For most people, making financial planning decisions involves an evaluation of financial trade-offs. In fact, any decision about whether to save (or not) effectively boils down to a trade-off about whether to consume now, or later.
Of course, all else being equal, we virtually always choose to consume now, if we can. Delaying gratification requires at least some kind of incentive, to make it worth delaying. Or viewed another way, we “discount” the value of something in the future – because we have to wait for it – which means waiting must make something more valuable to ever be worth the wait.
Mathematically, we can quantify this “time value of money” as a discount rate, which represents the rate of growth that would have to be earned to make the waiting worthwhile. And the use of a discount rate is especially helpful when trying to compare strategies or choices that are dispersed or occur over time, where it’s not always intuitively obvious which is the better deal in the long run.
For instance, discount rates are used to evaluate whether it’s better to take a lump sum rather than ongoing pension payments, and to determine when it’s preferable to wait for (higher) Social Security payments, rather than starting early… both of which are trade-offs that entail payments over a span of years or even decades, and can be difficult to compare without a common framework. By calculating the “net present value” of the various alternatives, adjusted by an appropriate discount rate of interest, it’s feasible to make better apples-to-apples comparisons.
The caveat, however, is that conducting such analyses still requires an appropriate choice for a discount rate of interest in the first place. In the context of financial planning strategies, the proper discount rate to use is literally the “time value of the money” for that individual – in other words, what return could be generated over time by the money, if it were in fact available today to be invested. Or stated more simply: the discount rate for financial planning strategies should be the long-term rate of return being assumed in the financial plan itself. Because it’s the portfolio to which the money could be added if taken earlier, and/or it’s the portfolio that will have to be liquidated to provide for spending needs if the payments are delayed until later.
Notably, the fact that the proper discount rate is the investor’s expected rate of return, means that the “right” discount rate will vary from one person to the next, based on their investment approach and risk tolerance. For those who are more inclined towards aggressive investments, a higher discount rate may be used, while those who are conservative will use a lower discount rate of interest (and those who hold all assets in cash might well use a discount rate near 0%!). Of course, the caveat is that investors must still be cautious to pick a discount rate that is actually realistic to the portfolio in the first place – otherwise, an unrealistically high discount rate will lead to decisions that turn out to be less-than-optimal after the fact, when the money-in-hand doesn’t actually produce the expected results!