Saturday, July 21, 2012

Lottery fantasizing

When lottery prize amounts for the Mega Millions go sky-high like it did a few months ago, it brings up a couple or three questions.

First - why would you buy a lottery ticket? You often hear the saying "Lotteries are a tax on people who can't count". All gambling is this way - so I can't argue that this isn't true, given the spirit in which it's said. Taken a different way, it's entertainment - and we all gladly part with our money to see a concert or a movie or a sporting event. These diversions usually make us feel good. Gambling - and lotteries - have the same effect if done in moderation. I, for one, get a Super Lotto or Mega Millions ticket every couple of weeks, on average. A crappy "investment" to be sure, but it's a delightful way to "authorize" myself to daydream about magically becoming a millionaire. Magical thinking at its finest!

Second - lump sum or annuity? I say lump sum ... most "experts say so, as well. The reason not to would be if you desire a steady, predictable income stream, and managing money creeps you out. The annuity would take the place of other annuities that financial advisers typically recommend to insure we have money when we get old.

Third - how much is enough?

Before I get into that question, I wanted to mention that the Mega Millions lump sum payout is presently $34.9M on a $45M prize, or 77.555%. That's a BUNCH - the highest I've ever seen it! That means that the after tax payout would be around 50.4 cents on the dollar - assuming a 35% maximum federal rate and no state tax.

So ... back to the question of "how much is enough?"

Assume, for discussion only, that we have no debt, but no savings - essentially zero net worth. That's just to make it simple. Assume also that you're 55 (I am roughly that age), so that you have 10 or 11 years before traditional retirement age, and that you and your wife (if you have one) will get $2100/month from social security when you retire - about half the total possible. These are just assumptions to keep the discussion simple.

Is $500K after taxes enough? Not for me - here in California. Assuming my house is paid off (it's not in real life, but bear with me) I still need health insurance for 10 years, food, clothing, sanitation, medical, home repair and auto repair and fuel costs. My wife and I might be able to live on 4 to 5 thousand dollars a month until we retire, then our health insurance costs recede and we start getting Social Security. We would have averaged a $54K withdrawal rate for ten straight years, or more than the principal we received when we won the lottery. If our investments were good and the inflation rate is low, then we may have 100, 200K dollars left for retirement, but it could have gone the other way as well, and we would have gone broke after 5 or 6 years.

Now, cost of living in Southern California is high, so you can look at this from the perspective of a cheaper place to live. There are places in the Midwest - Iowa for one, where the COL is about 55% of what it is here. You can verify this by looking at COL calculators online. Alternatively, there are more expensive places as well - San Francisco and New York City come to mind.

Is $1M after taxes enough? Eh ... it's better. Sticking to the 4500 bucks a month rule I fabricated for the first example, then we could conceivably have half a million dollars or more when we finally reach retirement age. It's not a slam dunk, but it's doable on a budget.

Two Million? Yes, I could do that. Again, if I stick to the budget, I can have over $1.5M left over when I reach traditional retirement age, maybe substantially more. Maybe substantially less, however.

Let's discuss the down side. The whole investment landscape can go sour for everyone in a bad way. It did in 2007 and 2008 with the real estate crisis and subsequent global economic meltdown - it did in 2000-2002 when the tech bubble burst. Imagine this. We take our 2 million bucks and put 500K in laddered bonds to get us through the pre-retirement years, and put the remainder in blue chip stocks - which we'll start to convert to bonds a little at a time a few years before retirement. Using the tech bubble burst as a metric, we could have lost about 50% of our net value at some point. Our $1.5M would have dropped to $750K. Now, I could personally live with that, but imagine if that happens in our $1M prize scenario - our $500K investment drops to $250K. You could still live, but it would be a real strain on your emotions. It would have destroyed us in the $500K scenario! The lesson there is to have that 6-8-10 year "cash and bond cushion" built up before retirement.

Sometime in the next few weeks, I might muse about what I'd do if I won 4 million, 8 million or more. Sane!

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