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Constant Dollars
Introduction
“Constant dollars” is a term used to describe an inflation adjusted future (FV) sum of money. Although it refers to US currency, dollars could conceivably be swapped for any other fiat currency.
Usage And Applications
Based on the Time Value of Money (TVM) concept, it is understood that inflation will reduce the purchasing power of money over time. As a result, when we conduct forward-facing financial planning activities that have goals and targets set in the future, failure to adjust for this loss of purchasing power will produce flawed results. Even though the dollar amount might be achieved by the plan, the purchasing power of that amount is then lesser than it was at the time the target was set. Put another way, the value of the dollars is not constant. To achieve constant dollars, a calculation must be made to adjust for the loss of purchasing power over time. To perform this calculation two things must be known:
1) The assumed rate of inflation over the period
2) The number of periods (years/months/weeks/days)
Constant dollars are often referenced in retirement planning exercises, and financial planners will often be tasked with determining the “constant dollar” value in series payment calculations.
Examples Of Use
Mrs. Client has told her financial adviser that she wishes to gift her granddaughter 100,000 USD on her 21st birthday. At the moment, her granddaughter is 15 years old. Mrs. Client has asked her financial adviser how much she will have to invest in the market annually to be able to gift her the present-day equivalent of 100,000 USD on her special day. Together, they agree on some assumptions regarding inflation, and average investment returns:
Average Inflation = 3% p.a
Average equity returns = 8% p.a
Term: 6 years
Target: 100,000 USD
The calculation to determine the necessary investment in year 1 would follow:
Real rate of return
1.08 / 1.03 = 1.0485 X 100 –> thus giving a real CAGR of 4.85% p.a
Annual investment required: 14,757 USD
Constant dollar annual investment required in Year 1: 14,757 X 1.0485 = 15,472 USD
Following years required contributions would be calculated by multiplying the prior year constant dollar amount by 1.0485.
Sources & Further Reading
- Journal of Financial Counseling and Planning 11 (1): 69–74 – Consistent Treatment of Inflation for Retirement Planning – Joyce, William B
- Retirement Planning and Employee Benefits. 12th ed. St. Metairie, Louisiana: Money Education – Dalton, Michael A., and James F. Dalton