By: James Philpot
In my prior column, I discussed principles for dealing with financial windfalls. To reiterate, financial windfalls do happen. Most are not very large (maybe in the five-figure range), but sometimes much larger windfalls (6-plus figures) force us to decide whether to take a large lump sum or a series of annual payments. I propose that almost everyone will be better off with the annuity.
For my arguments, I am going to assume we won January’s Powerball and face the choice of taking $980 million as a lump sum now or as a series of 30 annual $50 million payments beginning now. The analysis and conclusions change only slightly as long as we stay in the 7-plus figure range.
First, a common misconception of lottery players is, “If I die, I lose the payout.” That’s not what happens, because the payout is not a life annuity, but a period-certain annuity. If we die after payment number six, the value of the remaining payments goes with our estate to our heirs. Beyond lotteries, this is also the case (or can be specified) for other large windfall sources like legal settlements and life insurance policy proceeds.
Income tax (which generally does not apply to life insurance proceeds or legal settlements) can also play a role. With the huge amounts of money involved, and assuming constant tax rates over time, there is really little significant difference in the tax applied to the Powerball lump sum versus the annuity. However, the annuity offers tax deferral. Effectively, the lottery invests your lump sum for you during the annuity period, deferring income taxes on both the lump sum amount and on income earned until you take a payment. This is akin to the benefits of a traditional IRA.
Many people choose the annuity because they believe they are superior investors and can do better starting with a lump sum. Financial professionals know that any rate of return must be evaluated after adjusting for both tax and risk. Using the January Powerball numbers and a 39.6 percent tax rate, taking the annuity provides an after tax rate of return of approximately 3.25 percent to the winner. There is no investment risk — only counterparty risk, which can likely be insured. Compare this rate of return to the current after-tax rate on 30-year Treasuries (about 1.57%), and we see that this is an after-tax-and-risk investment performance matched by few professional managers. This return is also after the lottery’s cost of managing the funds, which could be significant for you. Still feeling lucky? Remember that you may have just used up a significant amount of luck in gaining your windfall in the first place.
Human behavior makes the most compelling argument for the annuity. Very few of us are already familiar with huge amounts of money, and anecdotes abound of lottery winners (and even celebrities and athletes who worked hard for their fortunes) who are presently broke. The annuity provides an annual limit of potential waste over a “safe” time horizon. If you are thinking, “That wouldn’t happen to me,” please remember once you likely also swore that you would not turn out like your parents, that your kids would always be well-behaved, and who knows what else.
Dr. James Philpot is a certified financial pPlanner and is associate professor of finance at Missouri State University. Statements in this column are intended for educational and informational use only and are not to be construed as investment.
This article appeared in the June 4th, 2016 edition of the News-Leader and can be accessed online here.