Freakonomics Radio - 12. Is America Ready for a "No-Lose Lottery"?

Episode Date: November 17, 2010

For the most part, Americans don't like the simple, boring act of putting money in a savings account. We do, however, love to play the lottery. So what if you combined the two, creating a new kind of savings account with a lottery payout?

There's something Peter Tufano wants to know about you. If you had to, could you come up with $2,000 in 30 days? That's the question he asked a whole bunch of people in 13 countries, including the U.S. Why $2,000? Because an auto transmission is about $1,500. Most estimates of what everyday emergencies are about are in that order of magnitude. If you were to have a sick or ailing relative on the other side of the country and you had to buy full price plane tickets, it could easily be that amount. And then why this language come up with as opposed to save, because what we wanted to see if people had access to resources between savings and credit

and friends and family. And about half of Americans are not able to come up with $2,000 in 30 days, which means that they stand only one emergency or crisis away from really quite dire circumstances. This isn't picked up in the national economic statistics. This is picked up at a much more local level, at a much more intimate level at what happens inside families. It's this lack of savings, as it were, that motivates me. Tufano is all about the motivation. He's a professor at Harvard Business School. One of his specialties is consumer finance.

He wants to know how many checks you write and for what, how much you borrow and why, and what you spend on beer, on toys, or on lottery tickets. A couple singles just lying in my pocket. I never lose more than $200. spend on beer, on toys, or on lottery tickets? A couple singles just lying in my pocket. I never lose more than $200. I'm going to win. From American Public Media and WNYC, this is Freakonomics Radio.

Today, America's sad savings rate may have met its match. If you like the lottery, we've got a bank account for you. Here's your host, Stephen Dubner. Americans are generally terrible at saving money. Think about what Peter Tufano just said. Half our country doesn't have enough money in the bank to survive one breakdown. And it's not just people who don't earn a lot of money. Tufano found that more than 20% of the households earning more than $150,000 a year couldn't come up with that $2,000 in 30 days. We are, however, excellent at spending money. Houses, cars, clothes, books,

electronics, and lottery tickets. Households that play the lottery spend, on average, about $1,000 a year on tickets. That's more than a typical household spends in grocery stores on dairy products and beer combined. This year, Americans will buy about $60 billion worth of lottery tickets. The other day, I went to a store at Penn Station in New York called Carlton Cards. It's pretty big. In the back, there are rack upon rack of greeting cards and some candy bins. But there weren't any customers back there. All the customers were jammed up front at the lottery counters. According to the New York State Lottery, Carlton Cards sells more lottery tickets than any other store in New York. Kareet Prajabadi is one of the managers. I asked him, how much lottery revenue does his store take in in a year?

It's about eight to nine in in a year? It's about $8 to $9 million a year. Holy crap! $8 to $9 million a year in lottery sales in one store in Penn Station? Yes. Okay, you see people buying tickets all day. You see winners a lot. Tell me how excited they are when they win. When they win, they forget about all those losses

and they get excited like they win something. Whatever they lose, they just care about their win. They give you a hug? They give you a kiss? Not really. Just handshake probably sometimes. That's probably all. You really probably don't want the hugger. No, not really. When I was in graduate school, there was a local little store by my graduate student housing unit,

and I would stop there on the way home and pick up milk and orange juice and notice lots of people buying lottery tickets. This is Melissa Carney. She teaches economics at the University of Maryland. And so I just sort of started chatting with the vendor and he said, oh, I have people coming in spending hundreds, thousands of dollars on lottery tickets a month, a year. And so being a graduate student, I just downloaded some data and started playing around and was struck in particular people do spend a lot of money buying lottery tickets. And so it was just sort of a passing curiosity, really, I started wondering about

what were they not buying in order to buy lottery tickets. So let's walk through some of the numbers on lottery gambling. In the U.S., how many people play the lottery? Half of U.S. adults surveyed say they play the lottery at some point in the past year. And would that make it the most popular form of gambling in the U.S.? Yeah, so by far. So two out of three American adults report gambling, and it's 50% say they play lottery. The next closest is casino, which is about one in five adults. Why do so many people play the lottery? Because it's fun. For a dollar or two,

you buy the chance to dream big. This remarkable bargain illustrates a phenomenon, a probabilistic oddity that economists call skewness. That's the idea that there's some big prize way out there that corresponds to a very small odd, but there's some potential of capturing that. And that's what your typical money market account can't give you. So you can have $1,500 in your money market account, and every month you might earn, you know, a dollar on it. But there's no chance in every month will you earn $100,000 or even $10,000. Now, I know as an economist, you're not trained to answer this question. But as a human being, tell me, why is skewness so important to us?

That's the chance of changing your life, right? That's the return, you know, that's the big win outcome that might allow you to buy a beach house or, you know, to send your kids to college, you know, or if it's less far out in the distribution, that might be what you need to make a down payment on a house or buy a car or throw your daughter the wedding you want to throw her. For a lot of people, skewness has an irresistible appeal. And so a handful of researchers like Melissa Carney are trying to harness its power, the unlikely chance of changing your life with a big prize in order to solve America's low savings rate. The idea is a new financial product that combines the thrill of the lottery with the goal of, say, accumulating more than $2,000 in a savings account so that a broken transmission doesn't become a full-blown crisis. Here's Carney's pitch.

So we know Americans like gambling. They always have. The majority of them do it, and they're going to keep doing it. And so what we do is take seriously the idea that people want some small chance of winning a large sum of money. That market, that asset is missing from the American landscape. Low wealth individuals, the only asset available to them that gives them some chance of accumulating a large amount of money is the state lottery. And in fact, a recent national survey of 1,000 adults, one in five American adults said their greatest chance of accumulating hundreds of thousands of dollars was through the lottery. That number jumps to 40% for folks making less than $25,000 a year. So a lot of Americans think the lottery is their only chance at winning big sums of money.

Why don't we take that appetite for gambling, for a product like this, and attach it to a savings vehicle that offers some positive return? It's a win-win situation. That win-win situation and the chance to make it happen in the U.S. has generated a lot of enthusiasm among economists like Carney and Peter Tufano, the Harvard Business School professor we heard from earlier. He's the man who's been researching what are called prize-linked savings, or PLS, all over the world. I started in the UK because they have a product called Premium Bonds, which has been around for about 50 years, a little bit more, and where the government offers a savings product to investors,

which at first glance would look almost perverse. Give us your money and we promise you no interest. But that's not quite how the program works because it's give us your money, you can take your money out at any time. And each month, we're going to take basically the interest pool and we're going to lottery it off so that one lucky person will become a millionaire. And literally every month, someone in Britain gets a knock on their door from Mr. Millionaire who tells them that they've won the million pound prize. There are, I believe, over 100,000 other people in the UK who find that they've learned smaller prizes. This was an intriguing concept. And so the research that I'd done tried to understand, was this more like gambling or savings?

Bottom line, it's both. Then this travel took me to South Africa where I met Robert Kipe, and he was creating a product called Mama, the million-a-month account. And I think in a word or in a phrase, he described the entire economics and in some sense the value proposition for savers quite simply, everything to gain, nothing to lose. It's a savings account where you can take your money out when you'd like. You always have access to your principal, and it will never go down in value. You may come out with a little bit of interest or you may come out with a little bit of a payment. You may come out with a remarkably large payment, but you can only go up and you can never go down. And then in respect to the extensive work on behavioral economics and behavioral finance, the logic of this product

is quite obvious. People have what's called loss aversion. They much prefer to protect against losses than to worry about gains. They tend to misestimate small probabilities. But when you put it all together in very plain English, people would rather have a small chance at a life-changing payout than an almost certainty of a pittance. So I can be guaranteed in this interest rate environment to put my money away and maybe be able to buy a coffee with the amount of interest that might come off a $100 account. Whereas I'm willing to say I'll give up that interest, but there's some possibility, remote as it might be, that I might be able to have a life-changing payout, an amount

that would allow me to buy a car or a house or even more. So this preference for highly skewed payoffs or the kind of payoffs that would normally be present in gambling or lottery products, when combined with savings, turned out to be tremendously effective around the world. But it was completely absent for legal reasons in the United States. So what are those legal reasons? As Tofano discovered, state law typically prohibits something like a prize-linked savings account because it's a lottery. And according to state laws, the only legal lottery is a lottery that's run by the state itself. Nice monopoly if you can get it, right? Now, you can hardly blame states for keeping lotteries to themselves. They generate billions in revenues. And so while most states

might like to help their citizens save more money, they might not be willing to pit their own lotteries against ones that might be run by, say, a bank. Ooh, loo, loo, loo, loo, if life is just a gamble, gamble if you want to win. Ooh, loo, loo, loo, loo, life is just a gamble. Peter Tufano's research into prize-linked savings programs around the world convinced him that the idea could help Americans, particularly low-income Americans, increase their frighteningly low savings rate. The lottery aspect made it illegal in most states, but in Michigan, there was a loophole. Last year, Stefano got a group of credit unions to pilot the idea. Here's Dave Adams, CEO of the Michigan Credit Union League. You know, banking can actually be pretty boring. It's not like we go to social events and talk

about how much we're saving and talk about a great new feature on our new checking account. Banking services are pretty mundane. So what people want and need is a fun way to save. And in Michigan, we've come up with what we think will accomplish that. It's a program called Save to Win. And what it is, is it's using a lottery concept so that for every $25 they put into one of these one-year certificates of deposit, they're going to get a chance at cash prizes. And the cash prizes are given out every month by participating credit unions ranging from $50 to $500. And then there's a grand prize at the end of the year, an opportunity to win a $100,000 grand prize. So Save to Win gives people what they need, which is they need to save more while giving them what they want, which is a fun way to do it, a game of chance that makes it interesting to save.

Something that you will want to talk about at a party. Say, hey, I won 100 grand. Exactly. So you're making savings sexy by introducing a lottery element. I think so. I don't know if it's so far as to say that it's sexy, but it's certainly far better than talking about the 0.5% that I'm getting on my savings account at the bank. So now you're getting a competitive interest rate. You're doing what you know you need to do, which is to be more responsible in the way that you save and plan for the future. But gee, you're getting a chance at some of these cash prizes, including a chance at $100,000 cash prize.

And the odds of winning are much better than what you would see if you were buying lotto tickets. Even with a sputtering economy and low interest rates, a handful of credit unions in Michigan opened 15,000 new savings accounts. Save to Win surveyed some of these customers. More than 60% of them had spent money on the lottery or gambling in the previous six months. 55% had had no savings plan. Save to Win was beating its goals, reaching the customers it was supposed to reach.

It makes you wonder, what would happen if a program like this took over an entire country? Well, my name is Robert Cape. I worked at First National Bank for 11 years where I headed up the investment product house, which was a business unit that really focused on retail deposits, both consumer and corporate deposits. And our focus was trying to look at ways of growing the funding base of the bank. First National Bank, or FNB, is in South Africa. In 2005, it started what would turn out to be a phenomenally successful prize-linked savings program. It was born out of South Africa's financial problems as the country struggled to put the apartheid era behind it. Millions and millions of black South Africans

did not use banks for anything. Robert Cape wanted to find a way to get some of them in the door. Now, in South Africa, because so much of the population is unbanked, so much of the population is unbanked. So much of the savings are literally sitting on the mattresses. Now, this has got a double effect. The one that it does really do badly at is it removes that funding from the mainstream banking environment. So it can't be harnessed to lend out and fund economic growth because retail funding tends to come in from consumers and then get lent out to businesses who can then create jobs. So that was the one problem.

And the second problem was really that these people with the money under their bank accounts were excluded from the banking system. And by being excluded from the banking system, you miss out on so many benefits, which really help with people's individual development. For example, developing credit records, being able to be less exposed to having your money stolen or lost on the way home. But Cape's bank had a problem. Interest rates at the time weren't keeping up with inflation. So putting your money in a plain old savings account might actually erode its value. Cape's job was to make it worthwhile for customers to deposit new money.

So instead of simply offering an account with a scrawny interest rate, he'd offer an account with practically no interest rate at all, but it came with the chance for a really big payday. So what we did, we literally pooled all of these little 0.25% of interest. And then what we did, we paid out that interest in lump sums to a few people. So we paid out 150 people a month in lump sum prizes. So the first prize would be a million rand, which is an enormous amount of money in South Africa. And then there were three prizes of 100,000 rand. And then we went down to 20,000 rand and a few prizes of 1,000 rand.

So really what we did, we just collected the little bits of interest that would be paid on all these little accounts, and then paid it out randomly to a few select lucky winners. So let's say I live in South Africa. I take the money I'm earning and put it under my mattress or maybe buy some high-risk equities. You're offering me the security of a bank account and the excitement of a chance to win a million rand, right? What do you call this idea? We call it the million a month account. Mama. And Mama became the trivial name for it. And you're the man who gave birth to Mama. Yes. How successful was Mama? Hugely. Probably too successful for its own good.

Mama attracted more than a million new customers to Capes Bank. Other banks in South Africa took note, and they complained to regulators. And then Capes Bank heard from someone else, the South African National Lottery. Well, we engaged with them before we launched. We wrote to them and asked them their opinion on the product. They wrote us a letter back

saying that they didn't think it was a lottery. They thought it fell into a promotional competition part of the legislation and that suggested that we just comply with the requirements of the promotional competition. We launched and then nothing

was heard from them for six or so months. And then they contacted us to say, actually, they don't like what we're doing and they think that it's a lottery now. So when you were starting out and there was very little money in your coffers, they thought it wasn't a lottery. But then after it got going for a while and you had how much, a couple hundred million dollars? About $200 million by the time we closed down. But more importantly, it was over a million customers that we had brought in. And the National Lottery Board changed its mind then.

It thought, oh, that thing that we said a little while ago was not a lottery now looks a lot like a lottery. Yes. And what did they do then? Well, we first engaged with them and tried to discuss it, but it was very clear that they were in no position or not wanting to even try to discuss what the issues were. And so they took us to court to have us closed down.

Hugh Malamdewitz is the man who took Mama to court. He's the lawyer who represented the South African National Lottery. Malamduitz argued that First National Bank's Mama program infringed upon the state lottery's right to be the only game in town. The case went all the way up to South Africa's Supreme Court of Appeals, and Malamduitz won every time. Hugh, you must be very good. I can't answer that, sir.

Now, when Mama was created, about 70% of low-income South Africans were said to be unbanked. The government was eager to cut this number. Mama made it easy to get people in the bank. All they had to do was deposit a minimum of 100 rand, or $15 into a 32-day call account or what we'd call a certificate of deposit. So what's wrong with that? Well, I suppose it is an inducement to bank, but for the period in which your money is deposited in the bank, you do not receive any interest. South Africa has a relatively high interest rate. Part of the motivation around the account was it was touted as being a no-cost account, which was correct, but also there was no interest earned. And South Africa, on a 32-day call account, your interest rate is fairly substantial. So for the days when your money wasn't, you weren't earning any interest whilst it was sitting in the bank account and the bank

was earning substantial sums. I think the idea was that it was driven towards the unbanked and hence the minimum amount of 100 Rand. But realistically, substantial amounts were being deposited into accounts with the chance of effecting the million Rand return. Now, how successful was the savings plan run by FNB in actually drawing in money from either the previously unbanked or citizens at large? How much money did they take in, in what period of time? Well, there was substantial money taken in, not necessarily from the unbanked or citizens at large? How much money did they take in? In what period of time? Well, there was substantial money taken in, not necessarily from the unbanked.

My understanding is that substantial funds came from their regular customers and really the customers who had sufficient means that they had the essentially free money sitting around that they could afford to put aside for the 32 days without effecting any return or any real return. So my understanding is that the funds were deposited not predominantly by the unbanked, but really predominantly by the banked and then I would, predominantly by the more wealthy customers.

The return that the bank made was fairly substantial. Malamduits' argument seems a bit at odds with itself. He says the bank took advantage of people by failing to give them a high interest rate, but also that most people who bought into Mama weren't the unbanked, that they were wealthier customers who had, as he puts it, free money sitting around. Well, if they want to play the bank's lottery with that money instead of the national lottery, why shouldn't they be free to choose? But Malamduitz was doing his job, protecting the interests of his client, the national lottery,

and it worked. Mama was shut down. Robert Cape, the man who created Mama at First National Bank, stands by its success. He says the excitement of the lottery payout got people in the door so fast that the cost of acquiring a new bank customer fell from $300 to $5. But that was Mama's goal in the first place, to expand banking. Cape says 20% of Mama accounts were opened by people who were previously unbanked. Sure, it wasn't the majority, but Mama reached that level in just the first three years. And it took in more than $200 million in deposits.

Last year, after Mama was shut down by the national lottery, Robert Cape was invited to Washington, D.C. to talk to federal banking officials about the program's success. On the next Freakonomics Radio, we take the idea of prize-linked savings to the lottery officials of America. They don't like it so much. From a purely lottery perspective, I think the Florida lottery is the only entity in Florida that can operate a lottery game. So I've got to say that it probably sounds illegal under current Florida law. And one of the first no-lose lottery winners in America describes how winning and saving feels. I don't know because I was stunned.

That's next time on Freakonomics Radio. Whoever thought a story about savings accounts could be so exciting? Freakonomics Radio is a co-production of WNYC, American Public Media, and Dubner Productions. You can find more audio at FreakonomicsRadio.com. And as always, if you want to read more about the hidden side of everything, go to the Freakonomics blog at NYTimes.com.