Annuities can get complicated for anyone, especially when you learn that there are two distinct types of annuities. Annuities are fixed cash flow streams set up between individual policyholders and insurance companies. Within an annuity contract, policyholders provide a lump sum of money to the insurance company in exchange for regular payments at specific points in the future.
These periodic payments can make a massive difference in your future finances, meaning it’s essential to consider if an annuity will benefit you. Before diving into buying an annuity, you should know the ins and outs of an ordinary annuity vs. annuity due agreements.
To get you started and help you decide if an annuity is right for you, we’ve compiled everything to know about the most common type of annuity to ensure you start on the right foot.
What is An Ordinary Annuity?
An ordinary annuity describes an annuity where the policyholder receives earnings paid out over a specific period. An ordinary annuity pays out to policyholders in intervals, and each payment occurs at the same interval, such as monthly payments made on a specific day. A common type of ordinary annuities might include the following contracts:
- Retirement annuity
- Home mortgages
- Dividend payments
Pros of Ordinary Annuities
All types of annuities have specific characteristics that could make them more or less attractive to you. Consider some of the benefits of ordinary annuities as you navigate this decision.
- Ordinary annuities are easier to set up and are more straightforward than an annuity due payment.
- Ordinary annuities offer a stream of income for the policyholder’s lifetime, making them a valuable resource for many individuals planning their financial future.
- These annuities are essential in many cases for retirement planning.
- An ordinary annuity payment is typically fixed, meaning that the policyholder knows the income they’ll receive monthly or quarterly.
Cons of Ordinary Annuities
While ordinary annuities are helpful for many policyholders, they come with a few cons, including the following:
- These annuities don’t offer immediate income, making them unsuitable for those seeking an immediate payout.
- While some ordinary annuities are affordable, others are more expensive when the annuitant seeks a higher income.
- Fixed payments mean that ordinary annuities sometimes struggle with inflation.
- If the policyholder passes away before receiving their payments in full, the ordinary annuity payments are lost.
What is an Annuity Due?
There are specific differences between an ordinary annuity and an annuity to be considered before buying one. Annuity due payment describes an annuity paid immediately at the start of each period. For example, landlords renting out apartments require annuity-due payments at the start of each month rather than quarterly or at the end of the month. Each interval period begins with a payment. The following are some examples of a standard annuity-due contract:
- Insurance premiums
- Rent payments
- Car lease payments
Pros of Annuity Due
Similar to ordinary annuities, this type of annuity has unique pros and cons that make it more suitable for some than others. Below are the most significant advantages of an annuity due payment.
- Annuity-due payments offer instant income.
- These annuities are typically more flexible compared to ordinary annuities and other options.
- Annuity-due policies are less expensive than some options.
- These annuities typically have a high rate of return than other annuities, such as ordinary annuities.
Cons of Annuity Due
However, there are some downsides to this annuity type to consider before jumping into a decision. Some notable cons of annuity-due payments include the following:
- While annuity-due policies are less expensive than some annuity options, they are sometimes costlier than ordinary annuities due to a higher interest rate.
- Policyholders have less time to invest their annuities with this option.
Ordinary Annuity vs. Annuity Due: Breaking Down the Differences
Now that you have a basic understanding of the payments made for ordinary annuities and annuities due let’s break down the core differences between these two styles.
Key Difference #1: Payouts
The first and most notable difference between an ordinary annuity vs. annuity due payments is the schedule each option follows. Though both types make payments once per period, policyholders will notice the payments occurring at different times. For instance, an ordinary annuity comes at the end of a specific period. However, an annuity due payment arrives at the beginning of a payment period rather than at the end.
Ordinary annuity payments are a series of payments spaced out over time. Unlike ordinary annuities, annuity-due payments are unevenly spaced out and are issued immediately when a new period begins.
Key Difference #2: Present Value
The next critical difference between these two annuities is the present value for each option. An annuity’s present value is determined based on your money’s time value. Because of inflation, a dollar today could have a higher value.
Your annuity’s present value can change drastically depending on the billing cycle length. Some people prefer annuity-due payments, as ordinary annuities typically have less value than annuity-due payments. Because of the potential for your present value to vary, it’s essential to use present annuity payments calculating when deciding whether to purchase an annuity.
Key Difference #3: Formulas
Ordinary annuities have a different formula than annuity due payments. Calculating the present value of an ordinary annuity is possible with the following formula:
- PMT: period cash payment
- R: interest rate per period
- N: total number of periods
Therefore, the present value of an ordinary annuity is calculated with the following:
Ordinary Annuity Present Value = PMT x ((1 – (1 + r) ^ -n / r)
Because annuity due payments are worth more than ordinary annuity payments, and given the different standards these options follow, an annuity due payment follows a different formula. To calculate the present value of the annuity due, use the following formula:
Present Value of Annuity Due = PMT + PMT x ((1 – (1 + r) ^ -(n-1) / r)
Key Difference #4: Best Use Cases
The final difference essential to understanding an annuity due vs. ordinary annuity is the best uses for each option. If you intend to use an annuity for payments, an ordinary annuity is more suitable, as they offer a low present value compared to an annuity due.
Annuity-due payments are best for receipts, as they have a higher present value than ordinary annuities and are less exposed to inflation.
Which Annuity is Best for Me?
Deciding which annuity option is best for you depends on various factors. As you decide whether to buy an annuity, remember the following to ensure you choose what works best for you.
- Consider your timeframe. If you want your annuity paid out sooner rather than later, an annuity due will be more suitable for you. If the timeframe isn’t as much of an issue and you’re looking to get payments over a more extended period, you can consider an ordinary annuity instead.
- Know the interest rate. Consider the formulas mentioned above and seek guidance from an attorney, financial advisor, or certified public accountant to determine which interest rate is more realistic for your financial situation.
- Know the risks. While annuities are relatively safe compared to other investments, there is always a risk a situation could occur that places your finances at risk, such as your insurer becoming insolvent.
You likely have some leftover questions about ordinary annuities and annuity-due payments. To help you out, here are some common questions policyholders have when approaching different types of annuities.
Can I Have an Ordinary Annuity and an Annuity Due Simultaneously?
Some annuities offer both annuity and annuity due options for policyholders, meaning you can have these annuities simultaneously within a contract. In this scenario, you could receive payments at the beginning or end of a specific period. However, discussing this decision with a qualified financial advisor or accountant is essential before taking on both annuities.
How Much Do Annuities Cost?
Annuities come in varying costs based on their type. For example, a fixed-rate annuity will have lower costs than a variable annuity. Generally, annuity riders cost an additional 0.25% to 1% yearly, while the average fees for a variable annuity equal 2.3% of the annuity contract value. However, this number can exceed 3% in some cases.
In some situations, annuities also require additional payments for premiums, commissions, administrative fees, and surrender charges. Opening a new annuity contract start at $5,000 but is often more expensive.
Can I Cash Out My Annuity Early?
While you can cash out your annuity early, this could result in a surrender charge and incur costly fees from your insurance provider. Canceling an annuity contract shouldn’t be done without speaking to an expert financial advisor, accountant, or attorney.