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TIME VALUE OF MONEY: AN INTRODUCTION TO PRESENT VALUECezary Podkul |

@Cezary

3/11/2016

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Link to Class Materials

• Everything you need is in Dropbox:

bit.ly/1XiGytY

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Roadmap• What we hope to cover today:

1. Sales Pitch: Why is it useful for you to know present value?

2. Example: We’ll model out a simple example together3. Application: We’ll apply what we

learned to a real-life example – CalSTRS

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Why Learn PV?Part 1

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Why Learn PV?• What is it?– A way to put a value today on a stream of

payments owed in the future, such as:• Pension payments• Lottery winnings• That Social Security check you’ll be getting in 40

years• Any flow of money

– All you need to know is the amounts, the time when they’ll be paid, and the interest rate

– Answers the question, “What is that flow of money worth to me today?”

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Why Learn PV?• Can lead to some great

reporting

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- The Washington Post, August 25, 2015

- The Wall Street Journal, October 19, 2012

- Bloomberg News, August 13, 2015

- ProPublica and The Washington Post, July 10, 2015

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Why Learn PV?• If you understand PV,

you can make sense of documents like this– Sample structured

settlement sale from Terry McCoy’s reporting

– Sells $1.6 million in nominal payments worth $844,00 for $40,000, or 5 cents on the present dollar

– Clearly a ripoff3/11/2016 NICAR 2016 | Denver

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Why Learn PV?• And documents like this

– Bond disclosure from NJ saying that their pension liability increased to $82.8 billion from $37.3 billion

– Fine print that made local and national headlines

– The culprit? Discount rate used in PV analysis: 4.29% vs. 7.9% makes a big impact; see our explainer here.

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Why Learn PV?• Better understand

headlines like these– Why is Michael Dell

willing to pay $67 billion for EMC?

– Depends on how much EMC’s business is worth to him today

– How do you find out? Present value of future earnings – plus takeover premium

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- Forbes, October 12, 2015

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Why Learn PV?• Plus, the math makes for great

visuals

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Why Learn PV?• And these concepts are coming to a

state legislature near you!– Anyone here from Alaska? This one’s yours:

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Why Learn PV?• So it’s worth knowing the

mechanics of these calculations

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Simple ExamplePart 2

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Simple Example• Formula for calculating present value

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Present ValueFuture Value

Discount Factor =

Where:Discount Factor = (1+ i )n

i = expected rate of returnn = number of time periods

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Simple Example

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Let’s test drive it!Open a blank Excel worksheet and

let’s pencil out an example together

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0 1 2 3 4 5 6 7 8 9 10 $-

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

Present value Cumulative annual payments

Simple Example• Mathematically, this is always true – why?

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Year

Amou

nt

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0 1 2 3 4 5 6 7 8 9 10 $-

$20

$40

$60

$80

$100

$120

Present value Cumulative annual payments Reinvested value

Simple Example• Mathematically, this is always true – why?

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Year

Amou

nt

Because of this

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Simple Example• A related formula that is worth knowing

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Net Present Value

Future ValueDiscount Factor

=

Where:

Discount Factor = (1+ i )n

i = expected rate of returnn = number of time periods

– C +

– C = Initial investment (negative because spending money)

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Application: CalSTRSPart 3

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Application: CalSTRS• Let’s apply what we just learned to a

public pension plan– CalSTRS: The 2nd largest U.S. public pension• Has $179.4bn in assets• Pays $1bn+ in monthly benefits• Covers 896,000 members and

beneficiaries–What’s the liability today? • Depends on future payments due to

retirees

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Application: CalSTRS• Projected cumulative pension payments of

$1.7 trillion due over the next 100 years

Present value of those payments = liability today3/11/2016 NICAR 2016 | Denver

20152019

20232027

20312035

20392043

20472051

20552059

20632067

20712075

20792083

20872091

20952099

21032107

2111$0

$200,000,000,000

$400,000,000,000

$600,000,000,000

$800,000,000,000

$1,000,000,000,000

$1,200,000,000,000

$1,400,000,000,000

$1,600,000,000,000

$1,800,000,000,000

Cumulative Benefits Due

$1.7 trillion of pension benefit

payments

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Application: CalSTRS• First a bit of pension accounting–The accrued liability (AAL) is the present

value of future payments to retirees–The pension asset value (AVA) is what’s

available today to pay future liabilities– If pension liabilities exceed assets, then

there is an unfunded liability (UAAL)–The size of the funding gap is measured

using the funded ratio (AVA/AAL) . . . More key terms available here

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Simple Example

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Goal: Calculate the AAL and use it to estimate the UAAL

Let’s walk through it together

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Application: CalSTRS• So how do we know if we’re right?

– Check the Comprehensive Annual Financial Report– ‘Schedule of Funding Progress’ is your best friend

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Application: CalSTRS

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- The Los Angeles Times, November 18, 2015

• The assumed rate of return matters – a lot!– CalPERS, the other big California pension,

shows why:

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Application: CalSTRS

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(See CalPERS’ response to Crane)

• Once you fall behind, catching up is hard– Taxpayers or markets have to pick up the tab– Even if markets do their part, it may not be

enough

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Application: CalSTRS• Homework: CalPERS

- CalPERS also provided us data for this exercise BUT:- Projections only for 30 years- ‘True-up’ based on partial data

. . . So take it with a grain of salt

- Benefit projections include future normal cost- Discount rate is same as CalSTRS, 7.5%

- PV the benefits and see how sensitive they are to the discount rate assumption

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Questions?cezary.podkul@propublica.org

@Cezary

3/11/2016 NICAR 2016 | Denver