Definition of an Ordinary Annuity
An ordinary annuity is a series of equal payments that are made at the end of each consecutive interval period for a specific length of time.
In other words, the annuitant receives payouts at the end of each month, the end of each quarter, or the end of another specific interval. The opposite of an ordinary annuity is an annuity due, which pays out at the beginning of each period.
The following is an example of an ordinary annuity. Eileen is a retiree who has purchased an immediate annuity payable for life. Her annuity is guaranteed to pay her $498 each month, and she receives these payouts at the end of each month, making it an ordinary annuity.
The concept of an ordinary annuity also applies to other scenarios, specifically ones in which the payments are made in installments over time to fulfill a larger obligation. One such scenario is a home mortgage, for which the homeowner makes mortgage payments at the end of each month. Similarly, car payments that are made at the end of each month are considered an ordinary annuity. Another ordinary annuity example involves stock dividends that are paid out to investors at the end of each quarter or at the end of each year.
Understanding Ordinary Annuities
It is important to understand the concept of present value as it relates to ordinary annuities. Present value is the current value of a sum of money or a stream of income that will be received in the future.
The concept of present value makes ordinary annuities more beneficial to the institution that is making the payouts because the money typically has a higher present value to the party making the payments. The reason is the party making the payouts hold onto the money longer. Obviously it has a lower present value to the receiver of the payments (because the receiver must wait longer to obtain the money).
There is a formula that can be used to calculate the present value of an ordinary annuity. The formula is as follows:
PV= PMT x ((1 – (1 + r)^ – n) / r)
– PMT= the periodic payment
– r= the interest rate per period
– n= the total number of periods
For example, if an ordinary annuity pays $45,000 for 10 years with an interest rate of 6%, the present value of that annuity would be as follows:
$45,000 x ((1– (1+ 0.06)^ -10) / 0.06) = $331,203.92
Ordinary Annuities and Interest
The time value of money also comes into play with ordinary annuities. The time value of money is a concept in which money is worth more the sooner you have it. Money is worth more now than the same amount will be worth in the future, since interest can be received on current funds to produce a heightened return in the future. Due to the time value of money, the present value of an ordinary annuity decreases when interest rates rise, and the present value of an ordinary annuity increases when interest rates decline.
The essential thing to understand about ordinary annuities is that the payments are made at the end of the intervals periods rather than at the beginning. It also is important to realize that the structure of ordinary annuities is to the advantage of the party that is making the payouts, and is to the disadvantage of the party who is receiving the payments at the end of each interval.
Special thanks in preparing this summary of “What is an Ordinary Annuity and How Does it Work?” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.
Olivia Faucher is an editorial intern with Eagle Financial Publications who writes for www.retirementwatch.com.