Recently, some lucky person won the lottery. The lottery winnings were reported to be $85.5 million. In reality, the winner got a choice of $2.85 million per year for 30 year or $46 million today.
A. Explain briefly why winning $2.85 million per year for 30 is not equivalent to winning $85.million.
B. The evening news interviewed a group of people the day after the winner was announced. When asked, most of them responded that, if they were the lucky winner, they will take $46 million up- front payment. Suppose (just for a moment) that you were the lucky winner. How would decide between the annual installments or the up-front payment?
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Well, there are different tax rates for the lump sum and yearly amounts. Most people prefer a bird in the hand to 30 in the bush. The tax amount on the lump sum might be more, but you would still initially have more. I would prefer the 30 yearly payments probably. History suggests the person is more likely to go through the lump sum.
As to Part A of your question, the reason that the two are not equal is inflation. With the lump sum, you are getting the whole amount in today's money. With the yearly payments, the value of the money (which will be the same nominally) will decrease every year. By the end of the thirty years, inflation will have eaten into the actual value of the payment. In addition, you lose all the potential return you could get if you took the lump sum and invested it.
I think the upfront payment is the better approach in today's economy. We are printing so much money that there will be inflation in the future. What compounds this fact is that most of the world is printing money as well. For this reason, as post 3 states, the same amount of money later would be worth less. In view of this, I would go for the lump sum and invest in real assets, so that the price of the assets would grow with inflation. In this way, you will be able to keep up with inflation.
The fact is that having the money in installments will be more likely to get your more money in net terms in the end rather than having the inital payment straight away. I guess the temptation would be to take the initial payment so you can pay off your debts straight away and live the kind of life you would like to live now. However, it would be more financially prudent to take the monthly payments.
Your decision of whether to take the annual installments or the up-front payment would depend on your estimate of what inflation in the future would be. Looking at the installments and the up-front payment the decrease in value has been estimated due to inflation is at approximately 4.56%. Inflation in the US would not reach such a high figure and persist at that value for 30 years. It would therefore be better to opt for the installments. You could take the up-front if there are avenues available for you to invest the money that you receive as up-front payment at a rate of return exceeding the rate of inflation and one which is totally secure.
I would take the up-front payment simply because one can never know what tomorrow may bring, including death. I assume that the monthly payments would cease if I died, whereas if I took the up-front payment I could invest the money, leave some to heirs and charities, and do other good things with it in the meantime.
I like the idea of the up-front payment, but there is a comfort in having that hefty yearly payment coming my way. I think I would opt for less money over time. So many lottery winners end up completely broke because they don't handle the money carefully. I would like to think that smaller amounts over time would make me more cautious in how I spent it. The money is a wonderful gift that would forever change your life no matter how you collected it.
Part of the answer to your question is information you don't give us - what would happen to the rest of the money if I took a yearly pay-out but died before the 30 years were up? Would the remaining payments continue to come to my estate on a yearly basis; would the remaining payments be sent to my estate in one lump sum; would the payments cease since I could no longer receive them?
I would probably take the yearly payment regardless of the above consideration - I think I could manage to live on $2.85 million per year without working for it!
I have always wondered about this situation myself, and I've come to the conclusion that a lump sum up front -- despite the higher tax burden -- is preferable, because you can simply drop the whole load into your savings account at even today's low interest rates and live off that forever. It is a better deal, especially in a credit union, than risking it in investments. Plus, you could spread it out over several banks and credit unions, protecting your initial monies in case one of the institutions goes under; interest from each can be consolidated into another, or used directly as cash. Eggs and baskets, you know.
In reply# 3
Thanks for your post, it being very helpful for me to have an understanding on the book and to be able to implemente into that questions
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