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An insurance company offers an ordinary annuity that earns 6.5% interest compounded annually. A couple plans to make equal annual deposits into this account for 30 years and then make 20 equal annual withdrawals of €25,000, reducing the balance of the account to zero.

(i) Compute the value of the fund based on the withdrawals required. [5 marks]

(ii) Compute the amount of each deposit needed in order to maintain the fund. [5 marks]

(iii) Compute the total interest earned over the entire 50 years. [5 marks]​

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Answer:

(i) To compute the value of the fund based on the withdrawals required, we can use the formula for the future value of an annuity due:

FV = P * ((1 + r)^n - 1) / r) * (1 + r)

where FV is the future value of the annuity, P is the annual payment, r is the interest rate per period, n is the total number of periods, and the extra (1 + r) factor is because the payments are made at the beginning of each period.

In this case, P = €25,000, r = 0.065, n = 20. We want to find the future value at the end of the 20-year period:

FV = 25000 * ((1 + 0.065)^20 - 1) / 0.065) * (1 + 0.065)

FV ≈ €743,704.96

Therefore, the value of the fund based on the withdrawals required is approximately €743,704.96.

(ii) To compute the amount of each deposit needed in order to maintain the fund, we can use the formula for the present value of an ordinary annuity:

PV = P * ((1 - (1 + r)^(-n)) / r)

where PV is the present value of the annuity, P is the annual payment, r is the interest rate per period, and n is the total number of periods.

In this case, PV = €743,704.96, r = 0.065, n = 20. We want to find the annual payment:

PV = P * ((1 - (1 + 0.065)^(-20)) / 0.065)

P ≈ €22,630.53

Therefore, the amount of each deposit needed in order to maintain the fund is approximately €22,630.53.

(iii) To compute the total interest earned over the entire 50 years, we can subtract the total deposits from the total withdrawals, and then subtract the initial balance. The total deposits are the annual deposit amount times the number of years (30), and the total withdrawals are the annual withdrawal amount times the number of years (20). The initial balance is the present value of the annuity that we calculated in part (ii).

Total deposits = €22,630.53 * 30 = €678,915.90

Total withdrawals = €25,000 * 20 = €500,000

Initial balance = €743,704.96

Total interest earned = Total withdrawals - Total deposits - Initial balance

Total interest earned = €500,000 - €678,915.90 - €743,704.96

Total interest earned ≈ -€922,620.86

Note that the negative sign indicates that the insurance company actually earned interest on this annuity, rather than the couple earning interest on their investment. This is because the withdrawals are greater than the deposits, and the interest rate earned by the insurance company is greater than the interest rate paid to the couple.

Explanation:

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