Investing Basics: Income Streams and Annuities


It is very important to understand an income stream from a conceptual standpoint in the world of financial management. In short an income stream is a regular inflow of money. Another more technical name for this flow of money is an “annuity”. Though there are some technical differences in the income stream you receive from your employer versus the income stream of an annuity purchased from Insurance Company, the concept is basically the same.

Anybody who has played the lottery has probably encountered the lump sum option or the regular payment option. This is a basic choice between an income stream and a lump sum distribution. So the question is this: What is the big difference between these two amounts? Or what is the main factor differentiating the two? The answer is time. More importantly proper logic tells us that the money we have in our hand today is worth more than any money we have in our hands in the future? Why is this so? Because any number of things could intervene between now and then. Thus, present money is always valued higher than future money.

The technical difference between these two types of distributions are calculated using the following formulas:

PRESENT VALUE OF AN ANNUITY

Future Value = Present Value x (1 + i)n

FUTURE VALUE OF AN ANNUITY

Present Value = Future Value x 1/(1 + i)n

These formulas essentially give a mathematical way to compare money in the present to money in the future. The variable “i” in the above equation stands for the % interest rate (i.e. .09 for 9%), while the variable “n” stands for the number of periods or terms being factored (if the income stream pays monthly then it would be 12 for each year – if yearly 1 for each year).

Once you have done the calculation you can easily determine whether it is wiser to take a lump sum lottery distribution or to receive yearly payments in the form of an annuity. Usually the better option will turn out to be the lump sum distribution. However, the lump sum distribution requires proper management to ensure that it is in fact the better option. Of course, the same concept applies to distribution from a retirement plan or even in calculating how much you will need upon retirement.

One easy exercise is to figure out for yourself how much you will need at retirement. All you need do is calculate your present level of income and then take 80% (the accepted sum of future living expenses by most financial planners) of that amount and then use the “Future Value” formula to calculate how much that amount would be in future dollars on the day you retire. Whatever that sum, it is the amount you need to accumulate in order to fund your retirement. You can then use this to determine how much you need to invest in order to reach that goal.

Categories Investing and Financial Planning, RetirementTags

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