Evaluating Annuities 

In order to evaluate an annuity, one thing that has to be kept in mind is that it is basically a series of fixed or variable payments spread over a certain period of time. During the accumulation phase, the investor makes the payment and during the payout phase, the investor receives the payment. The timing of each of these payments as well as the frequency of the payments may differ from one plan to the other, but the basic common factor among all these annuity plans is that they consist of a series of payments during a certain period of time, which may be fixed or uncertain. The most common payment frequencies are yearly, half-yearly, quarterly or monthly.

For the purpose of evaluation of annuities, they can be classified in two categories – ordinary annuity or annuity due. An ordinary annuity is the one in which the payment is made at the end of the period, whereas in the annuity due, the payment is made at the beginning of the period. A common example of ordinary annuity concept is the coupon payment made on a bond, in which the coupon payments are made at the end of every six-month period or one-year period depending on whether the bond provides for a semi-annual coupon payment or an annual coupon payment. Payment of rent is an example of the concept of annuity due, in which the payment is required to be made at the beginning of the period when a tenant moves in an apartment for the current month and is required to make payments at the beginning of every subsequent month for the corresponding month.

Because of the concept of time value of money, what is a dollar today is worth more than a dollar tomorrow, the present value of an annuity that pays certain amount of money in future is worth less than what it pays in total, spread over a period of time in future. The evaluation of an annuity basically involves determination of the present value of the series of such payments in future, either pre-determined in case of an annuity for a fixed period of time, or for a variable period, in case of the one for the entire life of the owner or beneficiary. In the latter case, an estimate is done on the expected life of the beneficiary and the valuation of the annuity is done accordingly.

The present value of an annuity is determined based on the payment frequency, or the number of payments in a year, the time at which these payments are required to be made, whether at the beginning or the end of the period, and the total number of such payments that are expected to be made. An important variable in the valuation of the annuity is the prevailing rate of interest rate in the economy that can be used for discounting the payments received in the future.