Annuity
IntermediateAn annuity is a series of equal payments made at regular intervals for a set period, such as monthly loan repayments or yearly pension payments. The word is also used for an insurance product that provides a guaranteed income, often in retirement.
Many everyday arrangements are annuities in the financial sense. A car loan repaid with 60 equal monthly payments is an annuity. So is a savings plan where you put in the same amount every month, or a pension that pays a fixed sum every year.
Because the payments are spread over time, each one has a different value today. Suppose you will receive 1,000 at the end of each year for five years and money can earn 5% a year. The five payments total 5,000, but their combined value today is only about 4,329, because later payments are worth less than earlier ones. If instead you saved each payment at 5%, you would have about 5,526 after five years.
These calculations explain how loan payments are set. The lender chooses the equal payment that, over the loan term, repays the principal plus interest.
As a retirement product, an annuity is bought from an insurer with a lump sum. In return, the insurer pays a regular income for a set number of years or for life, which protects against the risk of running out of money.
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