The Social Security fight is gearing up. In order to engage in the discussion we need to know some basics.
This is a brief (I attempted to stifle myself) introduction of Present and Future Value calculations and how they impact the Social Security debate.
General Introduction
You can either get a dollar today or a dollar in the future. A dollar you get today is worth, well, a dollar (No Shit Sherlock, right?) Figuring out what a dollar received in the future is worth - today - is a somewhat more complicated and is what this post is all about. Present and Future Value are fundamental tools of Financial Management. They are utterly uncontroversial. Understanding and using them made Warren Buffet gazillions of dollars (Appeal to Greed.)
First some jargon:
Compounding is the arithmetical process of calculating the final value of a payment or series of payments: $100 paying 5% interest compounds at $5 per year to $105 in 12/05. Discounting is the opposite of compounding: $105 in 12/05 discounted at 5% is $100. Why two of them? THEY CAN BE TWO DIFFERENT VALUES even in the same investment! And we will see the importance of this later.
Future Value is the amount to which a dollar, or a series of payments, would grow by a given date when compounded (added) by a given interest rate. Present Value is the value, today, of a future payment or series of payments when discounted (subtracted) by a given interest rate.
The financial virtue of compounding is that your interest payments are added to the investment and receive interest payments: your money makes money off the money you made.
Just to keep things simple I'm going to assume all investments return continuous and equal dollar payments. This is a huge assumption but it makes both of our lives easier.
Ok, here we go.
The Future Value of a $1,000 investment at an assumed 12% per year (average increase in the stock market over the last 100 years) over 40 years will net you $93,050.97. Sound's good, doesn't it? BUT the Future Value is actually $18,044.24.
What the hell? Where did $75,006.73 go?
In a word: inflation. The average inflation rate over the same period of time was 4.5% per year. 4.5% of your money received did not compound. To figure the real Future Value we need to subtract the inflation rate from the compounding rate, 12%, like this: 12 - 4.5 = 7.5.
We can use this as a basis to calculate future investment returns. If we use 12% return from the stock market as the growth potential, subtract the
4.5% inflation rate plus a 1.5% management, transaction, and other expenses (including the inevitable duds) for a total of 6% net return compounded yearly.
The Future Value for every $1,000 invested per year over 40 years, compounded at 6%, you wind up with $164,047.78 total. $40,000 is the principal and $124,047.78 profit.
Here be the figures:
Year Return Year Return
40 10,285.73 20 3,207.14
39 9,703.51 19 3,025.60
38 9,154.25 18 2,854.34
37 8,636.09 17 2,692.77
36 8,147.25 16 2,540.35
35 7,686.09 15 2,396.56
34 7,251.03 14 2,260.90
33 6,840.59 13 2,132.93
32 6,453.39 12 2,012.20
31 6,088.10 11 1,898.30
30 5,743.49 10 1,790.85
29 5,418.39 9 1,689.48
28 5,111.69 8 1,593.85
27 4,822.35 7 1,503.63
26 4,549.38 6 1,418.52
25 4,291.87 5 1,338.23
24 4,048.93 4 1,262.48
23 3,819.75 3 1,191.02
22 3,603.54 2 1,123.60
21 3,399.56 1 1,060.00
Now let's assume a 3.49% inflation rate (the rate over the last 100 years)plus the 1.5% expense rate to wit: 12% - 4.99% = 7.01% and plug this into the 40 year period you get $15,030.54 for the 40th year return or a $4,744.81 better return.
Now let's look at the last 10 years. The inflation rate from 1993 to 2003 was 2.27% giving 8.23% projected return from the stock market. Now your $1,000 investment over 40 years is (TA-DAH!)
$23,667.60 or a $13,381.87 return on your investment.
What the hell? (again.)
The projected futures earnings of $10,285.73, $15,030.54, or $23,667.60 are ALL TRUE based on a future projected minus a projected inflation rate. Every single one of these figures is mathematically justifiable and based on solid historical data.
To depress you, what happens if we go to an 8% inflation rate? Now your return is $4,801.02 over 40 years. Bummer. But WAIT ... what happens if deflation sets in so my net return is 14% compounded ... let's see ... WOW! $188,883.51! But why stop there? At 200% return per year your thousand bucks will grow to $12,157,660,000,000,000,000,000, approximately, the total economic output of the entire planet over the last 100 years. ("Bartender! Hit me again and put it on this guys tab!")
Isn't this fun?
The point I'm driving home is that the projected Future Value of your $1,000 bucks is completely dependent on the assumptions you make as to growth and the inflation rates.
Read that sentence again.
Now read that sentence again.
Write it down and nail it to a wall.
What is the Present Value of $1,000 compounded to $10,285.73? Stand by for some heavy arithmetic! It's worth ... $1,000.
That is if I make the compound rate equal the discount rate. This is another key point: IF the compound rate equals the discount rate a dollar at any point in the future is exactly equal to the dollar today.
Ok ... Who Cares?
When I, or you, look at two different investment opportunities the better investment can be found by using Present and Future Value. The following is a simple example just to illustrate the point.
More jargon (sorry), a zero-coupon bond is a bond that is sold at a price discounted over 20 years from $1,000 by the interest rate, say 5%. The selling price of that bond would be $376.89 and the bond will pay $1,000 in 20 years.
An investor can either buy those bonds or put the money in the stock market. Since I "know " - based on certain assumptions - my $1,000 will grow to $3,207.14 (see table above) I can figure where to put my money.
$1,000 discounted by 6% (compound rate of the stock market) is $311.80. With this bit of knowledge I can calculate I can either pay $376.89 for a $1,000 twenty years from now or I can pay $311.80 for a $1,000 twenty years from now. And it's a no-brainer: buy the stocks.
Now, finally, we can now ask THE vital questions about Social Security, to wit:
- How much is it worth to you to insure Grandma won't be eating Alpo for dinner: $100 per year, $200 per year, $500 per year?
- How much is it worth to you to insure your spouse's Grandma won't be eating Alpo for dinner?
- How much is it worth to you to insure someone else's Grandma won't be eating Alpo for dinner?
- How much is it worth to you to insure social stability because a thundering horde of Grandmas aren't eating Alpo for dinner?
- How much is it worth to you to insure you won't be eating Alpo for dinner in 2044?
UNTIL YOU PUT A DOLLAR FIGURE TO THOSE QUESTIONS ANY DISCUSSION OF SOCIAL SECURITY PRIVATIZATION IS TALKING PAST THE POINT!
And I don't apologize for shouting.
If you are going to talk about the return from private investment then you have to put a dollar figure to the return from "social" investment because that is the basis upon which they can be compared. Otherwise the discussion is merely shouting opinions back and forth.
I have no idea what the numbers are right now. What I can say is if turns out we are buying $1,000 Future Value for $200 Present Value with SS and the other option is paying $300 PV for $1,000 FV without SS then it's a no-brainer. (That, in fact, is my suspicion ... but I can't prove it. Yet.)
Future and Present Value are only two out of a host of other topics, such as risk assessment, Net Present Value calculation, Capital Allocation, and a whole bunch of other factors needing to be addressed before we can really start to have a useful discussion of Social Security but - Oh, God - not now.