Americans frequently dream about what they’d do with a multi-million dollar lottery jackpot if they are lucky enough to win it. Most think about mansions, sports cars and vacations, while few weigh the financial risks and consequences that come with instant riches. Stories of lottery winners being dead broke a few years after cashing their checks are all too common, and virtually all of them share the same circumstances.

Lottery winners need to understand the economics behind lotteries to make informed decisions as to how they receive their money.

Lottery Winners image by Montage Communications via Flickr.

Lump Sum vs. Annuity

Business Insider surveyed its readers last year when the Powerball jackpot hit $590 million, and 88 percent said they would take the lump sum. The question that always comes up with regard to the lump sum is why winners ultimately end up getting less than half of the advertised jackpot. Gloria McKenzie, who recently purchased a relatively modest $1.175 million home after winning the aforementioned jackpot, received “only” $278 million when it was all said and done.

The “$590 million” advertised jackpot is actually the value of a 30-year Treasury bond with a zero coupon rate purchased by the respective lottery. This means the bond pays out only at maturity and does not make periodic interest payments. The Federal Reserve has kept interest rates under one percent for the past several years. Low interest rates mean a higher value on a lump sum payment because lotteries subtract whatever the rate is every year from the bond’s value. The lump sum in McKenzie’s case was $371 million before federal taxes, according to the Washington Post. That would be the amount of the bond purchased by the lottery, knowing it will ultimately be worth the $590 million advertised amount. Florida, where McKenzie lived and purchased the ticket, does not have a state income tax, so she saved millions simply by living there.

The annuity option would have totaled the $590 million in 30 annual payments that increase each year. The $590 million number is derived from the funds collected from lottery participants plus interest over the 30 year maturity period of the bond. Yields on 30-year Treasurys as of July 22 are 3.55 percent. This relatively low yield is the reason why most people take the lump sum and (theoretically) invest elsewhere and receive a higher yield. Another option would be to take the annuity from the lottery and inquire with a third-party buyer about purchasing it from you. The lump sum you get from a third-party could be substantially higher than what the lottery offers.

The risks comes from the fact you may not live 30 years, you may not trust yourself with that kind of money all at once, and the U.S. dollar may collapse by then, leaving you with nothing.

Good Luck Turns Bad

Whether winners elect to receive the lump sum or annuity payments, instant riches do not necessarily bring instant happiness. William “Bud” Post won a $16.2 million jackpot from the Pennsylvania State Lottery in 1988. One year after winning, he had already been sued by an ex-girlfriend, nearly killed by a hitman hired by his brother and constantly hounded by relatives for money. Today he lives off food stamps and a monthly stipend of $450, according to MSN News.

Andrew “Jack” Whittaker won a $315 million Powerball jackpot in 2002, one of the largest ever at the time. He had $500,000 stolen from his car while he patronized a strip club in 2003. He was sued by an Atlantic City Casino for $1.5 million a few years later. Money was not the most important thing Whittaker has lost since winning. His daughter, granddaughter and the latter’s boyfriend all died within a five year period from 2004 to 2009.

Enhanced by Zemanta