Annuity vs Lump Sum

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.

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Cashflows from any contract, bearing financial obligation, can be structured in the form of annuities or lump sum payments. One of the striking differences is about a point in time or duration of the time over which the transaction takes place. In other words, annuity payments are made over some 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. Annuities could be defined as structured pay-outs of equal amounts at regular intervals over a while to investors throughout the life of the annuity. Investors opt for annuities to generate better returns over some 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 that pay the investor a lump-sum amount at the end of the maturity period.

Annuity vs. Lump Sum Infographics

Let’s see the top differences between annuity vs. lump sum along with the infographics.

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Applications of Annuity vs. Lump Sum

So how to decide whether to choose – annuity or lump sum cash flow. The following formula will help to solves this dilemma.

annuity vs lump sum formula

Where,

  • 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 while, 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 an annuity, 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 a few, some of the factors could be:

  • The health of self and family
  • Investment skills and savings
  • Daily expenses
  • Debt
  • Taxes
  • Other sources of income

Key Difference

Annuity vs. Lump-Sum Comparative Table

Basis of DifferenceAnnuityLump-Sum
StructureIn this arrangement of cash flow, the pay-out consists of regular amounts to annuity-holders over a while.In this arrangement of cash flow, the pay-out of the entire value of the contract happens at once.
InvestorIt 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.
TaxDeferred annuitiesDeferred AnnuitiesThe deferred annuity formula calculates the present value of the deferred annuity promised to be received after some time. Deferred Annuity = P Ordinary * [1 – (1 + r)-n] / [(1 + r)t * r]read more 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, resulting in increased taxes at the end of the year.
CashflowThe cash flow will generally add up to a larger amount than the lump sum.The cash flow is affected by tax and a discount and reflects the fact that the investor is taking the payment upfront.
ExampleSome common example of annuity includes lottery winners to ensure that recipients spread the money over a long time while earning a return on balance.Some common example of lump-sum includes fixed deposits and provident funds.

Conclusion

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. Several factors, such as cost of living, assets, etc. help decide 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.

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