The New York Lottery is proposing a gamble where the odds aren't always in its favor — moving its $1.3 billion prize fund into investments such as stocks, corporate bonds, real estate and hedge funds and out of the safety of U.S. Treasuries.

If the agency were to double its annual return to 8 percent as it projects, the prize would be $37 million more for state coffers as New York grapples with a record $13 billion budget deficit next year. Losses might reduce proceeds that fund education, said Gordon Medenica, the lottery's director.

New York would be the first state lottery among the 20 largest to shift to pension fund-style investments from Treasuries, according to annual reports. Treasury bond yields have fallen to near record lows as investors seek safety amid the global credit crunch.

"To get an 8 percent return, you have got to accept a lot of volatility and recognize that in some years you will have losses," said Michael Wright, an adviser to pension funds and endowments at New York-based Buck Consultants. The investment change should be gradual, spread over several years, he said.

The switch might allow the lottery to reduce the lump-sum payments it makes available to certain winners in lieu of full jackpots, which are paid in installments. Losses wouldn't reduce prizes, which are set by state law as a percentage of wagers. New York's is the biggest state lottery. Last year, it took in $7.55 billion and generated $2.56 billion for schools.

"We're not going to be wild and crazy with investments," Medenica said. He wants "solid investments, like a pension fund or endowment," that would earn more for the state.

'Almost Not Smart'

Recent market volatility, as reflected by a 35 percent drop in the Standard & Poor's 500 Index over the past year, may limit initial returns and slow the shift from Treasuries, "but over the long term it still makes sense," the lottery director said.

Medenica, 57, declined to specify the portfolio he'd like to see. The legislation that would allow the change doesn't spell out the investments that would be permitted.

The New York Lottery, like others nationwide, currently avoids risk by holding Treasury bonds to maturity, then redeeming them to pay annual prize installments, its annual report says.

"That's a belt-and-suspenders policy that is conservative up to the point of being almost not smart," said Medenica, who was appointed by former Governor Eliot Spitzer in October 2007.

Medenica, who holds a master's degree in business administration from Harvard University in Cambridge, Massachusetts and is a former strategic planner at the New York Times Co., said the idea for the change was "kicking around for a long time" before he was briefed on lottery investments by his deputy director for operations, Gardner Gurney.

Pension Fund Lost

Until New York Governor David Paterson, a Democrat, issued all-points bulletins to state bureaucrats last year for help shrinking the budget gap, "no one had really pushed to get the change," he said.

The projected 8 percent return is the same as the rate that New York's state pension fund assumes for planning. That fund's performance has varied widely. It lost 21 percent of its value in the nine months ended Dec. 31, shrinking to $121.7 billion. Its 7.2 percent average annual return from interest, dividends and price changes over the past 10 years includes a 10.2 percent loss in 2003 and 28.8 percent gain in 2004, according to its annual reports.

Jackpot winners who opt for lesser, one-time payouts instead of annual installments could lose out from an investment overhaul. About 90 percent of winners now take lump sums, because they assume they can earn higher returns than Treasury bond yields, Medenica said. Reducing the lump-sum amounts "could be a way we could make more money for education," he said.

Treasury Yields Down

That change is unlikely to reduce demand, said lottery player Phil Charte, a furniture maker in Cambridge, New York.

"Sure, I want a bigger prize," he said after buying two tickets at $1 each. "But if I win $30 million, it won't break my heart if the cash prize is $18 million instead of 20."

The lump sums equal the cost of the zero-coupon Treasuries the lottery buys to earn each annual installment paid over 20 or 26 years. The bonds, known as Strips, pay their face value at maturity and sell at a discount, which determines their yield.

Strips due in one year yield about 0.54 percent. That's down from a 3.87 percent weekly average for the 10 years before Sept. 21, 2007, when the Federal Reserve began reducing rates. Twenty- year Strips are at 4.15 percent, down from 5.46 percent for the 10-year period. Their name is an acronym for Separate Trading of Registered Interest and Principal of Securities.

No Changes Elsewhere

"When Treasury yields were higher, lump sum awards used to be about 50 percent of the jackpot," said David Gale, a spokesman for the North American Association of State and Provincial Lotteries based in Geneva, Ohio. Now "it takes more money to annuitize the jackpot amount."

One-time payments have averaged about two-thirds of prize amounts recently. The award for a Feb. 10 MegaMillions drawing is advertised at $47.4 million, or 64.9 percent of the $73 million prize total, down from 66.3 percent at a Jan. 27 drawing, when Treasury bond yields were lower.

John Musgrave, the North American lottery association's president and director of the West Virginia lottery, said he wasn't aware of any states besides New York seeking to change investment policies.

Approval Likely

Some states, including Massachusetts and New Jersey, buy insurance company annuities and Treasury bonds to make annual prize payments, while others, such as Connecticut and Pennsylvania, use annuities only, according to annual reports and interviews. Michigan has authority to make pension fund-type investments, though in practice it sticks to Treasuries.

Lawmakers in New York said the proposal hasn't attracted opposition and is likely to be approved.

"They can do better than Treasury bonds and still stay with very safe investments," said Assemblyman J. Gary Pretlow of Mount Vernon, chairman of the Racing and Wagering Committee, which oversees the lottery. Pretlow said the lottery should avoid stocks.

If the changes are approved, the lottery will first choose an adviser to help evaluate its options and then hire a manager to make the investments.

Thanks to Jazi76 for the tip.