Payouts from specific investments, contests or compensation contracts can be structured as either annuities or lump-sum payments. Annuities spread payouts over a long-term, whereas lump-sum payments provide the full payout amount to the recipient at once. Both annuities and lump-sum payments feature unique advantages and disadvantages, and each is best suited to different investors and economic environments.
What Are Annuities?
Annuities are structured to pay out regular amounts to annuity holders while accumulating interest on the outstanding balance throughout the life of the contract. Investors take advantage of annuities to keep their money safe over time while earning a sizable enough return to beat inflation. Investors can purchase an annuity at face value today, then receive the structured payouts over the life of the contract, coming out ahead in the end.
Annuities can also be used as a form of payment. Lottery-winners and professional athletes are often paid with annuities, for example.
Lump Sum Pros and Cons
A lump sum payout, as the name implies, pays the entire value of the contract at once. Common examples of lump-sum payments include holiday bonus pay and debt settlements. Lump sum payouts allow people to receive the entire amount of their payout at once, allowing them to spend, save or invest the full amount at will.
The ability to reinvest a lump sum payout can provide investors an opportunity to maximize the profits generated by the payout. It is possible, however, to spend a lump-sum payout much more quickly than an annuity, which can cause hardship in the future.
Pros and Cons of Annuities
Annuities can protect people who do not manage money wisely. Lottery winners are an ideal example of the power of annuities; lottery winners have gone from multimillionaires to flat broke in a short few years due to a lack of financial management experience. While recipients give up the opportunity to receive a large lump sum, accepting an annuity payout can ensure that recipients spread the money over a long period of time while earning a return on the balance.
Time Value of Money
Savvy investors decide between annuities and lump sum payments by analyzing the effects of the time value of money. The time value of money theory explains that a set amount of money today is not necessarily equal in value to that same amount in the future, due to economic factors such as inflation and currency exchange rates. An online calculator can help you to get an idea of the true value of your annuity over time compared to a lump-sum option.