Overstated Risk Perception
The Publisher's Clearing House sweepstakes

8 Jan 2007 in Regulatory Economics

It's that time of year, again. Time for the Publisher's Clearing House sweepstakes. You may have won $10 million.

Sweepstakes are subject to extensive (and apparently ineffective) regulatory oversight by the Federal Trade Commission. Their sponsors still lure customers by overstating the risk of winning and understating the risk of participating.

These risks are financial, but they have clear parallels to human health risk assessment. Health risks are often represented in terms that significantly overstate their likely magnitude; sometimes this practice is defended on the ground that it's "better to be safe than sorry." But the same reasoning is never used to justify the risk of winning a sweepstakes. For financial risks, a "better safe than sorry" risk assessment policy would require that sweepstakes promoters, for example, severely understate the value of winning.

Typical of sweepstakes and lotteries (including lotteries operated by State governments), the actual prizes awarded by Publisher's Clearing House are significantly lower than advertised. The $10 million grand prize, for example, is actually 29 annual distributions of $225,000 and a lump-sum distribution of $3,475,000 in year 30. These details are revealed in the fine print, but you have to look for them and understand what it is you're reading.

OVERSTATING THE VALUE OF WINNING

What is the grand prize actually worth? First, it's important to recognize the obvious: given a choice between the immediate distribution of $10 million (implied by the big print) and the actual distribution (stated in the fine print), everyone would prefer the immediate lump-sum payment. So the grand prize is unambiguously worth less than the plainly advertised amount.

How much less? Assuming that you are willing to postpone this year's consumption until next year if paid 5% interest, your $10 million Publisher's clearing House prize is worth about $4.2 million. If you are old or poor -- common characteristics of people who disproportionately enter sweepstakes and lotteries -- the higher will be the interest rate you will demand to defer consumption from this year to next. At a 10% rate, the grand prize is worth a lump-sum distribution today of $2.3 million.

Second, you must pay taxes on your winnings. The first annual $225,000 distribution will push you into at least the 28% tax bracket. Depending on your "discount rate," your after-tax winnings would be about $3 million (at 5%) and $1.7 million (at 10%). (Your tax rate might decline in the later years due to indexing, or Congress might raise tax rates.)

Third, your prize is not insulated from inflation. No one knows what the rate of inflation will be for the next 30 years, but over the past 30 years the rate (as approximated by the Consumer Price Index) has varied from a low of 1.6% (in 1998 and 2002) to a high of 13.5% (in 1980). If inflation averages 3%, a dollar received 30 years from now will be worth the same as 41 cents today. At 5% inflation, that dollar is worth just 23 cents.

So if you want an inflation-adjusted 5% rate of interest to postpone consumption to next year, then you need a nominal interest rate of perhaps 7 to 10%. If you are old or poor, you might want to discount future distributions at an even higher nominal rate -- perhaps 15% or 20%. That would reduce the after-tax value of your $10 million prize to about $1.1 million (at 15% nominal) or about $820,000 (at 20% nominal).

Publishers Clearing House says your odds of winning are 1 in 330 million. We can figure out the value of entering the sweepstakes by multiplying the lump-sum values above by the reciprocal of the odds.

In short, the expected value of a sweepstakes entry is less than a penny. It will cost you 39 cents just to mail your entry. To cover the cost of the stamp, the nominal value of the sweepstakes has to be at least 78 times greater.

UNDERSTATING THE COST OF PARTICIPATING

Publishers Clearing House does not transparently reveal why they are "giving" away money. In the fine print it says if you enter the sweepstakes you are giving them permission to use your contact information to sell magazine subscriptions and anything else its "marketing partners" want to sell. That's perhaps 100 million valid snail mail and email addresses -- a valuable commodity.

Some people resist all these offers, but many do not -- otherwise, there would be no sweepstakes. By offering you an infinitesimal chance of winning, Publishers Clearing House is gambling that you won't resist their marketing efforts. By entering, you are gambling that you are more clever than they are.

RISK ASSESSMENT AND RISK PERCEPTION

Publishers Clearing House operates according to the same principles as State lottery authorities. Both disclose probabilities, but prey on superstition. Both state nominal winnings as if winners receive them up front, but they pay off in small increments over many years. They don't warn contestants of the tax implications of winning. And in both cases they have weakly or undisclosed profit motives. Sweepstakes sponsors sell products, while States supplement tax revenues with lottery proceeds. Both strive to make people perceive the benefits of risk to be much greater than they really are, and get them to act on their beliefs rather than on the facts.

In health risk assessment, government regulatory agencies often assume the worst about environmental hazards and report unusually unlikely exposure scenarios. Understandably, people interpret what they are told to mean that the consequences of environmental risk are much greater than they actually are. You might be the one in 330 million people who is actually harmed.

Or you might win the Publishers Clearing House sweepstakes.

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