Understanding the Time Value of
Money
Sometimes, there is confusion surrounding the amounts paid to sellers for
their future cash payments. Many Sellers initially think that our prices amount
to only pennies on the dollar. This is simply untrue.
Part of the money you are getting in the future
is interest that
hasn't been earned yet.
On a structured settlement annuity for example.
The insurance company is simply paying you the interest on the money they
invested when you settled your case. The "amount" of the settlement (ie. the sum
of all the future payments) includes a great deal of interest that hasn't been
earned yet. Take the example of a United States Government bond:
As of August, 1998, a $100,000 zero coupon(pays zero interest) United States
Treasury Bond due August 20, 2017 was worth $31,780, less than one third of it's
nominal or face value.
Is the U.S. Government getting ripped off in a highly competitive global
free market?
The answer is obviously no.
The simple fact of the matter
is the promise to pay $100,000 (or any amount) in the future is not worth that
amount today. The further in the future it is due, the less it is worth
today.
It's the same as with lottery prizes.
Many state lotteries now
offer a lump sum option instead of the traditional 20 - 25 year annuity payout.
However, as we all know, when you elect to receive a lump sum you typically
receive about one half of the advertised prize amount. In fact, what the lottery
commissions do is identical to a structured settlement. An annuity or U.S.
Treasury bonds are purchased to fund the future payments due to the winner.
Attached is a copy of the State of New Jersey's lump sum formula and a thorough
description of the California Annuity Prize Payment Procedure from the
California Lottery. Both demonstrate that the actual value (the present value)
of the stated jackpot is really about half that amount and both states allow
people who have elected to receive an annuity to change their minds and sell
some or all of their future payments to a Lottery/Settlement Purchasing
Company.
Settlement purchases are similar to mortgages.
When one borrows
money for a home mortgage the bank gives you - say $100,000. But if you add up
the payments you make back to the bank they total 250,000 - 300,000 (depending
on interest rates and terms). In essence, settlement purchasers do exactly the
same thing only we take the risk if the insurance company goes bankrupt - you
owe us nothing. Also, since these transactions are not loans they don't affect
your ability to borrow from other sources.
Still not convinced? Consider the following:
It is an axiom that
the further in the future a you are expecting to receive a sum of money, the
less it is worth today, in part because of inflation. Inflation will make the
value of the payments shrink in coming years.
By converting future
payments into a lump sum, an individual gains a potent weapon in fighting
inflation. The following illustrates the effects of inflation and the power of
compounding:
A lump sum grows in value.
The Rule of 72 states
that an investment at a particular interest rate will double in a certain number
of years. You can easily determine how quickly your investments will double
simply by dividing 72 by the interest rate that you anticipate receiving in a
given investment. For example, an investment that will yield 10% per year will
double approximately every 7.2 years (72/10 = 7.2). A 12% yield would mean your
investment doubles every 6 years. Below is a chart with the Rule of 72 applied
to a $15,000 investment at various interest rates over the course of a number of
years. This gives you some idea of how much a lump sum today can be worth in the
future.
Future value of a $15,000.00 investment.
| Interest Rate* |
Value after 10 Years |
Value after 15 Years |
Value after 20 Years |
| 12% |
$49,505 |
$89,937 |
$163,388 |
| 14% |
$60,337 |
$121,012 |
$242,704 |
| 16% |
$73,514 |
$162,746 |
$360,288 |
* Assumes monthly
compounding.
Future payments aren't worth as much as you think.
Inflation is
like a cancer eating away at the value of your money. The further in the future
you are to receive a sum of money the less it is worth today because of, at
least in part, inflation. Thus, no matter what the source, structured settlement
payments, lottery prize or other type of annuity, inflation will make the value
of the payments shrink in coming years.
Just look at what inflation has done
over the past 34 years:
| 1964 Average Prices: |
| Salary: |
$ 6,080.00 |
| New House: |
$ 13,050.00 |
| New Car: |
$ 3,496.00 |
| Loaf of Bread: |
$ 0.21 |
| Gallon of Gas: |
$ 0.30 |
| Ounce of Gold: |
$ 35.00 |
Imagine how little
that "huge" $100,000.00 payment due in January 2021 will be able to buy at that
time.
Future Value of $1.00 Invested Today
Chart of Present Values
|
