Why are Structured Settlements or Multi-Year Lottery Payouts Worth Less Than Face value?

This is just a math problem as one might encounter in High School. If you actually are contemplating cashing an annuity, lottery win or structured settlement, be smart and go talk to a lawyer before you do anything else.

 

Structured settlements are where you've received a payout over some period of time as defined by Internal Revenue Code. The claimant accepts to resolve a personal injury tort claim or to compromise a statutory periodic payment obligation. Multiyear Lottery Payouts, or Lottery Annuities, are where the jackpot of the lottery is paid out over a number of years, commonly 20 years.

In both cases, one can often convert the multiyear payout into a "lump sum" payout, but for less money than the sum of the all of the periodic payouts.  But that lump sum is a lot less than the total amount. For example, if you win a lottery with a $10M payout over 20 years ($500k/year), but you want to take the lump sum instead of the 20 year payout, you'll get something more like $7.3M. How was that "discount" arrived at, you ask? It's arrived at by looking at this as if it were a bond and computing the "discount rate". The annual effective discount rate is the annual interest divided by the capital including that interest. So in the example above, the discount rate over 20 years is

($10M - $7.3M)/$7.3M = 37%

which means the annual effective interest rate is

1 - (1.37)1/20 x 100% = 1.587%

In other words, if you put that $7.3M in the bank at 1.587% annual interest, and did not touch any of it, after 20 years you'd have $10M. So in the example above, the lottery is allowing you to trade "future money" for "today money", and they are assuming the conversion between the two is the equivalent of an annual interest rate of 1.587%.

When contemplating "selling" a structured settlement or lottery win to get your cash sooner, the same type of calculation is made only in reverse. The person selling the structured settlement or lottery win has to decide how much of a discount they will take to get "today money" by trading away "future money", usually by looking at the interest rates for "safe" investments, and then doing the reverse calculation from the one illustrated above. (Remember, the lottery winnings or structured settlement payments are pretty much guaranteed to eventually come.) So for example, suppose we just received a structured settlement for $10M that pays $500k/year for 20 years, but we'd prefer all of our money at once. And suppose we know we can buy a 20 year Treasury Bond if we wanted to that paid 1.4%. What might be a reasonable price to take for our $10M-over-20-years money to get "today money"?  We'd basically estimate it like this:

$10M / (1.014)20 = $10M/1.321 = $7.58M

So something in the ballpark of $7.58M is what that "future money" $10M is worth in "today money" assuming that annual interest rate. Obviously, someone else may not agree that interest rate is a reasonable one.

 

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