How do we account for the time value of money?

In future financial planning, one of the smallest single pieces of data can have an outsized impact on the forecasts for how much the planning client will need to accomplish any or all of her/his goals.  This number is the discount rate, which determines the time value of money within the plan.  As we all know, a dollar today is worth more than a dollar next year, which is worth more than a dollar 5 years from now, which is worth way more than a dollar thirty years from now.  There are two main reasons why this is so.  First, with rare exceptions, the cost of goods and services always rise over time.  Think about how much you had to put into a vending machine to get a can of soda when you were a kid and compare that to what you pay now.  The inflation factor is much more prominent for big ticket items such as houses, education, and health care.  Second, the future is uncertain.  If I buy my dream (insert name of item) today, I can enjoy it.  If I wait to buy it, something might happen to prevent me from enjoying it.  It might be discontinued.  If it is limited or rare, it might sell out or become fully unavailable.  I might develop a condition that prevents me from fully enjoying it or in the very extreme, I might die before I buy it.  To take into account this difference between the value of today’s dollars and the value of future dollars, we “discount” future dollars.  As a result, we always assume you will need more—sometimes much more—money to obtain future goods and services. 

And that discount factor can make a very large difference.  For example, let’s suppose that I want to treat myself to a sports car when I retire in 20 years.  The cost of the car today is $100,000.  If inflation—which we use as the discount rate—holds steady at 2.5%, then the cost of my future car will be almost $165,000 in 20 years.  But if inflation averages more like 4%, the cost of my future car will be over $222,000 by that future time.  Of course, I don’t need a sports car, so I could always look for a less expensive retirement gift to myself if my future finances would not stretch that far.  But what about expenses that we really have to cover such as housing, health care, and long-term care?  Not only does the discount rate have an equally large impact on these necessary expenses, but also their costs tend to rise faster than the average.  Most of my clients have an additional concern, which is that they are planning to cover expenses for a child or adult child with a disability.  This makes the time horizon over which the discount rate is applied much longer, which amplifies its impact.

So, we know that things will be more expensive in the future, but we do not know by how much.  How do we make a reliable forecast of how many future dollars the family will need, particularly the younger generation?  First, we set a reasonable rate for base inflation.  We can do that by using historical figures and also by understanding that the Federal Reserve uses monetary policy to target a long-term inflation rate of around 2%.  To be on the conservative side, we may set base inflation in our models at 2.5% or 2.75%.  Then, most planning software allows the planner to adjust the inflation rate for categories of expenses or even for individual expense items.  Historically, the costs for higher education and health care, for example, have risen in excess of the inflation rate for most other expenses.  So, as a second level of precaution, we will increase the inflation rate for expenses that we expect to increase in excess of base inflation.  Using these techniques, we ensure that we do not underestimate future costs.

When we talk about the time value of money, there is the other side of the coin.  To cover future costs, we have future income streams, and we have assets set aside for future use that, if invested, will have grown by the time the family needs them.  Here, too, we need to be careful about what rates of growth we build into the plan.  For example, if the adults who are doing the plan are still working, they may reasonably expect that their wages or salaries will go up over time.  At the same time, we do not want to overestimate future earned income.  Even if the clients have been with an employer for a long time and experiences regular raises, we might want to use a lower rate than they had been receiving.  Certain future income, such as a pension or annuity, might provide definite forecasts of expected future income based on the plan rules but even there, we might want to adjust downward just a little.  As for assets, which grow by being invested and generating interest, dividends, or capital gains, we might use historical numbers for those returns but adjust them downwards in the model in order to be more conservative.  We would also take into account that many people invest in higher-risk/higher-return assets when they are in the accumulation phase of their plan, pre-retirement, and then transfer their assets into more stable lower-risk/lower-return portfolios when they retire.   Thus, we might adjust rates of growth downward again at a specific future date. 

The time value of money is an important variable in financial planning.  It is especially important for families that include a person with a disability in the second  generation, because the time horizon covers two lifespans.  There is no one right answer to the question of how fast expenses will grow over time or how much money one will need to accomplish a certain future financial goal, such as funding a Supplemental Needs Trust.  The most effective approach is a conservative one that assumes higher rates of cost increase and lower rates of asset growth than their respective historical averages.  That way, surprises that come will be on the upside.