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What Does Present Value Mean?

A reader writes in, asking:

“I’ve recently been using different Social Security calculators to compare claiming strategies. I’ve read that they calculate the ‘net present value’ of benefits received. What exactly does that mean?”

The concept of present value falls under the broader topic of “time value of money.” The idea of time value of money is one that people know intuitively: you would rather receive a dollar today than a dollar at some point in the future. The primary reason why you would (usually) prefer to receive a given amount of money now rather than the same amount of money at some point in the future is that, if you had the dollar today, you could invest it and start earning a return immediately.

The concept of present value asks: what is the value today of a certain amount of money at some point in the future? For example, how much would you be willing to pay today for $100 one year from now?

We answer that question by first figuring out a “discount rate,” which is the rate of return we give up by not having the money available today. For example, if we could safely earn a 3% return over the next year, then our “discount rate” would be 3%. This means that the present value of $100 one year from now would be $100 ÷ 1.03, or $97.09.

For many people, the concept of present value is easier to understand in reverse. In our example, $97.09 is the present value of $100 one year from now, because if we grow $97.09 by 3% for one year (i.e., we multiply it by 1.03) we get $100. So we would be indifferent between having $97.09 today or $100 one year from now.

And, using the same 3% discount rate, what would be the present value of $100 two years from now? It would be calculated as $100 ÷ 1.03^2, or $94.26. (And we can confirm that this figure is correct, because if we grow $94.26 by 3% for the first year and by another 3% for the second year, we do indeed get $100.)

Present Value of a Series of Cash Flows

We can also use the present value concept to calculate the present value of a series of cash flows. For example, what is the present value of an annuity that pays you $10,000 per year for the next 20 years? We would answer that question by calculating the present value of $10,000 one year from now, the present value of $10,000 two years from now, and so on all the way up to 20 years in the future. Then we would add all of those present values together.

And that’s what Social Security calculators are doing. They’re using data about mortality to calculate the present value of the stream of cash flows that you would likely receive with strategy A, and comparing that to the present value of the stream of cash flows that you would likely receive with strategy B.

So What Does Net Present Value Mean?

The net present value of an investment/strategy is the sum of the present values of all of the cash flows received, minus the sum of the present values of all of the cash outflows. In the case of Social Security claiming strategies, however, there are no relevant cash outflows. That is, the cash outflows are the Social Security payroll taxes you pay over the course of your career in order to qualify for a benefit, but those taxes are the same regardless of which claiming strategy you use, so we do not need to include them in an analysis that compares claiming strategies.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: More 401(k) Lawsuits

Over the last couple of weeks, lawsuits have been filed against a whole list of retirement plan sponsors. As Morningstar’s John Rekenthaler explains, the plans being targeted are not the worst plans around. In fact, they’re better than average. So why are these plans being targeted? And should we expect the lawsuits to result in any improvement for the employees in question — or the industry in general?

Other Money-Related Articles

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Raising the Social Security Retirement Age

A reader writes in, asking:

I just got laid off at age 58. I know people are saying it’s best to wait until 70 for SS, but I don’t think I’ll be able to do that. I know my savings can make it to 62, and once SS starts that will be enough to cover my cost of living. But I’ve read about politicians wanting to raise the SS retirement age to 68, and I don’t know what I’ll be able to do if that happens. How likely do you think that is?

Firstly, every proposal I’ve read for increasing the Social Security full retirement age would only affect people who are many years away from being able to claim benefits. People who are closer to being able to claim benefits would be unaffected.

More importantly though: Raising the Social Security retirement age would not mean you have to wait longer to claim benefits.

Every proposal I’ve seen on the matter is a proposal to increase the “full retirement age,” not the age at which a person can first claim benefits. In short, an increase in the full retirement age is simply an across-the-board cut in benefits for anybody affected — regardless of the age at which they claim.

The reason an increase in full retirement age is the same as a cut in benefits is that the amount of your monthly benefit check depends on how the age at which you claimed benefits compares to your full retirement age. For example, if you claim retirement benefits at 62 with a full retirement age of 67, you would be claiming 5 years early, meaning you would get 70% of your “primary insurance amount” (PIA). But if you claimed at age 62 with a full retirement age of 68, you would be claiming 6 years early, meaning you would get 65% of your primary insurance amount.

Similarly, if you claim benefits at age 70 with a full retirement age 0f 67, you would receive 124% of your primary insurance amount, because you waited three years beyond your full retirement age (with each year earning credits worth 8% of your PIA). But if you claim at age 70 with a full retirement age of 68, you would only be claiming two years past your full retirement age, meaning you would only get 116% of your PIA.

In short, if a person’s full retirement age were increased from 67 to 68, she would still be able to claim benefits at any age between 62 and 70. The difference is that she would receive 6-8% less per month than she would have received if her FRA had not been bumped upward by a year.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."

Investing Blog Roundup: How Often Do Tactical Allocation Funds Succeed?

Tactical asset allocation is the strategy of moving between various asset classes (e.g., from stocks to bonds or vice versa) in an attempt to outperform a simple static asset allocation.

This week, Luke Delorme takes a look at the performance of tactical asset allocation mutual funds to see how frequently they outperform a low-cost balanced fund (specifically, Vanguard’s Balanced Index Fund).

Investing Articles

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How Do Interest Rates and Dividend Yields Affect Asset Location?

For many years, the conventional wisdom with asset location has been that, if you have to hold some investments in taxable accounts (as opposed to being able to keep everything in retirement accounts), it’s better to hold stocks rather than bonds in the taxable account, given the favorable tax treatment of qualified dividends and long-term capital gains.

This conventional wisdom overlooks the fact that tax efficiency depends not only on the tax rate you would have to pay on the income generated, but also on the amount of income generated.

As an extreme example: If you own 1-month Treasury bills, yes, they generate interest that is fully taxable at the federal level, but the amount of that interest is so small that the total return lost to taxes will actually be quite low.

Calculating Expected Tax Costs

When deciding which fund(s) you will hold in your taxable account, it can be helpful to calculate the approximate tax cost for each of your various holdings.

For example, if you live in Missouri and you’re in the 25% federal tax bracket and 6% state tax bracket:

  • Ordinary interest income would be taxable at a 25% federal tax rate and 6% state tax rate,
  • Treasury bond interest would be taxable at a 25% federal tax rate but untaxed at the state level, and
  • Qualified dividends and long-term capital gains would be taxed at a 15% federal tax rate and 6% state tax rate.

So, we can use that information to get a rough estimate of the tax cost you would likely incur as a result of holding various funds in a taxable account.

In other words, the stock fund will probably result in a higher tax cost than either of the Treasury funds, and that’s not even including the eventual capital gains tax that you will (probably) owe on price appreciation for the stock fund.

Figuring out a ballpark estimate of the tax cost for something like Vanguard Total Bond Market Index Fund is a bit trickier, because approximately 40% of the fund is invested in Treasury bonds (which aren’t taxed at the state level), while the rest of the fund is invested in bonds that are taxed at the state level. The fund currently has an SEC yield of 1.74%. We can multiply 40% of that yield by a tax rate of 25% and the remaining 60% of that yield by a tax rate of 31% to determine that the fund would have a tax cost of very roughly 0.50%. But this understates the cost somewhat because the Treasury bonds account for less than 40% of the yield despite being 40% of the portfolio.

In short, the idea that stocks are more tax-efficient than bonds is only sometimes true. It depends which bonds and which stocks we’re talking about. And it depends on whether interest rates (and dividend yields) are currently high or low. With interest rates as low as they are right now, bonds are more tax-efficient than they would otherwise be. And as you can see above, some taxpayers will find that certain taxable bond funds are currently more tax-efficient than stock funds.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Investing Blog Roundup: Even CFPs Make Mistakes

To make progress in any field, it’s critical to learn from your mistakes. Even better: learning from somebody else’s mistakes. This week, author and financial planner Allan Roth shares several of his biggest financial mistakes, and lessons he learned from them.

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