This is the second of a two-part series on calculating the value of your job, specifically the present value of your future potential earnings. Part one covered the math of how to calculate present value of future earnings and the implications for those on track for a normal retirement at age 65. Part two covers the implications for people looking to retire early or downshift their careers and improve their lifestyle. Please read my earlier post on understanding present value for additional detail.
Present Value of Future Earnings
The first part of this series examined the math needed to figure out the present value of all your future earnings. With only four assumptions – current pay, annual raises, number of years until retirement and a discount rate – you can figure out the lump sum value of all your future earnings.
The big take away was that people early in their careers had a tremendously valuable asset, namely their ability to work and earn an income. The challenge, however, was that this was a depreciating asset that loses an increasing amount of value as you move closer to retirement age.
In order to offset that declining value, you have to save a portion of your income in order to build an investment portfolio able to support you once you no longer are working (i.e. present value of future earnings equals zero).
But what about people who don’t want to keep working until age 65? Or who downshift their careers to achieve better work-life balance? Taking either of these action is akin to voluntarily impairing an asset you own. That’s not to say you may have your reasons or the financial means to do it. Rather, simply make sure you’re comfortable with the choice and fully understand the implications.
Another Simple Example
In part one, we looked at a simple example involving Patty, a recent college grad with nothing but a dream and a willingness to work. When she started out making $40,000 per year that equated to more than $2.1 million of value if she worked until age 65.
Now let’s fast forward and revisit Patty eight years later at age 30. If she was getting a standard 3% raise, she’d now be earning a little over $50,000 a year. But she’s not. Let’s assume for a second that she went back to school and got a graduate degree. As a result, she’s making $100,000 a year. If all the other assumptions stay the same, the present value of her future earnings are worth about $4.2 million because of her higher income. The trajectory of her earnings value would look like this:
Her $4.2 million of value today at age 30 becomes zero at age 65 when she is no longer working. Because the starting amount is higher, the decline is steeper and the asset depreciates faster.
Implications for Early Retirement
But what if Patty doesn’t want to work until age 65, for whatever reason. Now her $4.2 million asset isn’t worth the same, even as she keeps on earnings exactly the same pay. How much less depends on how much she wants to curtail her working years. Here is the same graph as above but adding new lines with the target retirement date moved up by 10 years and 20 years.
The curve shifts both down and to the left. Why? There are two factors at play here:
- Future value of earnings is zero once you reach the age where work stops. So each of the future values has to get to zero quicker as you move up the retirement date.
- The fewer years working, the fewer cumulative dollars of earnings will be received. Retiring at 45 results in 20 fewer years of earnings than retiring at 65, and that reduces the value of future earnings as of today.
You can essentially think of the gaps between the lines as the value that is being impaired as a result of choosing to work less.
Returning to our example with Patty, let’s say that she works for a few more years, but decides at age 35 that she’d like to retire 10 years sooner than she previously thought. While she would have followed the blue line above all the way to age 65, now she gaps down to the orange line. Her new graph looks like this:
For those of you keeping score at home, that initial drop at age 35 is worth about $1.5 million dollars. In addition, she’ll now have no future value left after age 55, whereas she could have had more than $2 million of value had she chosen to keep working. Here is the relative value Patty is foregoing over time:
Until she makes the decision to retire early at age 35, there is no value difference, but it jumps up as soon as she makes the call. In addition, the value gap widens over the subsequent years, peaking at age 55. The reason the gap grows is because depreciation happens quicker the closer you get to the end. While both assets are depreciating, retire at 55 is always declining faster than retire at 65 because its end is ten years sooner. After age 55, the gap falls since retire at 55 is already at zero and retire at 60 is just catching up.
All in, choosing to retire early takes an ax to value of your future earnings. Intuitively it should make perfect sense, but you need to do the math if you’re considering doing this.
Implications for Downshifting Careers
Now let’s look at same analysis, but assume that instead of retiring early, Patty wants to switch to a career that would pay less, but will still plan to retire at age 65. In this case the curve doesn’t shift, it rotates.
The point of rotation is $0 of future earnings value at age 65 because it is common to all scenarios. Reducing the earnings compared to baseline simply rotates the curve counterclockwise. If Patty takes a job paying 20% less at age 35, she’ll experience a $900k reduction in present value of future earnings compared to before.
In the case of downshifting careers the gap between paths is widest at the point the decision is made, but then slowly reduces over time.
Comparing Early Retirement vs. Downshifting Careers
If Patty chooses to take a new job with a 20% pay cut, she’ll still experience an immediate decline in present value of future earnings, but not as severe as retiring 10 years early. This should make logical sense: cutting short the number of years is more punitive than taking a lower paying job and working longer. You can see it visually by overlaying the two charts on top of one another:
But there are cases where downshifting careers or retiring early result in exact same impact to present value of future earnings. You can actually calculate an equivalence between the two. All you have to do is figure out for a given retirement age, what decline in earnings results in the same (new) present value of future earnings. Here is that equivalence for Patty:
If Patty wants to retire at age 45, that would have the same present value outcome as taking a 67% pay cut today and working to 65. Retiring at 55 is the same as taking a 34% pay cut. While these numbers are specific to our example, you could do the same to understand the trade-offs between working longer at lower pay or shorter at higher pay.
One other point that can’t be understated when comparing these two alternatives: all present value of future earnings is theoretical until concrete action is taken. In the case of early retirement, that is when you actually stop working. A day before you give notice and you value of future earnings is effectively zero, you could change your mind and immediately return the value of the asset to its higher value. The value impairment doesn’t become locked in until you quit for good, and that decision is entirely within your control.
In the case of downshifting careers, the permanent value impairment happens much sooner: at the time of the career change. In addition, reversing it is no longer entirely in your control. Now you have to convince someone else to pay you more.
The Upshot / My Story
If you’ve read any of the introductory stuff I’ve posted about myself and our journey to financial independence, you’ll know that I chose to downshift my career instead of plowing through and retiring early.
My decision was mainly based on the realization that downshifting careers would provide lifestyle benefits my then current job just couldn’t match. While it would require me to work longer before reaching financial independence, I wouldn’t be working as hard while I was doing it.
The fact that I have young children weighed heavily on my decision as well. Continuing at my prior job would have allowed me to retire early, but would I have been working like crazy while my kids were growing up. It was important for me to be there for my kids and a less stressful, albeit lower paying, job allows me to do that. Yes, I’ll have to work longer, but the upshot is I get to be a dad in the here and now.
Readers, were you surprised to see how decisions regarding early retirement or downshifting careers impacts present value of future earnings? How do you weigh making choices like these?
John started Present Value Finance in 2017 to share his experiences and insights on personal finance to help people make better decisions and take control of their financial lives.
He achieved financial independence in 2016 by walking away from the high stress world of corporate finance to focus on his family. He’s a husband, father, family CFO, and all around finance geek.
He uses Personal Capital* to track his spending, investments and investments for free and recommends you do too.
* Affiliate link.