Time Value of Money
(or, how does a buyer decide how much to offer to pay today for a stream of payments to be received in the future?)
Understanding the time value of money is key to understanding how future payments are valued after the applicable discount rate is applied. In other words, if you ask, "Why is the amount I am getting less than the amount I am cashing in?" then the answer is its because the time value of money means money promised to you in the future is "worth less" than money in your hands today.
You can put this into perspective by thinking of a mortgage to buy your house. Imagine that you buy a $100,000 home, but you can't pay cash for it so you take out a mortgage. The mortgage requires monthly payments for next 20 years in our example (your own mortgage might be for fewer or more years). So, if we assume the mortgage payment is $800 per month, the total amount to be paid is $800 x 12 months x 20 years equals $192,000.
If you look at this as if all dollars are worth the same today, regardless of when they are paid, then you would think, "Wait a minute, I'm paying $192,000 for a $100,000 home. That's not right!" The difference is, that you could buy your home for $100,000 today, or you can pay $192,000 over the next 20 years for the opportunity to own that same home (worth $100,000 today). In effect, everyone is agreeing that $192,000 paid as a stream of income for 20 years is worth the same as $100,000 in hand today. (These are just examples for numbers. The actual mortgage payment would depend on the length of the loan, and the interest rate.
So, let's apply the mortgage situation to selling a structured settlement or annuity. When you "cash in" your payments, (or trade future dollars for dollars in hand today) it looks like a mortgage in reverse. To put this into an example, assume that you're to receive annuity payments from your settlement or payout of $800/month for the next 20 years. That would mean a total of $192,000 that you'd receive a little at a time for the next 20 years. If you want to sell that stream of income, no one will pay you $192,000. That's because if you want money today, the purchase price will be based on a discount rate. Simply put, tomorrow’s money is worth less than money today.
So if you decide to trade your stream of income for money today, you get a percentage of what you would have received had you continued to get your money over time. Exactly how this reduced amount (the "discounted present value") is calculated depends on the discount factor that applies. The discount factor will be larger (meaning you get less money) if the buyer wants to make a higher return on his investment in today's dollars. The larger the discount factor, the smaller the amount of money you will get by selling your settlement or annuity today.
Why does is money today is worth more than money tomorrow? There are several factors. First, money today is a certainty, but money tomorrow carries some risk (maybe the person will go broke, or refuse or be unable to make the payments for some reason; you don't have those risks if you already have your money.) Second, there is the investment value of the money, since today's dollars can be invested and grow. If you get $100 day, even if you just put it into a bank and it draws interest, by next year it will be worth more, let's assume only $3 more for this example. So, what you you do if its now one year later than today and I'm asking you to trade $100 for $103? Obviously, the $103 is worth more, so you wouldn't trade. Well, that's why no one would give you $103 today in exchange for your promise to pay them back $103 in the future. (Well, maybe your friends and family would but you won't find anyone quite so generous in the structured settlement industry, where they look at these questions solely in dollars and cents.) If I give you $100 now for your $103 due next year, that is called a discounted rate of return.
Factors that contribute to the determining the amount of the discounted rate of return include the following:
- Risk: future money carries some risk that it may not be paid.
- Lost iInvestment opportunity: you can't invest and earn a return on money that you're waiting for. You can invest money you have today, which makes it worth more.
- Market finances: as interest rates and inflation climb, the value of tomorrow's dollar gets smaller and smaller. That means you will not get paid as much today if interest rates and inflation are high (or are expected to get higher).