(A) Video on Net Present Value and Opportunity Costs
Video 1—How Net Present Value Shows the Value of Future Money in Today's Dollars
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(B) Application to state funding of pensions
Most states fund the pensions of their employees through promises and savings. If you are a public school teacher, the state will calculate how much money they will need to pay you in the future, and then they save and invest whatever amount of money is necessary to ensure your pension can be funded. For instance, if you are promised $60k in twenty years, the government will invest however much money will accumulate to $60k in twenty years (both numbers adjusted for inflation).
Lately states have not been setting aside enough money, and thereby are seriously underfunding their pensions. The error—though mind you, the error is deliberate—is to assume the state's investments will earn a 7.5% real interest rate, whereas in reality a rate of 2-4% is more realistic. To see how this error results in an underfunding of pensions, consider how much money needs to be set aside to secure you the $60k in 20 years you were promised, using Net Present Value (NPV). Using the unrealistic 7.5% rate, determine the Net Present Value of $60k in 20 years in today's dollars.
[1] NPV = ($60,000)(1.075)(-20) = $14,124.79
Now calculate the NPV using the realistic rate of 3%.
[2] NPV = ($60,000)(1.00)(-20) = $33,220.55
Due to an inaccurate discount rate the government only saves half the money it needs to fund your pension. This is a problem plaguing most all states and municipalities, and the problem is not just that they choose a poor discount rate, but that the voters let them get away with it.