How to Calculate Future Value With Inflation and Income Growth

by C. Taylor

An annuity offers annual payments, which can provide or supplement income during your retirement years. Typically, you receive fixed income payments during the life of the annuity, after which time the account balance is depleted. If you rely on these fixed payments as income, however, you run into a problem with inflation, which reduces the purchasing power of your annuity income. To keep pace with inflation, you need to calculate a growing income from the annuity, which affords you the lifestyle to which you are accustomed even after factoring in inflation.

Divide 1 plus the annuity interest rate by 1 plus the rate of inflation. According to the U.S. Dept. of Labor, the current rate of inflation is 3.6 percent at the time this article was written. As an example, if your annuity offers a 6 percent interest rate, you would divide 1.06 by 1.036 to derive the real interest growth factor of 1.023166. This equates to a real interest rate of 0.023166, or 2.3166 percent. As you can see, inflation reduces the effective growth of the annuity.

Raise the real interest growth factor to the power of the annuity's term. For example, if you wanted to receive payments for 15 years, raise 1.023166 to the power of 15 to get 1.409911.

Divide 1 by this number and subtract it from 1. In the example, you would subtract 0.70926 from 1 to get 0.290735.

Divide the real interest rate by the result in the preceding step. Continuing the example, 0.023166 divided by 0.290735 gives you 0.079681.

Multiply the result in Step 4 by your annuity's starting balance to calculate the annual income payment in today's dollars. If you have $500,000 in the annuity, this equates to annual present-day payments of $39,840. However, this payment figures in growth, equal to the rate of inflation. Therefore, you need to calculate each year's payment separately to get the future values, which is the amount you may withdraw in a given year.

Raise the real interest growth factor to the power of the payment year and multiply this value by the present-day income payment. This gives you the income payment for that year. In the example, to calculate the fifth year's payment, raise 1.023166 to the power of 5 to get 1.1213. Multiply this by 39,840 to derive the future payment value of $44,673.