Simply put an 'annuity' is a series of payments made at regular intervals.
They have the ability of being bought and sold. Thus annuities encompass a wide variety of financial tools used to generate income.
Examples of annuities are securities, bonds and equity; all annuities are designed with respect to the fundamental time value of money.
The time value of money is vitally important to understanding annuities because an annuity is a series of payments in the future for a current investment or sacrifice.
Here's a simple example to help you to understand the time value of money:
Suppose you were owed 20 dollars, would you prefer 20 dollars repayment now or 20 dollars repayment in a month? Any rational decision maker would prefer 20 dollars now and there are a number of good reasons why.
Firstly money in your pocket today is certain whereas the money given in the future isn't.
Hence there is risk involved in you receiving a payment at a later date because of unforeseen events which could prevent you receiving your money.
Secondly inflation will devalue the dollar over time meaning the 20 dollars in a month is valued less than the 20 dollars now (in consumer terms).
This may be rather insignificant over such a short period but it's still worth taking into account especially when talking about long term annuities such as bonds. Exposure to inflation is so dangerous to annuities as it is destroys the advantage of receiving fixed payments.
Lastly there is the "opportunity cost" of leaving your money with somebody else (the marginal cost of making the decision to tie up ones fiscal resources) that the lender needs to be compensated for. This has to do with the nationally set interest rate.
The nationally set interest rate is essentially a 'risk free' interest rate (also known as the yield) offered by the government.
The nationally set interest rate is the benchmark for return by investors. This is because why would anyone accept greater risk (such as leaving funds with an individual) without being compensated at all for taking on that risk.
Thus no investor or lender will (or should) ever accept no interest on their investment (except when such investments pose other benefits).
Thus in our example a rational decision maker would accept 20 dollars now and invest it at the current interest rate hence growing their investment instead of both risking their money and losing the interest they could otherwise earn 'risk free'.
Coming back to annuities, the longer the period invested the greater the risk and also the greater the yield (return on investment).
However the fixed payments in an annuity will have a diminishing present value the further into the future they may be. i.e.
The repayments may all be of the same denomination ($200) but since they are paid in the future they will have less than $200 dollars value in present terms.
A security is a common form of annuity. It is a contractual loan agreement made by a creditor (loan issuer e.g. a bank) which can be sold.
Securities are often issued by an ADI (commercial bank) and then sold off to provide liquidity to the bank or sold off to investment banks who will then batch the securities.
Upon purchasing a security you are buying this agreement between a borrower (e.g. a person buying a house) and a creditor (e.g. a bank).
In investing in security you are giving over a lump sum (the purchase price) for a series of equal payments (aka an annuity) which are to be made by the borrower.
Securities are invaluable to the financial system as they allow liquidity (ease of access to funds/ability to sell) for commercial banks as well as other creditors and investors.
Securities also happen to be one of the root causes for the 2008 financial crisis. However the most pertinent cause being a result of incentives problems and informational asymmetries.
For more information on the 2008 financial meltdown I recommend watching the documentary series "The Ascent of Money" and "Inside Job".
Equity is another form of annuity known as a perpetual annuity; equity, also known as stock, is an investment in ownership a company.
When you purchase equity many big companies (such as Telstra) issue what's known as dividends. Dividends are payments from the company to the stockholders (equity holders/owners) of that company.
Equity is known as a perpetual annuity because there is no foreseen expiry date to these payments.
This is where equity differs as an annuity to bonds or securities because securities and bonds have an expiry date and thus a fixed yield (or rate of return). The annuities of a security are no received once the loan is paid off (which is similar to a bond).
Therefore securities have an upper limit to how much capital (return on investment) they bring to the investor. Whereas equity has no upper limit a person can keep gaining on their investment hence perpetually growing return.
The drawbacks of equity are there is no requirement of a company to pay dividends (a company can choose whether or not to pay dividends at all) and on top of that an investor can lose their entire investment if the stock were to plummet in value.
Securities and bonds however do not have the same weakness they are legally enforced; if a person or corporation is to default on payments of a loan agreement in the security their own assets are liable.
This protects the investment of the investor (many securities and particularly bonds are guaranteed by government lessening the risk but not eradicating it.) making a security a 'safer' annuity than equity.
They have the ability of being bought and sold. Thus annuities encompass a wide variety of financial tools used to generate income.
Examples of annuities are securities, bonds and equity; all annuities are designed with respect to the fundamental time value of money.
The time value of money is vitally important to understanding annuities because an annuity is a series of payments in the future for a current investment or sacrifice.
Here's a simple example to help you to understand the time value of money:
Suppose you were owed 20 dollars, would you prefer 20 dollars repayment now or 20 dollars repayment in a month? Any rational decision maker would prefer 20 dollars now and there are a number of good reasons why.
Firstly money in your pocket today is certain whereas the money given in the future isn't.
Hence there is risk involved in you receiving a payment at a later date because of unforeseen events which could prevent you receiving your money.
Secondly inflation will devalue the dollar over time meaning the 20 dollars in a month is valued less than the 20 dollars now (in consumer terms).
This may be rather insignificant over such a short period but it's still worth taking into account especially when talking about long term annuities such as bonds. Exposure to inflation is so dangerous to annuities as it is destroys the advantage of receiving fixed payments.
Lastly there is the "opportunity cost" of leaving your money with somebody else (the marginal cost of making the decision to tie up ones fiscal resources) that the lender needs to be compensated for. This has to do with the nationally set interest rate.
The nationally set interest rate is essentially a 'risk free' interest rate (also known as the yield) offered by the government.
The nationally set interest rate is the benchmark for return by investors. This is because why would anyone accept greater risk (such as leaving funds with an individual) without being compensated at all for taking on that risk.
Thus no investor or lender will (or should) ever accept no interest on their investment (except when such investments pose other benefits).
Thus in our example a rational decision maker would accept 20 dollars now and invest it at the current interest rate hence growing their investment instead of both risking their money and losing the interest they could otherwise earn 'risk free'.
Coming back to annuities, the longer the period invested the greater the risk and also the greater the yield (return on investment).
However the fixed payments in an annuity will have a diminishing present value the further into the future they may be. i.e.
The repayments may all be of the same denomination ($200) but since they are paid in the future they will have less than $200 dollars value in present terms.
A security is a common form of annuity. It is a contractual loan agreement made by a creditor (loan issuer e.g. a bank) which can be sold.
Securities are often issued by an ADI (commercial bank) and then sold off to provide liquidity to the bank or sold off to investment banks who will then batch the securities.
Upon purchasing a security you are buying this agreement between a borrower (e.g. a person buying a house) and a creditor (e.g. a bank).
In investing in security you are giving over a lump sum (the purchase price) for a series of equal payments (aka an annuity) which are to be made by the borrower.
Securities are invaluable to the financial system as they allow liquidity (ease of access to funds/ability to sell) for commercial banks as well as other creditors and investors.
Securities also happen to be one of the root causes for the 2008 financial crisis. However the most pertinent cause being a result of incentives problems and informational asymmetries.
For more information on the 2008 financial meltdown I recommend watching the documentary series "The Ascent of Money" and "Inside Job".
Equity is another form of annuity known as a perpetual annuity; equity, also known as stock, is an investment in ownership a company.
When you purchase equity many big companies (such as Telstra) issue what's known as dividends. Dividends are payments from the company to the stockholders (equity holders/owners) of that company.
Equity is known as a perpetual annuity because there is no foreseen expiry date to these payments.
This is where equity differs as an annuity to bonds or securities because securities and bonds have an expiry date and thus a fixed yield (or rate of return). The annuities of a security are no received once the loan is paid off (which is similar to a bond).
Therefore securities have an upper limit to how much capital (return on investment) they bring to the investor. Whereas equity has no upper limit a person can keep gaining on their investment hence perpetually growing return.
The drawbacks of equity are there is no requirement of a company to pay dividends (a company can choose whether or not to pay dividends at all) and on top of that an investor can lose their entire investment if the stock were to plummet in value.
Securities and bonds however do not have the same weakness they are legally enforced; if a person or corporation is to default on payments of a loan agreement in the security their own assets are liable.
This protects the investment of the investor (many securities and particularly bonds are guaranteed by government lessening the risk but not eradicating it.) making a security a 'safer' annuity than equity.
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