Retirement planning is an extensive yet necessary step to take before leaving your working years. Many people are discouraged from planning their retirement because of the vast options they can choose from.
With a lot to learn about retirement planning, it’s crucial to start at the most basic, which is annuities. Under annuities, you can either purchase an ordinary annuity or an annuity due.
In this blog post, we’ll tackle the topic of an ordinary annuity. We’ll give you a brief explanation of what an ordinary annuity is and everything you need to know before investing in one.
A Quick Overview of Annuity
Before diving right into ordinary annuities, let’s briefly recap what an annuity is. An annuity is a retirement product or a contract between you and your insurance company in which you make regular payments for a specific period or pay a lump-sum amount.
In exchange, the insurer can provide you with periodic income payments starting immediately (immediate annuity) or at some point in the future (deferred annuity).
When and how long the insurance company will “pay” you is predetermined and is based on the policy you acquired. You may receive your payment at the start of each period (annuity due) or the end (ordinary annuity).
Understanding Ordinary Annuity
Now that we have refreshed our memory on the annuity concept, let’s get back to the topic at hand, which is the ordinary annuity. An ordinary annuity is an annuity in which income payments are explicitly received at the end of each payment period.
For example, you purchased an insurance policy in which you made a lump-sum payment. The income payments you’ll receive will only be available at the end of each period, i.e., after every year or at the end of each month.
Ordinary annuities come in fixed or variable rates, depending on your plan and your contractual agreement with your insurer.
A fixed-rate ordinary annuity would yield the same amount of income for every period. Whereas with variable-rate ordinary annuities, it would depend on the performance of your index fund or other investment options you’ve put your money in.
Examples and Applications of Ordinary Annuity
For better clarity of the concept, we’ll provide some examples below:
- Mary Jones paid a lump sum of $40,000 to her insurance company and signed a policy in which she would be paid $425 monthly for eight years. After a year, she started receiving the promised $425 monthly annuity, but she’s getting it at the end of each month. This is a case of an immediate ordinary annuity, as the annuity was given instantly after her initial payment and consistently at the end of each month.
- Ava Silva purchased a policy from an insurance agent wherein she was obliged to pay $150 every month until she reached $50,000 before her annuity kicked in. After years of working, Ava finally completed her payment. Once she reached retirement age, she started receiving an annuity of $500 monthly. This is an example of an ordinary deferred annuity.
The Value of an Ordinary Annuity
The value of how much you can earn and how much you need to pay in premiums in an ordinary annuity is determined by the present value and future value.
The present value of an annuity is the amount of money you need to pay in premiums to receive a specific amount in the future. It considers the time value of money, meaning that a certain amount now is worth more than when received in the future.
For example, if you want to receive a $500 monthly annuity for ten years, you would need to pay premiums of around $60,000 to make it feasible. Involving the time value of the money and the discount rate is a complicated concept, as it differs on a case-to-case basis.
The concept of present value lies in the belief that money’s worth today differs from its future value because of inflation. This means that your $500 today is worth more or less than $500 ten years from now, depending on economic performance.
In contrast, the future value of an annuity is the amount you receive when the term ends. In other words, it’s the total income you can potentially receive in the future.
For example, if Ava Silva’s annuity term is 10 years and she receives $500 monthly, then her total income, in the end, would potentially be $60,000. This increase in value results from the interest accumulated over time and the discount rate, which also differs on a case-to-case basis.
When you seek guidance from an experienced and astute financial advisor, they can give you a much more accurate estimation of the future value of an ordinary annuity, considering these factors.
Ordinary Annuity vs. Annuity Due
As mentioned above, an ordinary annuity and an annuity due are two different types of annuities. The main difference between the two is that with an ordinary annuity, payments are received at the end of each period, but with an annuity due, you receive your payment at the beginning of each period.
For example, suppose Ava Silva opted for an annuity due instead of an ordinary annuity. In that case, she would have received $500 monthly once a new month started.
As shown above, payout periods are the most distinct differentiation between an ordinary annuity and an annuity due. With an ordinary annuity, you receive payments at the end of each period, while with an annuity due, they are given at the beginning of each period.
An annuity due has a relatively higher present value than an ordinary annuity, meaning that your $500 due payment today would be worth more than the same $500 annuity payment received one month later.
This difference is because you receive payments in the present time, making them more valuable than payments due later.
Remember, the present value is mainly influenced by inflation and the time value of money. When you receive payments in the present, they will be worth more or less than when received in the future due to inflation and other economic factors.
Another difference between the two is the rate of interest. Ordinary annuities usually have a higher interest rate than an annuity due, as you get paid at the end of each period.
In contrast, with an annuity due, you receive payments at the beginning of each period, resulting in a lower interest rate. Time mainly affects the performance of interest. The longer you wait for payments, the more interest you can earn from an ordinary annuity.
Which One Is Better?
At the end of the day, it all depends on your situation. For example, if you need immediate access to funds, an annuity due would be better for you. On the other hand, if you’re looking to make more money from interest, then an ordinary annuity is the way to go.
An annuity due is not better than an ordinary annuity, and vice versa. It depends on your individual needs, goals, and the market conditions. Thus, it is essential to consult a financial advisor before deciding which one to invest in.
A licensed agent or financial advisor financial advisor can help you make the right decision by meticulously analyzing your situation and outlining each annuity type’s pros and cons. Only then can you make the right decision for you.
Talk to an Expert About Ordinary Annuity Today
Dealing with the ordinary annuity can be daunting and confusing. With all the complicated concepts and external factors, it’s easy to get lost and make critical mistakes.
At Safe Wealth Plan, we can help you understand the ins and outs of the ordinary annuity and determine if it’s the best retirement tool for you.
We have a team of highly-experienced professionals who can help you with your retirement planning. We’ll consider your unique situation and goals to devise a customized plan that fits your needs.
If you’re ready to learn more about ordinary annuity and how it can help you with your retirement, schedule a free consultation with us today.