CHAPTER THREE

ANNUITIES
SESSION ONE
 What is an annuity?
An annuity is a stream of equal, evenly spaced cash
flows.
The simplest annuity is an annuity certain, which
consists of equal cash flows of known amount paid at
regular intervals, either at the beginning or at the
end of each period.
When the first payment occurs at the end of the
current period, the annuity is an immediate ordinary
annuity certain (or simply ordinary annuity).
When the first payment occurs at the start of the
current period (i.e. now), the annuity is an immediate
annuity due certain (or simply annuity due).
 What is an annuity?
When the first payment is delayed by at least one
period, the annuity is a deferred annuity.
Not all annuities are level annuities.
Annuities may also increase per period either by a
fixed dollar amount (simple increasing annuity) or
at a fixed rate (compound increasing annuity).
When the periodic dollar increment or compound
rate is negative, the annuity is a decreasing annuity.
Again, not all annuities pay at yearly intervals.
Annuities that make p payments each year are said
to be payable pthly.
 Level immediate annuities payable
annually
Consider a series of annual payments of $1 each for
10 years, with each payment occurring at the end of
each year (in arrears), starting immediately. Interest
is 12% p.a. convertible annually.
One way to calculate the present value of this cash
flow stream is to discount each dollar at 12% per
annum and then adding across, thus:
++++++++
A quicker way however is to consider the present
value as the sum of a geometric progression, with the
first term as and common ratio as .
Thus
 Level immediate annuities payable
annually
The general formula for the present value of
an ordinary annuity of $1 each year payable
yearly for n years at an effective annual rate of
interest of is given thus:
From the above, we deduce that if the
payment per annum is any amount , the
present value of the annuity is:
 above is referred to as the present value
interest factor of an ordinary annuity paying
$1 per annum for years at per annum
effective ().
 Level immediate annuities payable
annually
 The general formula for the present value of an annuity
due of $1 each year payable yearly for n years at an
effective annual rate of interest of is given as:
 Thus we get the present value of an annuity due by
accumulating the present value of a corresponding
ordinary annuity for one year at
 From the above, we deduce that if the payment per
annum is any amount , the present value of the annuity
due is:

 above is referred to as the present value interest factor

of an annuity due paying $1 per annum for years at per
annum effective.
 Level immediate annuities payable
annually
Assume that the annuity in the previous
example was payable at the start of each year
(in advance) instead, then:
 Level immediate annuities payable
annually
The general formula for the accumulated value
of an ordinary annuity of $1 each year payable
yearly for n years at an effective annual rate of
interest of is given as:
From the above, we deduce that if the
payment per annum is any amount , the
present value of the annuity is:
 above is referred to as the future value
interest factor of an ordinary annuity paying
$1 per annum for years at per annum
effective ().
 Level immediate annuities payable
annually
The accumulated value of an ordinary annuity
of $1 each year payable yearly for 10 years at
an effective annual rate of interest of 12% is
given thus:
 Level immediate annuities payable
annually
 The general formula for the accumulated value of an
annuity due of $1 each year payable yearly for n years at
an effective annual rate of interest of is given as:
 Thus we get the accumulated value of an annuity due by
accumulating the accumulated value of a corresponding
ordinary annuity for one year at
 From the above, we deduce that if the payment per
annum is any amount , the accumulated value of the
annuity due is:

 above is referred to as the future value interest factor

of an annuity due paying $1 per annum for years at per
annum effective.
 Level immediate annuities payable
annually
The accumulated value of an annuity due of
$1 each year payable yearly for 10 years at
an effective annual rate of interest of 12% is
given as:
 Level immediate annuities payable
pthly
An ordinary annuity payable pthly at an
annual rate of $1 for n years pays an amount
equal to at the end of each period.
Thus instead of paying $1 at once at the end
of the year, the $1 is evenly distributed over
each of the p periods in a year.
At an effective interest rate of per period or
per annum, the present value of this annuity
is:
 Level immediate annuities payable
pthly
At an effective interest rate of per period or
per annum, the accumulated value of this
annuity is:
 Level immediate annuities payable
pthly
For example, an ordinary annuity payable
monthly at an annual rate of $1 for 10 years
pays an amount equal to at the end of each
month.
Thus instead of paying $1 at once at the end
of the year, the $1 is evenly distributed over
each of the 12 months in a year.
At an effective interest rate of per period or
per annum, the present value of this annuity
is:
 Level immediate annuities payable
pthly
At an effective interest rate of per period or
per annum, the accumulated value of this
annuity is:
 Level immediate annuities payable
pthly
Likewise, an annuity due payable pthly at an
annual rate of $1 for n years pays an amount
equal to at the start of each period.
Thus instead of paying $1 at once at the start
of the year, the $1 is evenly distributed over
each of the p periods in a year.
At an effective discount rate of per period or
per annum, the present value of this annuity
is:
 Level immediate annuities payable
pthly
The accumulated value of this annuity is:
 Level immediate annuities payable
pthly
NB: The effective discount rate of per period
above is equivalent to an effective interest
rate of per period, and the effective discount
rate of per annum is equivalent to an effective
interest rate of per annum.
 Level immediate annuities payable
pthly
For example, an annuity due payable monthly
at an annual rate of $1 for 10 years pays an
amount equal to at the start of each month.
Thus instead of paying $1 at once at the start
of the year, the $1 is evenly distributed over
each of the 12 months in a year.
At an effective discount rate of per period or
per annum, the present value of this annuity
is:
 Level immediate annuities payable
pthly
At an effective discount rate of per period or
per annum, the accumulated value of this
annuity is:
 Annuity Replacement
Given a level stream of payments made n-
times per year at the end of each period, the
equivalent stream of payments made m-times
per year at the end of each period is given as:

And the equivalent stream of payments made

m-times per year at the beginning of each
period is given as:
 Deferred annuities
Present value of an ordinary annuity of 1
each year for n years, payable pthly, with first
payment deferred by m years:

Present value of an annuity due of 1 each

year for n years, payable pthly, with first
payment deferred by m years: