Question

You just have won the PA lottery. This provides a payout of $50,000 per year for 20 years beginning immediately. What kind of annuity does this represent?

What factors should you consider as you make the decision to take either the annuity or a lump sum payable immediately?

Give at least 5 reasons for each alternative.

Answer 1

If the payout of $ 50,000 per year starts immediately, this kind of annuity represents annuity due. In this kind of annuity, the payment starts immediately instead of making the payment at the end the period.

The following formula is used to calculate the present value of annuity due.

Present value annuity due = Al (1+r)n - 1] -X rx (1 + r) (1+ r

When considering the decision  to take the lump sum payable immediately, one has to consider the following reasons:-

• Time value of money plays an important role in this decision as a $ 1 received today is worth more than a $1 received after 20 years as the value of money depreciates with time.
• The rate of inflation plays an important role as the purchasing power of money declines when inflation is high.Thus it is advisable to accept the lump sum.
• The discount rate determines the rate at which the money can be invested. If the lump sum can be invested at a higher interest rate, then it is suggested to take the lump sum.
• On the other hand if the interest rate is low, then it is advised to take higher annual payments than a lower lump sum.
• Taxes play an important role and any lump sum received is always taxable. Therefore tax policies should be considered when taking lump sum or annual payments.

When considering the decision to take annual payments, the following factors must be considered

• If taxes can be avoided by taking annual payments, it is advisable to take annual payment.
• Present value of the annual payments plays an important role and if the present value is higher than the lump sum received now, it is suggested to choose the annual payment.
• Receiving annual payments is advisable as any lump sum received can be spent quickly.
• Annual payment gives an assurance of constant income for a period of 20 years.
• The annual payment can be reinvested periodically which results in a higher rate of return compared to lump sum.