A person retires with a monthly income of $2,000. For the next 15 years, inflation averages 4.5%. That retiree's monthly income now will only purchase half of the goods and services that it did 15 years ago. Assuming the retiree's income is fixed, his or her standard of living has been cut in half.
A couple has $5,000 set aside for their only child's college education, which will start in 12 years. If college costs grow at 7% per year, this couple will need to amass over $11,260 during that time period to buy the same level of college services that their original $5,000 would have purchased 12 years prior.
As stated earlier in this course, the primary purpose of personal financial planning is to help individuals plan for the future. Understanding that the value of money—its purchasing power—changes or erodes with the passage of time is a key concept in the planning process.
Even if the inflation rate is zero, a dollar received in the future is worth less than a dollar received today, just as an obligation to pay a dollar in the future is less costly than the need to pay a dollar today. This is because a dollar invested wisely will provide some expected positive return. Compounding of interest is the dynamic behind the time value of money concept. For example, a person who invests $10,000 today in an account earning 4% will have $32,434 at retirement 30 years from now. If you double the return to 8%, compounded annually, she will have $100,626 at retirement 30 years from now. In this example we have doubled the return, but the ending balance is over three times as much, yet another example of the power of compounding. The compounding (or discounting) of money based on interest is the dynamic force behind the time value of money concept.
The time value of money concept has many applications in financial planning. For instance, it can be used to determine how investment dollars should be applied to best meet financial objectives. It can also be used to help determine retirement needs for a given client and devise a plan to meet those needs.
Additionally, it can be used to determine, in part, the financial effect of postponing taxes. This module introduces the basic time value of money concepts; however, you are encouraged to pursue additional resources to further your comprehension of this important topic.
This module illustrates how to calculate the following time value of money variables: future value of a single sum, present value of a single sum, interest rate per compounding period, present value of an ordinary annuity, present value of an annuity due, and periodic payment.
Because of the precision required in working time value of money problems, this curriculum requires that you use a financial function calculator (hereafter referred to as a financial calculator) both in completing this module and during the course final examination. The College for Financial Planning suggests using the Hewlett-Packard HP10BII+ (or the earlier version HP10BII).
Michael Angell, CFP®, EA is an associate professor at the College for Financial Planning. He obtained his bachelor's degree in mathematics at Creighton University. His 20+ years of work experience includes banking, insurance, investments, retirement, and estate planning. In addition to his responsibilities at the College, Michael also serves as a private client services advisor with an independent investment firm and is also a federally licensed tax practitioner with a nationally recognized company. You can contact him at email@example.com.