 2% every month

48
CALCUATING FV AND PV OF AN ORDINARY CONSTANT- GROWTH ANNUITY

• Future Value of an Ordinary Constant-Growth Annuity:

(1 + 𝑖)5 −(1 + 𝑔)5

𝐹𝑉 = 𝑃𝑀𝑇×
𝑖−𝑔
• Present Value of an Ordinary Constant-Growth Annuity:

1 − (1 + 𝑔)5 ×(1 + 𝑖)75

𝑃𝑉 = 𝑃𝑀𝑇×
𝑖−𝑔
• Sum of Constant-Growth Payments:

(1 + 𝑔)5 −1
𝑆𝑢𝑚 = 𝑃𝑀𝑇×
𝑔

49
EXAMPLES

• A business made end-ot-month investments in a high-growth fund starting at $500 and increased it
by 1.5% per month thereafter, for 15 years. The fund has an interest rate of 12% compounded
monthly.
a. What was the accumulated amount in the fund at the end of the period?
b. What was the total interest earned?
• Abel purchased a ten-year annuity that has an interest rate of 5% compounded semi-annually and
will provide him with payments at the end of every six months. The first payment received is $1000
and it increases by 2% thereafter, every six months.
a. How much did he pay for the annuity?
b. What was the total interest earned?
• Pejman made contributions growing at 2.25% at the end of every 3 months to his account that was
earning 8% compounded quarterly. In 30 years, his savings had accumulated to $147,034.45.
a. What was the size of the first contribution?
b. What was the total interest earned?

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THANK YOU !