What's Your Future Worth?

Using Present Value to Make Better Decisions

Peter Neuwirth

• Publisher: Berrett-Koehler Publishers
• Year: 2015
• ISBN:
  9781626563452
• Edition: 1
• Topic: Développement personnel
• Subtopic: Amélioration personnelle

We weigh every significant decision based on how it will affect our future. But when it comes to figuring that out, we mostly make the process up as we go along. While financial professional Peter Neuwirth can't help you actually predict the future, he can offer a simple, systematic way to make much better guesses about it—and so make better decisions.Neuwirth offers an accessible, step-by-step guide to using the powerful concept of Present Value—which allows you to determine the value today of something that might happen in the future—to evaluate all of the outcomes that might arise from choosing one path as opposed to another. Using examples that anyone can relate to, Neuwirth walks you through the process. Your old refrigerator doesn't work as well as it used to—should you buy a new one right away or muddle through for a while? You're offered a great discount on a service you don't need at the moment but eventually will—buy the service now or wait? With just a little math and some common sense, you can compare future costs and benefits with present costs and benefits and make "apples to apples" comparisons. This book will be indispensable for anyone who has ever had to figure out whether to stick with an awful job or follow his or her bliss, fix that old car or buy a new one, increase 401(k) contributions or keep the same take-home pay, and a thousand other decisions.

Chapter 1

MORDECAI’S PROPOSITION — A QUESTION OF PRESENT VALUE

“If I gave you $10,000 today would you be willing to give me 1% of all your future paychecks?”

Mordecai Schwartz, FSA, to a young actuarial student

It was 1979 and I had just started my first job out of college as an actuarial student with Connecticut General Life Insurance in Hartford, Connecticut. My boss was a long-haired libertarian from Arkansas who spoke so quietly you had to lean in close to hear him. He was edgy, sarcastic, and rebellious (he had only recently caved in to the company’s insistent demand that he get a haircut and begin wearing decent clothes to work), but he was also one of the top actuaries in the company with a nose for risk and a wizard-like ability to make the numbers sing and dance. He always said that what makes a good actuary is not his or her ability to calculate, or even to use sophisticated mathematical techniques to evaluate risk, but rather to understand the music in the numbers—to hear the melody, to anticipate the chord changes, and most importantly to detect the false note. He said that a good actuary should be able to look at two columns of numbers with vague headings like “prior year actual” or “current year allocated” and, with no knowledge of what the figures were supposed to represent, be able to immediately identify the wrong number.

But before I could even begin to develop those skills, I first had to learn and internalize the concept that is at the heart of all actuarial work—specifically the notion of Present Value. I was, of course, given books and files to read to learn the math behind Present Value,⁴ but Mordecai also wanted to find a way to teach me the practical importance of understanding how Present Value works, and true to his nature, he found a way to permanently embed that concept while at the same time benefiting himself and having some fun, at my expense.

You see, Mordecai was a gambler and game player. An excellent chess player, he was even better at poker, where he could combine his expertise in strategy, psychology, and probability with his fiercely competitive nature to outsmart his colleagues and make a little extra cash. He also enjoyed creating propositions and making bets—from politics to sports, from financial market behavior to actuarial matters, he was always willing to “put his money where his mouth was.” For him, it was often less about the money and more about the elegance and virtues of the proposition itself.

Not surprisingly, most of his bets involved Present Value calculations, at least in an indirect way, and the first one he proposed to me had it at its core. Having just passed the first three (out of ten) actuarial exams with only a minimum of effort, I opined one day that all the talk I’d heard about how long, hard, and treacherous the path was to becoming a Licensed Actuary⁵ was obviously nonsense and that I expected to be able to move through the rest of the exams without any difficulty. Mordecai smiled slyly and asked if I was willing to bet $500 that I would pass all of the final seven exams on my first try. Being overconfident and not understanding either risk or Present Value, I readily agreed. Of course this was an incredibly stupid move on my part. First, I had no idea what the next seven exams were like (Mordecai did). Second, even if my chances of passing any given exam on the first try was 90%, the probability of passing all seven without a miss was less than 50% (0.9 raised to the 7th power is about 0.48). Most importantly, I completely missed the fact that if I failed an exam, I could lose the bet years sooner than if I passed all the exams the first time. In other words, even if I won the bet, I wouldn’t collect for at least another four years (exams were given every 6 months) but if I lost I would have to pay Mordecai as soon as I failed, and this could happen as soon as the next exam. Given that interest rates at that time were well over 10%, this factor alone should have caused me to ask for odds.

So the fourth exam came a few months later and I completely bombed it. I walked out of the room knowing absolutely that I had failed. In a panic about the $500 that I didn’t have but would shortly owe my boss, I considered my options. The only factor that I realized was in my favor was that I knew I had failed but Mordecai did not (results would not be available for another two months) and so I had two months to negotiate a settlement. Eventually, I agreed to pay $50 immediately to extricate myself from the bet. Now to this day I wonder why Mordecai agreed. Perhaps he bought my presentation (I expressed supreme confidence that I’d passed but realized how long I would have to wait for my payoff and how I had underestimated future risks), perhaps he was being kind and/or didn’t want to risk the non-financial fallout when it became known how he’d taken advantage of his naïve young student. Or maybe he was just very risk averse, and having done his own Present Value calculation, decided that $50 was a reasonable estimate of the current worth of the future outcome of the bet. No matter what, it was a lesson well learned and one for which I owe Mordecai a debt far greater than the $50 price.

But Mordecai was not done. He had one more lesson about Present Value that he wanted to teach me, and this was the one that more than any set me on the path that has led to this book.

Mordecai’s Proposition

Shortly before the end of my time working for him, Mordecai came to me with an intriguing proposition. He asked me whether I would be willing to “sell” him a piece of my future earnings. Specifically he offered me $10,000 to enter into a contract with him whereby at the end of each year I would give him 1% of what I’d earned during the prior twelve months. At the time I was making less than $20,000 and so for the current year the bill would be under $200 and even for the next few years it seemed that I would only have to pay him a few hundred dollars. The idea of receiving fifty times the initial amount in one lump sum certainly seemed appealing, but having only just narrowly escaped a financial disaster, I decided this time to consider the question more carefully before I gave him an answer.

For the first time in my life, I tried to think systematically about the future and what it was worth to me in the present. I had to imagine what the rest of my earning career would look like. I had to consider all the possibilities—not only what my career trajectory might look like (e.g., would I rise to some senior actuarial position, change careers and strike it rich, or crash and burn struggling to get by), but also what the future economic world would be like. Would the market for actuaries get better or worse? Would inflation increase, rendering 1% of my future earnings so large as to make the $10,000 I got seem like a pittance? What would I do with the $10,000? If I invested it, what kind of return could I expect to receive and would it offset any inflation that might raise the annual amount I had to pay each year? These were the measurable factors, but there was far more to the proposition that had to be considered.

I needed to think about what it would mean to me to have this additional “tax” burdening me for the rest of my life. One thing I realized was that if I made a lot of money, the bill would be big but I could afford it. On the other hand, if times were tough, I would struggle to make even a modest payment. And then there were the relationships to consider. How would any future wife or family feel about this added “baggage”? And what about my relationship with Mordecai himself? He and I had a decent enough relationship, but what would it mean to be “in business” with him for the next few decades? Assuming my future working career would be at least forty years, lurking in the back of my mind was also another aspect of the proposition that suggested I should grab the money. Specifically, it seemed to me that while the $10,000 was a sure thing, would I really have to pay Mordecai each and every year for the next forty? Wasn’t it possible that some radical change in either his or my circumstance would render the contract unenforceable or moot? The $10,000 could be spent immediately, but were those future payments equally real? And finally, I had to grapple with the most important question in any Present Value calculation—what relative value should I put on amounts payable ten, twenty, or forty years in the future compared to the weight I put on amounts today. I had to figure out, for the first time, what my personal rate of discount was and—interestingly—whether it was different when I considered the value of the next few years’ payments compared to the payments I would be making in the very distant future.

In the end, I made the right decision and turned him down. I won’t go through how each of the five steps played out, but for me, step 4 turned out to be the critical one. The $10,000 just wasn’t as valuable to me as the large payments I expected to make down the road, and the freedom from such a long-term future obligation was too important for me to give up. For this particular decision, I used a relatively low personal rate of discount though others facing the same choice whose discount rate is higher might have done the right thing by accepting the money.

But whether or not I made the right decision is not the point. What is important is that Mordecai’s proposition is the essential question of this book. Namely, what is your future worth, and how do you determine it? For almost forty years I’ve been thinking about this question, and in the next few chapters I will tell you what I’ve discovered about how to answer it.

Chapter 2

PRESENT VALUE IN THE DAY-TO-DAY WORLD

The idea of Present Value lurks just below the surface of an overwhelming number of decisions we make on a day-to-day basis, and being aware of its presence and how to incorporate it will lead to making better choices. In this chapter, we will look at a few of the common types of mundane decisions that arise in everyday life and see how taking a few extra minutes to think in terms of Present Value can often shed an entirely new light on those questions.

Do We Need a New Refrigerator?

Shortly after I began writing this book, my wife came to me and said that she was pretty sure we needed a new refrigerator. Needless to say, this was not exactly welcome news, and my fiscal defenses were immediately mobilized. My first response—perhaps familiar to many of you—was, “Why? The one we have is still working fine. And besides, it’s only seven years old, and the guy at Sears told us it should last ten or fifteen years at least.” I had a sinking feeling that this was the first volley in a campaign designed to achieve a comprehensive kitchen remodeling. But my wife knows me better than to lead with esthetics, and so she quite reasonably pointed out that while it was true that the fridge was still keeping everything cool, the outside of it seemed to be running hotter than normal and as our electric bill had recently been outrageously high she was sure we would actually save money if we bought a new one. If true, this was a powerful argument and one that I could not effectively parry. Essentially, she was saying that putting all the nonquantifiable reasons aside (and believe me she was loaded for bear if I ever engaged in that discussion) the Present Value of our future refrigeration expenses would be less if we purchased a new one now than if we waited for the old one to live out its life using up more and more electricity to do so. Clearly, the question called for just the kind of systematic thinking described earlier, so let’s see how I applied our 5-step process.

Step 1—clarify the choice. While the decision to be made was clear (to buy or not), the cost of each option was not. So first I had to figure out how much more in electricity we were now spending than we would if we bought a new refrigerator. The cost of the electricity on the new models was easy to determine, as such figures were prominently displayed (in some cases more prominently than the price tag) on the front door of each model in the showroom. The tricky part was figuring out how much the current one was costing us. One way to approach this was to assume that before it “broke,” our refrigerator electric costs were the same as those on the new model and that what we would save would be the amount by which our electric bill had gone up since the current one started running hot. But even with this simpler calculation, there were two problems. The first was purely psychological—I just didn’t want to believe that we had a problem, that things had changed, and that the original projections given to us by the salesman at the store where we purchased the refrigerator were simply not valid any more. The second one was all the “noise” in the calculation—such as all of the month-to-month variations in weather, vacations, light use, and so forth (not to mention price changes)—that affect the bill. Both of these issues come up again and again whenever one tries to apply Present Value to real-world decisions.

I will spare you the details of how I dealt with both my psychological demons and the messiness of the calculation. At the end of the day, it seemed that we were paying about $15 per month more in electricity as a result of our faulty refrigerator, and with that information I was ready for the next steps.

Steps 2–4. In thinking about the future possibilities, I thought about—and projected—the purchase price of a new refrigerator (either now or when the old one died) as well as the electrical costs of each in the coming years. In terms of actual numbers, new refrigerators comparable to our current model were running about $1700 at the time. Assuming that the current one had eight more years to live and that the price of refrigerators goes up at 2–3% per year, a new one could be expected to cost about $2000 when the old one died. The Present Value of $2000 payable eight years from now is, as we know, much less. But to actually compare Present Values, we need to perform step 4 and choose a discount rate assumption (taking into account all the factors we previously talked about). As I have mentioned previously, finding your personal rate of discount (i.e., how to weigh the future vs. the present) is an important step in using Present Value. In this case, because it was only money (and not a lot of it) that would otherwise stay in my savings account (vs. being spent on something else that I valued), I only cared about how much I could earn on the money if I didn’t spend it. As a result, I chose a discount rate of 5% (what you could earn on bank CDs at the time).

Step 5—do the numbers. In chapter 4, we will describe the technique for doing this calculation (this was one of those cases where an actual calculation was required), but the important part of the result was that while the value today of waiting to buy a new refrigerator after the old one died was less than the $1700 it would cost to buy a new one immediately, the Present Value of the extra electricity costs associated with waiting more than offset that difference.

For those that are interested, the following is how the actual calculation went. Using our 5% discount rate, the Present Value of buying a new refrigerator eight years from now was $1353, while the Present Value of the extra electric bills that I would have to pay if we waited until the old refrigerator died was another $1163. Adding the two together ($1353 + $1163), we get a total Present Value cost of holding on to the old refrigerator of $2516. Given that $2516 is much greater than the $1700 a new refrigerator would cost, the conclusion was inescapable. As usual, my wife was right and we did need to go appliance shopping.⁶

This was a simple example (albeit one that required a little bit of arithmetic) because the alternatives were clear, the money impact was (mostly) measurable, and there was very little uncertainty about the future. Most of the situations we will discuss require less calculation, but are not quite as clear when it comes to some of the other steps in the process. Let’s now look at a couple of others.

A “Once in a Lifetime” Opportunity?

If you are like me, your mailbox, telephone, and e-mail are constantly inundated with marketing offers that seem too good to be true. From offers to switch cable companies to “free” home inspections, blowout sales at your local “big box” store, and Groupon deals, it seems that we go through life spending far too much money on the things we need and if we just took the time to read and act on all these “once in a lifetime” opportunities, we could improve our financial situation considerably.

Many of us are either so suspicious or have become so numb to sales pitches that we just refuse on principle to even investigate the offers. Others respond when the offer hits a chord within them or happens to come at a time when they are looking for exactly the service that is being presented. More often than not, when we do respond, we are disappointed in the results, but there are exceptions, and using Present Value can help you separate the winners from the losers.

To see what I mean, consider an offer that arrived in my mailbox a while ago. It came in the form of a bright yellow flyer from a local heating and plumbing company telling me that for $89.95, a licensed expert would come to our house and clean all the heating vents/air ducts and inspect our furnace. They would come at my convenience and there would be no further obligation. Since the last time we had our vents cleaned it cost about $300, this was an offer that caught my attention. However, before I made the appointment and began to use Present Value in earnest, there was one other important factor I needed to consider.

Specifically, I needed to determine whether this was a legitimate offer and, if so, why was the company providing such a deep discount. This is an important question in almost any special offer that arrives unsolicited, but in this case I had not only heard of the company (they were a company we had called previously to repair our furnace), but given that the offer came during a period when the economy was in recession and contractors of all sorts were struggling to find work, it seemed very likely that this promotion was driven by the company’s need to generate new business and utilize its otherwise idle employees.

So with that threshold question addressed, I started to think about the question from a Present Value perspective.

Starting with step 1, I had to decide whether or not the vents needed cleaning at all. Just because I was getting a $300 cleaning for less than a third of the normal price didn’t mean I should buy the service if the vents were not dirty. So I looked back and it turned out that our air ducts had been cleaned about three y...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Dedication
• Contents
• Preface
• Introduction Thinking About the Future in a Systematic Way
• Chapter 1 Mordecai’s Proposition—A Question of Present Value
• Chapter 2 Present Value in the Day-to-Day World
• Chapter 3 Making Big Decisions
• Chapter 4 The Mechanics of Present Value—What Is a Discount Rate?
• Chapter 5 Step 1—Clarify the Choice
• Chapter 6 Step 2—Imagine the Future
• Chapter 7 Step 3—Evaluate the Possibilities
• Chapter 8 Step 4—Weigh the Now and the Later
• Chapter 9 Step 5—“Do the Numbers”
• Chapter 10 Present Value for Organizations and Communities
• Chapter 11 When Money Doesn’t Matter
• Chapter 12 Present Value and the Distant Future—Planting Trees and Leaving a Legacy
• Chapter 13 The Value of the Actuarial Perspective and “The Rest of Your Life”
• Notes and References
• Acknowledgments
• Index
• About the Author