What is an Annuity Factor?
The annuity factor is a figure that can be used to calculate the present value of an future payments from an annuity. The figure is based on the annuity paying $1 (USD) for each payment period. This figure is then multiplied as appropriate to give the figure for the actual annuity in question.
An annuity is a financial product in which the buyer pays a lump sum and then receives a regular payment for a set period. In most cases, this period is the remainder of the buyer's lifetime. This means the lump sum and payment will usually depend on the age, gender, and health condition of the buyer. The most common use of an annuity is to provide a pension. In many countries, the money saved towards a pension must be spent on an annuity as part of the rules that allow those savings to be tax deductible.
When comparing different annuities, it can be tricky to quickly glance at the figures and work out which represents the best value. This is because this value depends on the relationship between the lump sum payment, the income paid from the annuity, and the period for which it runs. This comparison can be made easier through the annuity factor.
Somebody comparing different annuity offers can consult a present value annuity factor table. This compares the number of payments that will be made with the proportion each payment is of the lump sum payment. In effect, this latter figure is equivalent to the interest the annuity holder receives on their initial investment (though unlike most investments, they will not get the original lump sum back).
The present value annuity factor table shows the appropriate annuity factor. This can then be multiplied by the payment to show how much the future payments are worth to the buyer now. This will help the buyer decide if the annuity represents the best deal.
One limitation of the annuity factor is that it requires the buyer to know how long they will receive payments from the annuity for. With a fixed term annuity, this is no problem, but with one that runs for the rest of their life they will have to make a prediction of their remaining lifespan. Consulting an annuity factor table may often show that an annuity that offers the best value if the buyer dies after a few years may not be the best value option if they live for a longer time.
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