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Present value is the time value of money. Present value means a restatement in current dollars of future payment -- for example, the distribution of a pension -- to a current lump-sum equivalent. Money compounds based on the rate of return, which is the time value of money. A calculation of present value considers future compounding and then works in reverse, uncompounding it. Uncompounding is known as "discounting."
In divorce actions, the value of a future payment or series of future payments is discounted to the current date or to time period zero.
Present value is a way of calculating what tomorrow’s money is worth today. Usually, present value is calculated by the prevailing interest rate over a period of time.
Interest rates and present value work inversely. That is, the higher the interest rate money earns, the less money required to generate a certain return; the lower the interest rate, the more money is required to achieve a certain return in a given period of time. Thus, discounting by a lower rate of return produces a higher present value than discounting by a higher rate.
The present value can be used as a leverage factor in property settlement agreements when, for example, one party accepts less for full payment now. Nothing gets cheaper. For the spouse getting support this means that it is a good idea to negotiate a cost of living escalator into the separation agreement. A COLA, as it is called, ties increases in the local cost of living to the agreement, or it assumes a flat percentage increase.
Present value becomes a little more complicated in the distribution of pensions. In pension appraisals, the present value of a pension is sometimes calculated by discounting the anticipated pension benefits by the "real" interest rate.
As it applies to pensions, every pension payment is reduced to reflect the probability that the worker will receive that payment. The mortality reduction for each payment and the interest discounting factor, summed by all payments, gives present value.
In a divorce, sometimes the nonparticipant spouse may be offered an offset asset based on what is termed "a frozen present value," that is, the accrued value of the pension. The nonparticipant spouse thus passes the chance to maximize the value of her ownership of the pension. In short, it comes down a person getting the money now based on today’s dollars or getting the money later based on tomorrow’s dollars (if the QDRO so provides).
Authored By: Theodore K. Long, Jr., President, Pension Appraisers Online, Inc.
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