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By | October 28, 2011

Dear Toolkit,

Can you explain how people decide whether to take their lottery winnings in a lump sum or over a period of years?

Thanks,

Better Bettor

Dear Better Bettor,

Yours is the age-old question of annuitization vs. lump sums.

An annuity is generally defined as a stream of equal payments made at equal intervals. . .such as monthly or yearly. It's another way we can quantify value over time.

Let's say you actually were a better bettor and won your state lottery. You are given a choice of a single lump sum $1 million payout now or $50,000 annually over the next 25 years ($1,250,000). If you're like most folks you'll see this as "a bird in the hand is worth two in the bush," and you'll opt to take the lesser amount sooner. Sounds sensible. . .but how can you quantify this decision?

Before we can tackle this puzzle, we need to select some sort of interest rate or perhaps estimate what the inflation rate might be over the period of the annuity. . .for example, let's choose 4 percent. The problem now becomes to determine the present value of the $50,000 times 25 years discounted by 4 percent compared to the $1 million lump sum.

A good financial calculator is the quick way to compute this decision, but good old fashioned annuity tables will do just as well. . .they're generally just heavier to lug around. To solve our hypothetical problem, use an annuity table, to find the following figures:

  • locate the number of compounding periods (in this case years) -- 25
  • locate the interest rate -- 4 percent
  • locate where they intersect -- 15.622080
  • multiply the $50,000 payment by the 15.622080 factor
  • which gives you $781,104, and this is the present value of the future payments discounted for inflation.

Keep in mind that this example doesn't even take into account the lost opportunity cost of what you might have earned on the $1 million dollars if you took it immediately and invested it rather than taking the annuity. (For the sake of simplicity, these examples also don't include any tax computations.)

This exercise quantifies for you the fact that you'd be more than wise to take your $1 million dollars today. Yes indeed, knowing how to compute the time value of money will definitely come in handy when you win that big lottery jackpot. And when you do, be sure to call us.

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