Annuity vs Lump SumDifferences You Need to Know Between the Two!

Written By:
Adiste Mae

One of the most important decisions that a person must make in this life is whether to collect a pension upon retirement in an annuity or a lump sum amount.

The same dilemma is presented if a person wins a lottery.

There are different factors that need to be considered before making a decision such as the life expectancy of the person, lifestyle and spending habits, and inflation. 

Lump Sum vs Annuity

Lump-sum payments are paid all at the same time while annuities refer to regular payments spread across a pre-specified period of time, usually weekly, monthly, quarterly, or yearly. 

Pros and Cons if You Have a Pension

Getting a traditional defined-benefit pension plan means that when a person finally hits retirement, a decision of whether to receive a pension in annuities or a lump-sum amount is needed, bearing in mind the most sound choice of maximizing earnings. 

Pros and Cons of Annuity Pension

Weighing the options before making any decision on the best way to receive one’s pension is important.

Here are some of the pros and cons that will help decide a person’s choice of whether to go ahead with an annuity pension:

Pros

• A guaranteed source of income throughout a person’s lifetime. 
• Passing on the pension to a spouse or other beneficiary is possible. 

Cons

• The pension may not be able to afford the emergency medical expenses of a person. 
• There are other annuities that may not be passed on to a spouse or other beneficiaries. 
• A person may have to make adjustments to their lifestyle. 
• There is a possibility that a person might pass on before receiving the full amount of their retirement money. 

Pros and Cons of Lump-sum Pensions

For others, receiving a lump-sum pension amount makes sense according to their preference.

While there are advantages to receiving a lump-sum pension amount, there is also a downside to it. 

Pros

• Greater financial flexibility – ability to pay off debts, if any, or invest the money. 
• Any money left from the lump-sum payment of pension can be given as an inheritance. 

Cons

• Unmanaged retirement money could run out before a person passes on and create financial difficulties. 

Analyzing Your Options

Given the pros and cons in the manner of receiving one’s pension, there are also other factors that must be considered to maximize the earnings from a retirement fund such as life expectancy, return on investments, and the risk of return. 

Life Expectancy

It all boils down to the years left that a person expects to live.

If a person expects to live beyond the average life expectancy, the obvious choice would be to go for an annuity pension.

However, when a person feels that he or she only has a few years left to enjoy the fruits of hard labor, then it makes sense to get paid a lump-sum amount of their retirement fund. 

Choosing annuity payments when the spouse of a person is significantly younger is also a good option especially if a survivor benefit or term certain options are chosen.

When survivor benefit is chosen, the beneficiary is guaranteed to receive the pension, and this benefit will last their entire lifetime.

If a term certain option is chosen, the pension will also pass on to the beneficiary but the payments decrease by a little amount each month. 

Return on Investments

Some people still are able to have a steady stream of income after retirement.

If this is the case, they have the option of withdrawing the lump-sum amount of their retirement or annuity payments and then investing the money. 

There is also an option of getting a partial annuity pension – it allows a retired person to take half of the retirement fund as a lump-sum amount and the other half will be paid as annuities.

A person will then have the option of investing the lump-sum amount elsewhere.

Another option will be to take the lump-sum payment and then roll the funds over to an Individual Retirement Account (IRA) which will provide a tax-deferred option. 

Risk of Return

The retirement income that people receive is a product of hard-earned labor that has accumulated through a person’s years of employment.

As such, most people protect their pensions.

Those who are risk-averse and want to ensure that their retirement income is reliable choose annuity payments.

The credit rating of a pension fund or annuity provider must also be checked if it is the security of the annuity payments a person is after through the Pension Benefit Guarantee Corporation (PBGC). 

If a person is wary of the credit rating of the pension or annuity provider, it is better for the person to take the lump-sum payout instead. 

There are risks involved when it comes to investing in stocks, bonds, or securities but a person has to protect their annuity pension against inflation, especially if it does not have a cost of living adjustment. 

Pros and Cons if You Win the Lottery

For someone who wins the lottery, the person is not afforded the same time period that a person has when deciding how to receive their retirement.

The decision whether to receive the lottery winnings in an annuity or lump-sum payments must be made quickly. 

Pros and Cons of Annuity Payment

Pros

• The number of annuities paid to lottery winners tends to be a larger amount than the lump-sum amount. 
• Some annuities are taxed lower than lump-sum payments. 

Cons

• A person could die before receiving their total winnings. 
• There is little financial flexibility when a person only receives lottery winnings in annuity payments as compared to a lump-sum payment. 

Pros and Cons of Lump-sum Payment

Pros

• The money is available for a person’s disposal, in whatever way a person sees fit. 

Cons

• Mismanaged money has the tendency to run out easily. 
• The net amount of lottery winnings will be less due to the higher tax rate imposed as compared to annuity payments. 

Making a Decision

The decision of whether to choose annuity payments or a lump-sum payment of lottery winnings needs to be thought of properly. The two important factors that affect this decision are life expectancy and the return on investments. 

Life Expectancy

A person who is young and has many years ahead of them can choose to get paid in annuities and receive equal annuity payments or inflation-adjusted payments.

This means that a person is more financially secured in the many years to come. 

However, a person who is already advanced in age has the option of choosing a lump-sum payment so that he or she will enjoy the remaining years of their life.

However, if a person has chosen an extended payout, the remaining installments of a person’s winning will be passed onto the heirs. 

Return on Investments

Those who are investment-savvy will be better suited to going for the lump-sum option and investing their winnings, depending on their risk appetite.

Those who are risk-averse can choose more secured investment options, although it pays less than riskier investments. 

Some people who choose the lump-sum payment, end up spending all of their money within a few years and end up with nothing.

Choosing the annuity option will allow a person to learn how to manage their money and avoid people who will only take advantage of them. 

Bottom Line

The decision of which payment option to choose will rely heavily on how a person wishes to manage their money and maximize their earnings, ensuring that they will be able to make the most of their hard-earned money or lottery winnings. 

Essentially, if a person prioritizes security above all else, annuity payments make the most sense.

Those who wish to get a higher return can choose to take a lump-sum payment and invest it.