What is an Ordinary Annuity & How Does it Work?

Want to know how an ordinary annuity is beneficial for retirement? Well, it’s quite a beneficial financial tool that helps you build your ideal retirement life – a financially secure one! Moreover, it offers a consistent stream that offers you stability when needed the most. Want more information about how ordinary annuity works? Here is all you should know about this financial tool and how it helps you plan your golden years.

• An ordinary annuity involves regular payments made at the end of each pre-determined period.
• Fixed annuities offer predictable, stable payments, while variable annuities’ payouts depend on the performance of underlying investments.
• Ordinary annuities provide a predictable income source post-retirement, enabling retirees to plan and manage expenses.
• The downsides of ordinary annuity include limited liquidity, fixed payment amounts, and additional fees and charges.

How is an Ordinary Annuity Defined?

Before we talk about ordinary annuities, you should know about the basics too – an annuity. Well, an annuity is a financial tool that provides a series of cash flows over a specific time period. Besides, annuity is of two types: ordinary annuity and annuity due. This blog is all about ordinary annuity, how it works and its pros and cons. 

“An ordinary annuity is a financial tool with which payments or cash flows occur at the end of the period.”

Moreover, all aspects of this annuity are pre-determined (at the time of your purchase it including the interest rate, number of payments, and the amount of each payment, etc. You should know ordinary annuity payments are made at the end of the specified time period, either every month or every year, or any set time period. But mainly payments are made:

• Monthly
• Quarterly
• Semi-annually
• Annually

What’s more, these payments are of two types: fixed annuity and variable annuity. Both of these differ based on the predictability of payments.

Whatever type of ordinary annuity you choose, it can also help you achieve your long-term and short-term financial goals. With it, you can have a predictable income source that can be used to establish a reliable income for retirement. Most retirement plan consultants say that you can budget and plan your finances with an ordinary annuity to achieve your goals because it's predictable.

How Ordinary Annuity Works?

“When you decide to receive payments from your ordinary annuity, every payment will include a portion of the total amount invested, the interest on it minus the administrative fees” – National Council on Aging

Don’t know how an ordinary annuity works to benefit you? Well, here is an example to explain you in a better way. Let's say you want to save for retirement by investing in an annuity. You decide to invest $500 every month for the next 20 years, and the annuity provider agrees to pay you a fixed interest rate of 5% on your investment. At the end of the first month, you invest $500, and the provider adds 5% interest, making your balance $525. The next month, you invest another $500, and the provider adds 5% interest on your new balance of $525, giving you $1,051.25. 

This process continues for 20 years, with you investing $500 each month and the provider adding 5% interest on your balance at the end of each month. After 20 years, the annuity will mature, and the provider will stop adding interest. By this point, you will have made a total of 240 payments, and your final balance will include all the money you invested plus the interest earned over the 20 years.

What is the Ordinary Annuity Formula?

Want to know how much are you going to get from your annuity? Using a proper formula, you can easily calculate the future and present value of ordinary annuity easily. This will help you know what to expect. You can calculate:

• The future value of ordinary annuity
• The present value of ordinary annuity

To calculate these two, you have to consider three factors: the period cash payment (PMT), rate of interest per period ( r ), number of periods (n). And the ordinary annuity formula is:

• Present Value = PMT x ((1 - (1 + r) ^ -n ) / r)
• Future Value =   PMT×((1+r)ⁿ−1) / r)

Well, these formulas definitely help. But its even better if you choose to consult a financial advisor for unbiased and well-balanced advice.

How is an Ordinary Annuity for Retirement Planning? 

Did you know that an ordinary annuity is a popular choice for people who want to save for retirement? You may be wondering how. Well, retirement is a time when people don’t usually have a consistent income and have to save up well to maintain their lifestyle. Plus, there can be financial emergencies too. This is where you can use an ordinary annuity as a consistent income source for your post-retirement expenses. Let’s discuss the pros and cons of using it as a source of retirement income.

Pros of Ordinary Annuity as Retirement Income

We’ve been discussing what an ordinary annuity is and how it works. But we should also talk about its benefits. Let’s talk about them:

• A regular Income Source

Why ordinary annuity is preferred for retirement savings so much because it provides you a regular source of income for your life after you have quite your 9 to 5.  Besides, what makes it even more valuable as a source of income is that its predictable. You know what this means? Well, because you know the payments you are getting, you can easily plan your ongoing expenses and meet your financial objectives.  This will also be quite helpful in case of financial emergencies. Wondering “how to plan for retirement”? Well, annuity can be a great way for it. 

• Compound Interest

Another reason why ordinary annuity is so great for retirement planning is because of compound interest. This means the interest earned on each payment is reinvested, generating additional interest. This is a great way to maximize your retirement earnings. In other words, this compounding effect can significantly boost overall returns over time. With each period, the investment grows not only from the initial contributions but also from the accumulated interest. At the end of this, you have maximized your annuity’s potential and enhanced your overall earnings.

• Tax Advantages

When it comes to retirement savings, an ordinary annuity is a great option because it offers tax benefits. You should know that ordinary annuities often grow tax-deferred, meaning you don't pay taxes on the earnings until you withdraw the money. This allows your investment to compound more efficiently over time. As a result, it potentially reduces taxable income as it spreads over many years. These tax benefits make ordinary annuities a valuable tool for long-term retirement planning. After all, it lets you save more and lose less.

Cons of Ordinary Annuity as Retirement Income

Although an ordinary annuity is quite beneficial for retirement, it has some drawbacks too. Let’s talk about these too:

• Limited Liquidity

Ordinary annuity offers long-term benefits but it is a long-term investment too. Therefore, you have to keep investing consistently. This means you’ll have to add a significant portion to your income to this account. As a result, your annuity can limit your liquidity and flexibility in managing financial needs. This means, in case of an unexpected expense, you may face problem dealing with it if you’re relying on your annuity.

• Fixed Payments

Although consistent payments of ordinary annuity are a win-win for you, it has some downsides too: it’s fixed! You may be wondering what downside will we face with fixed payments. Well, with a fixed amount, you don’t have the option to adjust or change it based on your needs or situation. Apart from the payments, the terms and conditions are also unchangeable once they are set at the beginning. This can be really limiting as your financial needs evolve over time. 

• Fees and Charges

Just like other financial products or retirement plans like 401k or 403b, this plan also comes with management fees, administrative fees, and surrender charges. This means you have to pay an additional amount other than your investments on a regular basis. This can reduce your overall return too. Resultingly, you have less to save and more spending. It is a major downside if you are counting on this financial tool for your retirement planning.

Other Examples of Ordinary Annuity

We know that an ordinary annuity is a great option if you want to save up for retirement but do you know other examples in which it can be used for? Here, we are going to discuss the instances you have in terms of annuity.

“Some examples of ordinary annuities include rental leases and insurance payments.” – Wikipedia

➢ Mortgage Payments

Mortgage payments can be a great example of an annuity because they involve a series of regular, fixed payments made at the end of each period (typically monthly) over a specified term. Moreover, the homeowner is required to complete the total payments over a specific period of time. Besides, all periodic payments include the principal amount and interest. 

➢ Car Loan Repayments

Car loan repayments also resemble annuities as they consist of regular payments made after a specific period, typically monthly. These payments also include both principal and interest. Plus, they are made consistently over the loan term. This provides borrowers with a structured repayment plan and lenders with a steady income stream.

➢ Rental Payments

Rental payments are also similar to ordinary annuities in a lot of ways. After all, it involves regular, fixed payments made at the end of every month. Furthermore, the tenant has to pay rent to the landlord for a predetermined period – as long as he lives in the property. This structured payment system provides landlords with predictable income, much like an annuity.

Ending Thoughts!

Retirement is the time which you deserve to enjoy to the fullest. After all, you have worked so hard all your life. Therefore, it is always a good idea to max out your retirement savings. For this, exploring only employer-sponsored retirement plans is not enough. This is where an ordinary annuity comes in. Moreover, it's a great way to save for our financially secure future. Planning to travel the world? Or want to spend a peaceful life with your loved ones? 

At State Pension Advisors, we offer you the guidance you need to use financial tools like ordinary annuities for your benefit. Additionally, our well-vetted professionals will pave the way to fulfill all your dreams. With an extra consistent income by your side, you are all set to maintain your ideal lifestyle. So, don’t delay; start planning for your future now!