Winning Powerball, a little bit at a time, over and over and over...
May 20, 2013 2:20 PM   Subscribe

Huge jackpot lotteries in the USA, like Powerball and Mega Millions, offer the jackpot as either an annuity for the total amount of the prize, or a lump sum for a reduced amount. It seems that the vast majority of the winners pick the lump sum over the annuity. Which to me just makes no sense at all.

I'm wondering why that is. Now, I'm extremely naive when it comes to annuities and taxes and the like, but wouldn't one want a steady income for the next 26 years or so? Because especially when the jackpots get huge, you still are getting millions of dollars a year. So why not just pick the annuity and have that constant income stream?
posted by spinifex23 to Work & Money (42 answers total) 11 users marked this as a favorite
 
Apparently, you can't will the annuity, so if you die, that's the end of the money. If you take the lump sum, it's all yours to do with as you please.
posted by disaster77 at 2:24 PM on May 20, 2013 [8 favorites]


Because of Hyperbolic Discounting. What if the world ends tomorrow? They need that cash today!
posted by Potomac Avenue at 2:25 PM on May 20, 2013 [1 favorite]


Hmm, and the will thing. That makes sense too.
posted by Potomac Avenue at 2:25 PM on May 20, 2013


Because the state could go bankrupt at any time, I'll take my cash up front, thankyouverymuch.

Also, The Time Value Of Money, which says that the sooner I get it, the more valuable it is. I can invest it, or do tax deferred things with it. Lots of reasons. So even if it's a bit less, it's more valuable to me now.
posted by Ruthless Bunny at 2:25 PM on May 20, 2013 [6 favorites]


Why do you need a constant income stream if, yaknow, you have a ton of money already? Win enough, and you still have a constant stream of income provided by your investment of that money, if that sort of thing is important to you.
posted by Cycloptichorn at 2:27 PM on May 20, 2013 [2 favorites]


It seems that the vast majority of the winners pick the lump sum over the annuity. Which to me just makes no sense at all.

The thing is that you can probably end up with more money after 20 years if you take the lump sum and invest it conservatively over that time period. So it's a better investment to go with the lump sum now.

It works in both a short term and long term calculation: in the short term, it's better to have the money now. You could die before the 20 years are up. In the long term, if you're still alive after 20 years, you would want that pot of money to grow into something greater than you would have had if you took the annuity payments.
posted by deanc at 2:28 PM on May 20, 2013 [12 favorites]


People believe they can invest it better themselves. If it's true that the annuity can't be transferred if you die, that would be compelling. Some of the people who take the annuitized payout end up selling the annuity. There was an interesting comment about that on MeFi a while back. I'd be curious to know what interest rate the annuitized payout uses.
posted by theora55 at 2:28 PM on May 20, 2013


There's also the question of known tax rates right now, vs. unknown tax rates in the future.
posted by aramaic at 2:30 PM on May 20, 2013


For one person's perspective on this, Act II of this This American Life episode is an interview with a guy who buys people out of their winnings for the immediate but lower sum (his company then gets the annuities, more or less).
posted by Lutoslawski at 2:30 PM on May 20, 2013 [8 favorites]


The total amount of the annuity and lump sum options should be the same*--that is, the lump sum should be the present value of the annuity. If I offer to pay you $100 a year for ten years, or $772 today, you should/could/might be economically indifferent.

A few caveats: to come up with the lump sum amount, you need a discount rate. I used 5% to get $772. If you think the appropriate discount rate is 2%, you'd demand more money if you were getting the lump sum. If you thought the appropriate discount rate is 10%, you'd think $772 is a steal.

Second, you can't be sure the state is actually going to pay you what you're owed in the future.

Third, this doesn't take inflation into account, so you might want to maximize your spending power today.

Fourth, you may think you have an "opportunity cost" in (effectively) loaning the winnings to the state--i.e., you think investing a smaller amount today is better than investing a larger amount tomorrow.

Fifth, and probably most important, people just want all their money now Now NOW! It's an emotional thing. Even if the annuity were better economically, I think most people would ask for the lump sum. I'd rather be a millionaire today than have a measly $100,000 a year for life!
posted by Admiral Haddock at 2:33 PM on May 20, 2013 [4 favorites]


Another thing to consider on the balance of "invest lump sum" is whether that gain will recoup the larger taxes you'd be assessed on the large lump sum.
posted by dame at 2:46 PM on May 20, 2013


Yeah, this all depends on the discount rate being offered and the return rate you feel you can achieve. Perhaps people are unrealistic about their projected rate of return, but that's economics in a nutshell.

Also, paying off debts often has a very high effective rate of return. If I pay off my 6% mortgage that's a 6% ROR, which may be higher than the discount rate used to calculate the annuity payments. See here for the basic math on calculating annuity payments, which is very similar to calculating present value except it's the sum of a series vs a single value.

In a perfectly rational world, taxes also play a part - there may be opportunities to avoid taxes depending on whether you take an annuity versus a lump sum. In some sense people taking the lump sum are making the assumption that tax rates in the future will be higher and they'd rather pay all the tax right now.

In the real world as others have said most people are simply impatient and want to buy as much as possible immediately.
posted by GuyZero at 2:51 PM on May 20, 2013


Oh, for taxes for example - if I lived in WA but wanted to move to CA I'd be much better off taking a lump sum since there's no state income tax in WA and CA has high state income taxes. If I took then annuity I'd be on the hook for a bunch of CA state taxes in the future.

Conversely, if I lived in CA and wanted to move to WA I'd be better of with an annuity or waiting until I changed residency before I sold the annuity for a lump sum.
posted by GuyZero at 2:53 PM on May 20, 2013 [1 favorite]


Canadians are not taxed on lottery winnings, but would be taxed on an annuity, so the small number of Canadians who win US lotteries choose the untaxed lump sum. (I am not sure if Canadian lotteries even offer annuity options.)
posted by jeather at 2:58 PM on May 20, 2013


People get emotional about money and fail to make rational decisions. I doubt that most winners even make a comparison. I have met a few lottery winners and all had managed to spend fortunes with little to show for it.
posted by BenPens at 2:59 PM on May 20, 2013


from the (Canadian) Western Canadian Lottery Corporation: "Q: Are lottery winnings taxable?

A: No. All cash and merchandise prizes paid by WCLC are tax-free within Canada. However, prizes with an annuity option may have tax implications if the annuity is selected."

Big winnings (like 6/49) generally pay out over 20 years I believe.
posted by GuyZero at 3:00 PM on May 20, 2013


I just listened to the This American Life episode linked above a couple days ago, and I believe the guy in the episode said that the lump sum payment is HALF what the total annuity payments would be (both when his company was doing the buyouts and when the state offers them directly). And even still, most people want the cash upfront, which is crazy to me.

(It's possible that I misheard something, or that this is outdated info, so it would be interesting if anyone knows for sure.)
posted by ella wren at 3:26 PM on May 20, 2013


Some states make you pick annuity/cash ahead of time. In my experience unless you specifically ask for annuity (or even sometimes if you do) you get the default option of cash. The sales machines must be setup to default to cash, because sometimes when i ask for annuity the sales people can't figure out how to select it.

Oh to have the problems of having selected the wrong option and it mattering ;)
posted by TheAdamist at 3:33 PM on May 20, 2013 [1 favorite]


Assuming the rate is really like 50%, yeah, that's probably not the greatest decision. There is some rate at which taking the lump sum at a lesser amount is the "right" decision on paper because of future value of money. I'd also have to understand the tax ramifications. It might be that the wallop of tax on a large lump sump makes matters worse, or OTOH the "reduced lump sum" already has the taxes taken out and the annuity doesn't.


If you were really, really good at fiscal planning and understanding risk, future value of money, etc., odds* are good you wouldn't be winning the lottery in the first place.





*see what I did there? I'll be here all week. Try the veal.
posted by randomkeystrike at 3:34 PM on May 20, 2013 [2 favorites]


As has been noted many times on metafilter, taxes on high incomes are historically very low with no guarantee they'll remain that way.

Were it me, I'd want to get my hands on as large a percentage of the winnings that I could, and get those winnings into a tax shelter or into other assets that are taxed less than just straight annuity income.

There's also the fact that the annuity investment is very conservative (government bonds), so prudent investment would probably net you a greater return over the next two decades than you will get from the annuity.

Also, from a strictly personal point of view, given my age, the odds that I will live to see the end of the annuity get worse every year.
posted by madajb at 3:35 PM on May 20, 2013


Just a warning to you lottery winners reading this thread-- the lottery can do some tax withholding but typically won't withhold enough to cover your new tax burden. Assuming your current income is basically insignificant compared to the millions of dollars you've won, you'll pay 39% on the entire amount. In my state, they'll only withhold 15%, or less than half.

The other thing you should do is never associate your name publicly with the money, ever. The money should be in a blind trust after a lawyer claims the prize on your behalf. The last thing you need is all the parasites that target every winner.

For simple annuity math, payout over 25 years is $40K/million/year, which means you'll need around $5-7 million to hit the max tax bracket for a 25-year annuity.

Frankly, getting $180 million now (half of $600 million less 39% tax) seems like the absolute best option. At a reasonable 8%/year, you can double the money every 12 years. That's $720 million after 24 years, assuming you invested all of it, which of course you didn't, and before taxes. Suppose you only invested $100 million at 8%? You could spend or even lose $80 million and still have up to $400 million after 25 years.

You'd pay taxes on the interest/dividends/capital gains/property investments, but you can will everything to your cat, donate it to a good cause, buy a senator, whatever you want.
posted by Sunburnt at 3:36 PM on May 20, 2013 [10 favorites]


Using this calculator the the PV of a $100 once-annual annuity for 20 years is $1000 with a discount rate of only 7.75%.

It's actually pretty reasonable for the PV of a long-term annuity to be "half" of the simple total of all the payments. The miracle of compound interest.
posted by GuyZero at 3:39 PM on May 20, 2013


I found this site which claims to show the difference between annuity and cash for a $40MM Powerball jackpot.

In California, taking the annuity would net you $30MM in year 30 (but payments are not equal); taking the cash gets you $18.825MM after taxes today. A number of states currently do not tax lottery winnings (like CA); New York taxes the most at 8.82%.

I haven't used GuyZero's calculator to see if it makes financial sense, though, assuming the prize is fully transferrable upon death.
posted by China Grover at 3:45 PM on May 20, 2013


When I took a bankruptcy class they told us that if whomever the state buys the annuity from goes bankrupt, you have no recourse against the state. That might vary state by state, but that would be another significant concern.
posted by Hermes32 at 3:48 PM on May 20, 2013


Remember, these are people who play the lottery. Just by exchanging money for lottery tickets, they already reveal a preference for a chance of a huge sum now, versus a larger expected value spread over time.
posted by mbrubeck at 4:00 PM on May 20, 2013 [6 favorites]


I've day-dreamed about this myself: which to choose, the 20 years of annual payments or the cash payout? Like madajb above, I've come down on the side of the cash up front: considering my age, health and genetic background, it's unlikely I'd survive long enough to get all of the 20 annual payments.
posted by easily confused at 4:10 PM on May 20, 2013


I agree that in many cases this is a rational choice, even if there are multiple scenarios in which it's arguably "smarter" or "more conservative" to take the annuity. Money you have and control now is rationally better in many ways than money you don't have yet and won't control until later. Indeed, the "until later" is widely understood to be an artificial control on your own agency; and the Dunning-Krueger effect means that most people think they will be among the smarter managers of this sum.

I also underline what GuyZero said (the only mention thus far) about paying off debt, such as a mortgage. That's buying you a lot of future value as well as security, which is not entirely accounted for by the dollar value of the payoff.

And definitely after a certain age, you start to think about how what you're doing will accrue to the next generation. I'm already at that point, and the kids aren't even mine, but that's what I believe I'm working for. If I won the lottery it would be all about trusts and estate planning, stat.
posted by dhartung at 4:12 PM on May 20, 2013


Thanks for all the answers, they all make sense. I didn't even consider the state income tax requirements changing if you took out an annuity, and then moved.
posted by spinifex23 at 5:14 PM on May 20, 2013


The other thing you should do is never associate your name publicly with the money, ever. The money should be in a blind trust after a lawyer claims the prize on your behalf. The last thing you need is all the parasites that target every winner.

Most of the powerball states don't allow you to remain anonymous.
Most of them do allow you to skip the press conference/big check presentation, though.
posted by madajb at 5:15 PM on May 20, 2013


The Powerball cash payout is actually a pretty good deal due to current low interest rates and the long payout period of 30 years.

It pays out 63% of the nominal jackpot, which is quite a bit more than half. This works out to a discount rate of only 3.5% for equal payments for 30 years. If you think you could invest the cash at better than 3.5% for the next 30 years, you would be better off taking the cash.

Essentially, the Powerball managers buy zero coupon bonds from insurance companies to finance the payouts for 30 years. If you choose the cash up front, they give you the same amount of cash they would have to give to an insurance company to provide the 30-year revenue stream. When interest rates are low, insurance companies require a lot more money up front to guarantee they can make the payments. If you take the cash, it means that you get that extra money, not the insurance company.

Of course you would be betting that you could earn better than 3.5%. The riskless rate using a 30-year treasury bond is only about 2.8% right now. So you would have to take higher risk than treasury bonds to come out ahead, but still a pretty good bet if you put half in bonds and half in stocks.

The income tax is a wash, either way, assuming tax rates don't change drastically. This is because even if you take the annuity, you will be receiving about $40,000,000 a year, meaning that almost all of your income will be in the highest tax bracket no matter what.
posted by JackFlash at 5:53 PM on May 20, 2013


Big winnings (like 6/49) generally pay out over 20 years I believe.

I know this is off-topic, but this is not true. The Canadian national lottery games (6/49 and Lotto Max) pay the full amount in a lump sum, which is tax free.
posted by barnoley at 5:55 PM on May 20, 2013


just listened to the This American Life episode linked above a couple days ago, and I believe the guy in the episode said that the lump sum payment is HALF what the total annuity payments would be (both when his company was doing the buyouts and when the state offers them directly). And even still, most people want the cash upfront, which is crazy to me.

True. But that's twenty million dollars I didn't have ten minutes ago.
posted by jason's_planet at 6:47 PM on May 20, 2013


The nominal prize is more advertising than reality. What they are doing is essentially giving you the payout number, and letting you decide whether to let them buy you an annuity(*) with it, or take the cash.

Kind of like how there will be a sweepstakes where you can win a new Cadillac, or $15,000. You can't buy a new Cadillac for $15,000, but from their perspective, since they get the car for wholesale cost and maybe some incentive money from GM, either prize costs them $15,000. Taking the Cadillac is the better option for you in raw numbers, but maybe you just bought a Lincoln? You can't really use another car, and don't feel like trying to sell it, so $15,000 is the better option for you.

(*) An annuity is sort of like a mortgage from the bank's perspective. They give you $100,000, you promise to give them $1000 a month for 15 years. It is trading risk and cash flow. In this case, you give them $148 million, they give you $10 million a year for 30 years. Like most financial transactions, each side believes they can do better having made the deal than not. They believe they can take the cash and invest it such that they make money after writing you your check every month, and you believe you will come out better taking the $300m over time.

It's really a game of utility. At this moment, with inflation and opportunity cost, $150m now is worth exactly the same as $300m over 30 years. (Made up numbers.) Assuming the predictions made by the people making the calculations come true, at the end of 30 years, either option will net the same. Whether you take one option or the other is whether you believe their predictions or yours.
posted by gjc at 7:19 PM on May 20, 2013




Seems to me the smart thing to do would be to take the annuity and then borrow a bunch of money at extremely low interest with the annuity as collateral.
posted by empath at 7:54 PM on May 20, 2013


Seems to me the smart thing to do would be to take the annuity and then borrow a bunch of money at extremely low interest with the annuity as collateral.

Assuming the interest rates of the annuity and the borrowed money are the same, the results are exactly identical. In other words, your proposal is no different than just taking the cash payout. You would borrow the cash amount and pay it back with your annuity payment each year. So you would have the cash and no annuity payment. It's the same as taking the original cash payout. There is no free lunch.

In the real world there are people who do exactly that. There are brokers who will provide a cash payout for people taking the annuity and who change their mind and want a cash payout. Except, they do not get the same interest rate as the original annuity. They have to pay a higher rate on their borrowed cash so they lose money on the deal.
posted by JackFlash at 9:05 PM on May 20, 2013


Assuming the interest rates of the annuity and the borrowed money are the same

Why would you assume that?
posted by empath at 9:43 PM on May 20, 2013


Why would you assume that?

That is simply the break even rate at which your suggestion is identical to taking the cash payout. As I pointed out, in the real world you will always do worse than that -- your borrowing rate will be higher and you will lose money on the deal.
posted by JackFlash at 10:01 PM on May 20, 2013


I would take the lump sum because I think that I could invest and get better returns than what the state gets. The annuity is better if you have no self control, however.
posted by Gringos Without Borders at 10:43 PM on May 20, 2013


The answers about being unable to bequeath the annuity to your heirs is interesting. So are the comments about selling the annuity to a corporation, in return for a lump sum.

But if corporations can own annuities, what's to stop a lottery winner from setting up a corporation, selling the annuity to that corporation for $1, and then bequeathing that corporation to his heirs? Seems like an easy way to solve that problem.
posted by exhilaration at 12:29 PM on May 21, 2013


Seems like an easy way to solve that problem.

Not a problem.
posted by Floydd at 12:31 PM on May 21, 2013


Thanks, I shoulda read all the comments!
posted by exhilaration at 12:34 PM on May 21, 2013


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