UNDERSTANDING THE TIME VALUE OF MONEY is a fundamental pillar in improving spending decisions. Even with explicit personal values and goals, unless there is a full appreciation for the time value of money, implementation of tactics to achieve one’s goals may be inadvertently missed.
The truth is everyone can relate to hard cash in hand. When it comes to saving and investing, that is another matter. Today’s article continues the elaboration on the time value of money by considering a regular saving habit, and eventually being able to fund a pension. In each case we will consider what is called an annuity: a series of equal cash flows spaced evenly over time. For example: $100 per week every week; $300 per month every month; or $2 000 per year every year.
This example presents the future value of saving $300 per month over a 15-year period earning compound interest of 4 per cent per annum. Let us assume that the amount is invested at the end of each year as a lump sum, $3 600. You can google “future value annuity table”. This table will provide the relevant factor at row 15 and in the 4 per cent column as 20.024. This gives an accumulated amount of ($3 600 x 20.024) $72 086.40 for the ($3 600 x 15 years) absolute $54 000 that was invested over the 15 years.
Using the same table, if this saving habit had been maintained over a 30-year period, the factor from the table would be 56.085. The amount accumulated at that future time would be ($3 600 x 56.085) $201 906 for the ($3 600 x 30 years) absolute $108 000 that was invested over the 30 years.
From examining the table, you will surmise that the longer you save and the higher the compound interest rate the faster your investment will grow. This is because not only is your saved amount earning interest but you are also earning interest on interest on interest on interest the longer you invest and the more interest you earn.
Let us look now at providing a future annuity for 15 years discounted at 4 per cent with the accumulated funds. Again, you can google “present value annuity table”. There you will get the present value factor of 11.12 in the 15th row under the 4 per cent column. Thus the annuity that would be provided by the accumulated $72 086.40 would be ($72 086.40/11.12) $6 482.59 per year or the equivalent of ($6 482.59/12 months) $540.22 per month.
Alternately, if we had saved over a 30-year period then provided the 15-year annuity, the amounts would be ($201 906.00/11.12) $9 712.23 per year or ($9 712.23/12 months) $809.35 per month. In terms of providing a pension or a pension supplement, saving for over a 40-to-50 year period only starts to provide a significant pension contribution.
Your test is to work out the future value of saving $3 600 per year over a 40-year and then a 50-year period. Then with those accumulated amounts, work out the value of the monthly pension each can provide by an annuity for a 15-year period discounted at 4 per cent.
Your computations will show that saving over a 15-year period will provide a contribution of only ($582.97/$3 600) 16.2% of the original saving annuity amount saved. Saving over a 30-year period will provide 22.5 per cent; over a 40-year period will provide 42 per cent and saving over a 50-year period will provide just over 70 per cent.
The moral is the earlier you start to save and the more you save at the highest compound interest you can earn, the better you will be prepared for the time you can no longer work like you do at the peak of your career.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.
