Chapter 4 Finance
4.2 Annuities
Learning Objectives
By the end of this section, you will be able to:
- Find the future value of an annuity
- Find deposits needed to fund an annuity
- Find the interest earned
Savings Annuities
Most of us aren’t able to put a large sum of money in the bank today. Instead, we save for the future by depositing a smaller amount of money from each paycheck into the bank. This idea is called a savings annuity. Most retirement plans like 401(k) plans or IRA plans are examples of savings annuities.
Suppose we will deposit $100 each month into an account paying 6% interest. How much will we have after a year? We assume that the account is compounded with the same frequency as we make deposits unless stated otherwise. In this example:
[latex]r = 0.06 \text{ (6%)}[/latex]
[latex]k=12 \text{ (12 compounds/deposits per year)}[/latex]
[latex]d = \$100 \text{ (our deposit per month)}[/latex]
[latex]t=1 \text{ year}[/latex]
With ordinary annuities we assume the payment is made at the end of the period. The $100 we deposit at the end of the first month will earn interest for 11 months and at the end of the year will be worth [latex]A=100(1+\frac{0.06}{12})^{11}=100(1.005)^{11}[/latex].
The $100 deposited at the end of the second month will have 10 months to grow and will be worth [latex]A=100(1.005)^{10}[/latex] at the end of the year. This pattern continues down to the last deposit, which has no time to compound and will be worth [latex]A = 100[/latex].
In total, we will have accumulated:
[latex]A=100(1.005)^{11}+100(1.005)^{10}+...+100(1.005)^{2}+100(1.005)^{1}+100[/latex]
This equation leaves a lot to be desired, though—it doesn’t make calculating the ending balance any easier! To simplify things, multiply both sides of the equation by 1.005:
[latex]1.005A=1.005(100(1.005)^{11}+100(1.005)^{10}+...+100(1.005)^{2}+100(1.005)+100)[/latex]
Distributing on the right side of the equation gives
[latex]1.005A=100(1.005)^{12}+100(1.005)^{11}+...+100(1.005)^{3}+100(1.005)^{2}+100(1.005)[/latex]
Now we’ll line this up with like terms from our original equation and subtract each side:
[latex]\begin{array}{rcll} 1.005A & = & 100(1.005)^{12} + & 100(1.005)^{11}+...+100(1.005)\\ A & = & & 100(1.005)^{11} +...+ 100(1.005) + 100 \\ \end{array}[/latex]
Almost all the terms cancel on the right-hand side when we subtract, leaving
[latex]1.005A-A=100(1.005)^{12}-100[/latex]
Now we solve this equation for [latex]A[/latex].
[latex]A=\frac{100((1.005)^{12}-1)}{0.005}[/latex]
Recall 0.005 was [latex]\frac{r}{k}[/latex], 100 was the deposit [latex]d[/latex], and 12 was the number of months, [latex]kt[/latex]. Generalizing this result, we get the saving annuity formula.
Annuity Formula
[latex]A=\frac{d((1+\frac{r}{k})^{kt}-1)}{(\frac{r}{k})}[/latex]
[latex]A[/latex] is the balance in the account after t years.
[latex]d[/latex] is the regular deposit (the amount you deposit each year, each month, etc.).
[latex]r[/latex] is the annual interest rate in decimal form.
[latex]k[/latex] is the number of compounding periods in one year.
If the compounding frequency is not explicitly stated, assume there are the same number of compounds in a year as there are deposits made in a year.
For example, if the compounding frequency isn’t stated:
If you make your deposits every month, use monthly compounding, [latex]k = 12[/latex].
If you make your deposits every year, use yearly compounding, [latex]k = 1[/latex].
If you make your deposits every quarter, use quarterly compounding, [latex]k = 4[/latex].
Etc.
When Do You Use This?
Annuities assume that you put money in the account on a regular schedule (every month, year, quarter, etc.) and let it sit there earning interest.
Compound interest assumes that you put money in the account once and let it sit there earning interest.
Compound interest: One deposit
Annuity: Many deposits
Example 1
A traditional individual retirement account (IRA) is a special type of retirement account in which the money you invest is exempt from income taxes until you withdraw it. If you deposit $100 each month into an IRA earning 6% interest, how much will you have in the account after 20 years?
In this example,
[latex]\begin{array}{rcll} d & = & 100 & \text{the monthly deposit}\\ r & = & 0.06 & \text{6% annual rate} \\ k & = & 12 & \text{Since we're doing monthly deposits, we'll compound monthly.}\\ t & = & 20 & \text{We want the amount after 20 years.}\\ \end{array}[/latex]
Putting this into the equation:
[latex]\begin{array}{rcl} A & = & \frac{100((1+\frac{0.06}{12})^{20(12)}-1)}{(\frac{0.06}{12})}\\ A & = & \frac{100((1.005)^{240}-1)}{(\frac{0.06}{12})}\\ A & = & \frac{100(3.310-1)}{(0.005)}\\ A & = & \frac{100(2.310)}{(0.005)}\\ A & = & 46200\\ \end{array}[/latex]
The account will grow to $46,200 after 20 years.
Notice that you deposited into the account a total of $24,000 ($100 a month for 240 months). The difference between what you end up with and how much you put in is the interest earned. In this case it is $46,200 – $24,000 = $22,200.
You can work this problem with the TVM Solver calculator.
Example 2
You want to have $200,000 in your account when you retire in 30 years. Your retirement account earns 8% interest. How much do you need to deposit each month to meet your retirement goal?
In this example, we’re looking for [latex]d[/latex].
[latex]\begin{array}{rcll} r & = & 0.08 & \text{8% annual rate} \\ k & = & 12 & \text{since we're depositing monthly}\\ t & = & 30 & \text{30 years}\\ A & = & 200,000 & \text{the amount we want to have in 30 years}\\ \end{array}[/latex]
In this case, we’re going to have to set up the equation and solve for [latex]d[/latex].
[latex]\begin{array}{rcl} 200000 & = & \frac{d((1+\frac{0.08}{12})^{30(12)}-1)}{(\frac{0.08}{12})}\\ 200000 & = & \frac{d((1.00667)^{360}-1)}{(0.00667)}\\ 200000 & = & d(1491.57)\\ d & = & \frac{200000}{1491.57}\\ d & = & 134.09\\ \end{array}[/latex]
So you would need to deposit $134.09 each month to have $200,000 in 30 years if your account earns 8% interest.
You can work this problem with the TVM Solver calculator.
Exercise 1
A more conservative investment account pays 3% interest. If you deposit $5 a day into this account, how much will you have after 10 years? How much is from interest?
Solution
[latex]A = 21,282.07[/latex]
We would have deposited a total of [latex]5 \cdot 365 \cdot 10 = 18,250[/latex], so [latex]$3,032.07[/latex] is from interest.
Example 3
If you invest $100 each month into an account earning 3% compounded monthly, how long will it take the account to grow to $10,000?
This is a savings annuity problem, since we are making regular deposits into the account.
[latex]\begin{array}{rcll} d & = & 100 & \text{the monthly deposit}\\ r & = & 0.03 & \text{3% annual rate} \\ k & = & 12 & \text{since we're depositing monthly}\\ \end{array}[/latex]
We don’t know [latex]t[/latex], but we want [latex]A[/latex] to be [latex]$10,000[/latex].
Putting this into the equation:
[latex]\begin{array}{rclr} 10000 & = & \frac{100((1+\frac{0.03}{12})^{12t}-1)}{(\frac{0.03}{12})} & \text{Simplifying the fractions a bit}\\ 10000 & = & \frac{100((1.0025)^{12t}-1)}{(0.0025)}\\ \end{array}[/latex]
We want to isolate the exponential term, [latex]1.0025^{12t}[/latex], so multiply both sides by 0.0025.
[latex]\begin{array}{rcll} 25 & = & 100((1.0025)^{12t}-1) & \text{Divide both sides by 100}\\ 0.25 & = & (1.0025)^{12t}-1 & \text{Add 1 to both sides}\\ 1.25 & = & (1.0025)^{12t} & \text{Now take the log of both sides}\\ \log (1.25) & = & \log ((1.0025)^{12t}) & \text{Use the exponent property of logs}\\ \log (1.25) & = & (12t) \log (1.0025) & \text{Divide by 12log(1.0025)}\\ \frac{\log (1.25)}{12 \log (1.0025)} & = & t & \text{Approximating to a decimal}\\ t & = & 7.447 \\ \end{array}[/latex]
It will take about 7.447 years to grow the account to $10,000.
You can work this problem with the TVM Solver calculator.
Saving for the future by depositing a smaller amount of money from each paycheck into the bank.
An annuity where the payment is made at the end of the period.