What would you do if you were offered a choice of £1m today or £1,000 a week, tax-free for the rest of your life?

This was exactly the conundrum facing 18 year-old Charlie Lagarde, from the province of Quebec, when she won the Canadian lottery recently. Well, almost – her choice was between C$1m (about £550,000) or C$1,000 tax-free a week.

After speaking to a financial adviser (Charlie is clearly a very sensible teenager) she opted for the income option rather than the lump sum. But was she right? And what retirement planning lessons can we learn?

KEY CONSIDERATIONS

Whether or not Charlie made the ‘right’ decision depends on her own personal needs and circumstances. If she had significant credit card debts racking up interest or an expensive mortgage to pay off, for example, it might have made sense to take the lump sum in order to rid her of this burden.

Assuming this isn’t the case, however, it appears she has made the right call. Let’s start with the simplest example, ignoring the impact of inflation and assuming the money is stuffed in a 0% paying bank account.

In this scenario, it will take Charlie just 19 years to hit the C$1m tipping point, and if she lives until age 82 – the average life expectancy in Canada according to the World Bank – she’ll receive a total prize worth over C$3.3m by taking an income.

Even assuming average inflation of 3% steadily erodes the value of her income payments, she would still be better off in real terms by her late 40s.

Alternatively, Charlie might decide to invest all her winnings in order to protect it from the ravages of inflation and benefit from some market growth. Assuming investment returns of 5% after charges, she would again be better off taking the income prize option – but only once she reaches the age of 68. By the age of 82, she would have C$24.9m compared to C$23.8m by investing the lump sum.

‘HYPERBOLIC DISCOUNTING’

The key factor in Charlie’s case is her age – because she is so young, the weekly payments work out to be more valuable (provided she lives to somewhere near average life expectancy).

When you reach retirement, while there might be less time on your side, you should still think very carefully if you are offered the option to swap a guaranteed income stream for cash.

Let’s imagine Darren, a healthy 60 year-old steelworker with a ‘defined benefit’ pension offering a guaranteed income for life from age 65 of £10,000 a year. The pension comes with valuable inflation protection baked in too.

Darren’s former employer might offer him £100,000 in cold, hard cash to give up his pension. Many would be tempted to take such an offer because, as human beings, we often naturally prefer a smaller amount of money today over the promise of a larger amount tomorrow. This is known as ‘hyperbolic discounting’.

However, provided Darren lives into his 80s, the retirement income would be much more valuable – particularly because inflation risks eating away at the fund if he chose to cash in.

If you’re lucky enough to be in a similar position to Charlie – no matter what your age – be sure to consider the overall value of a secure income stream, and don’t make a rash decision based on the lure of a large lump of money right now.

Tom Selby, senior analyst, AJ Bell

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