Key Difference – Annuity vs Sinking Fund
Annuity and sinking fund are two types of investment options exercised by investors. Annuity is an investment that offers payments for a certain period of time as a result of a substantial sum paid up front. Investing in a sinking fund is similar to keeping aside a sum of money over a period of time to fund a capital expense in the future. The key difference between annuity and sinking fund is that while an annuity is an account where funds are withdrawn from, a sinking fund is an account where funds are deposited.
CONTENTS
1. Overview and Key Difference
2. What is Annuity
3. What is Sinking Fund
4. Side by Side Comparison – Annuity vs Sinking Fund
5. Summary
What is Annuity?
Annuity is an investment from which periodic withdrawals are made. To invest in an annuity, an investor should have a large sum of money to be invested at once where withdrawals will be made over a period of time. Compound interest is payable on such withdrawals, i.e., the interest paid will be continued to add up to the principal sum (original sum invested) as it is paid. It is basically the interest on interest. In addition, different withdrawal amounts in an annuity will pay interest of a varying length of time. Retirement funds and mortgages are most commonly invested annuities.
There are two main types of annuities as described below.
Fixed Annuity
A guaranteed income is earned on these type of annuities where the income is not affected by changes in interest rates and market fluctuations; thus they are the safest type of annuities. The below are different types of fixed annuities.
Immediate Annuity
Investor receive payments soon after making the initial investment.
Deferred Annuity
This accumulates money for a pre-determined time period before starting to make payments.
Multi Year Guarantee Annuities (MYGAS)
This pays a fixed interest rate each year for a certain period of time.
Variable Annuity
The amount of income varies in this type of annuities since they give the opportunity for investors to generate higher rates of return by investing in equity or bond sub accounts. Income will vary based on the performance of the sub account values. This is ideal for investors who wish to benefit from higher returns, but at the same time, they should be prepared to endure the probable risks. Variable annuities have higher fees due to the associated risk.
Difference Between Fixed and Variable Annuities
What is a Sinking Fund?
This is an investment maintained by making periodic deposits. Similar to annuity, sinking funds also calculate interest on compound basis. However, unlike annuity, interest will be earned on the sinking fund.
E.g. Assuming that a $1,000 deposit is made on the 1st of January at a rate of 10% per month, the deposit receives an interest of $100 per month continuing for the year. However, for the deposit made on 1st of February at the same rate, the interest will be calculated not on $1,000, but on $1,100 (including the interest earned in January). The interest for February will be calculated for 11 months assuming that this is a one-year sinking fund.
It is important for an investor to know what is the total sum that the fund will have at its maturity; this can be derived using the following formula.
FV= PV (1+r) n
Where,
FV= Future Value of the fund (at its maturity)
PV= Present Value (the amount that should be invested today)
r = Rate of return
n = Number of time periods
Continuing from the above example,
E.g. FV= $1,000 (1+0.1)12
= $3,138 (rounded to the nearest whole number)
This means that if a sinking fund deposit of $1,000 is made on 1st of January, it will grow up to $3,138 by the end of the year.
Figure 1: Compound Interest grows with time
What is the difference between Annuity and Sinking Fund?
Annuity vs Sinking Fund |
|
| Annuity is an account where funds are withdrawn periodically. | Funds are deposited at regular intervals in the sinking fund. |
| Users | |
| Generally, individuals who seek retirement plans invest in annuity. | Sinking fund investments are made by individuals and companies. |
| Initial Investment | |
| This requires a significant initial investment. | This does not require a significant initial investment |
Summary – Annuity vs Sinking Fund
The difference between Annuity and Sinking Fund is their investment requirement; Sinking Fund does not require a lump sum of money at the beginning of the investment, making it an attractive investment option for many investors. Investing in an annuity is usually done by a person closer to retirement in order to receive a guaranteed income during retirement. However, if the stock market conditions are not favorable, the investments in variable annuities will generate more volatile returns.
Reference:
1.”Empowering Women Investors.” How do Annuities Work? | Types of Annuities | Nationwide.com. N.p., n.d. Web. 10 Mar. 2017.
2.”Sinking fund dictionary definition | sinking fund defined.” Sinking fund dictionary definition | sinking fund defined. N.p., n.d. Web. 10 Mar. 2017.
3.”Present Value.” Present Value. N.p., n.d. Web. 07 Feb. 2017.
4.”Future Value (FV).” Future Value (FV) Definition & Example | Investing Answers. N.p., n.d. Web. 07 Feb. 2017.
5.Segal, Troy. “Compound Interest.” Investopedia. N.p., 09 Mar. 2017. Web. 10 Mar. 2017.
Image Courtesy:
1. “Compound Interest with Varying Frequencies” By Jelson25 – Own work (CC BY-SA 3.0) via Commons Wikimedia