How to understand present value

After running a report, the first page of the detailed reports is the Lifetime Balance Sheet.

This balance sheet is showing the present value of the sources of lifetime income and lifetime spending. What follows explains this concept of "present value."

The total lifetime amounts are the discounted present value of the annual amounts and will always be less than the simple sum of all the undiscounted annual amounts.

"Discounting" means to make less of. And that's exactly what present value discounting does. It reduces the reported amounts you will get in the future because getting money, say $1,000, in the future is not worth as much as having that $1,000 today. If you had the $1,000 today, you could invest it and end up with more than $1,000 in the future. Hence, $1,000 today is worth more than $1,000 in the future. Or stated the other way around, getting $1,000 in the future is worth less than getting $1,000 today.

The need to discount future dollars arises even when there is no inflation. Again, getting $1,000, say, in 30 years is worth less than receiving the $1,000 today and being able to invest it.

The purpose of discounting is to enable an apples-to-apples comparison of a series of future amounts that are received in different years. Neglecting to discount and simply adding up undiscounted dollar amounts is the same as assuming you can't earn a return on investing, which is clearly not the case.

For example, $1,000 today, in current year dollars can be invested and will grow to $1,338 current year dollars in 30 years if the real rate of return is 0.976% ($1000*1.00976^30=$1,338). So even though the purchasing power of a constant current year dollar is the same in 30 years as it is now, you will have 338 more dollars of current purchasing power 30 years in the future.

In our software you can modify our assumed values for the rate of inflation and the nominal rate of return. Our software calculates the real rate of return from these entries. For example, if inflation is 2.5% and the nominal rate of return is 3.5%, then the real rate of return is (1.035/1.025 - 1)*100% = 0.976%.

The present value of an amount x years from now is the amount /(1+r)^x, where r is [(1+i)/(1+p)-1] (r is the real rate of discount, i is the nominal rate of return you enter, and p is the inflation rate you enter).

See Time Value of Money on Wikipedia or any basic economic/finance website or book for more background.