5 Time value of money example from the real world
“A bird in the hand is worth two in the bush” is a phrase that almost everyone knows. On the surface, this proverb is about the risk of giving up something sure for the chance of something better that might or might not happen. But this old saying hides an important financial idea: the Time Value of Money (TVM).
Like with the bird-in-hand analogy, TVM recognizes that a dollar in hand today is worth more than a dollar promised later.
Inflation devalues the dollar over time, as we discussed in our prior column.
Nevertheless, “opportunity cost” suggests that a dollar spent on something productive today is worth more than a dollar in the future. On the other hand, investors who are willing to put off spending expect to be rewarded in the long run.
Economists and financial analysts often “discount” a stream of future payments by an implied interest rate to estimate their value in today’s dollars. This helps them compare things that are similar. Even though this is not a hard exercise, it is not obvious to the average person, so many people have trouble with real-world problems that are basically TVM problems. Here are a few examples:
Buyouts of pensions
Pensions used to be a big part of middle-class retirements, but employers are trying to get rid of long-term liabilities, so pensions are becoming less common. This is causing a wave of people to buy out their pensions. Workers are offered a lump-sum payment instead of the monthly checks they were promised for the rest of their lives. If they’re sick or broke, some workers may choose the lump-sum option, but it’s usually a lousy deal.
It is always less than the nominal amount of their pension payment and sometimes less than their annuity stream.
The Social Security system
Depending on birth year, the Social Security Administration allows “FRA” retirement between 66 and 67.
It also lets retirees start receiving benefits at a lesser rate at 62 or wait until 70. By waiting, you earn “deferral credits,” which make the monthly payments bigger for the rest of your life. In theory, all of these choices have the same value at the moment (based on actuarial average life expectancy). Since the annual deferral credit is big (around 8% on average), putting off Social Security makes more sense for more and more retirees in today’s low-interest rate environment, even though most people don’t understand why.
Lottery Prizes
Mega-lottery jackpots get a lot of attention, but the winners usually only get a small portion of the nominal prize. The reason for this is that most winners choose the lump sum payout instead of the 30-year annuity. Behavioral bias is almost certainly to blame for some of this (a lottery jackpot is the very definition of “found money”). There are also tax and estate planning issues that could make some people decide to take the lump sum. Most winners, though, would be better off in the long run if they chose the annuity.
Auto Financing
Customers often get a variety of deals when they buy a car from a dealer. Most of the time, you can choose between a cash rebate at the time of purchase or financing with no interest. The dealer may have mixed feelings about these incentives because they are meant to appeal to different types of customers. This makes the pool of possible buyers bigger. But if a customer has enough money to buy a new car with cash or get a loan, there is usually a clear right answer.
Contributions to a 401k
The magic of compound interest is that it basically just makes TVM work for you. If you start saving regularly when you are young, it will be much easier to reach your retirement savings goal. With the same annual expenditure, you can accomplish a higher objective with more time.
But, delaying retirement savings means saving faster later on to catch up.
Money’s time value example What is time value of money example
