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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.

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