Thursday, August 7, 2008

Gambling for savings

We all agree that playing the lottery is a very poor way to save for retirement. One can rationalize it under some circumstances, but it is generally frowned upon. It turns out that 40 percent of UK citizens play a lottery to save for retirement. And this is encouraged by the government.

They invest in Premium Bonds, a financial vehicle known around the world as lottery-linked savings (LLS). LLS programs are especially popular among low-income households and, in the case of developing economies, with people outside the banking system. How do they work? Bonds are issued that yield a rather normal return, but periodically a lottery is drawn among all bonds yielding some additional return, sometimes substantial. So it is like buying a bond and a lottery with the same ticket.

Do people who buy LLS bonds buy them for the savings or for the gambling? Peter Tufano answers this question by using time series of Premium Bond sales in the UK, comparing them to various betting schemes, other ways of saving, economic activity and marginal tax rates (PB winnings are not taxable). The outcome: the size of the largest prize matters, even though it represents only 2% of the expected return. PB sales respond positively to overall gambling activity, but also to relative yields with other financial vehicles. But the terms of the PBs do not affect their redemption, indicating that they are mostly a regular savings vehicle.

Are LLS bonds a good way to introduce low-income households to savings? The British experience seems to indicate so. But they are prohibited in many countries, including the Unites States, as they violate lottery laws.

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