Running Head: TIME VALUE OF MONEY IN RETIREMENT PLANNING

Time Value of Money in Retirement Planning

Ebere Obasi
FINC 510
Davenport University

TIME VALUE OF MONEY IN RETIREMENT PLANNING

Time Value of Money in Retirement Planning

Time Value of Money
The concept of time value of money entails the fact that the money which is currently
available (present time) will be having higher worth as compared to the money, which is of same
amount in future because it has a lower potential earning capacity (Berk, DeMarzo & Harford,
2012). The principle of time value of money depicts that a dollar which we will receive in future
has different value than a dollar which we will receive today (Ross, Westerfield, & Jordan,
2008). Its very important for finance managers of any organization to have sound grip on the
concept of time value of money. The reason is that it will allow the business to know the worth
of any project today and its total value in future (Brealey, Myers, & Allen, 2005). If we are given
a choice of receiving a dollar today or after a year, a feasible decision will be to choose a dollar
today option. This decision is taken due to the understanding that along with inflation and other
uncontrollable factors which affect the value of money, the investment possibility of a dollar in
hand is very lucrative (Berk, DeMarzo, & Harford, 2012).
The principle is that no matter what is the amount of money, it is worth more the sooner
its received. The concept of time value is a vital concept in the determining the accurate value of
money which is paid over a period of time for any investment (Berk, DeMarzo & Harford,
2012). Having thorough knowledge of time value of money will enable the mangers to make
feasible project decisions in which the company has to indulge. Calculating accurate time value
of money calculation will enable the managers to decide between different projects option, that
which ones must be approved and which ones must be withheld.

Retirement Planning

Retirement planning is the time in which a person takes to plan how they are going to
financially stable after many long years of working (Kapoor, 2015). Most people, when thinking

TIME VALUE OF MONEY IN RETIREMENT PLANNING

of their retirement, include everything from, where they are going to live to how much they will
need to cover basic living expenses. It is important to plan your retirement because, you want to
ensure that you can continue to live day to day, so that you are comfortable and secure. Planning
now for your retirement is encouraged because it helps in your long-term financial goal planning.
In my opinion, it is never too early to start saving for your retirement. It is better to start saving
now than to wait until you are approaching the retirement age (currently 66 for Social Security
benefits and 65 for Medicare) (Matthews, 2014).
Today more people are spending longer years in retirement; anywhere from sixteen to
thirty. To plan your retirement you should analyze current assets and liabilities; using this
information you should then estimate spending needs and make needed adjustments based on
inflation (Matthews, 2014). You would then evaluate the retirement income. If someone decides
that their income is not adequate they can take up a part-time job.
Sources of Retirement Income
There are several sources of retirement planning. The major ones are: social security,
employee pension plans, individual saving and investing (IRA or Keogh), and postretirement
employment(Matthews, 2014). Social security is the first. During planning, its advantages are
forced savings, portable from job to job, and the cost shared with an employer. Social Securitys
main disadvantage is the increasing economic pressure on the system as the U.S. population
ages. The next source is Employee Pension Plans. Its advantages during planning are forced
savings and cost shared or fully covered by employer. The disadvantages are that it may not be
portable, and there is no control over how funds are managed (Matthews, 2014).
Moreover, individual saving and investing is another source and its advantages during
planning are current tax savings; it is also easily incorporated into family and home equity, is
portable, and control over management of funds (Matthews, 2014). Its disadvantages are the
current needs compete with future needs and the penalty for early withdrawals. The last major

TIME VALUE OF MONEY IN RETIREMENT PLANNING

source is Postretirement Employment. Its advantage during planning is that special earning skills
can be used as they are developed and its disadvantage is that technology and skills needed to
keep up may change rapidly (Matthews, 2014).
Time Value of Money & Retirement Planning
The concept of time value of money is used in devising the retirement plans. When
calculating the amount of money that needs to be deposited each year for retirement the
underlying principle of time value of money is used which says that the money which is
currently available (present time) will be having higher worth as compared to the money, which
is of same amount in future because it has a lower potential earning capacity (Kapoor, 2015).
There are a variety of calculating methods which can be applied to the concept of earning interest
in future or present. These methods incorporate future and present value of any investment which
has diverse cash flows over years.
Any investment which gives constant cash flow is known as annuity. There are two types
of annuity, namely, ordinary annuity and annuity due (Kapoor, 2015). The difference is that in
ordinary annuity payment is made at the end of the year and in annuity due payment is made in
the beginning of the year. According to analysis and calculations observed in the above
questions, the present value of any investment is smaller than the future value. This distinction is
always true because there is significant amount of interest earned from the investment over the
years. The discounting factor is also greater than one and hence greater than the principal amount
(Kapoor, 2015).
An example of how the calculation of time-value-of-money is used to make retirement
decisions is discussed below. Peter is 60 years old individual who is opting for early retirement
in 2015. Peter currently has two options of taking $300,000 as a lump sum payment today or to
go for a monthly pension plan that gives of $3,000 for the rest of his life. In order to evaluate
which option is better the concept of time money is applied. If Peter accepts $300,000, he can

TIME VALUE OF MONEY IN RETIREMENT PLANNING

invest it at 8%. Lets assume that life expectancy of Peter is about 20 years. So using financial
concepts related to time value of money, it can be seen that Present Value of pension payments
spread over 21 years of $3,000 is $450,000. This amount if bigger than lump sum amount of
$300,000, therefore based solely on the concept of time value of money, Peter is better off with
the pension plan.

TIME VALUE OF MONEY IN RETIREMENT PLANNING

References
Berk, J., DeMarzo, P., & Harford, J. (2012). Fundamentals of Corporate Finance, 1/e. Retrieved
from: http://www.pearsonhighered.com/educator/product/Fundamentals-of-CorporateFinance/9780201741599.page
Brealey, R. A., Myers, S. C., & Allen, F. (2005). Principles of corporate finance, 8th Edition. The
McGrawHill. Retrieved from:
http://my.mmosite.com/5317812/blog/item/principles_of_corporate_finance_10th_edition
_pdf.html
Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of corporate finance. Tata
McGraw-Hill Education. Retrieved from: http://www.amazon.com/FundamentalsCorporate-Standard-Mcgraw-Hill-Insurance/dp/0078034639
Kapoor, J. R. (2015). Chapter 18 Starting Early: Retirement Planning (11th ed., pp. 618 - 650).
New York, NY: McGraw Hill. Retrieved from: http://finance.ewu.edu/finc200/Kapoor
%20Dlabay%20Hughes/Chapter%2018.html
Matthews, J. (2014). Social Security, Medicare and Government Pensions: Get the Most Out of
Your Retirement and Medical Benefits. Nolo. Retrieved from:
http://www.nolo.com/products/social-security-medicare-and-government-pensionssoa.html
Van Rooij, M. C., Lusardi, A., & Alessie, R. J. (2012). Financial Literacy, Retirement Planning
and Household Wealth*. The Economic Journal, 122(560), 449-478. Retrieved from:
http://www.nber.org/papers/w17339