5 Real-World Time Value of Money Problems
Nearly everyone is familiar with the expression "A bird in hand is worth two in the bush." On its face, this proverb conveys the risk of exchanging a sure thing for the uncertain prospect of something better. But underlying this time-tested truism is a core concept of finance: The Time Value of Money (TVM).
As with the bird-in-hand analogy, TVM recognizes a simple truth: that a dollar in hand today is worth more than a dollar promised on some future date. One important reason, as covered in our last blog post, is the long-term impact of inflation in eroding a dollar's purchasing power. But there is also an element of what economists call "opportunity cost"—a dollar put to productive use today will be worth more than a dollar in the future. Alternatively, investors willing to forego current consumption expect an eventual reward for their fiscal restraint.
To make an apples-to-apples comparison, economists and financial analysts commonly "discount" a stream of future payments by an implied interest rate to approximate its value in today's dollars. While not a complicated exercise, neither is it intuitive for the layperson, so many people struggle with real-world examples of what are essentially TVM problems. Here are just a few:
Historically a cornerstone of middle-class retirements, pensions are becoming rarer as employers look to shed long-term liabilities. This is leading to a wave of pension buyouts. Workers are offered a lump-sum payment in place of their promised lifetime stream of monthly retirement checks. While the lump-sum option may appeal to some workers (particularly those in poor health or with limited savings), it is frequently a bad deal. It invariably represents a discount to the nominal value of their pension benefit and, in some cases, a discount to the annuity stream's present value.
The Social Security Administration deems full retirement age "FRA" between 66 and 67 years old (depending on an individual's birth year). It also permits retirees to claim benefits as early as age 62 at a reduced rate or postpone benefits until age 70. Delaying earns "deferral credits," which increase the size of the monthly payments for life. Theoretically, all of these options have the same present value (based on actuarial average life expectancy). Since the annual deferral credit is large (roughly 8% on average), postponing Social Security makes more sense in today's low-interest rates environment for an increasing number of retirees (even if that's not intuitive to most).
Mega-lottery jackpots grab headlines, but the actual amounts paid to winners are typically a fraction of nominal prize. The reason is that a large proportion of winners opt for the discounted lump sum payout instead of a 30-year annuity. Part of this is undoubtedly the result of behavioral bias (a lottery jackpot is the very definition of "found money"). Moreover, there are tax and estate planning considerations that could sway some people toward the lump sum option. For most winners, though, the annuity would be better for their financial health in the long run.
Auto dealers commonly offer an array of purchase incentives to customers. A typical scenario is a choice between a cash rebate at purchase or no-interest financing. The dealer may be ambivalent between these incentives—they are designed to appeal to different customer niches, broadening the pool of potential buyers. But for the customer who has the resources to either pay cash or finance a new car, there is usually a clear right answer.
The wonder of compound interest is basically just TVM working in your favor. It's much easier to reach your retirement nest egg goal if you start making regular contributions at a young age. Giving your investments more time to compound means that you can reach a much higher endpoint with the same annual contributions. Conversely, procrastinating on retirement saving obligates you to save much more aggressively in later years, to catch up.
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