Winning $1.5 billion in the Mega Millions lottery is a financial windfall few of us will ever experience. It is a great problem to have, but still a problem, especially these days when investors have few good options.
If you don’t take jackpot as an annuity—or if you do and don’t spend $25 million (pre-tax) a year—you must figure out how to invest all that money. The stock market has been volatile lately, some economists and market commentators are concerned stocks are over-valued, and fear a fall is due. It is tempting to give the money to a professional money manager who promises to beat the market. But few can, at least not without taking extra risk. The best they can do is help you plan and offer discipline for your investing strategy.
A good strategy probably involves some balance of risky and low risk assets. Low risk usually means bonds, which make fixed regular payments. It is possible to buy bonds with different maturities to ensure regular payouts, but the interest rates on high-quality bonds remains very low, relative to rates 20 or 30 years ago. Further, if inflation goes up, bonds may not protect you. Inflation-index bonds—bonds where the principal increases with inflation—return barely more than 1%.
In today’s low-interest rate climate, the cost of low-risk investments is high. And if you don’t have a smart rate strategy, interest risk can be significant and take a big bite out of your income. Annuities, a virtually risk-free product sold by insurance companies, base payments on interest rates when you buy the annuity.The lower the rate, the more it costs. For example, 25 years ago when a 10-year bond yielded 6%, $500,000 would buy you an income of $40,000 a year for 20 years, now with rates at 3%, it only buys you $31,000. Once you have a fixed annuity the income is locked-in for life. But if you self-annuitize and buy bonds yourself, your income will vary, dropping when rates rise.
Of course the upside of rising rates is your low-risk investments will earn more money going forward. But low interest rates creates costs and uncertainty to anyone with a large amount of money, both lottery winners and recent retirees. You can invest in vehicles with low rates, and take less money, or seek more lucrative assets and risk loss.
The smartest decision for a lottery winner, and many retirees, is to take the money as an annuity. There are significant tax advantages to taking the money in smaller amounts over time, rather than all at once. It’s also less risky because you don’t manage the money and bear the risk. Lottery winners aren’t known for their money management skills and the annuity ensures large regular payments, starting at $25 million and eventually reaching $100 million (or $56 million after accounting for inflation), over the next 30 years, all before taxes. The annuity puts the investment risk on Mega Millions.
The annuity also impose a limit on how much money you can give friends and relatives. The $904 million (the lump sum payout), may sounds like more money than you can possibly spend. But lottery winners have blown through enormous fortunes in the past. Playing the lottery in the first place suggests a poor understanding of risk and probabilities. It is better to leave it to Mega Millions to manage it for you.
It is always better to have more money than less, but more money also means more problems, especially in this interest rate environment.