Have you been thinking lately about income streams in the future? Maybe you are getting closer to retirement, and are looking at products that will help provide regular cash flow as you age. If that’s the case it’s good to understand an Annuity vs. a Perpetuity.
Let’s start by saying that these two items really shouldn’t be looked at as entirely different things. There are a lot of blurred lines between annuities and perpetuities.
While they have some similarities, an annuity is mainly an insurance product purchased for retirement income, and a perpetuity is more often used in the business world as a means of valuation.
Now, not to cut you off before you start, but if you’re looking for retirement income options, you might just start learning more about annuities here. You aren’t going to find many perpetuities out there to add to your investment portfolio.
Essentially, both of these terms mean to receive payments over a period of time. The amount of time, how they are calculated, and situations in which they are used is often different. Let’s do a quick overview of each, and then look more specifically at the differences.
What is an Annuity
An annuity is a product that is typically sold by an insurance company as a retirement product. In this case, a person makes an up front lump sum payment, and in return gets payments for a determined period of time in the future.
They come in many different shapes and sizes, but the four main types of annuities are fixed, variable, immediate, and deferred annuities. You can find all sorts of variations, and it’s important to understand what you are purchasing. That said, if you are a low risk investor, an annuity is something you should speak with your retirement advisor about.
What is a Perpetuity
A perpetuity is defined as a bond or other security with no fixed maturity day. Cash flow payments are made at regular interval, just like an annuity, but for an indefinite period of time. That is whey a perpetuity can actually be considered an annuity with no end.
See what we mean by “blurred lines” between these two.
Annuities vs. Perpetuity Differences
Time Period
As previously discussed, the time period of an annuity vs. a perpetuity is a major distinguishing characteristic. This is because and annuity is an investment that typically has some defined end period. A perpetuity on the other hand is a regular payment that is indefinite.
While very uncommon, it is possible for a perpetuity to be an annuity if it is structure with indefinite payments. Otherwise, it is much more likely these two products terms are being used for different situations.
Present Value Calculation & Interest Rates
Another distinguishing characteristic between an annuity and perpetuity is the interest rate used to calculate their present value.
The present value of an annuity is calculated using compounded interest rates over the period of the investment. In other words the investor receives a return on the initial investment, and annual interest as it compounds on an annual basis.
PVOrdinary Annuity = C*[1-(1+i)-n]
C=Cash Flow per period
i=interest rate
n=number of payments
Even though a perpetuity never ends in theory, we calculate the present value by using a simple interest rate, as opposed to compounded rate. This allows us to see the value of that perpetuity as an infinite number of payments.
Check out this article by Investopedia if you’d like more information on the calculations and uses of perpetuities.
PVPerpetuity = C/R
C=Cash Flow per period
R=discount rate
Common Uses
Annuities and perpetuities both have there specific uses, but annuities are much more common.
Annuities are a growing product in today’s insurance world as people look to ensure income for longer lifespans. Essentially insurance companies will take up front payment for an annuity that will payout, typically in monthly intervals, over a specific period of time. You can purchase annuities that will begin paying out immediately, or defer the payments until a later date.
Perpetuities, or the calculations, are used more commonly in valuing a businesses future cash flow. This is a means of determining what investments are worthwhile given a set discount rate. By calculating the theoretical value of a given business or project based on it’s discount rate (often times the Weighted Average Cost of Capital), investors can determine which investments are potentially more valuable.
Types
There are a number of different annuity types to choose from if you decide this a the investment vehicle for you. Immediate and deferred annuities describe annuity types based on when you start receiving payouts. You can further divide annuities into fixed and variable, which describes the the level of investment risk, and rate of return you may be guaranteed on the annuity.
One other worthwhile distinction is the difference between an ordinary annuity, and an annuity due. Ordinary annuites are those paid at the end of the period, such as month, quarter, or year. An annuity due is paid at the beginning of a period. An annuity due would be when looking at something like rent payments which are paid at the beginning of each month.
There are two different kinds of perpetuities. A growing perpetuity, and a level perpetuity. The distinction here is very straight forward. A growing perpetuity is one where the cash flow grows at a constant rate from period to period. The level perpetuity on the other hand has a constant payment from period to period.
Annuities vs Perpetuity For Retirement
If you’ve made it this far, and are still wondering what you should be researching for retirement products, the answer is annuities. This is a growing segment of insurance companies business, and there is an ever growing selection of annuity products.
If you do enough research, you will see plenty of supporters and detractors of annuities. Detractors often site the high fees, and penalties, and both of these can be true. At the same time, annuities can play a role in the investment portfolio of conservative investors. If you aren’t as concerned about the rate of return, as you are of having dependable income, an annuity is worth looking at.
To buy either of these products you will want to speak with your insurance agent, or financial advisor.
Annuities vs Perpetuity Bottom Line
While these two products and concepts are very similar, you will most likely hear the term annuity much more frequently. It is very uncommon to see perpetuity products available as investments in today’s world.
Annuities are a common, and increasingly popular retirement products. They have fought some bad press due to high costs, but insurance companies are constantly coming up with new products to better meet customer demands. Work with a trusted retirement advisor to see if an annuity fits well into your portfolio.
Perpetuities are far less common in the investment world, but in business the theoretical calculations can be very useful. If you are thinking about investing in a business or anything else that might give you a continuous income stream, you should become familiar with these concepts. They can be very beneficial in determining what investments make the most sense.