Present Value Of An Annuity

Ever hear your grandparents wax nostalgic about how much things cost when they were kids? Like, a movie only cost four dollars, and they could get a hot dog, fries, and a large Coke for three dollars. Or college came free with 10 cereal box tops, and you could trade three baseball cards and a bag of Red Vines for a 5-year-old Ford Focus.

The point of those stories (to the extent that there is one) is that inflation is a real thing. A dollar today is worth more than a dollar will be in the future. This fact makes it difficult to value contracts that take a long time to unfold.

For example, think of an annuity. These contracts involve you paying a large chunk of money now in order to receive periodic income at some point in the future, usually for retirement. Part of the challenge of figuring out whether you're getting a good deal when you buy an annuity comes from the fact that you don't get the pay off until well into the future. The present value of an annuity helps you make that calculation.

The equation can get complicated and, by necessity, it's based on a number of assumptions, often related to inflation or growth rates. But it puts the comparison on a more apples-to-apples framework.

The figure provides the current value for an annuity. It gives its worth as a present lump sum, even though the contract itself pays off in installments during some future period.