3 Rules for a Windfall

Photo by David Villarreal Fernández

So you just won the lottery. According to the Texas Lottery, the Lotto Texas® jackpot for Saturday, May 9th is $5,500,000. Imagine what you could do with over $5 million!

A new house? How about a new sports car? A boat? (We discussed that last week!) You’re rich, right? Maybe.

First you better read the fine print. The $5,500,000 is the “Annuitized Jackpot”, or the sum total of payments over 30 years if you elect the payout in the form of an annuity. The lump sum is ONLY $3,820,000.

Misleading as the marketing may be, that’s no paltry sum. It also provides insight into my first rule of managing a windfall.

Rule # 1 – Count it. It may sound simple, but before you start spending a windfall you need to know how much you have. In the lottery example, $5.5 million actually is $3.8 million BEFORE taxes. Assuming you live in Texas and don’t pay state income tax, you would then give up to 39.6% or so to Uncle Sam, so you’d be left with around $2,307,280. That’s still better than chopped liver, but the $400,000 that a new Lamborghini Aventador cost would take a pretty big bite out of the remainder.

Legal settlements can have similar shrinkage once you factor in 30-40% going to attorneys, possible loans and finance charges, and taxes if any of the damages are punitive or for other non-injury cases.

Even inheritances can be subject to up to 40% Federal Estate Tax or US Income Tax in some circumstances.

Once you know how much you have to work with, you can move on to the next rule.

Rule # 2 – Payoff “The Man”. You’ll probably have no shortage of folks approaching you with “opportunities” to invest or spend your newfound wealth. It’s fine to listen, but the only truly guaranteed returns that are absolutely risk free and tax free are to pay off your debts. Let’s say you have a $250,000 mortgage with 20 years left at 4%. Paying that off today would save you $113,588 in interest over the life of the loan.

What you were paying each month can then be thought of as extra income that can be applied to other saving or spending goals. In the above example, that would be somewhere around $18,000 a year in payments you no longer would be making.

In addition, paying off debt should lead to less stress and other psychological benefits, such as not feeling like an indentured servant of the bank or other lender.

Rule # 3 – Endow yourself. When you hear about a school or hospital receiving a huge gift, typically the money is invested in an endowment to produce income that the entity then uses for their needs. This can also prove an effective strategy for an individual if they treat their windfall as an endowment and only use the earnings to supplement their lifestyle.

The National Endowment for Financial Education cites research estimating that 70% of people who suddenly receive a large sum of money will exhaust it within a few years. Lack of financial experience and discipline can likely be attributed in many of these failures.

Let’s look at this Saturday’s lottery as an example of how your “endowment” may work. If you play your lucky numbers and all six are selected (a 1 out of 25,827,165 chance), you would have about $2,307,280 after taxes to work with if you elect the lump sum. I modeled a 60% stock and 40% bond portfolio (fairly typical for an endowment asset allocation) in my financial planning software MoneyGuidePro®.

Withdrawing 4% a year ($92,291) adjusted annually for 2.5% inflation projects a successful outcome in 73% of the simulations over 30 year periods. In addition to the income, the best case scenario showed $13,630,703 left in your account at the end of 30 years, worst case is $0 in 18 years.  

A 73% chance of success may not be a slam dunk but versus a 70% chance of failure, it doesn’t sound so bad. Good luck in this week’s Lotto!

How to Fill a Hole in the Water - Rent a Boat

Photo by muffinn

“If we could sell our experiences for what they cost us, we'd all be millionaires,” is a great quote from Abigail Van Buren of “Dear Abby” fame. Nowhere is that more true than with our personal finances. Whether it was running up a credit card balance in college, buying internet stocks in January of 2000, or building a swimming pool, I have learned my fair share of lessons that have cost a small fortune. One of those lessons that I probably got off with pretty cheaply was as a high school kid in small town Texas.

There were four seasons in my corner of the world. Football Season, Duck Season, Baseball Season, and Lake Season were our versions of fall, winter, spring, and summer. Both Duck Season and Lake Season required one of two things: a boat or a friend with a boat.

When I was 17 years old, I decided I was going to be the friend with a boat, so I bought a used 14 foot aluminum john boat, trailer, and motor for about $1000.

I was very proud of my purchase and initially used the boat as often as possible. With use comes wear and tear, and pretty soon I had to pay a mechanic a couple hundred dollars to repair a problem with the motor. Then there was the blowout on the trailer that required a new tire. Then I bent the propeller on an underwater stump. It seemed there was always something that needed fixing. There were also annual registration costs, storage fees, and just regular maintenance.

All of those expenses easily added up to as much as I had originally spent on the boat over the following five years. To make matters worse, I found myself using the craft less and less as life got in the way. Finally, as I was about to graduate college, I sold the boat for about half of what I had paid for it.

I was reminded of this lesson recently as I was speaking to a friend about what he was going to do with some unplanned wealth, a settlement he was receiving from a lawsuit. He told me that he had always wanted to own a boat and that he was going buy a brand new one. “Life’s too short not to enjoy it,” he said.

“Unless life’s too long to enjoy because you’re broke,” I thought to myself. Instead, I asked him if he would mind if I did a comparison of the cost of owning the new boat vs renting one whenever he wanted to hit the lake. He agreed to hear me out.

First, I looked at boat ownership. The ski boat he was looking at cost about $100,000. The amount of depreciation can vary, but 10% a year seems to be a good conservative estimate after perusing area new and used boat listings. Further, I assumed annual ownership costs (maintenance, repairs, storage, registration, insurance, etc) at 10% of the purchase price, or $10,000 per year. I left out gas and taxes from my analysis, because I figured they would have similar impacts to both scenarios.

Over 10 years, the boat purchase price of $100,000, plus ownership expenses of $100,000, minus the future depreciated sales value of $34,868 at the end of the period, equals a total out of pocket cost of $165,132 ($100,000 + $100,00 - $34,868).

Next, I checked out the US Coast Guard 2012 National Recreational Boating Survey. There I learned that the average power boat user uses their vessel 12 times a year for 6 hours per boating day. Then I conducted a very unscientific survey of several Austin and Houston area marinas to see what it costs to rent a nice ski boat for an hour. The average was close enough to $100 an hour to use that for my analysis.

I took the same $100,000 the boat owner used for his purchase and modeled putting the money in a ladder of certificates of deposit. I checked rates on Nerdwallet and it looks reasonable to assume that you could structure the ladder to earn around 2%.

If you rent a boat 12 days per year for the average of 6 hours per day at $100 per hour, you would spend $7200 in annual rental expenses. I calculated the future value of $100,000 earning 2% with annual distributions of $7200, which would leave $43,061 in the bank after 10 years. That’s a net rental cost of $56,939.

Some folks say “a boat is a hole in the water into which you pour money.” In this example, my friend would save $108,193 by renting a boat instead of buying over a 10 year period.

That would fill a pretty big hole.  How big? US currency bills are 2.61 inches wide x 6.14 inches long x .0043 inches thick, so that equates to about 7,455 cubic inches.

That’s 32 gallons of dollar bills, more than a drop in the bucket!

Annuities – Hammers and Nails

Photo by Justin Baeder

“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail,” said the famous psychologist, Abraham Maslow in his book The Psychology of Science. He was referencing drug treatments for certain mental illnesses, but could have just as easily been referring to annuity salespeople. Prominent personal finance writers frequently rail against the inappropriate use of these products. There are even advisory firms that market their services by explaining why they “hate” annuities.

Why all the fuss? If insurance companies only offered straightforward annuities such as I describe below, there probably wouldn’t be much controversy. It’s the myriad of options and marketing tactics that confuse people as to what they are getting or what they may be paying for it. Today, I’d like to discuss the basic form of annuities and provide an example of where they MAY be used appropriately.

Annuities have been around since the Roman Empire. Even the word annuity is derived from the Latin word, “annua” which referred to contracts that made annual payments. Annuities, in their basic form referred to as immediate annuities, still offer a contract that trades a lump sum of cash for a stream of payments that can last for specific periods of time or even for a lifetime. Insurance companies use a combination of actuarial calculations and current interest rates to determine how much they are willing to pay out. Immediate annuities are most commonly used to provide an income similar to what a pension plan may offer, to payout certain judicial settlements, or just to spread out payments over a period of time.

For comparison sake, an investor can and should shop insurance companies of similar credit quality and compare payouts to determine where the best deal may be.  This is a fairly straightforward concept and represents a viable solution when an investor needs to provide for expenses that are non-negotiable, such as food and shelter.

The big tradeoff for receiving this guaranteed income stream is lack of liquidity. The downside of which can be observed on daytime television as actors or even opera singers implore you to call if you need “cash now” for your annuity or structured settlement. You can bet that the lump sum payment they offer someone willing to trade for their future payments will be at a significant discount, which is why you should only put money into one of these products for income that you can’t afford to do without.

For an example of where an immediate annuity may be attractive, let’s consider a 65 year old retiree with a $1,000,000 retirement account. Let’s say the retiree wants $40,000 a year, or 4%, of income from his account, and that half of that amount is needed for essential expenses.

Option 1: According to my financial planning program MoneyGuidePro®, a 65 year old man could invest in a balanced portfolio of 60% stocks and 40% bonds and have a 68% probability of success of withdrawing 4% per year adjusted for 2% inflation for a life expectancy to age 90. In other words, in 32% of the simulations, our investor would run out of money by age 90.

Option 2: According to Fidelity Investments Guaranteed Income Estimator, the same retiree could generate a lifetime income of $20,000 per year with a 2% inflation annual adjustment, for $381,769 in an immediate annuity. He would then have $618,231 left to invest in the same balanced portfolio, but would only need to withdraw 3.2% to generate the additional $20,000. The probability of success increases to a 90% chance through age 90.

The catches are that when he dies, the $381,769 goes to the insurance company or if he needed additional funds for current needs, he would likely be offered much less than his original investment in a lump sum. If he gets hit by a bus tomorrow, the insurance company wins. If he lives past his actuarial life expectancy, he wins. Pretty straightforward and simple. Additional guarantees can be bought to insure the payouts last for a specific period of time or for beneficiaries to continue to receive the income if the original recipient dies, but the costs of those guarantees may make the comparison less compelling.

Where does it get complex? When marketers start trying to take this simple concept and make it appear that you can get a free lunch. There are a myriad of annuity types that aren’t simple nor are they straightforward. If you want a taste of just how complex these products can be, try doing a web search with the terms “FINRA” and “Annuity”.

What they virtually ALL have in common is complexity, additional fees, and that they are not bought by investors. Instead, they are SOLD to investors. Keep that in mind if you are pitched one of these products next time you mention to your banker or broker that interest rates are low or that tax rates are too high.

If you would like to review your situation to see what your odds of success currently look like, please contact me to schedule an appointment.