What is Annuity?
An annuity is a cash flow at regular intervals for a specific period. This cash flow is fixed in amount and is bidirectional. It, therefore, involves both sending and receiving. The most defining characteristic of annuity is fixed term since these terms are made for a fixed time. Moreover, the interval of transactions can be weekly, monthly or quarterly. This interval is reached through mutual agreement of both parties.
Annuities are mostly insurance contracts that entitle you to a fixed income immediately or in the future. Most employees use annuities to finance themselves in their post-retirement life. There are no rigid rules and regulations in forming annuities because they can be tailored to meet the recipient’s needs. According to payout time, two main types of annuity are immediate annuity and deferred annuity. The former is paid right away, whereas the latter is paid on some date in the future.
There are three conventional annuity plans: fixed annuities, variable annuities, and indexed annuities. In fixed annuities, the amount to be paid by the insurance company is definite and does not change over time. Variable annuities, however, entail more risk factors, but they can result in a higher return amount. Due to its risk factor, people do not take much interest in it. Index annuities have a fixed minimum payout, but it involves higher fees. In this case, if you withdraw earlier, you have to pay special charges.
What is Perpetuity?
Perpetuity, in finance, is an annuity stretched to an infinite amount of time. It is a series of cash flows with no fixed time to end. Perpetuities are not as common among people as annuities, but their concept is emerging in finance. Perpetuity can make its payments aligned with inflation so that the buying power of the recipient does not fall. Experts suggest that the present value of a growing perpetuity is far greater than a fixed one.
Another striking characteristic of perpetuity is its lack of maturity date. It starts to pay interest with no further delay. Financial analysts think that in terms of value, perpetuity is also finite. They use a special method known as discounted cash flow (DCF) to determine the value of a perpetuity. They now think that perpetuity is more a theoretical concept, with previous examples like business and real estate.
For example, suppose you have a home or large property and rent it to someone. Now, as long as it exists, you will be paid a constant cash stream. Stock can be another example of perpetuity by assuming that the company will exist forever and keep paying dividends to an individual. Despite its inspiring financing plan, the present value of a perpetuity is finite. It thus cannot be overrated as the ideal source of financing.
Difference Between Annuity and Perpetuity
- An annuity has a fixed time of cash stream, whereas a perpetuity is an infinite cash stream.
- Annity’s future value can be known, whereas perpetuity’s future value is uncertain.
- An annuity is more popular and usable, whereas perpetuity is less common.
- An annuity is a distinctive finance plan, whereas a perpetuity is a form of an annuity.
- An annuity is based on compound interest, whereas a perpetuity is based on simple interest.
Comparison Between Annuity and Perpetuity
| Parameters of Comparison | Annuity | Perpetuity |
| Duration | Fixed | Infinite |
| Certainty of Value | Possible | Impossible |
| Usability | Common | Uncommon |
| Nature | A Mutual Contract | A Form of Annuity |
| Value Determining Interest | Compound Interest | Simple Interest |