| (Page 1 of 2) Wealth is the present value of your future income. What does that mean? Present value is a concept quite familiar to the financial types among you, but perhaps novel to others. It is not a difficult principle, drawing upon such well-known proverbs as “a bird in the hand is worth two in the bush”. I know you want to hear about wealth, but we have to get over this little hurdle first, so please bear with me. The idea is that a sum of money to be received in the future is worth a smaller sum today. The difference is like interest. To calculate a present value, you discount the future amount at an appropriate interest rate. $100 dollars a year from now is worth $90.91 today, if you use a 10% discount rate, because if you invested that sum for a year at that rate, you would have $100 at maturity. Interest compounds, so $100 in ten years time is only worth $38.55 now. If the money is certain to be paid, because it is from an FDIC insured certificate of deposit or a US Treasury Bill, then a modest rate of interest would be appropriate. $100 a year from now is worth $97.09 today at a 3% discount rate. If it is from a company in financial difficulties, but not yet bankrupt, like United Airlines, then a higher discount rate should be used to reflect the risk that you might not be paid. This lowers the present value. This talk is not directly about happiness, or what economists call utility. If you are twice as wealthy, which we can measure, it doesn’t mean you are twice as happy, which is rather subjective. Despite folk tales to the contrary, more wealth is preferable to less. It gives you more choices. If your particular circumstances seem to be different as more wealth brings less happiness, then you have the choice to fix the problem by giving away some of your wealth. Wealth is the present value of your future income. I don’t work for the IRS, so I don’t mean what you will list on your form 1040. Income comes in three major types: compensation (what you get for working: wages, commissions, bonuses, tips, etc.), investment income (interest, rent, capital gains, etc.) and transfer payments (gifts, social security, alimony, etc.) Some things don’t show up as cash, like if you own your own home, then the amount of rent you would have to pay to rent a similar dwelling would be counted as income. Some things you have to pay, like taxes, credit card interest, mortgage interest, etc., are considered as negative income in this measure. Typically, unless you have a big inheritance coming, early in your working life, most of your wealth is the present value of your future compensation. Gradually, the portions change until you retire, when all of your wealth derives from your future investment income and transfer payments. Let’s take a look at what a typical profile might be. The person’s age increases from left to right. I’ll draw two lines: one for income, the other for consumption (or expenditure). Both start low, increase, and then tend to decline, but the rate of change and volatility of income is greater. If you are earning more than you spend, then you are saving. If you are spending more than you earn, you are dipping into savings or borrowing. Children usually consume little but earn even less, but the gap is mostly covered by transfer payments, from their parents or guardians. Consumption jumps when they go to college or leave home. This leads to increased borrowing, whether for student loans, a car or installment and credit card purchases. Your largest borrowing, your mortgage, doesn’t figure in this graph, as you are borrowing money to buy an asset, your home, not to consume. If the imputed rent on your first home is higher than what you were paying before, then your consumption has risen somewhat, which would have an effect. This is partially mitigated by the decease in taxes due to the mortgage interest deduction. Eventually, your income should outstrip your expenditure, allowing you to repay prior borrowing and then begin building up your savings. Part of this may not show up in your checking account, if you are contributing to a 401-K, or your company has a pension plan. Some people just spend whatever they earn. That is usually inadvisable. A temporary decline in income, due to a lay-off, or a significant mandatory expenditure would require both a reduction in consumption and an increase in borrowing. For most people, reducing consumption is very unsettling, that is to say, quite unpleasant. It is useful to keep track of the accumulated savings or borrowings. If you are young but have good prospects, you are able to borrow against your future income. When you are older, past your peak earning years, or in retirement, it is more difficult. Even worse, it is fairly imprudent to put yourself in that situation. No one wants to just live off governmental transfer payments (social security), so you need savings to provide investment income. Traditionally, one did not invade principal, adapting one’s consumption so as not to exceed income. This makes sure you will not outlive your savings, and that your heirs will inherit something. If you haven’t saved enough to live within your income after retirement, annuities are a less conservative option, providing cash flow for life, but nothing for your estate. |