Tamping Down the Lottery Pipe Dream

“I think we should buy a Powerball ticket,”- Mrs. Chris on Wednesday, Jan 6.

As much as I disdain social media, I’m as addicted as most other people in my generation, so I know there are a lot of people buzzing about tomorrow (Saturday, Jan. 9, 2016), when a drawing will be made for a record $800 million Powerball jackpot.

In my younger years, I occasionally bought a Powerball ticket when the jackpots surged upwards and hit gaudy new records, entertaining fantasies of helping family and friends pay off their debts, travelling the world, and buying one of those miniature giraffes from the old DirecTV commercials.

I never won a dime off of those tickets.

As it turns out, Mrs. Chris and I did not buy a lotto ticket for Wednesday’s drawing – and nobody won. That means there’s a tiny, tiny chance that our numbers, usually chosen at random, could have won for us.

How tiny was that chance? One-in-292 million tiny. If every person in the U.S. bought one ticket, there’s a pretty good chance one of us would win the jackpot. So on Saturday, there will probably be millions of Americans huddled around their television sets at 10:59 PM, and one of them will end up a very happy and rich person at 11:01.

I won’t be among them.

My wife might be. And good for her. A two dollar investment to allow her to dream of a 9-digit windfall, even for a day or a few hours, isn’t terrible.

But I don’t have any faith in that investment personally, and I no longer dream of catching lottery lightening in the bottle.

Statistically, you’re more likely to remain in relative wealth and comfort if you avoid the lottery altogether. In fact, there’s economic research from economists at the University of Pittsburgh, Vanderbilt University and the University of Kentucky (my alma mater, go Cats!) that suggests lottery winners are more likely to declare bankruptcy than the general population – twice as likely as it turns out.

According to more recent statistics, a survey published last year by the Camelot Group, 44 percent of lottery winners spend all of their winnings with five years. These survey results may understate the problem, which is shared by entertainers, sports stars, and heirs to family fortunes – according to research by the National Endowment for Financial Education, 70 percent of people who suddenly receive a large fund of money lose it within a few years.

Let’s talk about how. For one thing, if my wife’s numbers are called on Saturday, she doesn’t get $800 million. She can choose to receive $800 million in annuitized payments over 29 years (subject to state and federal taxation), or she can take a substantially lower lump-sum payment of around $500 million.  This happens because the $800 million announced jackpot is not actually what you win – it’s the total nominal dollar payout of the annuity over the 29 year period adjusted to inflation – so the lottery is selling players a false bill of goods and misrepresenting the size of its jackpots to begin with. Not exactly a deal I want to get involved in.

The federal government takes 25 percent of that $500 million off the top, so it become $375 million. Unless you live in Delaware or Florida or another state that doesn’t have an income tax, you end up paying both state and federal income taxes on that money. In my state, federal income tax at the top bracket – so you’re paying the top federal rate of 39.6 percent, plus a 2 percent pseudo-surtax that high income earners are subjected to through the PEP and Pease provisions (these actually phase out exemptions and reduce deductions, but for all intents and purposes they’re an additional tax on wealth). We’re now down to $219 million.

Social Security and Medicare want their share, a little over 7 percent, which brings us down to around $203 million. Then my home state, New Jersey, wants to tax me another 9 percent, which brings us down to $184.7 million (it would be nice if, like California and Pennsylvania residents, New Jersey lottery winners were exempted from the state income tax). We’re not even considering how schools and municipalities are taking their share of the winnings.

So when all is said and done, if Mrs. Chris won on Saturday, she would take home at best 23 percent of the announced jackpot, and around 37 percent of the lump sum payment as figured before taxes. She can, of course, mitigate some of the tax bite by donating part of her winnings to charity or by making a gift to a family member (hear that, honey?).

But it is still true that when an individual wins the lottery, the government is always the biggest winner.

Still, $184 million after taxes is plenty of money — with my journeyman financial knowledge, I could easily make that money last my entire lifetime and probably build on the principle for my descendants. Why, then, do so many lottery winners go broke? Why are they declaring bankruptcy at twice the rate of the general population?

Because poor people play the lottery and rich people do not.  Lottery players tend to already have a lot of debt (Mrs. Chris should note that we have a pretty heavy debt-to-income burden). If $184 million doesn’t take care of your debts, you either suck at managing your finances or you’re a small island republic. But these folks aren’t using their windfall to pay off their debts.

In fact, lottery players tend to have below-average incomes and little-to-no financial literacy. In many cases, that’s why they’re playing the lottery in the first place – buying these $2 chances, twice a week, is their retirement fantasy (we can’t really call it a plan, plans have a better than 1-in-292 million chance of success).

But those who follow the weird syncretic study of behavioral finance, a chimera of economics, personal finance, psychology and sociology, also cite the impact of a sudden windfall like a lottery jackpot on people’s behaviors.

Those of us who have entered adulthood keep a ledger somewhere – in our heads, in our checkbooks, in our online account portals – somewhere – that reassures us that our income exceeds our expenses over a period of time – from days or weeks to years and lifetimes. This is because we’ve worked for our earnings – this money represents time we’ve invested.

When income is from winnings, not earnings, most people toss that careful accounting out the window for something behavioral accountants call ‘mental accounting.’ They develop a taste for luxury. They become impulsive spenders. They become the life of the party (as it turns out, winning the lottery has a negative impact on life expectancy, too).

For at least half of us, this behavior is difficult to avoid. It’s like finding out you’re prone to addiction, things start to happen when the conditions are right and you become a different person.

I can parse this for you. Think about candy, your favorite candy, in my case it’s Reeces mini peanut butter cups. Think about bringing in a little bag of 5-to-10 of them from home every day to your desk at work, and eating them throughout your workday. You’re probably not going to have any problem dusting off 5-to-10 Reeces minis in a day, but you ration them, eating one an hour or every 40 minutes, to maximize your enjoyment. Then, one day, your extremely nice boss (and I do work for great people) drops a bag of 50 Reeces minis on your desk. What happens?

Do you still ration-out your Reeces minis on an hourly basis? Do you start giving Reeces minis to your co-workers around the office? Behaviorally, chances are you end up with the same amount of Reeces at the end of the day that you did on any other day when you just brought 5-to-10 from home. You lost your incentive to budget and plan. This happens to lottery winners all the time.

There are real-life examples to back all this up – Jack Whittaker won a $315 million Powerball jackpot in 2002. He made good decisions at first – he gave to charity and started a family foundation. Then he started having problems – some drunk driving convictions, an incident where $545,000 in cash was stolen from him on the property of a strip club, and the suspicious death of a granddaughter. By 2007, he had burned through his winnings.

Whittaker is not at all an outside case – lists of lottery riches-to-rags stories abound on the internet, and are probably more prevalent than the rags-to-riches narrative lotteries and players are counting on.

Mrs. Chris should also know that the four-year divorce rate for lottery winners is also higher. Also, only around half of lottery winners claim to be happier after their windfall than they were before it.

As it turns out, lottery players, who on average spend around $700 a year on tickets, are gambling just as much for a chance at misery and ruin as they are for the chance to achieve their dreams.

That doesn’t mean you shouldn’t entertain a get-rich-quick fantasy and buy a ticket for Saturday’s drawing – just understand that, if your numbers are drawn, you might be in for more than $184 million worth of troubles.

I’m not playing. I prefer for my future to depend more on good, rational decision making, careful planning and skill than a stroke of nearly impossible good luck.

Where I’m at and where I want to be – A financial confession

I’m a financial editor and reporter, but nobody knows what a mess my finances have been. It’s time to come clean: I'm pretty much broke - but not for long.

My financial situation has suffered from 10 years of contingencies and neglect. That’s a brief explanation of what you’re about to read.

My wife and I graduated from college in 2008 with around $36,000 in student debt. Jobs were hard to come by – it was a terrible time to enter the professional workforce, especially for someone with a political science degree – useful but worthless – and a graphic/web design degree – valuable but relatively useless in central Kentucky.

Today, we’re still at negative net-worth. We still carry around the same amount of student debt, after a long period of forbearance, and we’ve tacked on $7,500 of credit card debt on top of that, in addition to a car loan with around $10,000 outstanding on it.

We have around $4,000 in cash to work with. Another $2,000 in savings accounts. Another $20,000 in retirement accounts.

$12,000 of that total is in the Templeton Growth Fund in my wife’s 401(k), generously started for her by her parents several years ago. We have not touched it, even as we sagged financially, but the fund has failed to perform.

Another $5,000 of our retirement is in my former employers’ 401(k)s waiting to be rolled-over or converted to a Roth account should our income really start to grow. This money is all placed into target-date funds set for a retirement some time between 2045 and 2050 (I was born in 1981 – I now want to retire in 2051). These funds have performed well over time and are currently balanced at around 90 percent equities and 10 percent bonds. I’m more aggressive than that in general, but I see no reason at this point to incur the fees with rolling over and transferring the accounts – I’m likely to keep them and not add any principle investment to them.

A little over $1,000 is in my current employer’s 401(k) plan, and I’m adding 9 percent of my personal income to that twice a month – 5 percent from myself, four percent in an employer match. Right now that money is 92 percent in equities, eight percent in bonds, with future contributions averaging in more equities than bonds at a 94 to 6 percent allocation. The core of this 401(k) is in the SchwabS&P Index (SWPPX).

I have around $1,700 in another RIA formed from a rollover – a former employer had defaulted me into a money market account, when I realized I took the money to Vanguard and immediately bought VOO (which is Vanguard’s S&P 500 Index ETF) right after the Aug. 24, 2015 stock slide - which was a good time to get into the market.

I also started a Roth IRA, which currently has less than $100 in it, but I’m contributing to it at a rate of $5 a week.

I’m giving you rough estimates. I know the exact numbers because I keep track of them using Vanguard’s great tools, Mint.com, and my own obsessive checking and re-checking. I’m essentially a passive investor who looks in on his accounts every day. I just like knowing the numbers.

The big numbers I track daily are not the value of my investments, or even my income and spending (I’ve gotten this part of my family’s financial life under control, I think), but my net-worth – which sits around -$18,000 right now – and my cash flow versus consumer debt (money in bank accounts minus total outstanding credit card debt) – which sits around -$1,000 right now.

This year, I would like to improve both of those numbers. I would like to get my net-worth up to at least -$9,000, and I would like to get my cash flow minus consumer debt to around $3,000 (a net gain of $4,000) by the end of the year. This still isn’t a great place to be for a 35-year-old middle class guy, but goals should be reasonable and measurable.

How do I get there?

The first thing I see is that my biggest debts are student loans. However, these are also my lowest interest debts – the monthly payments on that $36,000 only come to around $330, which is a bite out of my income, but feasible – the problem is that the $330 doesn’t really put much of a debt in the principle amount of the loans because of the extended period of forbearance my wife and I experienced. So I’m not really improving my situation by tackling student debt at this point.

The car loan is also fairly low interest, and the payments are only around $250 a month. Again, a substantial amount of our income, but not enough to kill us. It would be nice to pay the car down so I can get more generous insurance rates (and not be required to hold full coverage) but it isn’t yet a priority.

The credit cards have interest rates that almost double the rates of our auto loan and are even more expensive when compared to the student loans. As far as debt is concerned, these have to go first.

This debt is held in two accounts – one with about $5,000 that is being assessed 12% interest annually, and one with $2,500 that is being assessed 14% interest annually. I’m currently paying around $150 a month (net after the finance charge is covered) to pay down the larger account, and around $120 a month net to pay down the smaller. $270 a month times 12 becomes $3,240, that will bring me more than 80 percent towards my cash-flow goal and 30 percent towards my net-worth goal.

Clearly, the cash-flow goal is the easier to tackle, and at the rate I’m paying my bills, I’m going to have some excess cash on top of my credit card payments. While some people might argue convincingly that this excess cash should go to additional payments to reduce my debt, I’m not going to do that at first. I’m going to save – not in a retirement account or by buying investments, but in a savings account – for an emergency or rainy-day fund.

Most experts say that a rainy day/emergency fund should come to 3-6 months worth of spending. My long-term goal is 3-6 months of our net earnings, which comes out to about $31,000. Keep in mind that we have around $2,000 in our savings right now, so I have $29,000 to go until I hit that goal.

Right now, I’m saving around $260 per month in cash, or $3,120 per year, comfortably. That means, under ideal conditions, I will improve my net cash flow by $6,360 this year, far exceeding my goal. I’m on track, no changes needed there. Furthermore, that $3,120 gets me another 30 percent towards my net-worth goal. I only need to cover $2,640 to improve my net-worth to $9,000.

Luckily, I’m socking money away in retirement accounts, too, so let’s see if those cover the gap. $5 per week comes to $260 a year in my Roth IRA – I just need $2,380 more. As it turns out, I’m putting around $330 a month into my employer 401(k) when the match is included. That’s another $4,000. I’m going to exceed my net-worth goal for the year barring any major emergencies.

I’m only 35 –my retirement is still 30-to-35 years away. I am planning for that retirement and I have an idea of how much I should be saving (more than I am now) – but with our current levels of debt, our small nest eggs, and with 30 years of market uncertainty to weather, I can’t use retirement assumptions to make a year-long financial plan.

I have to start short-term and tackle the financial issues in front of me now – stabilizing my cash flow and eliminating my debt while building a buffer of savings – then I can ramp up my investments. This seems like a way that millennials and middle-income people of my generation who may have fallen behind or who may have lost hope for their financial futures can effectively plan and work their way out.

I’m not a financial advisor or a planner, I have no certifications or formal education in finance, and I am not qualified to give you advice. I am not suggesting you go out and buy a ton of VOO or SWPPX just because that’s where I’ve planted the first seeds of my retirement.

Note that I didn’t cover my actual monthly household income and expenses – I’m sure you can come up with an estimate from the information I’ve revealed here. The next financial plan post I write will cover how I itemize my expenses and income, whether I will end up with a greater surplus than I’ve envisioned here at the end of 2016, and whether I will increase my debt payments, my emergency savings, or my contributions to my Roth and 401(k) accounts – or spend a little bit on my wife and I - as a response. Afterwards, I’ll bring it all back down to earth with a very sobering look at my savings rate, why 9 percent isn’t nearly enough for a 35 year old, and how I'm going to get back on track.