I recall a conversation with a former colleague of mine, a sports fan like I am, talking about a $500,000 bonus that a former collegiate sports coach had lost based on violating terms of his contract. We were both shaking our heads, each of us having a hard time understanding how someone could basically just throw away this kind of money with a simple mistake.
My former colleague then made a comment to the effect of: “If you had $500,000, you might be able to retire.” This comment surprised me, as he was generally very bright guy, good at his work and a very sensible, level-headed person. The reason this was surprising to me is that he was in his late 30’s, with a family, and felt that he might be able to retire on that amount. Mind you, this means retire with no pension to supplement – just the $500,000 principal.
Intrigued, I asked him how this would work. He was someone who watched his expenses, like me, so I expected an answer based on extreme penny pinching. Rather, he told me that one could earn 10% in the stock market, and then would have $50,000 per year coming to them. Not bad as retirement income, passive income nonetheless, he said.
Of course, I had to jump in with my own feedback. Sure, 10% each year could happen, but the market would be up and down, so it isn’t a reliable way to earn a steady amount passively. That said, even if you had some investment that paid at that rate, you would have to pay taxes, have transaction costs, etc.
When I told him that his $50,000 would buy him less and less every year, he didn’t get it. The biggest thing he seemed to miss was the time value of money: a dollar today is worth more than a dollar tomorrow.
I didn’t get into a full discussion with him, but if I could go back and continue the conversation, I would tell him about the concept of PV – present value. PV = the value of future cash flow in today’s purchasing power. The calculation is as follows:
C / (1+I)^T
C = cash payment
I = inflation rate
T = Time – years into the future
In explaining the concept, I would illustrate with the following example:
Lets say you had $50,000 due to you. Which way would you like to receive it – all up front, in equal $5,000 installments for 10 years, or all at the end of 10 years? No reinvestment, compounding, etc. Just straight cash payments. Inflation rate is 3%. Let us examine the PV of each scenario.
Scenario 1 – All up front. PV is $50,000.
Scenario 2 – $5,000 at the end of every year, for ten years. PV is $42,651.
Scenario 3 – $50,000 at the end of the 10th year. PV is $37,205.
Clearly, getting the money up front is a better deal. Why? The time value of money – a dollar today is worth more than the same dollar tomorrow.
So, when my former colleague does his retirement planning, and projects what his needs will be in the future, lets hope he considers the impact of time on the value of his money. We should all do so.
Do you ever think of the time value of money in this way, where the purchasing power today is greater than it will be in the future?
How do you apply this concept to your finances?