The Powerball's wild card: How behavioral finance alters the jackpot

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With the odds of winning the $2 billion Powerball at one in 292.2 million, the accidental winners of this and other lotteries are the polar opposite of people who build wealth through scrupulous saving and methodical investing.

Still, jackpot victors face the same puzzle that financial advisory clients of all stripes face: how to maximize gains and minimize their tax bills. As the largest U.S. lottery in history drew numbers early Tuesday, a conundrum for the eventual winner looms: whether to take a windfall immediately and pay the associated taxes up front, or parcel out the money, and the tax hit, over nearly three decades.

It's a question that dredges up every investor's all-too-human beliefs about how to determine value based on the circumstances, along with notions, or cognitive biases, that prompt people to treat buckets of money differently, depending on their origin and intended use. Under such "mental accounting," for example, an annual bonus — or inheritance or winning lottery ticket — can be perceived as an unexpected windfall that should be spent on an expensive vacation, rather than socked away in a long-term nest egg.

It's also a question that splits financial advisors. 

Vermillion Financial Advisors in South Barrington, Illinois, argues that "If you lack the self-discipline to be a good steward of your money or fear the constant pressure to spend from those around you, then perhaps taking your winnings in annual installments is a better option." 

Patrick Yanke, a Raymond James financial advisor in Raleigh, North Carolina, counters that "it comes down to a matter of trust and an understanding of the time value of money."

A cornerstone financial concept, the "time value of money" would seem to point to the value of lottery winners taking their prizes up front instead of collecting 30 installments over 29 years. The idea is that dollars in hand now are worth more than dollars in the future. That's not just due to inflation's erosion of purchasing power over time — a dollar today buys less than a dollar did last year — but also to the ease of mind that comes from possessing money now and not having to worry whether it will be available in the future. Furthermore, money in hand now can be invested and earn returns that might outstrip the collective installment amounts banked later.

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Although planners may not have fiduciary duty to protect older clients, many see it as an ethical obligation.

November 4

But the time value of money idea is accompanied by a related concept that can prompt a different conclusion. "Net present value," an accounting term widely used by companies, reflects the value today of future cash flows from an investment. It's a bedrock tool of finance and Wall Street and is routinely used by businesses and investment analysts to gauge whether plowing money into a project or stock or bond will be worth it. 

Recall that a return of, say, $100 a year doesn't have the same value in year seven as it does in year one, due to inflation and other factors. So to compute what the investment that yields the $100 annual returns is worth today, the returns are "discounted" several or multiple percentage points. The present value will always be lower than the sum of the annual returns. 

Because the $2 billion Powerball represents the value of a windfall if paid out over 29 years, not immediately, that means a winner who takes a lump sum payout will get less than one who parcels payments out over nearly three decades. In other words, an immediate payout is "discounted" to its net present value.

The upshot is that waiting to collect the whole kitty yields more money. How much more?

The cash lump sum was pegged at $929.1 million before the $1.9 billion jackpot was updated early Tuesday, according to the official Powerball website. That 48% reduction reflects the net present value of $1.9 billion. And it's before the tax hit — winnings are considered ordinary income, like wages, and are taxed at both the federal and state level. An Illinois resident, for example, would pay the 37% federal and 4.95% state rates for a total of more than $389 million, leaving roughly $540 million.

But if the winner opts for annual "annuity" payments, the final cash out gets much bigger. With a $1.9 billion jackpot, yearly installments would pay out starting at $28.6 million, growing each year until they totaled $1.9 billion in year 29. An Illinois winner would net just over $1.1 billion after paying $94 million in taxes, according to usamega.com, a lottery website, more than twice as much if he'd taken the lump sum.

"Everyone thinks you should take the lump sum because they think you can invest it at a higher rate," said Blake Christian, a partner at accounting firm HCVT in Park City, Utah. But cashing in a multimillion-dollar prize upfront "is usually a poor decision because winners will generally take a permanent net present value haircut of 30% or more on their payout, plus pay 100% of the tax in the first year of winning."

The same dynamic appears with Social Security benefits, for which it pays to delay claiming as long as possible.

Whoever wins the Powerball won't save on taxes by choosing one payout option over the other. That's because the jackpot is so large, even splitting up payments over 29 years will keep the winner at the top 37% rate. But for smaller prizes of several million dollars, taking annuity payments pays off in tax savings, said Robert Pagliarini, a certified financial planner and the president of Pacifica Wealth Advisors, a fee-only firm in Irvine, California. 

A person who wins a $3 million lottery prize falls into the 37% bracket and owes $1.85 million in federal tax if they cash in immediately. But if instead they take 30 payments over 29 years, with each installment increasing 5% until the total hits $3 million, according to a usamega.com calculator, tax rates on each year's payout range from 22% to 32%, a significant savings.

Every corner of the wealth management industry is racing to deploy behavioral science findings to improve investment outcomes and make clients happier. But there are right ways and wrong ways to do it.

Three specialists, including Prof. Meir Statman, a leading scholar, take a deep dive into the field's applicability to financial advisors.

September 19

Pagliarini, who specializes in investment management for lottery winners, sees another advantage to annuity payments as well. 

"It buys you the flexibility and freedom to make mistakes," he said. "Your life can turn upside down when you win a lottery of this size. You can get bad advice from family members or bad advisors. This way, you can make mistakes and get a new deposit every year."

Still, the tendency to treat a financial bonanza differently from other dollars, such as a salary, can go unchecked even when people learn the workings of basic finance principles. A 2017 research paper in the Journal of Financial Education found that knowing basic financial principles such as the time value of money — which holds that a dollar today is worth more than a dollar tomorrow — did not impact a person's propensity to make irrational choices with their money. Americans who win between $50,000 and $150,000 are more likely to file for bankruptcy within three to five years compared to smaller winners, according to scholarly research in The Review of Economics and Statistics.

"People spend their money at the cadence they earn it," Christian said. "So if somebody gets a big windfall, they'll have a tendency to blow it right away, especially if they've never had money."

This story has been updated to reflect the increase in size of the Powerball lottery to $2 billion.

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Tax Wealth management Tax planning Income taxes Behavioral finance
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