Learn How to Calculate Present Value for Retirement
The term "present value" plays an important part in your retirement planning. Put in simple terms, the present value represents an amount of money you need to have in your account today, to meet a future expense, or a series of future cash outflows, given a specified rate of return.
Calculating Present Value
If you need $200,000 in your account ten years from now, the present value, or the amount you need to start with today, changes based on various assumed rates of return:
- if you earn a 3 percent return, you'll need $148,818 to start
- at 4 percent, you'll need $135,112
- if you get a 5 percent return, you only need to start with $122,782
You can do these calculations on an HP12C calculator app, or any other financial calculator app that you can download to your cellphone or tablet. You can also find financial calculators online.
Use these entries to do the calculations: n (number of periods) = 10, i (interest) = rate of return, PMT (periodic payment) = 0, FV (required future value) = $200,000. Then hit PV (present value) to solve for present value. Your present value result will be returned as a negative number since this shows the original investment you would pay into your account.
This simple present value calculation shows you that the higher the rate of return, the lower the amount needed today to fund your future expenses. This becomes a challenge in retirement planning.
To achieve a higher rate of return, you must typically choose a riskier portfolio, which means you have the chance of a higher return, with no guarantee. This seems like a dangerous way to handle your retirement savings.
If you want a future value that has more certainty, you must accept a lower rate of return, which means you'll need more savings to provide enough money for the same standard of living.
Retirement and the Unknown Time Horizon
Suppose you know that to live comfortably in retirement, you'll need $20,000 a year in addition to your Social Security income. How much do you need to save to provide the $20,000 a year? A present value calculation gives you the answer.
To do this calculation, you now have two unknown variables; the rate of return and your longevity. The table at the bottom of this article shows the respective present values taking both variables into account. In the table you see the range of results:
- If you live 20 years and can earn a 5 percent rate of return, you will need $261,706 to provide you with $20,000 a year.
- If you live 30 years and earn a 3 percent rate of return you need $403,769.
If your family and personal health history indicate you may be long-lived, you'll either need to save more or work longer than someone with a shorter life expectancy.
How to Use Present Value in Retirement Planning
Use the present value concept now to give yourself a rough idea of the amount of money you need to have saved at the start of retirement to meet your retirement spending needs. You can do this calculation and planning regardless of your age, and the younger you start, the less money you'll need to save at any interest rate because of the power of interest that compounds over the years you hold your investments.
Start by adding up your anticipated annual expenses, subtract out your anticipated fixed sources of income such as Social Security, determine how long you think you will live, and then calculate the present value of that stream of expenses.
Compare that to what you now have saved, or what you think you'll have saved by your retirement date and you'll have a rough idea of whether you're on track or not for your savings goal.
An Annuity Investment Example
Assume, for example, that you want to guarantee you'll receive $2,000 each month ($24,000 per year) in retirement on top of your Social Security income. You decide that you want a conservative investment, so you choose to invest money into an annuity that will make payments each month to you for the rest of your life once you retire.
Assume your annuity grows at a rate of 3.5 percent annually.
You would need to deposit $400,667 today (present value) in exchange for the security of your $2,000 monthly payment for life. By choosing higher-risk investments, you could earn a higher return on your money, but this deal may sound great to you if you value a low-risk investment and you anticipate you'll live a long life.
Calculating Present Value in Excel
When using a Microsoft Excel spreadsheet you can use a PV formula to do the calculations for you. The formula menu has a PV function with an interface that will ask you for the rate, total number of payments, the amount of payment, future value, and whether payments should be applied at the beginning or end of a period.
Present Value of Your Social Security Benefits
Present value calculations are the best way to compare one Social Security claiming choice to another. These online Social Security calculators use this methodology and do the calculations for you. This can help you visually see which choice is worth more to you over your expected lifetime.
Present Value of Pension Options
A present value calculation is also an effective way to compare different pension choices. If you have a long life expectancy one option may be worth more to you in terms of present value than another option. If you are married, you ought to consider joint life expectancy in your calculations.
Present Value Table with Different Time Horizons
|Present Value of $20,00 Per Year Income Stream|
|Return||20 years||25 years||30 years|