The present value of your annuity is the cash value of all the payments you’re due to receive during your retirement years at a set discount rate. Understanding this formula can help you to determine the true value of your annuity.
Here’s what you need to know about calculating your annuity’s present value.
What is present value?
Present value is based on a concept known as time value of money. Payments that are set to be made far into the future are worth less today. This is because it’s impossible to predict economic conditions years from now.
On the other hand, current payments are more valuable because they can be invested.
Look at it this way. Having $20,000 in your pocket today has a higher worth than being paid $20,000 over the next 10, 20, or 30 years.
If you own an annuity, you have the option to sell your future payments to a purchasing company. In turn, you’ll receive immediate cash. Receiving your funds early can be used for:
- Paying off debt
- Putting a down payment on a home
- Paying for major car repairs
Purchasing companies use the present value formula and other variables to determine what future payments are worth based on today’s economic conditions.
Calculating present value
If you’re considering selling future annuity payments, determining the present value is important for many reasons. First, you’ll get a clearer understanding of what your annuity is worth. You can then determine if you’re getting a good deal when selling.
To calculate your annuity’s present value, you’ll need several pieces of data, including:
- Number of payments you want to sell (n)
- Amount each payment (pmt)
- Discount rate (r)
Once you have these numbers, plug them into the following calculation. The answer is the present value of your annuity.
Present value (PV) = PMT x [(1 – (1+r)-n) / r]
Making the most of your annuity’s present value
Companies that buy annuity payments use discount rates to account for inflation and other market risks. Discount rates are also used to make a small profit by the company for giving you early access to your payments.
The discount rate directly affects not only the value of your annuity, but how much money you’ll receive when selling future payments.
Most discount rates fall between 8-15%. While some may be higher, most are within that range. The lower the rate, the higher present value your annuity has. A low discount rate means you get to keep more of your money.
When selling annuity payments, be aware that the sooner a payment is due to be paid, the more money you’ll get by selling it. For example, any payments that you’ll receive in the next five years are more valuable than those you’ll receive 20 years from now.
Calculating the true value of your annuity can help you to determine if selling makes sense, how much to sell, and when to sell. Shop around for the best discount rate and always ensure that you’re getting a fair deal.