Whether you are dealing with personal or corporate finance, there are four possible ways that investment cash flows can be realized. Cash flows can be variant, such as stock market returns, grow constantly, like a 401(k) plan to which you contribute regularly, or they can be consistent. Among investments with consistent returns, there are two types: annuities and perpetuities.
Annuities and perpetuities are prevalent in all forms of finance. Both give you regular, predictable and consistent returns, but there are four distinctions between annuities and perpetuities. First and most notably, they differ in their life spans. An annuity has an endpoint; annuity-type investments include traditional annuities, reverse mortgages, bonds and certificates of deposit. For a business, an annuity could be anything, from financing that extends to a customer to a bond which the company purchases. In contrast, perpetuities provide consistent cash flows that never end, such as corporate stock dividends, income from a rental property and other such investments.
The value of annuities differs greatly from the value of a perpetuity. With an annuity, the total cash flow that can be realized is definite so it has a face value. In this way, when you purchase an annuity, the return is set clearly such that the price is predictable. In contrast, perpetuities have to be valued. The value of a perpetuity is determined by the annual return of the investment divided by the annual cost of holding the investment, expressed as a percentage.
Annuities, in practice, carry the benefit of allowing a person or a company to make an investment that has a predictable return and a precise end date. This can be very useful when planning for a large future expense, such as an equipment purchase or retirement where the earnings are retained in the investment, or planning for a way to supplement income for a set period of time, such as a reverse mortgage.
Perpetuities are very useful when you want to generate extra income indefinitely. In exchange for a large upfront cost and occasionally a small regular investment, such as maintenance costs, you can get guaranteed income, usually in the form of monthly or yearly payments. Rent and dividends are good examples of perpetuities, but perpetuities can also be any other type of regular income that is unending and results from an initial purchase. As such, buying a company and taking a regular income or payout each year or purchasing an annuity that is guaranteed for life is a perpetuity, just like buying a rental property.
- moodboard/moodboard/Getty Images