Reports showing annual amounts in MaxiFi are presented in what we refer to as “today’s dollars.” This is another way of saying, “today’s purchasing power.” So when we look at any year of the annual discretionary spending report or net worth report, we are seeing amounts in today’s dollars, adjusted for inflation to represent the purchasing power we are familiar with in the current year.
However, other reports in MaxiFi are shown in today’s dollars but with an added adjustment. These reports -- such as the Lifetime Budget and the Final Estate value in the comparison report -- present today’s dollar amounts as time-weighted values. Because $100 today is more valuable than $100 twenty years from now, not just because of inflation (both are in today’s dollars) but because of the investment opportunity that having the $100 today affords us. We say that the future $100 twenty years from now must be “discounted” relative to today in order to reflect the fact that it does not have the same opportunity for investment that we would have with the $100 in hand today. This kind of future discounting is referred to as future discounted “present value.”
This present value of an amount comes into play when we look at some amount, say the final value of the estate, that is way out in the future. There’s nothing wrong with looking at this final value in today’s dollars. Indeed, that’s what we want to do in most cases. We just want to know what the purchasing power of that amount will be taking into account inflation after so many years have elapsed. But when comparing two reports where these amounts might not reflect the same year, the only way to properly understand the relative value of these two amounts is to calculate and compare their present value. Remember $50,000 in 2055 is not discounted as much as the same $50,000 in 2060.
Another situation where present value is important is when comparing two streams of annual expenses or receipts. If you could have $1,500 over the next five years, would you rather have that given to you in today’s dollars as $100, $200, $300, $400, $500? Or would you prefer to have the sequence be $500, $400, $300, $200, $100? Remember, inflation is not an issue here because all amounts are in today’s dollars and the sum total of each stream is exactly the same. Nevertheless, we’d rather have the second stream because while waiting for the end of the 5th year, the money you can collect each year has the opportunity to be invested at a safe rate of return, discounting money in the far term compared to the near term.
So when MaxiFi compares streams of income and spending and presents them in the Lifetime Budget sheet and some other reports, it represents them as present values so that you are able to make a fair comparison of the lifetime value of these various streams of money.
MaxiFi uses the real rate of return as its discount rate to calculate these lifetime present values.
Math Details
The purpose of discounting is to enable an apples-to-apples comparison of a series of future amounts that are received in different years. Neglecting to discount and simply adding up undiscounted dollar amounts is the same as assuming you can't earn a return on investing, which is clearly not the case unless your real return on regular assets is 0%.
For example, $1,000 today, in current year dollars can be invested and will grow to $1,338 current year dollars in 30 years if the real rate of return is 0.976% ($1000*1.00976^30=$1,338). So even though the purchasing power of a constant current year dollar is the same in 30 years as it is now, you will have 338 more dollars of current purchasing power 30 years in the future.
In our software you can modify our assumed values for the rate of inflation and the nominal rate of return. Our software calculates the real rate of return from these entries. For example, if inflation is 2.5% and the nominal rate of return is 3.5%, then the real rate of return is (1.035/1.025 - 1)*100% = 0.976%.
The present value of an amount x years from now is the amount /(1+r)^x, where r is [(1+i)/(1+p)-1] (r is the real rate of discount, i is the nominal rate of return you enter, and p is the inflation rate you enter).
See Time Value of Money on Wikipedia or any basic economic/finance website or book for more background.
* Note that when the real rate of return is negative in MaxiFi, this creates a "negative discount" wherein the effect is to make the future amount higher, not lower, and thus the "discounted future value" is a higher, not lower amount compared to the mere sum.