Finite Math

5.2 Notes

Name_________________________

5.2 ANNUITIES
Future Value of an Annuity
annuity - a sequence of payments made at regular time intervals.
Term (of the annuity)- the time period in which these payments are made
Depending on whether the term is given by a fixed time interval, a time
interval that begins at a definite date but extends indefinitely, or one that is
not fixed in advance, an annuity is called an annuity certain, a perpetuity, or
a contingent annuity, respectively.
Hence,
Annuity certain _______________________________________________________________________
Perpetuity annuity ____________________________________________________________________
Contingent Annuity ____________________________________________________________________
Ordinary annuity - An annuity in which the payments are made at the end of
each payment period Annuity Due - An annuity in which the payments are
made at the beginning of each period
Simple Annuity - An annuity in which the payment period coincides with the
interest conversion period Complex Annuity An annuity in which the
payment period differs from the interest conversion period
Annuities are subject to the following conditions:
1. The terms are given by fixed time intervals.
2. The periodic payments are equal in size.
3. The payments are made at the end of the payment
periods.
4. The payment periods coincide with the interest
conversion periods.
The annuity formula is given by the accumulated amount S of an annuity,
suppose that a sum of $R is paid into an account at the end of each period
for n periods and that the account earns interest at the rate of i per period.

Then, proceeding as we did with the numerical example, we obtain

1

Finite Math

5.2 Notes

S = R + R(1 + i ) + R(1 + i )2 + + R(1 + i )(n

( 1+i )n1
R
i

Name_________________________
1)

The expression inside the brackets is commonly denoted by

ni

(read s

angle n at i) and is called the

compound-amount factor.
n i

In terms of the compound-amount factor,

S=R S

Example 1
Find the amount of an ordinary annuity consisting of 12 monthly payments of
$100 that earn interest at 12% per year compounded monthly.
Solution:
Since i is the interest rate per period and since interest is compounded
monthly in this case, we have
0.12
i=
= 0.01.
12
Using the Formula above: R = 100, n = 12, and i = 0.01, we have
100 [ ( 1.01 )121 ]
s=
1268.25
0.01
Thus, the amount of the annuity is $1268.25.

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5.2 Notes

Name_________________________

Present Value of an Annuity

Since the amount P invested now and earning interest at the rate of i per
period will have an accumulated value of P(1 + i )n at the end of n periods.
But this must be equal to the future value of the annuity S.
Therefore, equating the two expressions, we have
( 1+i )n1
P (1+i )n=R
i

Multiplying both sides of this equation by (1 + i )n gives

n
n ( 1+i ) 1
P=R ( 1+i )
i

[
[

( 1+i )n (1+i )n (1+i )n

i

1( 1+i )n
R
i

Example 2
Find the present value of an ordinary annuity consisting of 24 monthly
payments of $100 each and earning interest at 9% per year compounded
monthly.
Solution:
R=

P=R

r
i= = =
m

1( 1+i )
i

and n=

]
3

, so

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5.2 Notes

Name_________________________

1+
]
(
1

Thus, the present value of an ordinary annuity is $______________________.

Important application of annuities:
During the 1980s, Congress created many tax-sheltered retirement savings
plans, such as Individual Retirement Accounts (IRAs),
Keogh plans, and
Simplified Employee Pension (SEP) plans.
These plans are examples of annuities in which the individual is allowed to
make contributions (which are often tax deductible) to an investment
account.
Example 3
During the 1980s, Congress created many tax-sheltered retirement savings
plans, such as Individual Retirement Accounts (IRAs), Keogh plans, and
Simplified Employee Pension (SEP) plans.
These plans are examples of annuities in which the individual is allowed to
make contributions (which are often tax deductible) to an investment
account.
Invest bonus in regular savings account:
You will first have to pay taxes on the $2000, leaving $1440 to invest.
At the end of 1 year, you will also have to pay taxes on the interest earned,
leaving you with

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5.2 Notes

Name_________________________

or $1522.94.
Invest bonus into the IRA:
The entire sum will earn interest, and at the end of 1 year you will have
(1.08)($2000), or $2160, in your account.
On the other hand, if you put the money into the IRA, the entire sum will earn
interest, and at the end of 1 year you will have (1.08)($2000), or $2160, in
your account.
Of course, you will still have to pay taxes on this money when you withdraw
it, but you will have gained the advantage of tax-free growth of the larger
principal over the years.
The disadvantage of this option is that if you withdraw the money before you
reach the age of
60, you will be liable for taxes on both your
contributions and the interest earned, and you will also have to pay a 10%
penalty.
Example 5
Caroline is planning to make a contribution of $2000 on January 31 of each
year into a traditional IRA earning interest at an effective rate of 5% per year.
a. After she makes her 25th payment on January 31 of the year following her
retirement at age 65, how much will she have in her IRA?
b. Suppose that Caroline withdraws all of her money from her traditional IRA
after she makes her 25th payment in the year following her retirement at
age 65 and that her investment is subjected to a tax of 28% at that time.
How much money will she end up with after taxes?
Solution:
a. For part a we will use

( 1+i )n1
S=R
i

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5.2 Notes

b.

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