Definition
Present value is the amount that a future sum of money is worth today after accounting for the return that could be earned on money in the interim, converted using a discount rate that reflects the time value of money.
Why it matters
Every lifetime income analysis rests on comparing amounts received at different times, and comparisons across time require a common reference point. Present value is that reference point, translating streams of future income into a single figure that can be set alongside a premium paid today. Without it, arrangements with different payment timings cannot be evaluated on the same basis.
How it works
Present value is computed by discounting each future cash flow at a rate that reflects the return money could earn between now and when the cash flow arrives. A dollar received one year from now, at a 3 percent discount rate, is worth about 97 cents today; a dollar received twenty years from now, at the same rate, is worth about 55 cents today. The further into the future the cash flow arrives and the higher the discount rate, the smaller the present value. For a stream of cash flows, such as one thousand dollars per year for twenty years at 3 percent, the present value is the sum of the individually discounted amounts, which in this case totals roughly $14,880. When the future cash flows are contingent on survival, each is also weighted by the probability that the individual will still be alive to receive it; this is the modification that turns ordinary present value into an actuarial present value.
In practice
For an individual evaluating a lifetime income arrangement, the relevant question is what stream of future income the arrangement is expected to deliver and what that stream is worth today at the individual's own discount rate. A quote of "5,000 dollars per month for life" cannot be compared to a $500,000 premium without a present-value conversion. A professional working through a lifetime income decision will typically compute the present value of the income stream under the individual's survival curve and discount rate, then compare to the premium; the direction and size of the gap is what the analytical framework is built to characterize. Individuals encountering marketing figures that report only nominal payouts (total dollars over expected lifetime, for instance) should recognize that these are not present-value figures and are not directly comparable to a premium paid today.
Related terms
- Future value
- Discount rate
- Actuarial present value
- Cost of income
- Annuity factor
- Net present value
- Real versus nominal discount rate