Having a million dollars would be great, wouldn’t it?
Yes, of course it would be! For most of us, it’s not likely that we’re making that annually, but it’s possible that we might eventually save that much. Financial independence would be ours!
Or not.
It’s always interesting to me how we read about the amount of money one could have, if you just saved X amount per year and earned Y percent rate of return. I do these calculations too, and have included such analyses here on Squirrelers as well.
The catch – which I regularly point out – is the time value of money. Why is it that we don’t read more about this? In my MBA program, it was one of the more basic, useful concepts that I learned early on. A dollar today is worth more than a dollar tomorrow, except when there’s deflation – which we don’t want of course.
Example:
Let’s say that someone is saving for a goal of becoming a millionaire in the next 5 years. If this is a realistic goal for you, that’s fantastic. Assuming 3% inflation, that million dollars in 5 years will equal $862,608 in today’s dollars. So, that original million dollars will be able to buy about $862,608 of goods based on today’s prices.
Calculation: $1,000,000 / (1.03) ^5
Fair enough.
The thing is, the further your time horizon, the lower the purchasing power of that future $1 million becomes. Expanding the timeframe further, and keeping the same 3% discount rate, we can see this illustrated more clearly:
Present Value today of $1 million in 10 years = $744,094
Present Value today of $1 million in 20 years = $553,676
Present Value today of $1 million in 30 years = $411,987
All nice sums of money, but not the $1 million windfall that would meet the eye without discounting back these sums at 3%.
I really think that the concept of purchasing power, and how it erodes over time, is a basic fundamental of personal finance and planning for the future. People need to plan accordingly in terms of income, savings, and rates of return, in order to be able to plan for the future. My perception is that the average person out there does not think about this concept when planning for the future.
Of course, many people do absolutely no planning for the future in the first place, which is not good. We know better, being personal finance enthusiasts, whether we’re bloggers or not.
Questions for You:
At what point did the light bulb go on for you, when you realized the need to base future retirement funds on the purchasing power of the time at which you plan to retire?
Do you think that this is something that the average citizen out there really even considers?
For me it was much more simplistic. I know there is no way in hell I can save all the money I need for retirement during my last few years of working. In addition to that, I also know that I have no idea if I’ll even be able bodied by that time to be able to save. What if I get sick and injured.
The only thing I know for sure is that I’m working now and I best save some of that money for later…just in case. Perhaps it’s just that I don’t trust my future self because I don’t know what kind of life and/or hardships she may be going through. I’m always more likely to bet on the sure thing and for now, that’s saving the money I’m earning now. The compound interest thing was never a driver because that’s also a bit unpredictable.
First Gen – At a simple level, saving as much as one can as early in life as possible – due to health and skills – is a smart idea. The compounding part makes it imperative.
So you’re saying if we live long enough we will all eventually become millionaire due to inflation. 🙂
I always knew about inflation, but the light bulb didn’t really go on until recently. I’ve been investing and saving for a long time, but now I know that’s not enough. That’s why I am getting more into real estate investment. The inflation helps with mortgage and also the rent. Of course, there are risks, but I still think now is a good time to get into real estate.
retirebyforty – well, maybe we will be millionaires, though a million won’t likely have the same cache (or purchasing power) well into the future. Diversification is a good thing, and as far as real estate – it’s better to buy once the bubble burst, isn’t it? I just wonder if the bubble will still keep deflating a bit. We’ll see.
I don’t think most people think in these terms because it would make the reality of a million dollar retirement (if not more) next to impossible.
Evan – Yes, I don’t think most people don’t think in such terms. Maybe the fantasy of millions is better than the reality of how purchasing power decreases over time. Or, maybe the whole concept of time value of money is a foreign concept to some.
Can’t go wrong with NPV. Good example of a timely lesson. A million bucks isn’t what it used to be 🙂
Barb – you’re right about that, a million isn’t what it once was. And it will be worth even less in future! Of course, most of us would still like a million today 🙂
The time value of money is also accounted for when you win the lottery jackpot. Here in California, you can choose on how you are going to be paid: annual payments or one lump sum. The lump sum is so much less than the jackpot prize because they have discounted it due to the time value of money. As an example, if you win the jackpot prize of $1,000,000, you can elect to receive $50,000 for 20 years or just $750,000 (not the real amount but is used as an example) lump sum.
Spruce – First, it would be great to have that decision to make, wouldn’t it? Second, it’s amazing how folks everywhere think they’re being ripped off by getting “less” money up front.
Ah, always a fun topic to consider. To have the same spending power as one million dollars today, I’ve set as an informal goal my personal desire to be worth at least four million by the time I hit 65 (in 37 years). That should (emphasis, should) provide me with enough money to invest and generate a cash flow of about $200,000 per year (the equivalent nowadays of about $50,000). Not spectacular, but enough to live a decent lifestyle. Always good to get a reminder of how high you need to set the bar so you don’t fall flat on your face.
Roger – I like the way you put that: “a reminder of how high you need to set the bar so you don’t fall flat on your face”. Without considering time value of money, less analytical plans might be destined to be on their “figurative” faces.