I was playing around with our firm’s pension tool the other day after plopping in assumptions for retirement date, assumed future salary increases and other factors, the model would return what various pension options would pay me per month. For instance, if I wanted my survivor (wife) to enjoy the same monthly income after my death, the payment’s lower than if it were payments to me alone. These numbers are all based on actuarial assumptions about life expectancy. However, what I found to be misleading, and especially so for people who don’t often think in terms of present versus future value, is that all values are quoted in future dollars. If you don’t get a pension, chances are you’ll be receiving (or at least you’re promised as of now) Social Security. These projects are also quoted in future dollars.
Future Dollar Quotations are Deceiving
The problem with quoting future obligations in future dollars is, $2,000 in 25 years is worth just a fraction in today’s dollars – so it will be woefully inadequate to live on. For this reason, looking at these dollar figures is completely futile, useless, unless you’re only a couple years from retirement (or really, receipt of funds). In order to make a meaningful assessment, you need to convert to present day dollars.
This is a simple as making an assumption on future inflation and then performing a simple excel calculation. If you want to do this on the fly, there are even tricks you can do in your head.
- Excel – There are PV, NPV and FV functions out there, but to really see how present value is calculated, it’s as simple as first identifying the inflation rate and the number of years you have in mind. If I want to know what $5,000 25 years into the future is worth at an assumed 3% inflation rate, I simply input the following equation: =5000/(1.03)^25 . The answer is $2388. Note that your future payment is worth only HALF what you were presented with on the screen. This is inflation at work.
- Rule of 72 – The rule of 72, while not perfect, is a pretty good way to determine how many years it takes for a value to double at a particular interest rate. In this case, if you assume 3% inflation, then, 72/3 = 24. In excel, this works out nicely such that (1.03)^24 = 2.03. That’s good enough for me. What it says is that every 24 years, your purchasing power will be cut in half at that given interest rate.
So, a nice rule of thumb would be that if you’re say, 22-28 years from retirement and you see a pension estimate of $4,000 a month in retirement, just realize that you’re really looking at about $2,000 in today’s dollars – ballpark.
These concepts apply to so many facets of personal finance and investing I couldn’t possibly list them here. It’s good to understand the basics because inevitably, you’ll be presented with a decision or information at some point where this would come in handy.
Do You Always Convert Back to Present Value?