Annuities is a source of retirement income as they provide a steady stream of payments at regular intervals. An annuity involves a series of recurring payments made over a period of time to achieve an investment goal or settle future obligations. An annuity is one of the important tools for an investor to achieve financial freedom over time. This is because, at a realistic yield, an investor with a low income can consistently grow his or her wealth in the long run.
Forms of Annuity
Annuity can be broadly categorized into two:
- Annuity Due: Annuity due is said to have occurred whenever the payment is made regularly at the beginning of investing periods. A good example of an annuity due is the rent payment which occurs regularly at the beginning of a period.
- Ordinary Annuity: As opposed to annuity due, ordinary annuity payment occurs at the end of the investing period. This arrangement is usually suitable for a debt issuer since the fund received can be put to productive use before payment is made.
Benefits of Annuities
- Financial Security: Annuities can be structured to provide a dependable source of income to a person following his or her retirement. In fact, this is one of the reasons why annuities are useful in wealth planning.
- Flexibility: Investors with a little amount to invest need not worry much as annuity rewards a consistent investor over a considerable period.
- Sinking Fund: Annuity is suitable for planning the payment of future obligations. For example, determining what you need to put into an investment to fund your child’s university education.
- Example of Annuity
- Mr. Emeka is a car parts dealer, popularly known in Ladipo market. Although he was not educated, Emeka has a dream to put his 2 children, Chibuzor and Kelechi into a top Nigerian University in 15 years while also owning a family house which would cost about N6.0m at the end of this period.
- He recently met with a top portfolio manager, who advised him to invest N20,000.00 monthly in a mutual fund over this period. He was further advised that the mutual fund generates an average return of 10.0% annually and that it would cover his children’s tuition which is projected to be a million naira at that time while also leaving him an additional cash flow that can be used to purchase a family house.
- Solution
- Estimating the Future Value of the annuity
- FV= A((1+r)^n-1)/r
- Where FV = Future Value
- A = regular payment
- r = interest rate
- n = number of periods
- Therefore the FV = N8,289,406.92
Note: The portfolio manager’s projection was quite realistic since the value of Emeka’s investment would be N8,289,406.92 in 15 years, enough to cover his children’s tuition and the purchase of a family home while also leaving him with an extra N1.3m.
- Also note that the amount contributed over the years is N3.6m, implying a net gain of N4.7m. This shows that despite having little, an annuity can multiply wealth for small investors over the long run. Having an annuity in one’s portfolio can aid one’s retirement.
