Present Value vs. Future Value: Why Annuity Investors Should Focus on the Present
Investing in annuities can help you secure your future retirement funds. As investors, we want to know the worth of our investment in the coming years. The concepts of present value and future value play a significant role in calculating the worth of your annuity investment.
In this article, we will delve deeper into the concepts of present value and future value, and why annuity investors should focus on the present value more than future value.
Present Value vs. Future Value
Let’s start by understanding the fundamental concepts of present value and future value. Present value (PV) is the current worth of a future sum of money or cash flow, whereas future value (FV) is the value of an asset or cash at a specified point in the future after investing it in an interest-bearing account.
Present value is a crucial concept because it tells you what a future sum of money is worth today, considering the inflation rate and the present value of money.
Essentially, if we know what an amount of money will be worth in the future, we can calculate its worth today or at present, using the present value formula.
PV = FV / (1+r)t
where PV = present value, FV = future value, r = interest rate, and t = time or the number of years.
If we plug in the figures for a $10,000 investment in ten years, with an annual interest rate of 5%, then we’ll get the present value of that investment today, as follows:
PV = 10,000 / (1+0.05)10
PV = $6,139
So, the $6,139 represents the value of the $10,000 investment today.
On the other hand, future value calculates the worth of an investment at a later date, given the interest rate over time (number of years) when invested.
FV = PV*(1+r)t
where FV = future value, PV = present value, r = interest rate, and t = time or the number of years.
For instance, if we invest $10,000 for ten years at 5% interest rate, our future value will come as follows:
FV = $10,000*(1+0.05)10
FV = $16,386
Therefore, $16,386 represents the sum of money we will have after ten years.
Basically, present value and future value concepts help you calculate the worth of a lump sum investment today or in the future, respectively.
Why Annuity Investors Should Focus on Present Value
When investing in annuities, focusing on present value is critical, as it helps you make informed investment decisions.
Here’s why you should focus on the present value of annuities over future value.
1. Inflation Rate
Inflation is the decrease in the purchasing power of a currency over some time. It’s a crucial factor that affects the worth of your investment. When calculating future value without considering the inflation rate, the amount could ultimately be worth less than what was initially invested.
For instance, if you calculate an investment’s worth after ten years at 5% interest rate and then find out that the rate of inflation is 7%, you’re bound to have a lessened worth of your investment in reality.
Therefore, considering the inflation rate when calculating the present value of annuities helps you make better-informed decisions.
2. Time Value of Money
Time value of money (TVM) is the concept that money today is worth more than the same amount of money in the future because of its earning capacity.
For instance, $1000 today can earn an annual interest rate of 5%, which means it’ll be worth $1,050 next year. So, holding on to money now when investing in annuities is more valuable than holding it in the future.
Therefore, investors who focus on the present value of annuity investments will be able to make more informed decisions based on the time value of money.
3. Uncertainty
It’s impossible to predict what the future holds. There are several factors such as inflation rates, global economic changes, and geopolitical risks, which could negatively affect our future investments.
For instance, if your annuity investment was projected to last twenty years, but you die in five years, your future investment worth won’t matter much.
Therefore, to make informed investment decisions, annuity investors should focus on the present value of their investments to enjoy the investment while alive.
Frequently Asked Questions (FAQs)
Q: What is the difference between present value and net present value?
A: Present value is the current worth of a future sum of money or cash flow, whereas net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over time. Net present value helps determine an investor’s profitability in an investment by comparing the costs of investing against the future value he/she expects from the investment.
Q: What is the formula for calculating the present value of an annuity?
A: The formula for calculating the present value of an annuity is:
PV = ( C / r ) x ( 1 – ( 1 + r) -n )
where C is the constant payment or cash flow, r is the interest rate, and n is the number of periods.
Q: What is the importance of focusing on the present value of an annuity investment?
A: Focusing on the present value of an annuity investment helps investors to make informed investment decisions based on the inflation rate, time value of money, and uncertainties.
Conclusion
In conclusion, the concepts of present value and future value are essential in determining the value of an annuity investment. While future value highlights an investment’s potential worth in the future, present value ensures informed investment decisions based on various factors such as inflation rate, time value of money, and uncertainties. Therefore, annuity investors should focus more on the present value to make informed decisions, and they could use a financial advisor’s help for better decisions.