Chapter 4 Finance
4.3 Payout Annuities
Learning Objectives
By the end of this section, you will be able to:
- Find the present value of an annuity (principal required)
- Find the payments that can be made from a payout annuity
Payout Annuities
In the last section, you learned about annuities. In an annuity, you start with nothing, put money into an account on a regular basis, and end up with money in your account.
In this section, we will learn about a variation called a payout annuity. With a payout annuity, you start with money in the account and pull money out of the account on a regular basis. Any remaining money in the account earns interest. After a fixed amount of time, the account will end up empty.
Payout annuities are typically used after retirement. Perhaps you have saved $500,000 for retirement and want to take money out of the account each month to live on. You want the money to last you 20 years. This is a payout annuity. The formula is derived in a similar way as we did for savings annuities. The details are omitted here.
Payout Annuity Formula
[latex]P=\frac{w \left( 1- \left( 1+\frac{r}{k} \right) ^{-kt} \right) }{ \left( \frac{r}{k} \right) }[/latex]
[latex]P[/latex] is the balance in the account at the beginning (starting amount, or principal).
[latex]w[/latex] is the regular withdrawal (the amount you take out each year, each month, etc.).
[latex]r[/latex] is the annual interest rate in decimal form. (Example: 5% = 0.05)
[latex]k[/latex] is the number of compounding periods in one year.
[latex]t[/latex] is the number of years we plan to take withdrawals.
Like with annuities, the compounding frequency is not always explicitly given but is determined by how often you take the withdrawals.
When Do You Use This?
Payout annuities assume that you take money from the account on a regular schedule (every month, year, quarter, etc.) and let the rest sit there earning interest.
Compound interest: One deposit
Annuity: Many deposits.
Payout annuity: Many withdrawals
Example 1
After retiring, you want to be able to take $1,000 every month for a total of 20 years from your retirement account. The account earns 6% interest. How much will you need in your account when you retire?
In this example,
[latex]\begin{array}{rcll} w & = & 1000 & \text{the monthly withdrawal}\\ r & = & 0.06 & \text{6% annual rate} \\ k & = & 12 & \text{Since we're doing monthly withdrawals, compound monthly.}\\ t & = & 20 & \text{We want the amount after 20 years.}\\ \end{array}[/latex]
We’re looking for [latex]P[/latex], how much money needs to be in the account at the beginning.
Putting this into the equation:
[latex]\begin{array}{rcl} P & = & \frac{1000 \left( 1- \left( 1+\frac{0.06}{12} \right) ^{-20(12)} \right) }{ \left( \frac{0.06}{12} \right) }\\ P & = & \frac{1000 \left(1-(1.005)^{-240}\right)}{(0.005)}\\ P & = & \frac{1000(1-0.302)}{(0.005)}\\ P & = & 139600\\ \end{array}[/latex]
You will need to have $139,600 in your account when you retire.
Notice that you withdrew a total of $240,000 ($1,000 a month for 240 months). The difference between what you pulled out and what you started with is the interest earned. In this case it is $240,000 – $139,600 = $100,400 in interest.
You can work this problem with the TVM Solver calculator.
Evaluating Negative Exponents on Your Calculator
With these problems, you need to raise numbers to negative powers. Most calculators have a separate button for negating a number that is different than the subtraction button. Some calculators label this [latex]\begin{array}{|c|}\hline \text{(-)}\\ \hline \end{array}\;[/latex], some with [latex]\begin{array}{|c|}\hline \text{+/-}\\ \hline \end{array}\;[/latex]. The button is often near the [latex]\begin{array}{|c|}\hline \text{=}\\ \hline \end{array}\;[/latex] key or the decimal point.
If your calculator displays operations on it (typically a calculator with multiline display), to calculate 1.005 – 240, you’d type something like: 1.005 [latex]\begin{array}{|c|}\hline \text{^}\\ \hline \end{array}\;[/latex][latex]\begin{array}{|c|}\hline \text{(-)}\\ \hline \end{array}\;[/latex]240
If your calculator only shows one value at a time, then usually you hit the [latex]\begin{array}{|c|}\hline \text{(-)}\\ \hline \end{array}\;[/latex] key after a number to negate it, so you’d hit: 1.005 [latex]\begin{array}{|c|}\hline \text{y}^{x}\\ \hline \end{array}\;[/latex] 240 [latex]\begin{array}{|c|}\hline \text{(-)}\\ \hline \end{array}\;[/latex] =
Give it a try—you should get [latex]1.005^{-240} = 0.302096[/latex]
Example 2
You know you will have $500,000 in your account when you retire. You want to be able to take monthly withdrawals from the account for a total of 30 years. Your retirement account earns 8% interest. How much will you be able to withdraw each month?
In this example, we’re looking for [latex]w[/latex].
[latex]\begin{array}{rcl} r & = & 0.08 & \text{8% annual rate}\\ k & = & 12 & \text{since we're withdrawing monthly}\\ t & = & 30 & \text{We want the amount after 30 years.}\\ P & = & 500,000 & \text{We are beginning with \$500,000.}\\ \end{array}[/latex]
In this case, we’re going to have to set up the equation and solve for [latex]w[/latex].[latex]\begin{array}{rcl} 500000 & = & \frac{w \left( 1- \left( 1+\frac{0.08}{12} \right) ^{-30(12)} \right) }{ \left( \frac{0.08}{12} \right) }\\ 500000 & = & \frac{w \left(1-(1.00667)^{-360}\right)}{(0.00667)}\\ 500000 & = & w(136.232)\\ w & = & \frac{500000}{136.232}\\ w & = & 3670.21\\ \end{array}[/latex]
You would be able to withdraw $3,670.21 each month for 30 years.
You can work this problem with the TVM Solver calculator.
Exercise 1
A donor gives $100,000 to a university and specifies that it is to be used to give annual scholarships for the next 20 years. If the university can earn 4% interest, how much can they give in scholarships each year?
Solution
Solving for [latex]w[/latex] gives $7,358.18 each year that they can give in scholarships.
It is worth noting that usually donors instead specify that only interest is to be used for scholarship, which makes the original donation last indefinitely. If this donor had specified that, [latex]$100,000(0.04) = $4,000[/latex] a year would have been available.
With a payout annuity, you start with money in the account and pull money out of the account on a regular basis.