Payout Annuities

Learning Outcomes

  • Compute a payout annuity given a finance scenario

Removing Money from Annuities

In the last section you learned about annuities. In an annuity, you start with nothing, put money into an account on a regular basis, and end up with money in your account.

In this section, we will learn about a variation called a Payout Annuity. With a payout annuity, you start with money in the account, and pull money out of the account on a regular basis. Any remaining money in the account earns interest. After a fixed amount of time, the account will end up empty.

Black and white aerial shot of hands exchanging money

Payout annuities are typically used after retirement. Perhaps you have saved $500,000 for retirement, and want to take money out of the account each month to live on. You want the money to last you 20 years. This is a payout annuity. The formula is derived in a similar way as we did for savings annuities. The details are omitted here.

note the similarities and differences

When using formulas in application, or memorizing them for tests, it is helpful to note the similarities and differences in the formulas so you don’t mix them up. Compare the formulas for savings annuities vs payout annuities.

 

Savings Annuity                                                    Payout Annuity

 

[latex]P_{N}=\frac{d\left(\left(1+\frac{r}{k}\right)^{Nk}-1\right)}{\left(\frac{r}{k}\right)}[/latex]                                    [latex]P_{0}=\frac{d\left(1-\left(1+\frac{r}{k}\right)^{-Nk}\right)}{\left(\frac{r}{k}\right)}[/latex]

 

 

 

Payout Annuity Formula

[latex]P_{0}=\frac{d\left(1-\left(1+\frac{r}{k}\right)^{-Nk}\right)}{\left(\frac{r}{k}\right)}[/latex]

  • P0 is the balance in the account at the beginning (starting amount, or principal).
  • d is the regular withdrawal (the amount you take out each year, each month, etc.)
  • r is the annual interest rate (in decimal form. Example: 5% = 0.05)
  • k is the number of compounding periods in one year.
  • N is the number of years we plan to take withdrawals

Like with annuities, the compounding frequency is not always explicitly given, but is determined by how often you take the withdrawals.

When do you use this?

Payout annuities assume that you take money from the account on a regular schedule (every month, year, quarter, etc.) and let the rest sit there earning interest.

  • Compound interest: One deposit
  • Annuity: Many deposits.
  • Payout Annuity: Many withdrawals

Example

After retiring, you want to be able to take $1000 every month for a total of 20 years from your retirement account. The account earns 6% interest. How much will you need in your account when you retire?

View more about this problem in this video.

Try It

 

Evaluating negative exponents on your calculator

With these problems, you need to raise numbers to negative powers.  Most calculators have a separate button for negating a number that is different than the subtraction button.  Some calculators label this (-) , some with +/- .  The button is often near the = key or the decimal point.

If your calculator displays operations on it (typically a calculator with multiline display), to calculate 1.005-240 you’d type something like:  1.005 ^ (-) 240

If your calculator only shows one value at a time, then usually you hit the (-) key after a number to negate it, so you’d hit: 1.005 yx 240 (-)  =

Give it a try – you should get 1.005-240 = 0.302096

Example

You know you will have $500,000 in your account when you retire. You want to be able to take monthly withdrawals from the account for a total of 30 years. Your retirement account earns 8% interest. How much will you be able to withdraw each month?

A detailed walkthrough of this example can be viewed here.

Try It

Try It

A donor gives $100,000 to a university, and specifies that it is to be used to give annual scholarships for the next 20 years. If the university can earn 4% interest, how much can they give in scholarships each year?