If you’re seeking a regular stream of income in retirement, an annuity can provide it. If you want your estate to fund an organization for the long-term, there’s another type of annuity you can fund, the perpetuity annuity. The difference between an ordinary annuity and perpetual annuity is considerable. One way to distinguish between the ordinary annuity and perpetuity annuity is their differing time periods, and the way the annuity vs. perpetuity formulas differ in applying interest.
Annuity Vs. Perpetuity
Ordinary annuities are available in two different forms, the deferred and the immediate. With the former, funds are invested over time until withdrawals are taken in retirement. The immediate annuity begins issuing payments to the owner right after he or she makes the investment. Immediate annuities are most often purchased by those close to or in retirement.
Ordinary annuities are paid on a monthly, quarterly, semiannual or annual basis, depending on the contract. The ending date of the ordinary annuity may vary, but is usually the owner’s death date. Some ordinary annuities involve a deadline – no pun intended – with payments lasting a prescribed number of months. On the other hand, there’s never a deadline with a perpetual annuity.
That’s because perpetual means forever, and that’s how long a perpetual annuity lasts. These are not annuities purchased by the average retiree, none of whom are destined to live in perpetuity. Instead, the annuity might fund an annual scholarship in perpetuity, or otherwise supply charities with a perpetual source of income.
Fixed or Variable Annuities
Immediate and deferred annuities are either fixed or variable. With a fixed payout, the annuity owner receives a certain dollar amount each payment period, although cost-of-living adjustments as per the contract are usually included. With a variable annuity, the owner chooses from investments offered by the annuity seller, and the amount of the payout varies by investment performance. With either type of payout, capital gains are tax-deferred until the owners begin making withdrawals.
Withdrawing Annuity Funds
As with employer-sponsored retirement plans and traditional IRAs, withdrawing funds from an annuity before the age of 59 1/2 will usually cost the owner a 10 percent early withdrawal penalty. The good news is, unlike these other retirement plans, there is no annual limit to the amount of money a person may contribute to an annuity.
Annuities are not designed to serve as a retiree’s primary source of income, but they are a steady source when combined with Social Security, retirement account withdrawals and other investments owned by the individual. Annuities are especially useful for people who fear they have underfunded their retirement and need to catch up as quickly as possible.
Using the Annuity Formula
When it comes to annuities marketed for retirement income, the purchasers provide a lump sum for the annuity and are then guaranteed regular, smaller payments for the rest of their lives. The annuity seller, usually an insurance company, takes the risk that the purchaser will outlive the funds with which the annuity was purchased.
The annuity formula for determining period cash flow is its payment amount divided by the interest rate per time period and the number of periods. Deriving the value of the annuity involves compounding the stated interest rate, as per Investopedia.
Using the Perpetuity Formula
Since a perpetuity payment goes on forever, it is impossible to determine its face value. It is possible, however, to determine its current value. Figure the current value of a perpetuity annuity as the same as the discounted value of each periodic payment.
Use the actual interest rate, not including any compounding. The current value is the payment per time period divided by the interest rate per time period.