1 Varying Annuities: 1.1 Annual Payments

Page 1 Math 336- Introduction to Actuarial Mathematics
.
1 Varying annuities
1.1 Annual payments
For an annuity in which the payments are not all of an equal amount it is a
simple matter to find the present (or accumulated) value from first principles.
Thus, for example, the present value of such an annuity may always be
evaluated as:
X v
i
t
i
n
i
= == =

1
where the ith payment, of amount X
i
, is made at time t
i
.
If there are also continuous payments then the present value may be calculated as:
X v t v dt
i
t
i
n
t
i
=

z
+
1
( )
where ( ) t is the rate of payment per time unit at time t.
In the particular case when X t i
i i
= == = = == = the annuity is known as an increasing
annuity and its present value is denoted by ( )
|
Ia
n
.
( )
|
Ia
n
, therefore, represents the present value of payments of 1 at the end of the first
time period, 2 at the end of the second time period, , n at the end of the nth time
period.
Thus:
2 3
|
2 1
|
( ) 2 3
Hence: (1 )( ) 1 2 3
n
n
n
n
Ia v v v nv
i Ia v v nv
" "" "

" "" "
(.1)
By subtraction, we obtain:
2 3 1
|
|
( ) 1
n n
n
n
n
i Ia v v v v nv
a nv

" "" "

Math 336- Introduction to Actuarial Mathematics Page 2
.
So:
( )
|
|
Ia
a nv
i
n
n
n
= == =

In the exam you might not be given this Iormula so it is recommended that you learn
this Iormula.
The graph below shows the profiles of the payments of ( )
|
Ia
5
.
The present value of any annuity payable in arrear for n time units for which the
amounts of successive payments form an arithmetic progression can be
expressed in terms of a
n
|
and ( )
|
Ia
n
. If the first payment of such an annuity is P
and the second payment is ( ) P Q + ++ + , the tth payment is ( ) P Q Qt + ++ + , then the
present value of the annuity is
( ) ( )
| |
P Q a Q Ia
n n
+ ++ + (2.2)
Alternatively, the present value of the annuity can be derived from first
principles.
On a time line we can show the payments as:
0
1
2
3
4
5
0 1 2 3 4 5
Time
A
m
o
u
n
t
Payments
Time
1 3 2 4
P + (n 1)Q P P + 2Q P + Q P + 3Q
n
Page 3 Math 336- Introduction to Actuarial Mathematics
.
Alternatively, these payments can be thought of as the sum of the following two sets of
payments:
ie we have a level annuity with payments of P Q and an increasing annuity that
increases by Q each time.
Payments
Time
1 3 2 4 n
P Q P Q P Q P Q
P Q
Payments
Time
1 3 2 4
nQ Q 3Q 2Q 4Q
n
Math 336- Introduction to Actuarial Mathematics Page 4
.
Example
Find the present value as at 1 January 2005 of a series of 10 annual payments starting at
500 on 1 January 2006 and increasing by 100 each year. Assume an effective rate of
interest of 8% pa.
Solution
We can think of this series of payments as a combination of:
a level annuity of 400 and
an increasing annuity of 100
So the present value of the payments as at 1 January 2005 is:
10
|
10
| | |
10 10 10
10
400 100( ) 400 100
7.2469 10(0.46319)
400 6.7101 100
0.08
5, 953
a v
a Ia a
i
or this can be calculated using the Tables.

The notation (

)
|
Ia
n
is used to denote the present value of an increasing
annuity-due payable for n time units, the tth payment (of amount t) being made
at time t 1. Thus:
(

)
|
Ia
n
= == = + ++ + + ++ + + ++ + + ++ +

1 2 3
2 1
v v nv
n
"
= == = + ++ + ( )( )
|
1 i Ia
n
= == = + ++ + + ++ +

1
1 1
a Ia
n n
| |
( )
Page 5 Math 336 - Introduction to Actuarial Mathematics
.
Practice Question 1
Derive a formula for ( )
|
Ia
n
(i) algebraically and
(ii) by general reasoning, starting from the formula for ( )
|
Ia
n
.
The graph below shows the profiles of the payments of ( )
|
Ia
5
.
0
1
2
3
4
5
0 1 2 3 4 5
Time
A
m
o
u
n
t
Practice Question 2
Calculate the present value at time 0 of payments of 50 at time 0, 60 at time 1, 70 at
time 2 and so on. The last payment is at time 10. Assume that the annual effective rate
of interest is 4.2%.
Math 336 - Introduction to Actuarial Mathematics Page 6
.
Practice Question 3 (Ignore this question, we'll cover it later)
A Rent on a property is payable continuously for 5 years. The rent in the first year is
thereafter the annual rent increases by 500 pa. Calculate the present value of ,3,000
the rent at the start of the 5 years, using an annual effective rate of interest of 6%.

1.2 Decreasing payments
We can also use increasing annuities to find the present value of annuities where the
payments decrease by a fixed amount each time.
Example
The following payments are received:
50 at time 1, 45 at time 2, 40 at time 3 etc
The last payment is received at time 6.
These payments are equivalent to:
55 at time 1, 55 at time 2, 55 at time 3, etc
LESS the following payments:
5 at time 1, 10 at time 2, 15 at time 3, etc
In symbols this is:
6 6
55 5( ) a Ia
.
Practice Question 4
A man makes payments into an investment account of $200 at time 5, $190 at time 6,
$180 at time 7, and so on until a payment of $100 at time 15. Assuming an annual
effective rate of interest of 3.5%, calculate:
(i) the present value of the payments at time 4
(ii) the present value of the payments at time 0
(iii) the accumulated value of the payments at time 15
.
2 Special cases
2.1 Irregular payments
Where the interest rate is constant, we can use the trick illustrated in the following
example. This involves converting the payments into a simpler series of payments with
the same present value.
Example
Find an expression in terms of annuity functions for the present value as at 1 January
2004 of the following payments under the operation of a constant rate of interest:
100 on 1 January, 1 April, 1 July and 1 October 2004
Solution
We can convert the payments for each calendar year to an equivalent single payment with
the same present value payable on 1 January that year. For example, the payments in 2006
are equivalent to a single payment of 1200
1
4
|
( )
a payable on 1 January 2006. So, the
payments are equivalent (in terms of present value) to the following five payments:
1 400
1
4

|
( )
a on 1 January 2004
2 400
1
4

|
( )
a on 1 January 2005
...
5 400
1
4

|
( )
a on 1 January 2008
This is just a simple increasing annuity (payable annually in advance) where the payment
amounts increase by 400
1
4
|
( )
a each year. So the present value is ( )
|
|
( )
Ia a
5
1
4
400 .
.
3.2 Sudden changes in interest rates
Sudden changes in interest rates were considered for single payments earlier in the course.
We now consider a series of payments.
Example
Calculate the present value as at 1 January 2004 of the following payments:
100 on the first day of each quarter during calendar years 2006 to 2015 inclusive.
Assume effective rates of interest of 8% per annum until 31 December 2010 and 6% per
annum thereafter.
Solution
Here we must value a ten-year annuity payable quarterly in advance, deferred for two
years. We have to split the ten-year annuity into two five-year annuities to allow for the
change in interest rates.
The present value here is:
(4)@8% (4)@6% 2@8% 5@8%
| |
5 5
400 ( )
1 0.68058 1 0.74726
400 0.85734 0.68058
0.076225 0.057847
400 6.1420 2, 457
v a v a +
_
+

,

Practice Question 5
The following payments are made:
1,000 pa payable quarterly in arrears from 1/1/05 to 31/12/10
The annual effective rate of interest is 3.4% for calendar years 2005-2008 and 4.2%
thereafter. Calculate:
(i) the present value of the payments at 1/1/05
(ii) the accumulated value of the payments at 1/1/12.
.
3.3 Compound increasing annuities
We have already looked at simple increasing annuities, such as ( )
|
Ia
n
, where the
payments increase by a constant amount each time. We will also need to be able to value
compound increasing annuities where the payments increase by a constant factor each
time.
Example
Calculate the present value as at 1 January 2003 of an annuity payable annually in arrear
for 15 years. The first payment is 500 and subsequent payments increase by 3% per
annum compound.
Assume effective rates of interest of 10% per annum.
Solution Method 1
A payment of 500 is made on 1 January 2004. A payment of 500 1.03 is made on 1
January 2005. A payment of
2
500 1.03 is made on 1 January 2006, and so on.
The final payment of
14
500 1.03 is made on 1 January 2018.
From first principles, we can write down an expression for the present value of this
annuity as follows:
2 2 3 14 15
500 500 1.03 500 1.03 500 1.03 + + + + " PV v v v v (*)
This can be rearranged as follows:
( )
2 2 14 14
500 1 1.03 1.03 1.03 PV v v v v + + + + "
The expression in brackets is simply a geometric progression of the form:
2 1
1
1
1
+ + + +
"
n
n
x
x x x
x
where
1.03 1.03
1.03 0.936364
1 1.1

+
x v
i
and 15 n .
.
Using simple substitution we get:
( )
15
1.03
1.1
1.03
1.1
1
500
500 9.853407 4, 479
1.1 1
PV v
Method 2
Well now consider a slightly different way of solving this problem. The equation (*)
could be rearranged and written as:
( )
( )
2 2 15 15
2 15
500
1.03 1.03 1.03
1.03
500
1.03
PV v v v
v v v
"
"
+ +
+ +
where 1.03 v v .
Remember that:
2
1
@ % where
1
n
n
a v v v i v
i
+ + +
+
"
If we introduce a new interest rate i , we can define:
2
1
@ % where 1.03
1
n
n
a v v v i v v
i
+ + +
+
" (**)
This is just the value,
n
a
, of an annuity certain, calculated at interest rate i .

From (**) we get:
1 1.03 1.1
1 6.7961%
1 1.1 1.03
i
i
=
+
.
So we can now write the present value of the annuity as:
( )
15
15
1
1.067961
500
@6.7961%
1.03
1
500 500
9.2264 4, 479
1.03 0.067961 1.03
PV a

,
The value of a compound increasing annuity can be valued using the present of a level
annuity at a different interest rate.
Method 3
Finally, well consider a slight adaptation of Method 2, using an annuity due instead of
an annuity in arrear. In Method 1, we rearranged the equation (*) as:
( ) ( )
14 14 2 14
500 1 1.03 1.03 500 1 PV v v v v v v v + + + + + " "
where 1.03 v v .
This time the expression in brackets is an annuity-due and so we can write:
15
500 PV va

We must be slightly careful when evaluating this expression. The v in the expression
must be calculated at 10%, whereas the annuity must be calculated at our new interest
rate 6.7961% i as before. So:
( )
15
1
15
1.067961
0.067961
1.067961
1
1 500 500
500 9.8534 4, 479
1.1 1.1
v
PV v
d
_
_

,
,
We have considered three slightly different methods here. There is no best method to
use. You can choose which ever you feel most comfortable with. Methods 2 and 3 may
appear to be a little more complicated at first but its worth trying them out. Theyre not
quite as complex as they might first appear.
Before you have a go at an exercise yourself, heres another look at Method 2 in a more
general context.
Page 13 Math 336 - Introduction to Actuarial Mathematic
.
Present value of a compound increasing annuity
If payments increase in such a way that the payment at time t is ( ) 1+ e
t
, then:
the PV of a single payment paid at time t n = is v
n
the PV of a series of payments paid at times t n = 1 2 , , , ! is a
n
|
where the functions with dashes are calculated at the rate of interest =

+
i
i e
e 1
.
To value compound increases, subtract the rate of increase from the interest rate and
divide by 1-plus-the-rate-of-increase
Proof
The present value of a single escalated payment at time t is
( )
( )
1
1
1
1
+
+
=
+
+
F
H
G
I
K
J
e
i
e
i
t
t
t
.
If we introduce a new interest rate i defined by the equation
1
1
1
1 +
=
+
+ i
e
i
, we find that
the PV of a payment at time t n = can be expressed as
1
1+
F
H
G
I
K
J
i
n
, ie it is just v
n
,
calculated using the interest rate i .
Similarly, the present value of a compound increasing annuity is:
+ + + v v v
n 2
"
which is just the value a
n
|
of an annuity certain, calculated at interest rate i .

We can rearrange the equation for i to find an expression for i in terms of i and e :
1
1
1
1 +
=
+
+ i
e
i
=
+
+
=
+ +
+
=

+
i
i
e
i e
e
i e
e
1
1
1
1 1
1 1
( ) ( )
.
Practice Question 6
Calculate the present value (at time t = 0 ) of payments of 20, . 000 10381
1
t
payable at
times t = 1 2 3 10 , , , , ! , assuming a constant annual effective rate of interest of 9%.
Practice Question 7
Calculate numerical values for the following actuarial functions assuming the interest rates
shown in brackets. Ignore first two parts for now.
(i) a
7
|
(7% pa) (ii) ( )
|
Ia
5
(10% pa) (iii)
|
( )
s
15
4
(10% pa convertible quarterly)
(iv) s
10
|
()
(1% pa) (v) a
14
4
|
( )
(4% pa) (vi)
(3)
5|
8
a (6% pa)
Practice Question 8
Calculate the present value as at 1 January 2005 of a 5-year annuity consisting of
payments of 100, starting on 1 January 2005 and payable on the first day of each month
with an R in its name. Assume a constant annual effective rate of interest of 8%.
.
4 Exam-style question
Heres an example of an exam-style question involving compound increasing annuities.
Have a go at it yourself before turning the page and working through the solution.
Question
An investor wishes to find the present value of a stream of property income payments.
She proposes to make the following assumptions.
The level of current payments is 20,000 per annum, paid quarterly in advance.
Payments will remain fixed for 5-year periods. At the end of each 5-year period
the payments will rise in line with total inflationary growth over the previous
five years.
Inflation is assumed to be constant at 3% per annum.
The interest rate for the calculation is 12% per annum effective.
Find the present value of the income stream assuming that the payments continue for 50
years. [6]
.
Solution
(i) The present value of the first five years worth of payments (working in
thousands of pounds) is 20
5
4
|
( )
a (calculated at i = 12%).
The present value (still at time 0) of the next 5 years worth of payments is:
20 103
5
5
4 5
.
|
( )
a v
Note that we must increase the annual payment by
5
1.03 because we are given
an annual rate of inflation and the payments will rise in line with total
inflationary growth over the previous five years.
The next 5 years worth of payments will be worth:
20 103
10
5
4 10
.
|
( )
a v and so on
So the total present value will be:
@ %
@ %
(4) (4) 5 5 10 10 45 45
|
| | 10
5 5
20 1 1.03 1.03 1.03 20
j
i
a v v v a a
1
+ + + +
]
"
where the last annuity term above is calculated at the rate j for which
5
1 1.03
1 1.12
j
v
j
_

,
+
. This gives a rate of interest for j of 52.021%.
So the total present value is:
@ %
@ %
10
5
(4)
|
| 10 (4) 5
1
1
20 20
20 3.87131 2.87797 222.830
j
i
j
j
v
v
a a
d
d

So the present value of the income stream is 222,830.
.
Solution 1
(i) Algebraically ( )
|
Ia
n
is equal to 1 2 3
2 1
+ + + +

v v nv
n
! .
In this case, it is easiest to derive the formula by multiplying by v and
subtracting (rather than multiplying through by ( ) 1+i ). So we get:
2 2 1
|
2 2 1
|
2 2 1
|
|
| | |
( ) 1 2 3 ( 1)
( ) 2 ( 2) ( 1)
(1 )( ) 1
( ) ( )
n n
n
n n n
n
n n n
n
n
n
n
n n n
Ia v v n v nv
v Ia v v n v n v nv
v Ia v v v v nv
a nv
ie d Ia a nv Ia
d
"
"
"

+ + + + +
+ + + + +
. + + + + +
.
(ii) The formula for ( )
|
Ia
n
follows by general reasoning by noting that the payments
for ( )
|
Ia
n
are the same as for ( )
|
Ia
n
, but advanced by 1 year.
So:
( ) ( )( ) ( )

| |
| |
Ia i Ia i
a nv
i
a nv
d
n n
n
n
n
n
= + = +
1 1
Solution 2
On a time line we can show the payments as:
Payments
Time
1 3 2
150 60 80 70
10
50
0
.
Notice that there are 11 payments. Alternatively, these payments can be thought of as
the sum of the following two sets of payments:
ie we have a level annuity with payments of 40 and an increasing annuity which
increases by 10 each time.
The present value of these payments is:
11 11
40 10( ) a Ia +
We have:
11
11
1 1.042
9.03074
0.042 1.042
a

11
11
11
11
11
9.03074 11 1.042
( ) 50.48174
0.042 1.042
a v
Ia
d

So the present value is:
40 9.03074 10 50.48174 866.05 +
Payments
Time
1 3 2
10
20 30 40
110 10
0
Payments
Time
1 3 2
40
0 10
40 40 40
40
.
Solution 3
On a time line the rent is as follows:
The present value of these payments is:
5 5
2, 500 500( ) a I a +
Evaluating these annuities:
5
5
1 1.06
4.3375
ln1.06
a

5
5
1 1.06
4.4651
0.06 1.06
a

5
5
4.4651 5 1.06
( ) 12.5078
ln1.06
I a

2, 500 4.3375 500 12.5078 17, 097.66 +
.
3,000 3,500 4,000 4,500 5,000
0 1 2 3 4 5
Payments
Time
.
Solution 4
The payments can be thought of as:
210 at time 5, 210 at time 6, 210 at time 7, , 210 at time 15
LESS the following payments:
10 at time 5, 20 at time 6, 30 at time 7, , 110 at time 15
(i) The present value of these at time 4 is:
11 11
210 10( ) a Ia
Evaluating these, we get:
11
11
1 1.035
9.0016
0.035
a

11
11
1 1.035
9.3166
0.035 1.035
a

11
11
9.3166 11 1.035
( ) 50.9201
0.035
Ia

210 9.0016 10 50.9201 1, 381.13
(ii) To find the present value at time 0, we need to discount the answer to part (i) by
4 years:
4
1, 381.13 1.035 1, 203.57

(iii) To find the accumulated value at time 15, we need to accumulate the answer to
(i) by 11 years:
11
1, 381.13 1.035 2, 016.40
.
Solution 5
(i) The present value is:
(4) (4) 4
@3.4%
4 2
@3.4% @4.2%
1, 000 1, 000 a v a +
Evaluating these:
1
4
(4)
@3.4%
4 1.034 1 0.03357
_

,
i
1
4
(4)
@4.2%
4 1.042 1 0.04135
_

,
i
The present value is then:
4 2
4
1 1.034 1 1.042
1, 000 1, 000 1.034
0.03357 0.04135
3, 728.432 1, 670.965 5, 399.40

+
+
(ii) We need to accumulate the answer to part (i) by 7 years. Four of these years
have an interest rate of 3.4% pa and the remainder have an interest rate of
4.2% pa:
4 2
5, 399.40 1.034 1.042 6, 701.36
.
Solution 6
( )
2 9 10
10
20, 000 1.0381 1.0381
20, 000
1.0381
PV v v v
a
" + +
Note that in this case we have had to divide by 1.0381 to ensure that the power we raise
1.0381 to matches the power we raise v to in each term of the original expression. This
wont always be the case. Its usually best to work form principles and use simple
algebraic manipulation to obtain an expression of the form:
2 2
(1 ) (1 ) (1 )
n n
e v e v e v + + + + + "
which can be valued as an annuity in arrear (or as a sum of a geometric progression).
or of the form:
1 1
1 (1 ) (1 )
n n
e v e v

+ + + + "
which can be valued as an annuity-due.
However, once you have practised quite a few of these you may be able to spot a few
short-cuts but be careful not to slip up.
The interest rate to use for the annuity is:
=

+
=

+
= i
i e
e 1
0 09 0 0381
1 0 0381
0 05000
. .
.
.
which is almost exactly 5%.
So the present value of the payments is:
20 000
10381
20 000
10381
7 7217 800
10
,
.
,
.
. 148,
|
@5%
a = =
.
Solution 7
(i) a
v
7
7 7
1 1 1075
1075
54928
|
.
log .
. =

=

=
(ii) ( )
. .
.
.
|
|
Ia
a v
5
5
5
5
41699 5 0 62092
0 095310
11177 =
=

=
(iii) 10% pa convertible quarterly is equivalent to an effective rate of 2% per

quarter. So, converting to quarterly time periods gives:
(4)
| |
| 60 60
15
@2%
1 1 1
(1 ) 1.025 135.9916 34.848
4 4 4
+ s s i s
(iv) s
i
i
s
10
10 2
001
101 1
10 4622 10 410
|
()
()
|
.
[ . ]
. . = =
=
or:
s s
i
i
10
1%
5
2 01%
5 5
2 2
1 1
2
10201 1
0 0201
10 410
|
()@
|
@ .
( ) .
.
. = =
+
L
N
M
M
O
Q
P
P
=

F
H
G
I
K
J
=
or:
() 2 4 6 8
|
10
2[1 (1 ) (1 ) (1 ) (1 ) ]
2[1 1.02010 1.04060 1.06152 1.08286] 10.410
s i i i i + + + + + + + +
+ + + +
(v) a
v
i
14
4
14
4
14
1 1 104
0039414
11005
|
( )
( )
.
.
. =

=

=
(vi)
8
(3) (3) 5 5
5|
(3) 8 8
1 1.06
1.06
a v a
d

where
1 1
3 3
(3)
3 1 (1 ) 3 1 1.06 0.057707 d d
_ _

, ,
. So:
(3)
5|
8
4.8247 a
.
Solution 8
Payments are made at the beginning of:
JanuaRy, FebRuaRy, MaRch, ApRil and
SeptembeR, OctobeR, NovembeR, DecembeR
ie the first 4 months and the last 4 months of each calendar year.
First, consider the first 4 payments in 2005. We have payments of 100 made at the start
of the next four months.
Working in years, the present value of these payments at 1 January 2005 is:
(12)
4/12
1, 200 @8% a pa
(Note that the normal annuity formulae work for fractions of a year too, provided that
the fraction of a year is compatible with the payment interval, ie working in months, the
fraction should be a multiple of
1
12
.)
Looking at each element of this expression:
The length of the annuity is 4 months and so working in years the term must be
4
12
.
The annuity is paid monthly and so this is represented by (12). The payments are made
at the start of each month, which gives a. Finally, because we are working in years, we
must multiply the annuity by the amount that we would have paid in a whole year had
the payments continued, ie 12 payments of 100, which of course equals 1,200.
Similarly, the present value as at 1 January 2005 of the payments made in September to
December is:
(12) 8/12
4/12
1, 200 @8% v a pa
because these payments commence in 8 months time.
.
So the payments in each calendar year have the same value as a single payment on
1 January of:
1 200 1200 1
4 12
12 8 12
4 12
12 8 12
4 12
12
, ( ) , ( )
/
|
( ) /
/
|
( ) /
/
|
( )
a v a v a + = + (*)
So the value of the 5-year annuity is the value of these payments made at the beginning
of each year is:
(12) 8/12
|
| 5
4/12
4/12 5
8/12
1, 200(1 )
1 1.08 1 1.08
1, 200(1 1.08 ) 1.042824
0.08 0.08/1.08
3, 331.32

+

+
PV v a a
(*) You could have solved this by working in monthly time periods instead.
The present value as at 1 January of the payments made in the coming year is:
( )
8
4 4
100 @0.643403% PV a v a + (the effective monthly rate).
8
4
100 (1 )
100 3.96181 1.94999
772.547
+

a v
So, reverting back to working in years and using an effective interest rate of 8% pa, the
present value of the annuity is:
|
5
5
772.547
1 1.08
772.547
0.08/1.08
3, 331.32
a

1 Varying Annuities: 1.1 Annual Payments

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Page 1 Math 336- Introduction to Actuarial Mathematics

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or this can be calculated using the Tables.

, of an annuity certain, calculated at interest rate i .

of an annuity certain, calculated at interest rate i .

Inflation is assumed to be constant at 3% per annum.

(iii) 10% pa convertible quarterly is equivalent to an effective rate of 2% per

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