The Lottery Effect

Today’s Powerball estimated jackpot of $500 million has created a fair amount of buzz in the media. We all know how it works. You buy a ticket and instantly begin fantasizing about what you will do when you win. We’ve crunched some numbers to help optimize your daydreams.

Lump Sum or Annuity?

With a $500 million jackpot, you could elect to receive a $327 million lump-sum or 30 annuity payments over 29 years averaging $16.67 million.* To figure out the best deal, we need to examine taxes and calculate the rate of return on the annuity. The top tax bracket is currently 35%, so if you took the lump sum in 2012, you would receive $212.8 million after taxes.** In 2013, the top tax bracket is scheduled to jump to 39.6%, so you would receive your first payment at the 35% bracket. However, if we assume all following payments are at the 39.6% marginal bracket, you would only need to earn a 2% after-tax return to be better off taking the lump sum. Even better, if take the lump sum and earn a 5% after-tax return you would have $296 million at the end of 29 years – even if you spend the same amount as you would have received after tax from the annuity each year.

Odds of Winning

The odds of winning the jackpot are a little better than 1 in 176 million. Most people will tell you that buying a lottery ticket is a poor plan for financial success, but why are we willing to play even when we know the odds aren’t in our favor? The reason is we are often willing to accept a high probability of poor returns for a small chance of earning large returns. This is often called the “lottery effect.” This is also why investors are willing to concentrate positions in single issue stocks or invest in the next “hot” startup company. The excitement of large returns clouds our better judgment and we make decisions that reduce our overall chances of success.

At Financial Plan we strive to give each of our clients the greatest chance of success for accomplishing their goals. Rather than succumbing to the “lottery effect”, we focus on creating diversified and efficient portfolios. Whether or not you win the next big jackpot we’ll be here, but if you do happen to win, we expect to be the first call you make.

*The actual amount received is increased by 4% each year, but the average amount is $16,666,667

** This assumes you live in a state like Washington with no income tax.