Chapter 6: Level annuities

0.1 Level annuities

In this chapter we will study the pricing of a level annuity contract that has been issued for a
xed term of n years. This contract needs to be distinquished from that of a life based contract
that remains in force only while a policyholder is still alive.
-
1: Payments in arrears

6
1
6
1
0 1 2 n
6
1
PV = a
n| i
=
1 v
n
i
AV = s
n| i
=
(1 + i)
n
1
i
-
2: Payments in advance
1

6
1
6
1
0 1 2 n 1 n
6
1
6
PV = a
n|
i
=
1 v
n
d
AV = s
n| i
=
(1 + i)
n
1
d
-
3: Continuous stream of payments
.
.
.
.
.
.
.
.
.
0
Area = n
(t) = 1 per annum
.
.
.
n
PV = a
n| i
=
1 v
n

AV = s
n| i
=
(1 + i)
n
1

1
In order to prove these results note that
a
n| i
= v + v
2
+ + v
n
=
v(1 v
n
)
1 v
=
1 v
n
i
and
a
n|
i
= 1 + v + v
2
+ + v
n1
=
1 v
n
1 v
=
1 v
n
d
Furthermore
a
n| i
=
n

0
e
t
dt =
1 e
n

=
1 v
n

The accumulation in value based formulae can be derived by simply multiplying the above
expressions by a factor (1 + i)
n
.
Deferred level annuity based notation:
m
|a
n|
= v
m
a
n| i
0 m
6
1
m + 1
6
1


6
1
m + n
= PV
_
_
_
_
_
_
_
_
Worked Examples
Example 1:
Calculate the present value as at 1 Jan 1990 of a series of payments of $1,000 that are payable
on 31 Dec of each year starting from 31 Dec 1990 to 31 Dec 1995 inclusive. Assume a com-
pound rate of interest charge of 10% eective per annum.
Solution:
(i) Chosen time period unit: 1 year.
(ii) Eective rate of interest for that choice of time period unit: i = 0.10 v = (1.10)
1
.
(iii) Total number of payment periods: n = 6.
(iv) Total payment rate per period: R = 1000
(v) Focal date: 1 Jan 1990
Because these payments are being made in arrears, we have the result that
PV = 1000 a
6| 0.10
= 1000
_
1 (1.10)
6
0.10
_
= 4355.26
years
6

6 6
0 1
31/12/90
2
31/12/95
6
6 @R1000
..
2
Example 2:
An investor deposits R2000 and then withdraws a xed amount X at the end of every year
starting one year after the deposit has been made. If, immediately after the 11th annual draw-
ing, the investor has R400 left in the account, what xed amount X must be withdrawn if
interest is being calculated at a compound rate of 8% eective per annum?
Solution:
(i) Time period unit: 1 year.
(ii) Eective rate of interest: i = 0.08.
(iii) Total number of payment periods: n = 11.
(iv) Total payment rate per period: X.
Using the date of his original deposit as a focal date, the following equation of value
2000 = 400(1 + i)
11
+ X a
11| i=0.08
implies that
X = 256.12
years
6
6

6 6
?
0 1 2 11
400
2000
11 @X
..
Note: a
11| 8%
=
1 (1.08)
11
0.08
= 7.13896.
Example 3:
An investment of R200 is due to be made at the beginning of each year for 10 years. If interest
is calculated at a compound rate of 6% eective per annum, how much will the investment be
worth at the end of 10 years?
Solution:
(i) Time period unit: 1 year.
3
(ii) Eective rate of interest: i = 0.06.
(iii) Total number of payment periods: n = 10.
(iv) Total payment rate in each period: R = 200.
Because these payments are being made in advance, the accumulated value after 10 years is
given by
AV = 200 s
10| 0.06
= 200
(1.06)
10
1
0.06/1.06
= 2794.33
years
6

6 6 6
0 1 2 9 10
10 @200
..
Example 4:
Find the present value of an annuity contract that is payable continuously for a term of 10
years at a rate of $15 per annum. Assume an eective rate of interest of 5% per annum.
Solution:
STEP 1: Time period unit: 1 year
STEP 2: Eective rate of interest for that period: i = 0.05 = ln(1.05) = 0.04879
STEP 3: Total number of payment periods n = 10
STEP 4: Rate of payment per period: 15
PV = 15 a
10|
= 15
1 (1.05)
10
0.04879
= 118.69
Example 5:
Assuming an interest rate of 12% per annum that is convertible on a monthly basis, calculate
(i) the present value of an immediate annuity that is payable on a monthly basis in arrears
with payments of R1000 per annum for the rst 6 years, R400 per annum for the next 4
years and a lump sum payment of R2000 at the end of the 10 years.
(ii) Now calculate the amount of the level annuity that is payable on a continuous basis for
10 years such that it has the same present value as the payment that has been made in
(i).
4
(iii) Calculate the accumulated value after 7 years for the payments that have been used in
(i).
(iv) Calculate the accumulated value after 7 years for the payments that have been used in
(ii).
Solution (i):
STEP 1: Time period unit: 1 month
STEP 2: Eective rate of interest for that period: i = 0.12/12 = 0.01 v = 0.9901.
STEP 3: Rate of payment per chosen time period interval: Note that R1000 p.a. implies that
R = 1000/12 per month for the rst 6 years, and R400 p.a. implies that R = 400/12 per
month for the next 4 years. Because the payments are being made in arrears
PV =
1000
12
a
72|
+
400
12
v
72
a
48|
+ 2000v
120
=
1000
12
51.504 +
400
12
0.48850 37.9740 + 2000 0.30299
= 4, 262.53 + 618.34 + 605.99 = R5,487
Solution (ii):
STEP 1: Time period unit: 1 year
STEP 2: Eective rate of interest for that period: 1 + i = (1 + 0.12/12)
12
i = 0.126825
= ln(1 + i) = 0.1194 p.a. Now
X a
10| 0.126825
= 5, 847 X = 939.947p.a.
Solution (iii):
STEP 1: Time period unit: 1 month
STEP 2: Eective rate of interest for that period: i = 0.12/12 = 0.01 v = 0.9901
The accumulated value of 7 years (i.e. 84 monthly periods) for the payments that are being
made in (i) is given by
1
AV = (1 + i)
84
_
1000
12
a
72|
+
400
12
v
72
a
12|
_
= 2.3607
_
1000
12
51.1504 +
400
12
0.4880 11.2551
_
= R10,255
1
Note that as solution can also be given by the expression
AV = (1 + i)
12
1000
12
s
72|
+
400
12
s
12|
5
Solution (iv)
STEP 1: Time period unit: 1 month
STEP 2: Eective rate of interest for that period: i = 0.12/12 = 0.01 v = 0.9901
The accumulated value after 7 years (i.e. 84 monthly periods) for the payments that are being
made in (ii) is given by
AV =
940
12
s
84|
=
940
12
131.324 = R10,287
6
10
6 6 6
..
9
6
7
6 6 6
6
6 6
.. ..
5
6
1
6 6
..
0
2000
years


6 TOTALS = 1000
..
4 TOTALS = 400
..
Example 6:
An annuity certain that is payable on a continuous basis for a term of 10 years provides pay-
ments at the rate of $2 per month. To what value will the annuity payments accumulate by
the end of the term if interest is 10% per annum convertible half-yearly?
Solution:
STEP 1: Chosen time period unit: 1 month
STEP 2: Eective rate of interest for that period: 1 + i = (1.05)
1/6
i = 0.00817
STEP 3: Rate of payment: $2 per month
The accumulated value after 10 years (120 months) is given by
AV = 2 s
120| i=0.00817
= 2
(1.00817)
120
1

= 406.63
OR
STEP 1: Chosen time period unit: 1 year
STEP 2: Eective rate of interest for that period: i = (1.05)
2
1 = 0.1025
STEP 3: Rate of payment: 2 12 = $24 per annum
The accumulated value after 10 years is given by
AV = 24 s
10| i=0.1025
= 24
(1.1025)
10
1

= 406.63
OR
STEP 1: Chosen time period unit =
1
2
year
STEP 2: E.R. = 5% per
1
2
year
6
STEP 3: Rate of payment = $12 per
1
2
year
.
.
. AV = 12 s
20| 5%
= 12
(1.05)
20
1

( = ln(1.05))
= 406.63
Example 7:
In return for a level premium that is payable annually in advance for a term of 15 years, assume
that a company wants to issue a so-called capital redemption policy (CRP) that promises to
pay a sum assured of $10,000 at the end of the term of the contract. Given that the company
can earn interest at a rate of 8% p.a. eective on the premium income that they receive,
calculate the appropriate annual premium amount that they should charge (in advance) on
this policy given that an allowance needs to be made for an initial expense of $100 plus 10% of
the rst premium payment and a renewal expense of 4% of the annual premium for the second
and each subsequent annual premium payment.
Solution: Let P denote the annual premium charge. Noting that this premium payment must
cover all the benet payments and expense charges
P a
15| 8%
= 10000v
15
+ 100 + 0.1P + 0.04Pa
14| 8%
= 10000v
15
+ 100 + 0.04P a
15| 8%
+ 0.06P
Solving this equation
P =
10 000v
15
+ 100
0.96 a
15| 0.08
0.06
= 368.99
?
10 000
15
6
14
3

6
2

6
1
6
0.9P 100
0
14 @0.96P
..
7
0.2 Annuities Payable pthly
Consider the following cashow diagrams.
-
6 6
6
6
C
C
C
C
0
1
x
2
x
. . . . . .
. . . . . .
(m1)
x
m
x
S
1
:
An amount C paid in arrears of each successive time interval of length 1/x.
-
6 6
6
C
C
C
0
1
x
2
x
. . . . . .
. . . . . .
(m1)
x
m
x
S
2
:
6
C
An amount C paid in advance of each successive time interval of length 1/x.
In either case: xC = constant rate of payment per b.t.u. Therefore we can calculate the
present value and accumulation in value of these payments as explained in the previous sec-
tion. In this case PV(S
1
) = Ca
m| i
(x)
/x
and PV(S
2
) = C a
m| i
(x)
/x
.
Similarly we have AV(S
1
= Cs
m| i
(x)
/x
and AV(S
2
= C s
m| i
(x)
/x
4. Some Examples (Constant )
8
(a)
-
0
1
3
2
3
1
4
3
5
3
2
C = 100
x = 3
6
6
66
6
6 6
100 100 100 100
100
100
PV = 100a
6| i
(3)
3
= 300a
(3)
2
| i
(b)
-
0
1 2 3 4
5
6 7
8
C = 50
x =
1
2
PV = 50 a
4|
2i
(1/2)
= 25a
(1/2)
8
| i
6
6
6
6
50
50
50
50
(c)
-
6
6
6
6 6 6 6
6 6
0
2
5
4
5
1
6
5
8
5
2
12
5
14
5
3
16
5
PV = 20 a
9| 2
5
i
(5/2)
= 50 a
(
2
1
2
)
18/5
| i
9 @20
..
C = 20
x =
5
2
(d)
9
-
6
6
6
6
6
0
1
3
2
2
3
4
9
2 5
6
7
15
2
8
x =
2
3
C = 60
60
60 60
60 60
PV = 60 a
5
| 3
2
i
(3/2)
= 40 a
(2/3)
15/2
| i
10. Non-integer values of n
Let p be a positive integer. Until now the symbol a
n|
(p)
has been dened only when n is a
positive integer. For certain non-integral values of n the symbol a
n|
(p)
has an intuitively obvious
interpretation. For example, it is not clear what meaning, if any, may be given to a
23.25|
, but
the symbol a
23.25|
(4)
ought to represent the present value of an immediate annuity of 1 per an-
num payable quarterly in arrear for 23.25 years (i.e. a total of 93 quarterly payments, each of
amount 0.25). On the other hand, a
23.25|
(2)
has no obvious meaning.
Suppose that n is an integer multiple of 1/p, say n = r/p, where r is an integer. In this
case we dene a
n|
(p)
to be the value at time 0 of a series of r payments, each of amount 1/p, at
times 1/p, 2/p, 3/p, . . . , r/p = n. If i = 0, then clearly a
n|
(p)
= n. If i = 0, then
a
n|
(p)
=
1
p
(v
1/p
+ v
2/p
+ v
3/p
+ + v
r/p
)
=
1
p
v
1/p
_
1 v
r/p
1 v
1/p
_
=
1
p
_
1 v
r/p
(1 + i)
1/p
1
_
Thus
a
n|
(p)
=
_

_
1 v
n
i
(p)
if i = 0
n if i = 0
()
The standard formula for a
n|
(p)
therefore applies for non-integer values of n when n is an integer
multiple of 1/p.
Note that, as seen previously, by working in terms of a new time unit equal to 1/p times
10
the original time unit and with the equivalent eective interest rate of i
(p)
/p per new time
unit, we see that
a
n|
(p)
at rate i is equal to
1
p
a
np|
at rate i
(p)
/p
The denition of a
n|
(p)
given by equation () is mathematically meaningful however for all non-
negative values of n. It is therefore convenient to adopt equation () as a denition of a
n|
(p)
for
all n.
This is only a mathematical denition. It is not easily translated into the present value of
a series of payments.
Consider the following payment stream:
6 6 6 6
6
6
-
6
0
1
p
2
p
. . . . . .
. . . . . .
1
. . . . . .
. . . . . .
n-1
. . .
n
T = n + f
s
f|
(p)
np payments of
1
p
..
(n -1
+
1
p
)
Here we have T = n+f, where n is an integer multiple of
1
p
and 0 < f <
1
p
, we can then write
a
T|
(p)
= a
n|
(p)
+ s
f|
(p)
v
T
(or a
n|
(p)
+ a
f|
(p)
v
n
)
Algebraically we can prove this in the following way:
a
n|
(p)
+ s
f|
(p)
v
n+f
=
1 v
n
i
(p)
+
(1 + i)
f
1
i
(p)
v
n+f
=
1 v
n
+ v
n
v
n+f
i
(p)
=
1 v
n+f
i
(p)
= a
n+f|
(p)
= a
T|
(p)
11
We can extend the above results to nd formulae for a
n|
(p)
, s
n|
(p)
and s
n|
(p)
for all non-negative n.
If i = 0, we dene for all non-negative n
a
n|
(p)
= (1 + i)
1/p
a
n|
(p)
=
(1 v
n
)
d
(p)
s
n|
(p)
= (1 + i)
n
a
n|
(p)
=
(1 + i)
n
1
i
(p)
s
n|
(p)
= (1 + i)
n
a
n|
(p)
=
(1 + i)
n
1
d
(p)
If i = 0, each of these last three functions is dened to equal n.
Examples to be done in class
1. Prove that
1
a
n| i
=
1
s
n| i
+ i.
2. A savings plan provides that in return for n annual premiums of RX (payable annually
in advance), an investor will receive m annual payments of RY , the rst such payment
being made one year after payment of the last premium.
Show that the equation of value for the transaction can be expressed in either of the
following forms:
(a) Y a
n+m|
(X + Y )a
n|
= 0 or
(b) (X + Y )s
m|
Xs
n+m|
= 0
12