By: Arjun Goyal
Want to play the lottery with your Savings Account? It’s not as risky as it sounds
Let’s pose a question first. What would you rather have: a certain chance of winning $1, or a 1% chance of winning $100? The statisticians amongst you must have calculated that the expected payoff (average payoff) in both cases would be the same. Some of you may even have inferred that the decision depends on the risk profile of the individual (whether they are risk-loving or risk-averse). But people aren’t inclined to calculate expected values, or risk profiles, when assessing questions like this. I asked my roommate this question, and he immediately responded by choosing the latter. The rationale is simple: the second option gives you the opportunity to win an exponentially larger prize even if the chance to win it is low.
This is the same reasoning used by millions everyday, while buying lottery tickets. If they win, the stars have aligned, and their family wouldn’t have to work a day in their lives. If they don’t, they’ve lost a couple of bucks. The odds seem favorable, even if they realistically aren’t. Now, imagine if this psychology could be used to induce positive change, specifically in the personal finance sector. This is what prize-linked savings accounts aim to do.
What are PLSAs?
Savings accounts, in the status quo, yield no more than 0.05% on deposits. This number may be higher in other countries like India or Indonesia, but they are still extremely low. Prize-linked Savings Accounts (PLSAs) put a twist on this by using the effective interest rate in a different way. Rather than allocating interest to each account holder based on a percentage of their deposits, banks pool the interest that would be given out into prize bundles. Then, they enter each account holder into a raffle, with the number of tokens for each holder depending on their deposit in the savings account. A draw is made and the winners of the raffles are allocated to the prize bundle that have been formed with the pooled interest. To make this clearer, let’s give an example. You have $10,000 in your PLSA, and your friend has $20,000 in theirs. Let’s say that the scheme both of you have enrolled in entitle you to 1 raffle ticket per $50 held in your respective accounts. This would enter 200 tickets in your name and 400 tickets in your friend’s name. Then, the standard procedure of a raffle is conducted, and the winners are awarded the pooled interest from all accounts in the scheme.
It seems quite counterintuitive to think that anyone would want to enroll themselves in this form of a program. Why would anyone forgo a sure interest gain to enter into a lottery where there is a minuscule chance of them winning a prize? The answer to this lies in the same reasoning that makes humans choose the second option in the first problem I posed above. It is deep rooted in the study of behaviour.
Why does it work?
One of the first reasons people would enroll in programs like PLSAs or lotteries would be due to the availability effect. What this entails is that since there is the availability of a large prize and how certain lucky individuals have won it in the past, people have an unrealistic assumption that they are going to win it. They ignore the fact that when these lucky individuals won the prize, there were millions who did not win the prize.
This fallacy contributes to the near-miss effect. The near-miss effect occurs when an individual does not win the prize. With the notion of an unrealistic probability of winning, they think that even though they lost in this turn, there is a good chance that they will win the prize the next time they enroll. They ‘just missed’ winning the prize, and they will have better luck next time.
The most important part of behavioural psychology that PLSAs tap into is the notion of loss aversion. PLSAs present themselves as alternatives to lotteries, with one key feature: as Steven Dubner puts it, it’s a “no-lose lottery”. While a lottery loss means that one has lost their initial investment of buying the lottery tickets, a loss in the PLSA raffle does not lead to a loss of anything. All the money being deposited remains as is. To anyone this would seem like an extremely attractive offer. Why put money in a normal savings account and earn interest that is close to nothing, instead of putting your money in an account where you have a chance to perhaps buy a new TV?
How have they been implemented?
One of the first implementations of PLSAs was in South Africa. The primary objective of instituting was to increase the savings rate in the country. After publicizing this financial product, the savings rate skyrocketed, and after a while the number of PLSAs were much larger than the number of traditional savings accounts.
Other countries like Argentina, Brazil, Colombia, Iran, Japan, and Sri Lanka, have banks that provide these services. In fact, Iran it is the most widely used method of saving, since it complies with the Islamic Law stating that it is illegal to have guaranteed interest on an asset.
The US, however, have only a handful of states that have legally permitted instituting these schemes. As of now, 20 states permit banks to run PLSAs, a growing number compared to how many have permitted them in the past.
What problems have arisen?
As of now, PLSAs seem like a fairytale and the perfect banking option for anyone with cash to store. Unfortunately, the institution of this policy may not be as easy or as beneficial as it seems.
One of the fundamental issues with this policy is the effect it has on state-run lotteries. PLSAs, as called by Dubner, is a “no-lose lottery”. Why would anyone play the traditional lottery instead of enrolling in a PLSA? Sure, the payout of the lottery is much larger. However, the no-loss nature of PLSA, and much more realistic winning chances of it makes it much more attractive. It would draw a very large part of the lottery players away. This is precisely why state-lotteries have sued many banks, including the First National Bank in South Africa, and have often won. They have stated that it infringes on the law that allowsstate-sponsored bodies to run the lottery.
While they seem like the villains, they make a legitimate case for themselves. Lotteries are a large part of the revenue for the government, and drawing money away from said government revenue towards the private banking sector would severely dry this income stream. This is precisely why the law to give exclusive lottery rights to state-sponsored bodies was put in place. Moreover, if banks would be allowed to run lottery schemes like this, it may provide a precedent that might help to legalize other forms of gambling run by other institutions.
PLSAs may also enforce an exorbitant focus on saving. While this is good in countries where much of the money is out of the system (and stored in physical cash), it may not necessarily be good for the economy since it may reduce spending. A large part of economic growth is driven by consumption and spending, and in developing countries PLSAs may slow this down.
Beating a new path
Still, PLSAs seem to be the way to usher those who have been out of the financial system, into it. They have become popular around the world, and legislation is changing even in the United States in order for these to run.
The real selling point on allowing PLSAs is the effect it has on its users. After a few months of PLSAs being run in South Africa and with its surging popularity, the state sued First National Bank and successfully shut the program down. However, those who had opened PLSAs, did not pull out their money and store it in cash like they did before. They simply changed to traditional savings accounts in the same bank. PLSAs were simply a hook to get them to store their money in their bank.
In addition to this, Professor Benjamin Iverson of Northwestern Kellogg School of Management also believes that these schemes can help to beat the poverty trap. He states that the incremental interest earned on savings accounts fail to make a dent in their income, but large prizes like those from PLSAs can help them to get out of the trap.
Both of these reasons are incentives for PLSAs to run in developing countries, especially in those with abysmal savings rates. Rather than seeing PLSAs as the competition, perhaps governments can create state-sponsored PLSAs in their respective nationalized banks, which would give them the benefit of having more savings at their disposal, and perhaps increase liquidity in the financial system.
We should make the most of the no-lose nature of prize-linked savings accounts. While it may be playing games with money and minds, and have some setbacks in short run, the long-term benefits it can create would make many, many people better off.
- Account Interest Rates for Savings, Checking, CDs & IRAs. (n.d.). Retrieved February 01, 2018, from http://www.bankofamerica.com/deposits/bank-account-interest-rates/.
- Dubner, S. J. Who Could Say No to a “No-Lose Lottery”? Retrieved February 01, 2018, from http://freakonomics.com/podcast/freakonomics-radio-who-could-say-no-to-a-no-lose-lottery/
- Prize-linked savings account. (2018, January 22). Retrieved February 01, 2018, from https://en.wikipedia.org/wiki/Prize-linked_savings_account
- Based on the research of Shawn Cole, Benjamin Iverson and Peter Tufano. (n.d.). Using the Lure of a Lottery to Spur Savings. Retrieved February 01, 2018, from https://insight.kellogg.northwestern.edu/article/using-the-lure-of-a-lottery-to-spur-savings
- Kearney, M., Tufano, P., Guryan, J., & Hurst, E. (2010, October). Making Savers Winners: An Overview of Prize-Linked Savings Products (Working paper No. 16433). Retrieved February 1, 2018, from NBER website.