Most state lotteries in the U.S. give Lottery winners of particularly large priz

Question

Most state lotteries in the U.S. give Lottery winners of particularly large prizes the option of taking the total prize as an annuity over several years, usually 10-20, or as a discounted lump sum now. What are the various factors that should be considered in choosing either alternative if the goal is to maximize the total benefit to the Lottery winner? What are the risks associated with each alternative?

What does this relationship suggest to potential investors as far as setting important priorities using the relationship of present and future value? What is the most important determinant of meeting retirement goals?

Explanation / Answer

A lump-sum payment will make a definite payment to the lotter winner at immediate time without waiting for future payments. But the disadvantage is the high amount of tax that would be deducted from this amount.

For a periodic annuity payment,

Present value of the annuity = Annual payment x (1 + Interest rate)Number of periods

So, only the annual payment is fixed, but PV depends on both the interest rate and the number of years over which the prize money should be given. So, depending what which interest rate and how many years are chosen, the PV of this annuity payment will vary. The lottery winner decides from the two choices based on the present value of both alternatives, and in this case, interest rate maynot remain unchanged over years. If interest rate falls, the PV of annuity will also decrease, resulting in a los opportunity cost.

The PV/FV relationship suggests that any future amount receivable can be compared with the current amount only after discounting it using a market interest rate that will give the present value. Whichever option gives higher PV, is more attractive.

The most important determinant of returement goal is to ensure there is a steady stream of income after retirement which will be sufficient to cover the post-retirement financial obligations and targets. The future value of current savings should ensure that the future value can generate sufficient post-retirement annual or monthly income as desired by the investor.

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