An annuity is a contract between you and an insurance company in which the company agrees to pay you a series of disbursements after you pay the insurer in a lump sum or series of payments. The payments can begin either immediately or sometime in the future. One important thing you need to know is the internal rate of return (IRR) of the annuity to calculate your cash flow and tax liability.
Consider Also: Characteristics of an Annuity
What Is IRR of Annuity?
Annuities are available in three different types: fixed, variable and indexed. Fixed and variable annuities are like fixed and variable rates on a loan that you take out, such as a mortgage. Like many other financial instruments, fixed annuities often have lower returns and lower risk. Variable returns can provide a higher return, but they have higher risks. Indexed annuities offer a balance between higher risk and a guaranteed minimum payout.
What Does IRR Tell You?
The IRR of an annuity is much like a yield on any other type of investment instrument. This is the most commonly quoted rate when you apply for universal or term life insurance. To understand the IRR of annuity payments, you must get out of linear thinking when it comes to calculations. It does not build up like compound interest, especially if you have a variable or indexed annuity.
The IRR rule may help you determine if a specific annuity is right for you. The IRR rule states that an annuity is worthwhile if the IRR is greater than the minimum required rate, or hurdle rate. The hurdle rate is the desired return on the investment to make it financially beneficial. Most investors will set a higher hurdle rate for annuities that have a higher risk, and a lower rate for those that have a more guaranteed return.
If you have two potential annuities from which to choose, the IRR rule method can help you pick the one that will result in the highest profits in the end.
Calculating IRR on an Annuity
Calculating the IRR of annuity returns is similar to calculating the net present value (NPV) of the investment. This can be done by using a spreadsheet, like Excel, or an online annuity return calculator.
You can begin by entering the initial investment as a negative number, as this is an outflow of capital. Let’s say that you start an annuity with $200,000 in a lump sum. The terms of the annuity state that you will begin receiving payments immediately of $20,000 for 30 years. Here is the formula.
IRR of $200,000 investment = Payment amount *[(1-(1+r)^-number of periods)/r]
r = rate of return
IRR of $200,000 investment = $20,000 *[(1-(1+r)^-30)/r]
In this case, the IRR is 9.31.
Excel has an IRR function that can be used to calculate the IRR quickly, and some calculators have this function too.
Monthly Payment on $100,000 Annuity
Now that you know how to calculate the IRR of annuity instruments, you'll also want to know the cash flow that your annuity will generate. To calculate this, the age at which you purchase the annuity, whether it is for you only or you and your spouse, and the length of time before taking income from it are factors.
The average annuity payment can range from $417 to $1,211 per month based on these factors. This is the rate if you assume that you will begin receiving immediate lifetime income at age 60. If you wait until age 70, your payments will begin at around $475 to $521 per month.
Consider Also: What Is an Annuity Starting Date?
Now that you understand a little about IRR and how it can be used to decide whether an annuity offer is worthwhile, you have one more tool in your retirement-planning toolbox.
Consider Also: Annuity Vs. Pension
- Using the steps above, the IRR of an annuity costing $1,000 and paying $400 per year for five years is 28.65 percent. If you are looking at different annuities, select the one with the highest internal rate of return.
- The IRR is the rate the makes the net present value value of future cash flows equal to its current market value, returning a zero value. Technically, you can attempt to manually calculate the IRR of an annuity by plugging in different rates of return that will produce a net present value of zero; however, this is a labor-intensive process that could take hours.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.