Present value is a term that is important to your retirement planning. Put in simple terms, present value is the amount of money you need in an account today, to meet a future expense, or a series of future cash outflows, given an assumed rate of return.
○ How you calculate present value
If you need $200,000 ten years from now, below is the present value based on various assumed rates of return:
• 3% $148,818
• 4% $135,112
• 5% $122,782
(I did these calculations on an hp12C calculator app that I use on my iPhone and iPad. Entries to do this are: n = 10, i = rate of return, PMT = 0, FV = $200,000. Then hit PV to solve for present value.)
This simple present value calculation shows you that the higher the rate of return, the lower the amount needed today to fund the future expense. This is a challenge in retirement planning; in order to achieve a higher rate of return you must typically choose a riskier portfolio, which means the higher return is possible, but not certain.
If you want something with more certainty, you must accept a lower rate of return, which means more savings are required to deliver the same standard of living.
○ Gets even trickier in retirement due to an unknown time horizon
Suppose you know you in retirement that in order to live comfortably you will need $20,000 a year in addition to your Social Security income.
How much will you need to save to provide the $20,000 a year? A present value calculation gives you the answer.
To do this calculation, there are now two unknown variables; the rate of return and your longevity. In the table at the bottom of this article are the respective present values taking both variables into account.
In the table you see that:
• If you live 20 years and can earn a 5% rate of return, you will need $261,706 to provide you with $20,000 a year.
• If you live 30 years and earn a 3% rate of return you need $403,769.
If your family and personal health history indicates you may be long-lived, you'll either need to save more or work longer than someone with a shorter life expectancy.
○ How to use present value in retirement planning
Present value can be used to give you a rough idea of the amount you need to have saved at the start of retirement to meet your spending needs. You would add up your anticipated annual expenses, subtract out your anticipated fixed sources of income such as Social Security, determine how long you think you will live, and then calculate the present value of that stream of expenses. Compare that to what you now have saved, or what you think you'll have saved by your retirement date and you'll have a rough idea of whether you're on track or not.
You can also use present value calculations to make choices about risk.
For example, assume you are a single female, age 65 and you need $20,000 a year ($1,666 a month) for life. Using the quote system at immediateannuity.com you can see that right now (April 2016) it will cost you about $320,000 to provide $1,666 of monthly income for life in the form of an annuity.
In this example you can compare that to the present values in the table at the bottom of the article.
Is $320,000 for $20,000 a year a good deal? It depends. If you live long, and don't want investment risk then it's a pretty good deal!
○ Calculating present value in Excel
When using an Excel spreadsheet you can use the PV formula to do the calculations for you. The formula tool will ask you for the rate, total number of payments, amount of payment, future value, and whether payments should be applied at the beginning or end of a period.
○ Present value of your Social Security benefits
Present value calculations are the best way to compare one Social Security claiming choice to another.
These online Social Security calculators use this methodology and do the calculations for you. This can help you visually see which choice is worth more to you over your expected lifetime.
○ Present value of pension options
A present value calculation is also an effective way to compare different pension choices. If you have a long life expectancy one option may be worth more to you in terms of present value than another option. If you are married, you ought to consider joint life expectancy in your calculations. On Financial Architects website, in the spreadsheets section of their Resources page, you'll see a spreadsheet titled "Pension Options Analysis Spreadsheet". It uses present value and will also factor in life expectancy probabilities to help you compare pension options.