Most people probably are relatively ignorant about how to best manage multimillion dollar portfolios, and there’s not much reason to care about optimizing your payoff if the extra money isn’t going to meaningfully affect your lifestyle.
There is no such thing as a completely safe investment. That’s the whole point of paying interest.
They can give you 5 million today. No risk.
They can pay you in installments. There is a risk that they might go broke before it’s over.
That’s why they offer you 10 million, to persuade you to take the chance.
Or why you demand 10 million to let them take the chance.
They presumably turn to an insurance company that offers annuities (annuities being like the opposite of life insurance in many ways) and purchase an annuity. They presumably already have a working relationship with one.
How does the insurance company make money on the deal in a down market? They don’t. But they make it back when the market is doing well. They charge a premium on the fact that they’re the ones taking the risk rather than the buyer of the annuity. This is why it’s generally seen as a very poor move to buy an annuity of any type; you can get better results on average by using a good investment advisor. But annuities are extremely safe compared to other investments, only hinging on the ability of the insurance company to pay. Just go with someone owned by Berkshire Hathaway and you’re all set - Buffett has said that Berkshire is set up the best of company to be in the insurance business, because they have plenty of capital to absorb losses.
Saying they invest it is kind of misleading.
Basically they have 5 million bucks that they collected from the lottery participants after fees, the state’s cut, etc…are deducted.
At that point, they can pay you that 5 million outright as the cash option, or they can drop that 5 million into an annuity that’ll pay out somewhere between 8 and 9 million over 30 years. It’s the winner’s choice.
They already know the value of the annuity beforehand, so they’ll say “9 million lottery jackpot!”, because that is the actual amount you’ll end up with if you take the annuity, as summed up over 30 years.
The state/lottery commission doesn’t make any money from the annuity; they just get the benefit of having a larger overall jackpot to advertise, and fewer complaints from people spending it all on blackjack and hookers in a month.
If the advertised payout is $25 million, then the cash payout would be ~$11 million before federal tax, not after. After taxes, you are sitting on closer to $6 million.
Still better to take than the annuity.
I think the states generally buy an annuity from a AAA rated insurer. The insurers base their annuity rates for something like this on the rate they can get from a ladder of Treasury securities, which are as safe as any investment is in America. I have not heard of an annuity provider (i.e, insurance company) failing to pay a lottery prize. I suspect if an insurer went bankrupt while it still owed lottery annuitants money, it would be a complicated issue under state law and bankruptcy law whether the state was still on the hook to make the continuing payments.
For something like this, they would match their investments with their liabilities. That is, if they owe $1 million next year and every year thereafter, they would buy Treasury securities that paid out $1 million next year and each year thereafter. This is about the lowest risk investment the insurance company could make and they have pretty much locked in their profits on day 1 without caring one whit what happens in the market afterwards. They make their money because they will charge more upfront for the annuity than it will cost them to buy the matching Treasury securities.
Signed, former insurance company treasury employee.
If you could match the return of an annuity with treasuries, why wouldn’t people just buy treasuries instead? If that’s enough to get the return that they need, why involve the insurance company? For individuals perhaps it makes sense to simplify things, but the lottery board wouldn’t need to buy an annuity if they just could get the required return with treasuries.
They probably do - here is a passage from a NYS Lottery report regarding the fiscal years ending 3/31/20 and 3/31/19. Maybe it makes sense for a small state to buy annuities but I don’t think large states would do that especially since they are usually already investing pension funds.
The Lottery is authorized by the Office of the State Comptroller per State statute to invest prize funds, which will provide for the payment of prizes payable (see Note 4). The Lottery invests in U.S. Treasury bonds, U.S. Treasury strips, bonds guaranteed by the U.S. Agency for International Development and New York City Transitional Finance Authority municipal bonds, which are guaranteed by the full faith and credit of the United States.
State lotteries are rarely more than a few million dollars. The BIG ones are multistate, covering ~46 of the states.
As Doreen noted New York does just buy Treasuries and some other states likely do too. Other states probably decide it’s easier to buy an annuity than to hire someone to run a portfolio and someone else to distribute the money. The implicit cost from the insurance company is very low. Their risk is nearly zero so they can sell the annuity for a very small amount more than it costs the insurance company to buy the bonds.
If you are asking why lottery winners don’t just do the same thing, they could but they have to know enough about money to recognize the opportunity and lottery winners, on the whole, probably know less about money than the average person. In fact though, I understand that most lottery winners take cash rather than an annuity when they have a choice.
Who manages investing for the multi-state lotteries?
Here’s a simple example of Net Present Value - what you would take today to get the same value for assorted interest rates:
For $10M paid every year, for 25 years (so $250M) compounding once a year for simplicity
1% - $220,231,557
2% - $194,234,565
3% - $174,131,476
4% - $156,220,799
5% - $140,939,446
6% - $127,833,562
7% - $116,535,832
10% - $90,770,400
So the question is - offered $10M a year for 25 years, can you beat the interest rate they assume for current prize?
I see this about Powerball - “Estimated Jackpot $401 Million - Cash Value: $205.4 Million.”
They confuse matters by having the payout increase by 5% every year, so it’s not as simple a comparison, but a quick spreadsheet could probably provide the answer. But a current cash prize of half the nominal prize amount is about 6%. Allowing for higher future payments instead probably means an actual interest rate of 4% to 5%. If you think you can beat that, take the cash.
The other point is - so what???
Once you have $10M to blow, who needs a few million more or less? Would it hurt you if your average income each year was $9M instead of $12M?
the NPV calculation might be more relevant for a smaller prize, like say $10M. Then taking $5M cash might be preferable to an annuity of (guessing) $400,000 a year if you want to buy a house or something, but you will then have to be careful how you spend the rest and invest wisely. However, since the gravy train ends in, say, 25 years - still need to lay in a nest egg from the annuity unless you are already retired.
My sister is fond of pointing out that your age might also be a factor. If the annuity pays out over 20 years do you expect to live another 20 years? For someone 30 the answer might be yes. If you win the lottery at 70? Maybe not so much. Between her age and health problems she says she’d take the lump sum because odds are she isn’t going to live another 20 years.
If that’s a serious concern, taking the money and buying a life annuity with a payout based on actuarial statistics would probably yield a higher income.
I wouldn’t say that. Lottery players maybe, those who buy $20 in tickets every drawing. But about half of lottery winners are not regular players. I sometimes buy a ticket for my birthday, for Christmas, or when I happen to notice that it’s up to some ridiculous amount(and very occasionally when I would like to get revenge on someone).
It’s not like it’s that hard to get a pretty decent return just by investing in a Vanguard index fund. Historical average is over 5%, and the ten year is 10%.
Past performance and all that, but yeah, in almost all cases, you are going to be better off taking the cash and investing in index funds.
For me personally? I have ambitions. I don’t need a big house or a fancy car, but I am a business owner, and I have a number of other business ideas that I’d love to do if I had the resources.
Depending on jackpot size, I have “plans*” on expanding and securing my business, to venturing out into completely different industries.
*one may actually call them fantasies.
That’s where I am, and another factor is if you have kids who could inherit the lump sum.
Yet another factor is value to you. 20 years from now, when I’m 90, I may well not want to do things to spend money, while I would enjoy an around the world trip today.
Good. It all depends on motivation - there’s the guy who’s richer than anyone, yet sleeps on the factory floor. And there’s the other guy who’s so rich his obsession is a yacht so big it won’t fit the exit to the harbour. I’m reminded of the Warren Buffet quote: “I gave my kids enough so that they could do anything, but no so much that they could do nothing.”
Life is very different when you consideration of the cost of a European vacation or a new car is like the average person considering the cost of a cup of coffee.