Financial companies tend to offer their clients, as part of their retirement solutions portfolio, the opportunity of receiving two types of payments once their contracts are due.
They can either take a lump sum payment or they can agree to receive a certain number (sometimes unlimited number) of subsequent payments as part of the distribution phase of their annuity.
In this sense, a lump sum payment and an annuity are different, even though they are both related with the same transaction or financial instrument.
What is an Annuity?
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An annuity is a set of consecutive payments issued by a financial institution on behalf of the beneficiary of a certain insurance policy or investment portfolio. The annuity can be an annuity due or an ordinary annuity.
An annuity due is one that is paid at the beginning of the time period and an ordinary annuity is one that is paid at the end of the time period. In any case, most annuities are extended to beneficiaries for a certain number of months or years, or, in some cases, they can last for as long as the beneficiary is alive.
What is the Lump Sum?
A lump sum is another alternative payment for an insurance policy or an investment portfolio. In this context, a lump sum is a one-time payment offered by the financial institution to settle the policy or investment account without having to extend any other subsequent payment.
The beneficiary is responsible of administering this lump sum as he wishes in order to fulfill his needs for the years to come and, therefore, the issuer no longer has a fiduciary duty over the funds.
Key Takeaways
Payment Structure and Timing: An annuity provides a series of payments over a period of time, offering a steady income stream, which can be beneficial for long-term financial planning and stability. In contrast, a lump sum is a one-time payment, giving the recipient immediate access to a large amount of money, which can be advantageous for paying off debt, making large purchases, or investing.
Tax Implications: The choice between an annuity and a lump sum can significantly affect the recipient’s tax liability. Annuity payments are typically taxed as income in the year they are received, potentially spreading the tax burden over many years, whereas a lump sum could push the recipient into a higher tax bracket in the year received, increasing the immediate tax liability.
Investment and Risk Considerations: Opting for a lump sum provides the opportunity to invest the funds, potentially leading to greater returns over time depending on the investment choices and market conditions. However, it also exposes the recipient to investment risk and the temptation to spend the money quickly. An annuity offers a risk-averse option by guaranteeing a fixed income, which can protect against the risk of outliving one’s savings, but it may result in lower overall returns compared to investing a lump sum.
Lump Sum vs Annuity Formula
The best way to estimate which of these two alternatives will be the most beneficial for a beneficiary would be to calculate the present value of the annuity with the lump sum that is being offered.
If the lump sum amount is higher than this calculation, then the beneficiary would be better off by taking the lump sum and vice versa.
This is the formula to calculate the present value of an annuity due and an ordinary annuity:
Ordinary Annuity Formula
PV = P x ((1 – (1 / (1 + r) ^ n)) / r)
Annuity Due Formula
PV = P + P [(1 – (1+r)-(n-1)) / r)]
Where:
P = The amount of each payment.
r = The discount rate.
n = The number of total time periods of the annuity.
The discount rate should be understood, in the context of an annuity, as the potential interest rate or rate of return that the investor could earn on the funds by investing them himself.
The reason for this is that if the investor decides to pick the lump sum instead of the annuity, he will be the one responsible of investing the money to continue to produce money to cover for the years to come.
Key differences Between Annuity and Lump Sum
The primary difference between an annuity and a lump sum is the frequency of the payments. An annuity can be extended for a large number of months or years, while the lump sum will only be paid once.
On the other hand, there are also alternatives that offer partial lump sum payments spread across a certain number of years. These alternatives alleviate the need to pick among those two options, providing a third door that investors may be attracted to.
The main benefit of a lump is the fact that the beneficiary has full access to his money and he can spend it or invest it at his discretion. For those who are perhaps in a rush to enjoy the money they are entitled to, or for beneficiaries who intend to pursue a certain business venture, a lump sum could be the most attractive alternative.
On the other hand, the main benefit of an annuity is the fact that the investor can receive a steady stream of fixed income for, in some cases, an indefinite period of time. This is very attractive for more conservative people who prefer to receive money constantly than receiving the burden of administering a huge amount of money by themselves.
Additionally, annuities provide a better alternative for those who are looking to retire comfortably by relying on a certain fixed payment. If the beneficiary already has a budget he can live with an annuity can be the most attractive alternative for him.
Let’s look at some other differences between these two retirement options.
Structure
The accumulation phase of a retirement account is structured similarly for both payment schemes. During this phase, the account holder deposits money periodically or the money is deducted directly from his paycheck, and this money is immediately invested in certain financial instruments that produce returns on his behalf.
The earnings obtained from these investments is typically reinvested to generate compounded returns that increase the size of the retirement funds over time until the distribution phase starts.
The distribution of these funds typically starts once the account holder reaches certain age (the minimum age for retirement) and that is the moment when the account holder can choose between an annuity or a lump sum payment.
These are some of the benefits and disadvantages associated with both annuities and lump sum payments:
Advantages of an annuity:
- Annuities guarantee a steady stream of income for the retiree.
- The remaining funds continue to be invested until the retiree is deceased.
- Taxes on annuities are deferred, as each payment is taxed at the income level.
- They are a better alternative for individuals with limited retirement funds as they can organize their budget based on the amount they receive.
Disadvantages of an annuity:
- The holder cannot use the remaining funds for other purposes.
- Depending on the conditions of the annuity, once the beneficiary is deceased the payments may not be transferred to his relatives.
- The amount of the annuity may not be enough to cover the holder’s regular expenses or it may fall short if certain emergency expenses have to paid.
Advantages of a lump sum:
- The beneficiary has more flexibility in terms of how he uses the funds.
- The retiree can decide how to invest the funds.
- The remaining funds once the beneficiary is deceased can be easily transferred to his relatives.
Disadvantages of a lump sum:
- There’s a risk that any bad investment decision may endanger the funds that are supposed to cover for the retiree’s expenses for the rest of his life.
- Taxes on a lump sum are usually high since the amount is usually large which means that the tax bill resulting from taking a lump sum can significantly diminish the funds available for retirement.
Investors of each
Annuities are usually the best choice for conservative individuals who have limited expenses and have no large purchases in mind. For example, people who already own a home and have no financial knowledge should go for an annuity as they can rely on these periodical payments to cover their living expenses.
In contrast, a lump sum may best the most suitable alternative for individuals who may want to invest the money somewhere else, perhaps on a certain business venture that could produce enough funds to cover for both their retirement expenses and generate returns that outperform the ones offered by the annuity issuer.
Taxation of each
Once a retirement account enters the distribution phase, taxes are applied only once a withdrawal is made. Through an annuity, taxes are deferred as they are only paid on the amount withdraw from the account to cover for the annuity payment and these payments are usually taxed as ordinary income.
On the other hand, taxes on a lump sump payment tend to be higher and could significantly diminish the amount of money available to cover for the retiree’s living expenses.
Cash flow
Cash flows from an annuity are received periodically, typically on a monthly or annual basis and they are usually a fixed amount. This means that the beneficiary of an annuity can rely on predictable cash flows once the distribution phase starts.
In contrast, there’s only one cash flow associated to a lump sum payment and it is received once the distribution phase starts. After that, the retirement account is typically closed and the balance of ends up at zero.
Lump Sum vs Annuity Calculation Example
Martin is a 65-year old engineer who recently retired from a prestigious consulting firm he worked with during the last 30 years. Ever since he started working with the company he has been paying for a separate retirement planning account with a financial services company. Now is the time to collect the money from this account and he has been presented with two alternatives:
- He can take a lump sum payment of $401,050
- He can agree to receive $25,000 per year for the next 25 years.
These payments will be issued the first 5 days of each year, which means the formula that Martin would have to employ to estimate the present value of this annuity would be the annuity due formula.
Additionally, Martin is confident that he could earn 5% per year by investing the money he will obtain from the lump sum payment in a conservative investment portfolio mostly comprised of investment-grade corporate bonds.
Therefore, the calculation of the present value of the annuity should go as follows:
PV = $25,000 x ((1 – (1 / (1 + 0.05) ^ 25)) / 0.05)
PV = $369,966
In this case, Martin would be better of by taking the lump sum, assuming he can actually produce a return of 5% per year on the funds. If that return declines or if he experiences a loss during some of those years, the actual attractiveness of this alternative will diminish.
Bottom Line
Considering the main element involved in the comparison of a lump sum and an annuity payment as potential alternatives is the rate of return earned on the lump sum, investors should be conservative in their assumptions in order to make sure they are not exaggerating their capacity to earn returns on this funds by themselves.
Frequently Asked Questions
What are the main advantages of choosing an annuity over a lump sum?
An annuity offers a guaranteed income over a period of time, providing financial stability and reducing the risk of outliving your savings.
How does receiving a lump sum payment affect taxes compared to an annuity?
A lump sum payment can significantly increase your taxable income in the year it’s received, potentially placing you in a higher tax bracket, whereas an annuity spreads out the tax liability over several years as payments are received.
Can choosing a lump sum over an annuity impact my investment potential?
Opting for a lump sum gives you the potential to invest the funds for possibly higher returns, but it also requires you to manage and assume the risk of those investments.
How does the decision between an annuity and a lump sum affect my estate planning?
A lump sum can be included in your estate and passed on to heirs, offering more flexibility in estate planning, while an annuity often ceases upon the annuitant’s death or after a specified period, potentially offering less to your heirs.
