Motley Fool tells us about Lou Eisenberg who just seems like another Global Financial Crisis statistic: broke and living in a mobile home, supported by $250 per week in Social Security and pension payments …
… except that in 1981 Lou “won what was, at the time, the largest-ever lottery payout”, valued at $5 Million.
Now, with the 25 year inflation rate averaging around 3.25% (at least, according to my calculations), I put that at something approaching $9.5 million 2009 dollars …
… a fortune in anybody’s language!
So, what went wrong?
A number of things: for a start, Lou didn’t actually get $5 million in cash, instead he received a 20 year ‘annuity’ of $130,000 a year after tax.
Even so, that’s $250,000 a year (for 20 years!) in today’s dollars – plenty for anybody to live a very nice lifestyle … so, what went wrong?!
The article doesn’t actually say, but I’ll take a stab:
Like most lottery winners, Lou thought that he was rich and set for life, and probably started spending like it. Big mistake!
In reality, because the money is fixed and runs out after 20 years, it’s nowhere near like having $5 million in the bank: with $5 million, you would put $250k aside and pay off your debts and have a nice holiday and buy a slightly nicer car with the change.
As for the other $4.75 million, you would buy some nice income-producing real-estate for $4.5 million – keeping $250k as a buffer against ‘problems’ – and, live off whatever 75% of the rent gives you … probably something like $225k indexed for inflation for life (and, your kids and/or charities have an inflation-protected estate worth $4.5 million in 1981 and probably around $11 million today).
Now, THAT’S rich 🙂
But, Lou didn’t get $5 million … he ‘only’ got $130,000 a year for 20 years.
So, even though he didn’t know it at the time (but, he sure knows it now that it’s too late) he wasn’t even comfortable … the lottery only gave him enough – IF he planned things well enough – to stop work and live a $65k a year lifestyle!
How can that be so?
Well, for a start, the $130k a year only lasts for 20 years then stops suddenly … so, what does Lou do then?
Secondly, the $130k a year does not increase with inflation …
…. do you begin to see the problem?
You see, Lou should be looking at:
1. What is the buying power of his FUTURE $130k today?
2. And, how much of that $130k can he replace on or before the 20 years is up with passive income?
He should always aim to live off the inflation-reduced lesser of the two.
This is not terribly different from somebody who is planning to retire in 20 years, in that Lou has to use some of his current ($130k p.a.) income to produce a nest-egg large enough to support him in real-retirement (i.e. when he stops working AND the regular ‘pay checks’ stop coming in) except that Lou:
i) Does know what his final ‘salary’ will be (i.e. $130k after tax), and
ii) Doesn’t have to actually do any real ‘work’ ever again … at least, not if he had read this post in advance 🙂
So, here’s the logic that you need to apply if you win the lottery, or even if you just plan to work for the next 20 years, and haven’t actually thought about saving or investing until now:
Step 1
Estimate your final salary i.e. $130,000 (after tax) a year in 2001
Note: You should deflation-adjust that figure into ‘today’s (i.e. 1981 for Lou) dollars. At 3.25% inflation, $67,000 would have the same buying power in 1981 as $130,000 would in 2001. In other words, if Lou didn’t want to lower his standard of living over the 20 year period of his payouts, he would need to spend something less than $130k a year from 1981 onwards.
In fact, to maintain exactly the same standard of living year-upon-year (from 1981 to 2001) he should spend only $67k a year in year one and build up to $130k by year 20, giving himself a 3.25% ‘pay-rise’ each year to keep pace with inflation.
Step 2
Decide what % of your salary that you would like to spend and what % you would like to put towards your future (i.e. when the 20 years is up and your ‘salary’ abruptly stops, or when Lou’s $130k a year checks stop rolling in). Because you can’t spend all the money in the early years, anyway (see Note above), your ability to save is kind’a built in.
I suggest starting with 30% ie that means that Lou should start by spending only 30% x $130k = $39k a year of his payout checks; this is nearly half the full $67k that $130k 2009 dollars is worth in 1981, but (in Lou’s case) is necessary to make the numbers work [AJC: as will become apparent].
Before you say that $39k is paltry, remember that this is all happening in 1981, and his self-provided ‘pay-rises’ will ensure that Lou builds up to a ‘salary’ of $95k in 2009 …
… in fact, the $39k in 1981 IS $95k in 2009: not too shabby 🙂
And, Lou hasn’t lifted a finger in over 25 years!
Step 3
Start saving the balance (i.e. the other 70% in 1981) of the yearly $130k payout check; now, this is a tidy $91k in 1981 dollars (which would be like saving nearly $223k a year, in 2009 … a VERY tidy sum).
Why spend only 30% and save as much as 70% of his payouts? Because Lou has to build his own ‘retirement fund’, he has to do it all on his own, and he has only 20 years to do it in!
Let’s put him 100% into stocks and/or mutual funds [AJC: yuk] and, to be extremely conservative, I simply used the ‘guaranteed’ 20 years stock market return of 8%, to the tune of $91k invested in the first year (1981), slowly decreasing to $56k annual “top ups” by the final year (2001).
Why reducing?
Well, Lou needs those 3.25% pay increases each year to keep up with inflation, but his $130k a year total income is fixed, so something has to give … the good news is that Lou can comfortably afford to increase his spending and decrease his savings rate, IF he plans it well and does it slowly … again at that magic 3.25% annual rate. Get it?
Step 4
With all that money going into reasonably conservative investments, over the 20 years, Lou will manage to keep ‘pay-rising’ his way to a $73k annual ‘salary’ in 2001, yet still manage to build up a $4 million nest-egg!
The Rule of 20 says that even after the lottery checks stop coming, Lou should be able to comfortably live off $200k a year (indexed for inflation for life) by way of passive income generated by his investments (i.e. by a combination of dividends and/or selling a small portion of his stock holdings every year), commencing in 2001
Step 5
Instead of giving himself a sudden ‘pay-rise’ to $200k p.a. when the lottery checks stop kicking in, and the retirement nest-egg dividend checks take over, Lou can simply iterate this model by saving less than 70% of his 1981 income, until his 2001 lottery-spending closely matches his 2002-onwards Rule of 20 nest-egg payout …
… according to my figures, this actually allows him to start by saving exactly half of his first annual $130k lottery check, and spending the other half without guilt:
That’s $65k in 1981 or an annual salary of $160k (in today’s dollars) – indexed for inflation – and, for life!
So, the secret – if there is one – is to:
a) Always think in terms of paying yourself an annual ‘salary’ (whether your windfall comes in one chunk or many), and
b) Always try and live off less than you think that you can reasonably build up in passive income by the time that you need it, and
c) Apply all the other rules that I have shared on this blog, when it comes to deciding how and when (and on what) you will spend that ‘salary’.
Of course, you can always just decide to have fun, splash your money around, and retire to your trailer park, like Lou … easy come, easy go 🙂
True indeed.. Money makes money if it falls into the right hands.
I’ve got $5mil invested(in equities) and is collecting dividends yearly. With the dividends, I have been able to spend it on anything I want without worrying that the principal will be touched.
Though after this great financial crisis, I intend to have one last stab at the stock market before switching to properties forever.
AJC,
Media LOVES to jump on the lottery winners around the world who F it all up. E! has a 90 min garbage special on it, and whenever the news doesn’t have anything to report they’ll interview someone some where.
But it always makes me wonder, how many people did the right thing? How many followed your advice or decided to live very safetly ($2.5mil in Muni bonds paying 5% = $ 125/yr tax free)? Where are those stats!
Well, Lou’s problem is the same as with anyone elses that is spending everything they earn. This mindset doesn’t get fixed even you win enormous sums of money. It actually just strengthens it! They keep spending everything they have but this time just with bigger sums….ending up in the same situation: being broke.
And the planning only helps if they have their mindset for a correct approach. With the mental model where you spend all you have the planning doesn’t help.
People must learn first to finish before they can start.
@ WJ – Inflation? Over the long run, equities will outpace inflation … but, how do you deal with the rising/falling of dividends as the markets cycle?
@ Evan – Ditto. $2.5mil in INFLATION-PROTECTED Muni bonds paying 5% = $ 125/yr tax free, mebbe? 🙂
@ Kohti – “People must learn first to finish before they can start”. Nice!
I read this story about LOU, and he says he is quite happy even though he is back to living in a trailer. He has spent this money helping others(friends and neighbors) spent much on himself partying and traveling). But in your story above, I would make maybe 1 or 2 changes. I would never invest in mutual funds. they normally have too large a fee (which we all know will pretty much kill your plans for growth),so a better choice would be ETFs ,as they have lower costs and are more liquid. I would also maybe opt to invest some of that money into Real Estate,and perhaps even a business.
@ Steve – Great suggestions! And, you know I agree with you on mutual funds; I guess I should have said: “Even if you JUST invest in yukky old mutual funds …” 🙂
Dividends will keep pace with inflation.
Imagine Coca-Cola have been increasing the absolute amt of dividends paid even though the dividend yield remains the same.
Anyway, for my case, I re-invest the dividends as I do not need the money in my portfolio for another 5 years.
Like I said, once the market reaches madness, Hopefully(there’s no certainty in life much less the market), I would have doubled my money (ie, 5 mil becomes 10mil) and I hope I have the guts to take money off the table. I believe 10mil is enough for me to buy a few prime properties to live off the rental income with not as much stress as compared to being in the market.
What’s your gameplan? 🙂 I see you are actively doing JVs and buying properties. That’s why I am here to learn from you as well 🙂
@ WJ – The JV and property purchases that I am doing are more MM201 (accelerating my wealth) rather than MM301 (protecting my wealth) which was my gameplan other than for a quirk of fate … I think MM301 is yours, too, in which case you should search this blog for “MM301”, “Zvi Brodie”, and/or “Paul Grangaard” … or, just keep reading and commenting (it seems that we all have a lot to learn from somebody who has already made $5 mill., too)
Adrian,
You certainly offered a much sounder plan for Lou. If he had even bought one home and paid it off with some of his winnings he would be significantly better off today. At least he would have a place to live.
He could have afforded to do that just by being smart in the last few years he had the payouts.
-Rick Francis
@ Rick – Much sounder than ‘spend it all and then live in a trailer park on gov’t handouts’?! I guess that the point that you are making is that ANY plan would have been better than NO plan for Lou 😛
Good Analysis! I’m always amazed how saving + investing + time can provide a substantial nest egg for retirement.
@ Jeff – to be fair, he has to save 50% of his income … this works really well when you get a huge increase in income; for example:
a) winning the lottery,
b) getting your first job
… a week before either you had little to no income and now you have 50% of a LOT of income to spend. How can saving the rest be hard? 🙂
@Adrian,
I agree…after winning the lottery (or getting a substantial raise in income), it is easier to save 50%+ of your income…but I think your lesson of saving (and investing) over 20 years can be applied by almost anyone with enough will power.
I guess my question is when will inflation start to kick in. When will interest rates start to climb, 2010, 2011? I know its going to happen but when? And what is the plan of attach when it hits?
@ Chino – I would start to cheer … then, invest like crazy … because rising interest rates / inflation (within reason!) are a sign of a growing economy 🙂
Adrian, can I disagree here? While Inflation may be a sign of a growing economy, I don’t think rising interest rates are always a good sign. I believe interest rates can rise even in a weak or stable economy,especially when governments are spending like there is no tomorrow, there will be extreme pressures on interest rates .Due to extreme debt levels.
Everyone needs a spending plan (also known as a budget) that you review monthly. With $130/year he could have bought a nice income producing rental property every year and paid someone to manage it for him. Unfortunately it’s difficult to learn how to use your money to make money because there is a lot of different ways to do that.
“Unfortunately it’s difficult to learn how to use your money to make money because there is a lot of different ways to do that.”
Well put!
Which is why I tend to concentrate in this blog on giving you the tools to discern what might work for YOU best, rather than telling you how and where to put YOUR money 🙂
I’m really happy to see everyone is taking lessons from this gentleman’s situation. However, I have noticed that most point to what he could or should have done. The problem here is not what he could or should have done, cause he did what made him happy. He has no regrets about his current situation.He stated in interviews, that if he had it to do again, he may do a couple things differently, but as a whole, he has already done with the money, what he wanted. Helping others, traveling, etc, and is now happy where he is.
Everyone’s situation and dreams differ. Remember that. Yours will differ from his, so you can take lessons from this for your own dreams.
Steve,
True, you should be able to do what you want with the money as long as you are happy with it.
On the flip side, if he had done proper planning, he would have been able to do things that he is happy with for a more sustainable period than a once-off affair.
Example, Had he planned and created a sustainable passive cashflow yearly, wouldn’t he be happier every year helping people or doing the things he loved?
I think most of us here are saying , yes do what you want with your money, but take a long term view.
We are not talking about making more money. We are talking about using the money as an enabler to creating a more sustainable way of fulfilling our dreams.
wj, you have some extremely good points.And I believe this is what (at least most of us are looking for)for ourselves.
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