An annuity provides predictable income, paying you a set amount regularly in return for an upfront investment. Your investment’s internal rate of return affects how much money you will make. You can calculate the IRR based on the present value of your investment, the payment amount and the number of payments. Adjusting any of these variables will change your IRR, which could help you achieve your investing goals.
Prices for annuities are often quoted in terms of the monthly income they produce or the annual payout rate that they provide. For example, if you purchase an annuity for $150,000, its pricing could be quoted as $625 of monthly income that you would receive or as an annual payout rate of 5 percent ($7,500 worth of payments over 12 months in a year).
Internal Rate of Return
The IRR is the effective interest rate you would earn if the money you would eventually receive were to equal the investment you make now in today’s dollars. Put another way, it is the interest rate that makes the net present value of all cash flows equal to zero.
An annuity payment includes interest, principal and sometimes mortality credits, which represent the gains that you make in a participating annuity when other investors die after they pay their premiums but before they receive all of their payments, thereby leaving their investments to the broader pool. No fees are taken from the payments you receive.
The number of payments you actually receive will depend in part on how long you live. But you could calculate the rate of return on annuities based on the number of payments you expect to receive. For example, you could calculate the IRR on your $150,000 investment based on 30 years of annual payouts. Your return would increase as you live longer.
The present value is how much your future annuity payments are worth in today’s dollars. Present value is calculated by multiplying the amount of each annuity payment by the interest rate between payments and the number of periods in the annuity. As an equation, it is: PV = PMT * [(1-(1+r)^-n)/r], in which PV = present value, PMT = payment amount, r = interest rate and n = number of periods.
Calculating Rate of Return
In calculating the IRR, you will determine the interest rate that you would have to earn to make the present value of the annuity equal to the amount of money you paid for the annuity. You can use time value of money functions on a financial calculator to determine the IRR when you have the present value, payment and number of periods.
Items you will need
- Financial calculator
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