This is a topic that should be understood by everyone who is serious about financial matters. We usually understand the time value of money in two contexts: the growth rate of an investment, and the inflation rate.
To conceptualize this, sketch out a timeline of your life. At the leftmost point is your date of birth. The rightmost point is your date of death. In between, mark your retirement date, and today’s date. If you are not yet retired, then the time value of an investment pertains to you in particular.
Let’s look at investment growth rates. Say you want to project out your IRA balance over the next 10 years, assuming an 8% rate of return, compounded monthly. Your current balance is $250,000, and you are depositing $300/month – less than what is permissible by law. I make the following entries on my HP12-C calculator:
Present value: -$250,000
Time (or number of compounding periods): 120 (10 years * 12 months/year)
The result: $609,793.87
The future value of that investment, then, is nearly $610K. The calculation is linear – it assumes that each dividend received and each dollar of interest received from the investment portfolio is invested at 8%. It assumes that the underlying securities prices will increase by 8% evenly each year over 10 years. Is this a useful calculation, then? Yes, by all means – it is a place to start. Knowing that market returns are never a straight line on a graph, but rather a jagged one, perhaps over time an 8% average is a fairly useful number to use for projections. Indeed, over the past 25 years the return on the S&P 500 (a portfolio of 100% stocks) has averaged around 10%.
Back to the timeline you conceptualized above, what is important if you’re to the right of your retirement date? You want to pay attention to both the time value of money pertaining to investment growth as well as to inflation.
The retiree’s biggest risk is, of course, running out of money. That unhappy circumstance would have to do with various factors: rates of return on investment, inflation rate, rates of spending, and so on.
Let’s consider where a retiree is vulnerable to inflation. If you go into retirement with a mortgage, that monthly payment won’t change, unless you have a variable rate mortgage. What will change? Gasoline, groceries, health insurance premiums, Rx costs – in short, many things. Here’s a personal example: when I was in college, I purchased gas for $.259/gallon. This morning, driving to the office, I see gas is now $2.179/gallon. Over 42 years, this is an increase of 5.2%. Pretty stiff – and prices have recently dropped significantly. Did you ever image paying nearly $5 for a loaf of bread? The clear implication here for the retiree is this: Will your income keep up with inflating prices on the things and services you need to purchase over the next 30 years? Anyone retiring today at age 65 could easily have a 30 year retirement ahead of him, if not longer! That is a long time for investments to work.
This is where financial planning is key. Once you retire, your investments are earning (one hopes) and being depleted at the same time, as you drawn down the balance for living expenses. The word to the wise here is to factor in an appropriate inflation rate, and be very careful and intentional with one’s planning.