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Financial Mathematics Deferred Annuity

2010 http://www.weallstartsomewhere.com
1
Calculating Future Value Deferred
Annuities

Future value of an ordinary annuity

FV = R_
(1 + r)
n
-1
r
_

FV refers to future value
R refers to the regular payments per compounding period
n refers to the number of compounding periods
r refers to the interest rate per compounding periods

A lot of students find calculating future value deferred annuities quite
complicated and difficult to understand. The thing is they are a trick
question. The period that the annuity is deferred for is irrelevant.
A FV deferred annuity is calculated the same way as a FV ordinary
annuity. The best examples of deferred annuities are contracts. Contract
payments can be delayed until the person wishes to receive them.

If you read the tutorial on ordinary annuities you will recall Alex making
contributions into his superannuation account. Here is a recap question!

FV ordinary annuity recap example 1
Alex is currently 40. Alex is planning to retire when he reaches the age of 60.
He wants to make sure he has enough in his superannuation account for when he
retires. At the moment his employer is contributing 9% of his monthly wage
which is \$5,000. Alex himself is contributing an additional \$100 each month.
The interest rate is 4.50% p.a. compounded monthly. How much will Alex have
in his superannuation account when he retires?

There is 20 years until Alex retires. Regular payments are made monthly (12
times a year). Therefore n is 20yrs x 12 = 240 periods

The p.a. interest rate is 4.50%. The interest rate per compounding period r is
0.0450 12 = 0.00375.
Fv = R_
(1 +i)
n
- 1
i
_
FV =?
R = \$550
r = 0.0450 12 = 0.00375
n = 20yrs x 12 = 240

Fv = \$SSu_
(1 + u.uuS7S)
240
-1
u.uuS7S
_

Fv = \$21S,468

When Alex retires he will have \$213,468 in his superannuation account.

Financial Mathematics Deferred Annuity

2010 http://www.weallstartsomewhere.com
2
Deferred Annuity Example 1
Say that Alex decides that he doesnt want to start contributing to his
superannuation account yet, but would rather wait until he is 55 and then begin
making contributes until he turns 60. Assume that \$550 is still being deposit
each period and the interest rate is 4.50% p.a. compounded monthly

Alex has deferred payment into his superannuation account for 15 years. So
instead of this being a 20 year annuity, it is simply a 5 year annuity. The
deferment period is irrelevant.

Alex will be making contributes for 5 years (between the age of 55 and 60) every
month.
The compounding periods is therefore 60 (5yrs x 12)
The interest rate per compounding period is 0.0450 12 = 0.00375

Fv = R_
(1 +i)
n
- 1
i
_
FV =?
R = \$550
r = 0.0450 12 = 0.00375
n = 5yrs x 12 = 60
Fv = \$SSu_
(1 + u.uuS7S)
60
-1
u.uuS7S
_

Fv = \$S6,9Su

When Alex retires he will have \$36,930 in his superannuation account.

Example 2
Josh wants to determine the future value of a 3 year contract, that pays \$10,000
each year and the first payment is deferred until the end of the 2 period.
Interest rate is 7.50% p.a.

Fv = R_
(1 +i)
n
- 1
i
_
FV =?
R = \$10,000
r = 0.0750
n = 3

Fv = \$1u,uuu_
(1 +u.u7S)
3
-1
u.u7S
_

Fv = \$S2,Su6

The future value of the contract is \$32,306

Financial Mathematics Deferred Annuity

2010 http://www.weallstartsomewhere.com
3
Calculating Present Value Deferred
Annuities

Present value of a deferred annuity

PV = R_
1 -(1 + r)
-n
r
_ _
1
(1 +r)
m
_

FV refers to present value
R refers to the regular payments per compounding period
n refers to the number of compounding periods
r refers to the interest rate per compounding periods
m refers to the number of deferred periods

Unfortunately the present value of a deferred annuity is not the same as
the present value of an ordinary annuity. Deferred annuities are
calculated in two stages. First the present value of an ordinary annuity is
calculated and then discounted back to todays value.

Say we have a 5 period annuity and the first payment is deferred until the
beginning of the fourth period (or the end of the third period as this is the
same point in time). Each period we are paying \$10 and the interest rate
is 7.5% p.a.

The timeline below helps us picture our situation graphically. If we
pretend that the beginning of the 4
th
period is the 1
st
period (as this is
when the first payment is) then we can just use the present value
ordinary annuity formula. Then we simply discount it back 3 periods
(however many periods payment was deferred for), in order to get the
value of the annuity today. The value of the annuity is going to be worth
less today then in 3 periods.

Students really tend to tear their hair out when trying to work out present
value deferred annuity problems. They can quiet difficult. The trick is to
first determine the number of periods as if you are just calculating an
ordinary annuity and then discounting it back by however many periods
the annuity was deferred for to get the present value.
Financial Mathematics Deferred Annuity

2010 http://www.weallstartsomewhere.com
4
Example 3
Josh is 20 and wants to retire when he is 55. He wants to find todays value of
an annuity if he was deposit \$500 twice a year into superannuation account
earning 6% compounded semiannually. The first payment occurs on his 25
th

birthday. Josh decides that he would rather not start making deposits right now
but will wait until he is 25 and then begin making the \$500 payments twice a
year.

First pretend as if this was an ordinary annuity question. For how many
years will Josh be making deposits for? He will begin making deposits at age 25
and stop at age 55. This is 30 years. Josh is making 2 payments every year. So
the number of periods is 60 (30yrs x 2).

Pv = R_
1 -(1 +i)
-n
i
_
PV =?
R =\$500
r = 0.06 2 = 0.03
n = 30yrs x 2 = 60

Pv = \$Suu_
1 - (1 + u.uS)
-60
u.uS
_

Pv = \$1S,877.78

Now we need to determine how many periods Josh has deferred payment for. It
is always best to draw a timeline so that you can clearly see how many periods
payment has been deferred for. Payment has been deferred for 5 years with the
first payment on Joshs 25
th
birthday. Payment ends up being deferred for 9
periods as depicted below.

Pv = \$1S,877.78 _
1
(1 + i)
m
_
r = 0.06 2 = 0.03
n = 30yrs x 2 = 60
m = 9

Pv = \$1S,877.78 _
1
(1 + u.uS)
9
_

Pv = \$1u,6uS.S

The present value of Joshs superannuation account is \$10,605.5

Financial Mathematics Deferred Annuity

2010 http://www.weallstartsomewhere.com
5
Example 4
Instead Josh decides to invest his money into the first home owners savings
account. It pays 17% p.a. in order to encourage young people to start early to
save for a house. He intends on making \$1,000 contributions into the account
every year until he buys a house. If Josh is currently 20 and intends on buying a
house when he turns 27, but doesnt begin making deposits into the account until
he is 22, what is the present value of the annuity?

First pretend as if this was an ordinary annuity question. For how many
years will Josh be making deposits for? He will begin making deposits at age 22
and stop at age 27. This is 5 years. Josh is making 1 payment every year. So
the number of periods is 5 (5yrs x 1).

Pv = R_
1 -(1 +i)
-n
i
_
PV =?
R =\$1,000
r = 0.17
n = 5

Pv = \$1,uuu_
1 -(1 +u.17)
-5
u.17
_

Pv = \$S,199.S46

Now we need to determine how many periods Josh has deferred payment for. It
is always best to draw a timeline so that you can clearly see how many periods
payment has been deferred for. Payment has been deferred for 2 years with the
first payment on Joshs 22
nd
birthday. Payment ends up being deferred for 3
periods.

Pv = \$S,199.S46 _
1
(1 + i)
m
_
r = 0.06 2 = 0.03
n = 30yrs x 2 = 60
m = 3

Pv = \$S,199.S46 _
1
(1 +u.uS)
3
_

Pv = \$2,928

The present value of Joshs first home owners savers account is \$2,928

Financial Mathematics Deferred Annuity

2010 http://www.weallstartsomewhere.com
6
Example 5
Josh decides that he would like the present value of his first home owners
savings account to be worth \$15,000. Josh also believes that he may need more
time to save for his first home, so he doesnt plan to purchase a house until he is
30. Josh also decides to start making regular payments at 21. How much will
Josh need to deposit each period, if he makes 2 payments a year and the interest
rate is 17% compounded semiannually?

We are trying to determine the amount that Josh needs to deposit into the
account per period, R.
If Josh begins payment s at 21 and stops at 30 then this is 9 years. The number
of compounding periods, n, is therefore 18 (9 x 2).

The interest rate per compounding period is 0.17 2 = 0.085

Pv = R_
1 -(1 +i)
-n
i
_ _
1
(1 +i)
m
_
PV =\$15,000
R =\$?
r = 0.17 2 = 0.085
n = 9 x 2 = 18

To determine how many periods Josh has deferred payment for draw a timeline.

Payment has been deferred for 1 period. Thus m =1

\$1S,uuu = R_
1 -(1 +u.u8S)
-18
u.u8S
_ _
1
(1 +u.u8S)
1
_

\$1S,uuu = R(9.uSSS) u.922

\$1S,uuu = 8.S461R

R =
\$1S,uuu
8.S461
= \$1,797.2S

Josh will need to deposit \$1,797.25 into his account each period.