What it means
The structure has two distinct phases. During the accumulation phase nothing is paid out and the invested amount earns a return, and during the payout phase the holder receives regular instalments.
The length of the gap between the two is what makes the annuity deferred rather than immediate. The appeal is straightforward for anyone whose income need starts at a known future date.
Someone aged 50 planning to stop work at 65 can buy a deferred annuity now, let it grow for fifteen years, and receive a predictable income afterwards without having to time markets at the moment of retirement. The insurer or provider carries the investment and longevity risk in exchange for the premium.
Businesses meet the same structure in other clothing. Deferred compensation arrangements, structured legal settlements, delayed lease payment schedules and instalment sale agreements all behave like deferred annuities, and they are valued using exactly the same discounting method.
Recognising the pattern makes otherwise complicated contracts easy to price. Valuation is a two-step discount.
First the payment stream is valued using an ordinary annuity factor, which gives its worth one period before the first payment, and then that figure is discounted back across the deferral period to today. Skipping the second step is the single most common error in this calculation.
The main nuances to check are timing and inflation. An annuity due pays at the start of each period rather than the end, which shifts the arithmetic by one period, and a fixed nominal payment loses purchasing power over a long deferral.
Anyone comparing offers should also check surrender terms, since a deferred annuity is usually difficult or costly to exit during the accumulation phase.
In practice
Real-world examples.
Example
A dentist aged 52 pays a single premium into a deferred annuity that will start paying a fixed monthly income at 67. She accepts a lower headline return than an equity portfolio in exchange for knowing exactly what her income will be. The fifteen-year accumulation phase does the compounding work.
Example
A senior executive agrees to a deferred compensation package that pays out over ten years starting five years after retirement. The company values the obligation as a deferred annuity and carries the discounted amount as a long-term liability. The unwinding of that discount appears as a finance cost each year.
Example
A claimant settling an injury case accepts a structured settlement paying $60,000 a year for 20 years beginning in three years' time. Her adviser discounts the stream to compare it fairly against the lump sum alternative on the table. The comparison changes her decision.
Formula
Calculation
Present value = payment x [(1 - (1 + r)^-n) / r] x (1 + r)^-d
where r is the periodic rate, n is the number of payments and d is the number of periods until one period before the first payment.
An investor is offered an annuity paying $20,000 a year for 15 years, with the first payment arriving at the end of year 11, and the appropriate discount rate is 6%. First calculate the ordinary annuity factor for 15 payments at 6%: (1 - 1.06^-15) / 0.06 = 9.7122. Multiplying gives $20,000 x 9.7122 = $194,244, which is the value of the stream as at the end of year 10, one period before the first payment. Next discount that back ten years: 1.06^10 = 1.7908, so $194,244 / 1.7908 = $108,468. The deferred annuity is therefore worth about $108,468 today, well under the $300,000 of nominal payments it will eventually deliver.Case study
Seen in the real world.
Fernhill Engineering is a fictional company used here for illustrative purposes. When it sold a division, part of the consideration was structured as a deferred payment annuity: nothing for four years, then $250,000 a year for eight years. The selling shareholders initially described the deal as worth $2 million because that is what the payments add up to.
Their adviser recalculated the value properly, discounting the eight payments back to the end of year four and then discounting that result back four more years. At the discount rate appropriate to the buyer's credit quality, the present value came out at little more than half the headline figure, and the shareholders understood for the first time what they were actually accepting.
Armed with the number, they renegotiated. The final deal shortened the deferral by two years and added a modest interest uplift on the deferred amount, which closed most of the gap between the headline figure and the economic value.
Watch out
Common mistakes.
- Valuing the payment stream with an annuity factor and then forgetting to discount the result back across the deferral period.
- Discounting by the wrong number of periods, since the standard annuity factor already gives a value one period before the first payment.
- Comparing the total nominal payments against a lump sum alternative without adjusting for the time value of money.
Questions
People also ask.
What is the difference between a deferred and an immediate annuity?
An immediate annuity starts paying almost straight away, while a deferred annuity has an accumulation phase before any payment begins.
Does the deferral period always increase the value?
It increases the accumulated amount but reduces the present value of a fixed payment stream, because the money arrives later.
Can a deferred annuity be cashed in early?
Usually only with surrender charges or a significant reduction in value, so it should be treated as a long-term commitment.
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