Discounting lump-sums in the future

[paul]

Excellent tool - a friend recommended it and its all and more what he said!

Question on lump sum's and how they are handled. I read all the forum documentation and FAQs and posts and still don't quite get it.

Specifically, if my retirement calcuation from my company says that I will get say, $200k lump sum in 2018 for retirement based on "todays" wages (no projections for increases or inflation are included) and in "todays" dollars, what number should I enter in the additional inputs as a misc. income - $200k?

I think your planner discounts that value by the inflation rate for the 10 yrs between now and then, and uses that number in the calculations. However, that does not take into effect any inflation/ COL increases I will get in my pay over the next 10 years.

The point being that I expect the "purchasing power" of the $200k to be exactly the same in 10 years since pay increases will offset the inflation rate. How do I account for that?

Thanks in advance!

Paul

[jimr]

Hi Paul,

Thanks for the post and for trying out the planner. Your question is a good one. It's been a while since I've delved into the lump sum cola/no cola part of the code, so I had to do some research to see exactly what the planner does.

First, if you use the additional inputs window to specify a $200k lump sum addition to savings 10 years into your plan, what you'll get is $200k worth of purchasing power added to the portfolio in the tenth year of the plan. You can see this by looking on the detail view tab in the "new investments" column. All the values in this table (and nearly everywhere in the planner) are shown in today's value dollars. So even though the row for year "today +10" shows $200k, in reality, the lump sum that's added to the portfolio in that year will be much higher in inflated dollars.

If your situation was reversed, and you knew you would get exactly $200k in ten years, not adjusted for inflation, you'd have to do a bit more work, but you can still model it. I didn't include a feature to add a non inflation-adjusted lump sum (like I did with misc income), but you can simulate it with a multi-step process.

Steps to include a lump sum that isn't adjusted for inflation:

Code: Select all

1) Restart the planner (reload the page) and set up your expected inflation rate.  Next, create a "misc income (no cola)" cash flow that starts in the year when the lump sum will arrive.  Enter the amount of your expected lump sum with the taxable percent set to 0. 

2) Run the planner and look at the detailed view tab for the first year amount of the discounted misc income cash flow.  It will be in the table in the column called after-tax income and will be much less than the value you entered in the additional inputs window because inflation will erode its purchasing power.  (for example, for a $200k amount in ten years with 3.5% inflation, the purchasing power will be only $140k).  

3) Next, fill in all your planner inputs and go to the additional inputs window and enter the reduced (inflation adjusted) value that you got in step 2 as an addition to savings in the year you expect the lump sum (should be same year as in step 1).  Even though you expect a $200k lump sum, you'll enter a much smaller number (around $140k with 3.5% inflation) because your lump sum's purchasing power is reduced by 10 years of inflation.

4) Run the planner again to see your results.  You probably should look at the year-by-year cash flows in the detailed view to make sure the planner did what you expected.

In general, the "detailed view" tab of the planner is very handy for experimenting with varied cash flows and making sure that the planner is doing what you expect it to. The trick to understanding this page is to realize that each amount is presented in today's value dollars. In reality, the amounts that the table represents will be much higher in real life, especially in the later years of the plan.

Hop that helps. If you have more questions, please follow up. This is an important aspect of understanding how to use the planner, so I'm happy to answer any follow-up questions.

Regards,

Jim

[Guest]

Excellent information Jim, excellent! You exactly understood the nuance of my issue. Since the next layer of the problem is that my lump sum estimate is based on "todays" income, then I wanted to account for expected pay increases (say 2% annual) against the inflation rate (say 3.5%). I used your "green text" to calculate the value of the net 1.5% decrease and then use that discounted lumpsum value in the simulator. I also did the reverse of (separately) increasing the lump sum value by 2.0%, and then used your "green text" at the 3.5% inflation rate to find the discounted value. Came out essentially the same either way.

Just what I needed. Thanks a million!

Paul