1 Discounting is like investing, but in reverse. Say Tim expects a return of 12% over a period of one year. If Tim has $100,000 today and invests for one year, he multiplies $100,000 by 1.12, for a future value of $112,000. If Tim expects to receive $100,000 one year from today and wants to know how much this is worth today, he divides $100,000 by 1.12, for a present value of $89,286. Investing multiplies to go from present value to future value; discounting divides to go from future value to present value.
2 Discount rates are provided as examples and will vary based on capital market conditions and an investor’s assessment of their career and industry, among other factors. For bond-like careers, investors can use a discount rate for a government or corporate bond, say 3 to 6%, depending on how they assess the stability of their career. For stock-like careers, investors can use a discount rate — say 8 to 12% for a large or medium company, or 12 to 20% for a small company — depending on how they assess the riskiness of their career.
3 To perform this calculation in Microsoft Excel, enter the income for years 1 to 5 in cells A1 to E1. Then, in another cell, enter =NPV(0.12, A1:E1). The first part of the formula is the discount rate, 12%. The second part of the formula is the future income you want to discount.
4 As a general rule, investors may wish to allocate no more than 80% to stocks or bonds when assessing their career — recognizing that even stable careers have some element of stock-like risk, while even risky careers have some element of bond-like stability. Applying this rule, investors can assess their career on a continuum from 20% stocks and 80% bonds to 80% stocks and 20% bonds, in increments of 10%. The aim is to be approximately right, not precise.
5 Since Tim’s $400,000 career allocation to stocks resembles Canadian mid-cap equity, he decides that his $350,000 portfolio allocation to stocks will emphasize U.S. and global large-cap equity. This provides diversification across his total stock position.
6 Many careers are like a blend of stocks and bonds. For these careers, something in the range of 50% stocks and 50% bonds might be appropriate, plus or minus 10%; the discount rate would be the expected return for a balanced portfolio.
7 Calculating the present value of a pension is beyond the scope of this article. A simplified approach is to take the gross annual payment from all pensions and divide by a bond-like discount rate. For example, a gross annual payment of $25,000 and a discount rate of 5% would amount to a present value of $500,000, calculated as $25,000 divided by 0.05.
8 Since Yamini’s $500,000 pension allocation to bonds resembles Canadian federal government bonds, she decides that her $250,000 portfolio allocation to bonds will emphasize Canadian and U.S. corporate bonds. This provides diversification across her total bond position.
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