Annuitization

An annuity is a stream of equal payments made at equal intervals, such as monthly or yearly. Annuities are another way to quantify the value of money over time.

Let's say you lucked out and won your state lottery. You are given a choice of a single lump sum $1 million payout now or $50,000 annually over the next 25 years ($1,250,000). If you're like most folks you'll see this as "a bird in the hand is worth two in the bush," and you'll opt to take the lesser amount sooner. Sounds sensible....but can you quantify this decision?

We need to select some sort of interest rate or perhaps estimate what the inflation rate might be over the period of the annuity. Based on historical rates, four percent is a reasonable estimate. The problem now becomes to determine the present value of the $50,000 times 25 years discounted by four percent compared to the $1 million lump sum.

A good financial calculator is the quick way to compute this decision but good old fashioned annuity tables will do just as well; they're generally just heavier to lug around.

Financial Calculators This calculator works just like a pocket calculator. And this more advanced calculator computes present value, future value, payments, and/or number of periods.

There are additional, related, computations that you might want to make. For example, you may wish to examine the impact of various interest rates.

Planning Tools Use this Annuity Table to compute the present value of a series of payments to be paid in the future, based on varying rates of interest.

Using the annuity table, find the following figures:

• locate the number of compounding periods (in this case years) -- 25
• locate the interest rate -- 4 percent
• locate where they intersect -- 15.622080
• multiply the $50,000 payment by the 15.622080 factor
• which gives you $781,104 -- the present value of the future payments discounted for inflation.

Keep in mind that this example doesn't even take into account the lost opportunity cost of what you might have earned on the $1 million dollars if you took it immediately and invested it rather than taking the annuity. (For the sake of simplicity, none of the examples here include any tax computations.)

This exercise quantifies for you the fact that you'd be more than wise to take your $1 million dollars today.

Yes indeed, knowing how to compute the time value of money will definitely come in handy when you win that big lottery jackpot.