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 varied, such as stock market returns, grown 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 by Definition
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.
There are several types of annuities but the two main types are deferred and immediate. This makes it possible to open an annuity at any point, even after retirement age.
Read More: Examples of Annuities
Perpetuities by Definition
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.
There are three types of perpetuities that investors can choose from. The first is constant cash flows such as real estate investing. The second type is increasing cash flows, and the third type is decreasing cash flows. There are many investments that fall into these categories.
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.
Read More: How to Calculate the Interest Rates on Perpetuity
Life Span Differentials
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 and bonds. 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.
Investment Value on Return
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.
Read More: How to Calculate the Annual Payment of a Perpetuity
Renee O'Farrell is a freelance writer providing valuable tips and advice for people looking for ways to save money, as well as information on how to create, re-purpose and reinvent everyday items. Her articles offer money-saving tips and valuable insight on typically confusing topics. O'Farrell is a member of the National Press Club and holds advanced degrees in business, financial management, psychology and sociology.