Understanding the Present Value of an Annuity
There are few financial concepts that cause more confusion than time value of money. For this reason, it is often even more difficult to understand the present value of an annuity as compared to future values, as annuities are not known to be simplistic investment vehicles. However, when all the smoke and mirrors are removed, annuities and time value of money are not as difficult to comprehend as they may appear at first glance.
First, it is important to understand exactly what an annuity is. An annuity is an investment vehicle in which money is placed, which pays out monthly, quarterly, or yearly payments at set future dates. This is the basic definition of an annuity. Therefore, when you look at the time value concept, you are looking at the value of your money today as compared to the future payment dates.
The present value of an annuity is based on the current value of the money being held. Of course, at first glance, you only see the dollar amount in the account. However, when looked closely, it becomes apparent how today's value is different than the future value.
Can you buy as much with $100 today than you could ten years ago? Of course not; why is this? The answer is inflation. In the last ten to twenty years, because credit cards have become a mainstay in the economy, every dollar is actually worth less than it was. However, credit cards are not the only reason; inflation is a naturally occurring process. If you consider the buying power of today's dollar as compared to 100 years ago, inflation is also apparent. It has just become more severe as plastic waters down the buying power of today's dollar.
How does this affect your annuity? The problem with annuities and structured settlements is that they are based on today's dollars even though they are paid in the future. The inflation rate is currently over 4%; therefore, the money in your annuity will actually be worth less when this value is factored into your future payments. Although the dollar amount may be the same, you will not be able to purchase as much with your future dollar as you can today. This is one of the primary reasons for selling an annuity at today's rates instead of waiting for future payments. Every day your money sits in an annuity, it loses value.