State Sponsored Lotteries

State Sponsored Lotteries

There are many state sponsored lotteries promising humongous dollars of prizes, yet when a winner is announced the fixed payout amount is much less.

The wining prize payout is announced as the aggregate of the thirty annual payments. However, the winner is provided with the choice to receive a lump sum payment, which is lower and what is usually chosen.

The reason for the lower cash payout is that the thirty years of payments include interest that will earned by the Lottery Commission retaining the funds until making the annual payments. The total of these 30 years of payments is what is advertised – not the lump sum that is claimed. People take the lump sum for various reasons such as anticipating a greater investment return, or being able to spend what they want now, or to just hold on to the money and know they have it.

The state is using a financial technique called discounting and employs principles of compounding. Here is the general rule:

• Money you will receive in the future is worth less today.

Here is how this works:

• Assume someone will pay you $1,000.00 in five years.
• Would you rather have $784.00 today or wait five years to get your money?
• Assuming there is no default risk, the $784.00 was calculated using an interest rate of 5.0%.
• Therefore if you think you can earn more than 5.0% you should take the $784.00 today. If you think you cannot earn at least 5.0% you should wait.
• If you don’t care how much you can earn because you want to spend the money now, take the $784.00.
• If you don’t care how much you can earn because you will feel better having the $784.00 in your account, take the money.

The Lotteries work the same way. In a recent Powerball the interest rate used was 2.843%. Assuming the payout was $1 billion to one person. A lump sum (pretax) payment would be $620 million which is a 38% discount. The first payment would be $15,067,000 and would increase 5% each year until the final payment grows to $61,000,000. I always thought that the payments were equal amounts – not so.

Next is that if you take the annual payout and die your heirs will receive the balance of the payments, BUT your estate would be liable for Federal and possibly State [depending upon where you live] estate taxes, and would most probably not have the money to pay the taxes. The estate might be able to borrow against the future payments or get a lump sum settlement at that time [depending upon what your state’s rules are]. Either way this is a complication. An alternative is to buy a fixed premium declining term life insurance policy to cover the estate taxes, but then this would further reduce your investment proceeds.

If you take the lump sum it is advisable to hire an investment manager, understanding that those fees will reduce your cash flow. Also, taxes will be due on the lump sum now. If you take the annual payments and the tax rates go up, you will receive much less than at today’s tax rates. Bottom line: It ain’t simple, but I am sure you wouldn’t mind having these problems.

Getting back to the 2.843% rate, this might sound like a low rate, but there are very little alternative guaranteed rates today. The 30 year Treasury rate at that time was 2.79% [it is lower today], but the rates for each of the years up to 30 years are lower than that. Here, the Lottery Commission is offering a fixed 2.843% for the entire period. This is reasonable. By the way, if the rate they offered was greater, the lump sum payout would be lower. In the $1,000.00 example if the rate was 7.5% instead of 5.0% the lump sum today would be $697.00 instead of $784.00.

There are other issues for those fortunate enough to win the lottery, but I wanted to discuss the compounding and present value financial features and the estate tax complications.