Difference Between Annuity and Lump Sum
Annuity refers to a fixed payment on a regular basis which can be monthly or quarterly or on any other basis as per the contract whereas lump sum is a payment of the whole amount due at once and the whole amount is received in one payment on the discretion of an investor.
Cashflows from any type of contract, bearing financial obligation, can be structured in the form of annuities or lump sum payments. One of the striking differences is in reference to point in time or duration of the time period over which the transaction takes place. In other words, annuity payments are made over a period of time while on the other hand lump-sum payments are made at once.
- Whenever someone refers to cash flows, it could be in the form of a single payment or multiple payments at different points in time spread over a pre-agreed time period. Annuities could be defined as structured pay-outs of equal amounts at regular intervals over a period of time to investors throughout the life of the annuity. Investors opt for annuities to generate better returns over a period of time in a safe fashion. A real-life example of annuity could be money-back schemes offered by many financial institutions.
- On the other hand, a lump sum is a cashflow arrangement where the pay-out of the entire value of the contract happens at once. Lump sum payouts allow the investor to invest or spend the entire amount as per their whims and wishes. It also provides an opportunity for the investors to maximize the profits generated by the pay-out through reinvesting in better investment avenues. A real-life example could be fixed deposits in banks which pay the investor a lump-sum amount at the end of the maturity period.
Annuity vs Lump Sum Infographics
So how to decide whether to choose – annuity vs lump sum cash flow. The following formula solves this dilemma.
- PVA = present value of the annuity
- PMT = payment per period
- i = interest per period
- n = number of periods
If the investor has an option to receive a lump sum amount right now vis-à-vis regular annuity payments over a period of time, the decision could be made based on whether the lump sum amount is greater than the present value of the annuity. If the lump sum amount, being paid right now in time, is more than the present value of annuity then it does make sense to go for lump sum payment instead of annuity payments.
But if the lump sum payment puts the investor in a higher than normal tax bracket than the comparison must be drawn based on after-tax lump sum payment and the after-tax present value of the annuity. Whereas if the present value of an annuity is greater than the lump sum payment then the obvious choice will be to go with the annuity option.
But easier said than done, it all depends on some personal conditions as well. To list few, some of the factors could be:
- The health of self and family
- Investment skills and savings
- Daily expenses
- Other sources of income
- One of the major benefits of an annuity can be listed as the investor receives a stable income for the period of a contract. This may provide an income stream to the recipients. In the end, the payments from annuity add up to a larger sum in comparison to the lump sum.
- The lump-sum payments attract tax all at once whereas the annuity attracts tax at a much lower rate. Annuities can be considered financially less flexible in a way that it may not be sufficient to cover the basic expenses of everyday life.
- Wait, do not write off lump sum as yet! It does have some lucrative benefits. It can be passed on as an inheritance to another generation or can be used to pay off large debts. Having said that, one should not ignore the risks associated with the large corpus. It should be dealt with utter caution and financial know-how during reinvestment.
Lump Sum vs Annuity Comparative Table
|Basis of Difference||Annuity||Lump-Sum|
|Structure||In this arrangement of cash flow, the pay-out consists of regular amounts to annuity-holders over a period of time.||In this arrangement of cash flow, the pay-out of the entire value of the contract happens at once.|
|Investor||It can protect people who do not manage money wisely and may end up spending the entire corpus.||It is advantageous for people who want to invest in other financial instruments to earn higher returns.|
|Tax||Deferred annuities let the investor postpone paying taxes on earnings until the investor starts making withdrawals.||Taking a lump sum distribution may move the individual into a higher tax bracket, which may result in increased taxes at the end of the year.|
|Cashflow||The cash flow will generally add up to a larger amount than the lump sum.||The cash flow is affected by tax and as well as a discount and reflects the fact that the investor is taking the payment upfront.|
|Example||Some common example of annuity includes lottery winners to ensure that recipients spread the money over a long period of time while earning a return on the balance.||Some common example of lump sum includes fixed deposits and provident funds.|
People may want to choose between a regular income stream (or annuity) and a lump sum payment to pay for the expenses of daily life. Since this decision affects ones’ financial future, people should make an informed choice. A number of factors such as, cost of living, assets, etc. help in deciding which option works the best.
Nowadays a variety of hybrid financial instruments are being offered by financial institutions and intermediaries. Such hybrid instruments offer the benefits of both annuity and lump sum during the life of the investor and even extends the benefits to the beneficiaries. Such hybrid instruments provide a decent return along with the security of an insurance product as well. But investors should read the documentation and calculate the returns on their investments as many companies portray unrealistic returns based on far-from-reality assumptions. The number-crunching may come across as a daunting task for the common man but only an informed mind can make the best investments by evaluating all the available alternatives.
This has been a guide to Annuity vs Lump Sum. Here we discuss the top differences between lump sum and annuity along with infographics and comparison table. You may also have a look at the following articles –