Living Economics

Most credit card users don't think too much about paying 15% annual interest on their overdue credit card balance. But if they won a $2 million lottery that pays $200,000 a year for 10 years and cashed it for a lump sum payment of only $1 million, they might think that they had been taken to the cleaner. A whopping "50% discount" over the sum of all future payments. Yet, the present value of a constant annual future payments of $200,000 over 10 years at 15% annual interest rate is about $1 million.

Converting future payments into present value always generates disbelief in how big the "discount" is. Even at an annual interest rate of 9%, the "discount" amounts to 36%. The "big discount" results from the fact that distant future payments are worth a lot less when they are discounted into the present even at very reasonable interest rate.

This disbelief is turned into a marketing dream when an initial outlay of $1 million can be advertised as a $2 million prize. Similarly, an accident victim might be mollified a lot easier if the insurer commits to pay a much bigger damages spread over a number of years than a much smaller lump sum that is discounted from future payments. Indeed, there is a thriving business in selling streams of annual payments (i.e., annuities) to insurers to cover insured accident victims. Because these so-called structured settlements might also encourage prudent spending behavior, payments have been tax-exempted in the U.S.

When factoring companies started buying these annual payments from accident victims for lump sum cash, they have been subjected to venomous attacks from insurers and structured settlement brokers. Horror stories of accident victims made destitute after soon exhausting their lump sum cash appeared on newspaper front pages. Interest rates used to discount these annual payments were alleged to have been 30% to 40%. State legislatures and the U.S. Congress were clamouring to pass laws to regulate such factoring practices. It is not clear whether the legislators acted out of their paternalistic impulse or to mollify the lobbying efforts from the $40 billion industry of structured settlement sellers.

Suppose the discount rates had been more reasonable, what would be the objection against recipients of structured settlements selling them to the factoring companies? A predictable stream of future payments may not always match the time profile of finanical needs of the recipients. It is perfectly understandable that some settlement payment recipient might occasionally need a lump sum to get over some financial humps. Is converting future settlement payments into current cash any different from getting a car loan? Both cases involve borrowing from future income streams. The only financial difference is the type of collateral used. In the case of cashing in future payments, the assured future payments serve as collateral. In the case of car payments with uncertain future borrower income, the collateral is the car itself.

Unless we think that accident victims are inherently more short-sighted and less self-restraining than a typical car buyer. In hindsight, most people regret their past decisions and wish that they had done things differently, including car buyers. That accident victims are reported to regret having sold their settment payments is not an indictment against borrowing from the future.