Monday, June 16, 2008

The Economics of Windfalls

Watching the US Open Golf Championship and its top prize of $1.26 million made me think about windfalls. Many of us dream of coming into a large sum of money whether it is by winning a sporting event, a lottery, or getting an inheritance.

If only you could win a million dollars; you’d be set for life, right? Not so fast. A little analysis will show that with a million dollars, you’re nowhere near as rich as you might think. Just ask the 8 lottery winners in this article who won millions and lost it all in a few years.

Let’s assume that our lottery winner, Leon, starts out with a lump sum of one million dollars. His winnings aren’t being spread out over many years, and if he has to pay US taxes on lottery winnings, the prize was large enough that he is left with a million dollars after taxes.

If Leon wants to be set for life, he has to grow his windfall by at least enough each year to cover inflation. He can only spend the investment gains that exceed inflation. Otherwise he is dipping into his capital and will eventually run out of money.

Let’s start by assuming that Leon invests the whole million in a few low-cost stock index ETFs. A rule of thumb that many people use is that you can draw 4% from a stock index each year and have the principal still grow enough, on average, to cover inflation. Leon can draw $40,000 in the first year.

Of course, he will have to pay taxes on this money. Let’s say that given the mix of capital gains, dividends, and return of capital, Leon pays 20% taxes on this income. This leaves Leon with about $2700 per month to spend on top of whatever he makes from the job that he isn’t able to quit.

This is a lot less spending money than most people would have guessed. And this is a very optimistic scenario. What if Leon can’t handle the volatility of an all-stock portfolio and puts 40% of his money in bonds? The bond returns will only average about 2% above inflation, and the tax rate on this income will be higher, say 40%. Now Leon draws an income of $24,000 from stocks, $8000 from bonds, and after taxes, he can spend $2000 per month.

Even this scenario is too optimistic. What if Leon hires a financial advisor who puts him into stock and bond mutual funds that cost Leon 2% more in fees each year than he would have spent in commissions and spreads from trading ETFs? Now Leon can’t draw any income at all from the bonds, and only a 2% income from the stocks. His income is $12,000 from the stocks, or about $800 per month after taxes.

You guessed it. Even this scenario is too optimistic. A few times over the years when the stock market drops, Leon will become dissatisfied with his financial advisor and switch to a new one incurring deferred sales charges or front-end fees on a new set of mutual funds. This will drive Leon’s returns below inflation. It is now inevitable that Leon will run out of money at some point.

A windfall of $3 million is enough to produce an after-tax income of about $8000 per month indefinitely, growing with inflation, if handled properly. This is enough to provide a very comfortable life without having to work, but it isn’t enough for extravagant spending. It’s no wonder that many lottery winners go broke quickly.

7 comments:

  1. I remember watching a show about powerball winners (the people who win those massive jackpots of $100 million and more). Many also end up right where they started after a few years of poor decisions. Granted, a lot of them lost the bulk of their winnings off the top by taking the lump sum versus the annuitized income stream. But really, the lottery corporation should force them into the income stream unless they present a business plan, or financial plan, that shows that they have thought about how they will manage their money. That concept will never fly in the States, but it's astounding how many BIG jackpot winners are back to paycheck-to-paycheck living in often less than a decade.

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  2. Preet: It seems that average people can burn through even tens of millions of dollars in only a few years.

    I'm not sure there is much that can be done to force people to live with an income stream. A bank would certainly lend money based on such an income stream, and I've seen television commercials for companies that specialize in turning a stream into a lump sum. The focus of the ads were insurance settlement income streams, but they would likely do the same for lottery winnings.

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  3. You are right, unless the income stream is somehow mandated to never be reverse-annuitized (made that up), those structured settlement guys would eat that up - those guys take a big cut converting payment streams to lump sums, too.

    I doubt as well that it could ever happen - just ranting. :)

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  4. It's not just the average person who gets into money trouble. The weekend Ottawa Citizen had a story on celebrities who filed for bankruptcy simply because they couldn't handle a lumpy income with some windfalls in between (say winning a role in a major motion picture).

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  5. CC: It's true that many prominent people seem to handle their money poorly. These people are obviously not average in terms of their profile, but they definitly don't seem to be above average at managing money.

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  6. Wow, I've never seen such a clear example of the destructive impact of mutual fund fees.

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  7. Patrick: I was a little surprised myself as I put together the numbers for this post.

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