Wealth is the present value of your future income. What does that mean? Present value is a concept quite familiar to the economics majors among you, but perhaps novel to others. It is not a difficult principle, drawing upon such well-known proverbs as “a bird in the hand is worth two in the bush”. I know you want to hear about wealth, but we have to get over this little hurdle first, so please bear with me.
The idea is that a sum of money to be received in the future is worth a smaller sum today. The difference is like interest. To calculate a present value, you discount the future amount at an appropriate interest rate. 100 ducats a year from now is worth Ð90.91 today, if you use a 10% discount rate, because if you invested that sum for a year at that rate, you would have $100 at maturity. Interest compounds, so Ð100 in ten years time is only worth Ð38.55 now. If the money is certain to be paid, because it is from an insured certificate of deposit or a Government Treasury Bill, then a modest rate of interest would be appropriate. $100 a year from now is worth $97.09 today at a 3% discount rate. If it is from a company in financial difficulties, but not yet bankrupt, like Marticon, then a higher discount rate should be used to reflect the risk that you might not be paid. This lowers the present value.
This talk is not directly about happiness, or what economists call utility. If you are twice as wealthy, which we can measure, it doesn’t mean you are twice as happy, which is rather subjective. Despite folk tales to the contrary, more wealth is preferable to less. It gives you more choices. If your particular circumstances seem to be different as more wealth brings less happiness, then you have the choice to fix the problem by giving away some of your wealth.
Wealth is the present value of your future income. I don’t run for the federal finances, so I don’t mean what you will list on your tax form. Income comes in three major types: compensation (what you get for working: wages, commissions, bonuses, tips, etc.), investment income (interest, rent, capital gains, etc.) and transfer payments (gifts, social security, alimony, etc.) Some things don’t show up as cash, like if you own your own home, then the amount of rent you would have to pay to rent a similar dwelling would be counted as income. Some things you have to pay, like taxes, credit card interest, mortgage interest, etc., are considered as negative income in this measure.
Typically, unless you have a big inheritance coming, early in your working life, most of your wealth is the present value of your future compensation. Gradually, the portions change until you retire, when all of your wealth derives from your future investment income and transfer payments. Let’s take a look at what a typical profile might be. The person’s age increases from left to right. I’ll draw two lines: one for income, the other for consumption (or expenditure). Both start low, increase, and then tend to decline, but the rate of change and volatility of income is greater.
If you are earning more than you spend, then you are saving. If you are spending more than you earn, you are dipping into savings or borrowing. Children usually consume little but earn even less, but the gap is mostly covered by transfer payments, from their parents or guardians. Consumption jumps when they go to college or leave home. This leads to increased borrowing, whether for student loans, a car or installment and credit card purchases. Your largest borrowing, your mortgage, doesn’t figure in this graph, as you are borrowing money to buy an asset, your home, not to consume. If the imputed rent on your first home is higher than what you were paying before, then your consumption has risen somewhat, which would have an effect.
Eventually, your income should outstrip your expenditure, allowing you to repay prior borrowing and then begin building up your savings. Part of this may not show up in your checking account, if you are contributing to a Eutopian pension plan. Some people just spend whatever they earn. That is usually inadvisable. A temporary decline in income, due to a lay-off, or a significant mandatory expenditure would require both a reduction in consumption and an increase in borrowing. For most people, reducing consumption is very unsettling, that is to say, quite unpleasant.
It is useful to keep track of the accumulated savings or borrowings. If you are young but have good prospects, you are able to borrow against your future income. When you are older, past your peak earning years, or in retirement, it is more difficult. Even worse, it is fairly imprudent to put yourself in that situation. No one wants to just live off governmental transfer payments (social aid), so you need savings to provide investment income. Traditionally, one did not invade principal, adapting one’s consumption so as not to exceed income. This makes sure you will not outlive your savings, and that your heirs will inherit something. If you haven’t saved enough to live within your income after retirement, annuities are a less conservative option, providing cash flow for life, but nothing for your estate.
Let’s work through an example. A recent college graduate might have a starting salary of thirty thousand ducats, for a business or econ major. Humanities would be lower; engineering would be higher. Let’s forecast a working life of 40 years. Thus, if they never got a raise, they would collect at total of Ð1.2 million in salary over their working life. Instead, let’s project raises of 8% a year for the first 25 years and 3% a year thereafter. The power of growth is such that they would earn Ð6.1 million over the full forty years. However, we are not immortal, so combining this with standard mortality experience, an average person in this situation would be expected to earn about $5.8 million during their working life. This needs to be discounted. At a 10% interest rate, the present value of compensation portion of that recent graduate’s wealth is $735,000, pre-tax. Tax rates can go up and down. I’ll assume that, on average, taxes eat a third of your income, leaving our hypothetical recent grad about $490,000. To get a complete picture of their wealth, you would deduct the value of any loans outstanding, and add in the value of any investments and the present value of any future transfer payments.
What can you do to make yourself wealthier? You can raise your expected income or lower your personal discount rate. There are two main ways to raise your expected income: saving money will increase your future investment income, or investing effectively in yourself by education to increase your value in the job market.
Your personal interest rate is subjective. If you engage in unsafe sex with dubious partners, smoke, drive after drinking, or drive a Yugo, the number of years you will earn an income is uncertain. Therefore, the interest rate you should use to discount your future income is higher, so its present value, your wealth, is lower. Cut those and other destructive behaviors out, and exercise, and your wealth increases. The proverb that speaks to this is, “without your health, you have nothing”.
Another influence on your personal interest rate relates to your patience and self-discipline. If you are a credit card junkie, paying high APR’s, then it is hard to argue that your interest rate is lower than what you are willing to pay. If we recalculate the recent graduate’s wealth using an 18% interest rate, it plunges to about $202,500, or less than 42% of what it was when we used 10%. An “I really want it NOW” attitude is going to cost you, big time.
By this definition of wealth, are you a millionaire? Even without any money in the bank, the typical one of you is halfway there, if you are young enough, with a good enough income and good prospects for advancement. But unlike the traditional definition, under this one, you still have to work to earn your wealth. And, of course, a half-million isn’t what it used to be.
The point is not to brag about achieving a particular milestone, but to help you plan and keep track of your progress. If you are young or are giving advice to some who is, there is a temptation to think that at that age, their choices don’t matter, when in fact, the consequences are magnified as they carry forward throughout their lifetime. Like the ad says about what some luxury will cost you in future retirement savings, you will still be paying for that sports car you bought when you land that great job well after the last payment has been made and well after you have traded it in. There are two types of mistakes people make, undervaluing and overvaluing themselves. If you are young and cash poor, don’t undervalue yourself and treat yourself shabbily, particularly when it comes to taking needless risks. Don’t drive around in a car with bad brakes and bald tires. Measure your wealth as the present value of your future income and you will decide that you can afford to take better care of yourself. Later, when you have more money in the bank, ask yourself if drinking Dom Perignon at Ð150 a bottle is a good idea, when you have always thought Veuve Cliquot, at a quarter of the cost, was an excellent champagne. You can “live a little”, but just because you have amassed some dollars, don’t lose your sense. Don’t get carried away by either extreme.
You students are smart. You can figure out that if you were to only work six hours a day in your peak earning years, you will have to trade that for something else, sooner or later, and the longer you wait, the more you will have to give up for that leisure. This isn't news. Think of the old sayings: "Make hay while the sun shines." or "Strike while the iron is hot." Think for yourselves, don't let me or any one else hand you a slogan for you to chant without you deciding whether it makes sense or not.