Ordinary Annuity vs. Annuity Due Which Is Better? [EXPLAINED]

Saving and planning for retirement can be a complex task that involves weighing the risk of many different products and investments, with the goal of having enough diversification and income to last you the rest of your life and even beyond. One of the ways you can ensure that you don't outlive your projected retirement income is to purchase annuities, either ordinary annuities, annuities due, or a mix of both. But if you can only get one, which is better for your situation?

The best annuity for you will depend on your life stage, and if you are going to be making or collecting payments. If you are younger, you're more likely to be making payments, which would make ordinary annuities better. If you are retired and looking to collect payments, an annuity due is better.

The differences between an ordinary annuity and an annuity due are numerous and relatively complex, so being fully informed of their specifics can help you be much better prepared for retirement. In order to better understand the nuances of each, we're going to do a deep dive into annuities. You'll learn what exactly they are, the differences between the two, and even how they're calculated. In the end, you'll be able to decide which may be better for you.

What Is An Ordinary Annuity

An ordinary annuity is a financial product that consists of a series of equal payments that are each made at the end of specified periods. An ordinary annuity has a fixed term that it is active for, and it can generally be set up to require payments over a range of intervals. Common ordinary annuity payment intervals are weekly, monthly, quarterly, semi-annually, or annually.

An example of how ordinary annuities work is buying bonds and receiving interest payments from them. These are generally made semi-annually. Another example would be a dividend stock or fund that has maintained somewhat of an even payout for the last several years. To put an ordinary annuity in the context of a homeowner, when a homeowner makes their monthly mortgage payment, the payment is to cover the entire month leading up to the current payment date.

Ordinary annuities are highly dependent on prevailing interest rates to determine their present value. Due to the principle of the time value of money, increasing interest rates will reduce the present value of an ordinary annuity. This also means that the inverse is true and that falling interest rates will increase the present value of an ordinary annuity. This is related to the potential for that same principal to earn money in a different investment since, in theory, if you can get higher rates elsewhere, it decreases the value of the annuity.

What Is An Annuity Due

An annuity due is similar to an ordinary annuity, with a few important differences. While an ordinary annuity has payments made at the end of the payment period, an annuity due has payments due at the beginning of the payment period. In other words, each annuity has a "covered term," and with an annuity due, the payment is made at the beginning of that covered term rather than at the end as with an ordinary annuity.

Examples of this in another context would be the analogy of rent. When a renter makes their monthly rent payment, they are paying ahead for the month. If they pay rent on June 1st, that payment is for June's rent, in contrast to an ordinary annuity, which is more similar to a mortgage payment that would come at the end of the month. Paying the insurance premiums for auto or homeowner's insurance is another prime example since the insurance payment comes at the beginning of the covered term, not the end. You must pay first to have the coverage or the benefits.

This has a heavy influence on the time value of money, just as with an ordinary annuity. With an annuity due, the time value of money has a significant role since the money that is paid today has a higher value than the same amount of money paid in the future. This is because it has a far greater potential to grow and create a return on investment. With inflation growing daily, this simply means that $250 paid now has a greater value than $250 paid 12 months from now. Just because it is the same amount of money doesn't mean it will have the same value.

The bottom line with an annuity due is that since payments are due prior to the covered term, there is a far greater present value, and as such, the calculation method for present value will be different than with ordinary annuities.

What Is The Time Value Of Money

The time value of money is the financial principle that any particular sum of money is automatically worth more now than the same amount later. The Time Value of Money is hugely related to the interim earnings potential of that sum. The time value of money is a core financial principle and is essentially the financial equivalent of "a bird in the hand is worth two in the bush."

One of the biggest reasons for the time value of money to be so important is that for fields like investing, it has such a significant potential to grow and generate returns on investments. Over the time of the annuity, this money has a considerable potential to earn interest, which contributes to the snowball effect of compound interest.

This is one of the primary reasons that money in savings accounts is doomed to rot away to inflation and other cost-of-living decay. If money is put into an investment that returns even a slightly better result than inflationary decay, that money has likely already generated a better return than any savings account could. If left in a savings account, the sum initially deposited will have less buying power than the same sum put into an annuity.

The time value of money also relates to the opportunity cost and is closely related to the time value of money. Money can only grow over time if it's wisely invested over a set period and it & creates a net positive return. The time value of money is also essential to risk management for people that manage large retirement funds like pensions to ensure that the funds mature with enough funds in them for eventual retirement.

Annuity Formula

The formula to determine the present value of an ordinary annuity is written as:

Vp = Pmt x ((1 – (1 + R)-n)/R)

Where:

• Vp = Present value
• Pmt = Period cash payment
• R = Per period interest rate
• n = Total number of periods in the annuity
• To view an example of present value, let's assume a hypothetical ordinary annuity pays $50,000 annually for five years, coupled with a non-variable interest rate of 7%. Putting these figures into the ordinary annuity formula gives:

50,000 x ((1 – (1 + 0.07)-5)/0.07)

This comes out to a present value of $205,010.

Annuity Due Formula

The formula to determine the present value of an annuity due is expressed as:

Vp = Pmt + Pmt x ((1-(1 + R)-(n-1)/R)

Where:

• Vp = Present value
• Pmt = Period cash payment
• R = Per period interest rate
• n = Total number of periods in the annuity

If we were to create an example of an annuity due using the same figures as the hypothetical annuity, we have:

50,000 + 50,000 x ((1-(1 + 0.07)-(5-1)/0.07)

This returns a result of $219,360.

Ordinary Annuity vs. Annuity Due Which Is Better

Ultimately, the answer to whether an ordinary annuity or an annuity due is better depends highly on whether you will be the payer or the payee. The payee will generally prefer the annuity due since payment for the specified term is received upfront. This gives the payee the opportunity to use the funds right away as they see fit and therefore realize a greater present value of the annuity in relation to an ordinary annuity.

As a payer, the ordinary annuity is generally preferable since you will make the annuity payment at the end of the term rather than the beginning. This means you have a longer window in which to use those funds, as well as the benefits of the annuity itself before the payment comes due. In many cases, you will not have a choice of ordinary annuity or annuity due since it will often be decided by the product generating the annuity payment initially.

Understanding The Differences Between An Annuity Due & An Ordinary Annuity Can Help You Build Long-Term Income

Depending on which side of the payment fence you are on, making sure you are informed of the amount of annuities is crucial. If you are going to be making payments yourself, you should aim to go with an ordinary annuity. Conversely, if you're going to be the party collecting payments, the annuity due structure is more desirable. Make sure you keep this in mind when shopping for financial products like whole life annuities.