iPod or IRA?

It's 2 p.m. You've worked through lunch and now you're starving. You're about to buy a Snickers bar from the vending machine when a co-worker snatches the bill from your hand. "Hey, a buck for that little candy bar? Get serious! Give me the dollar and I'll bring you two candy bars tomorrow." Tempted? Not even remotely. You want that Snickers and you want it now, despite the offer to double your return in 24 hours.

A week later you win a lottery. You can take $1,000 today or $1,000 one year from today. Duh! Of course you'll take the money now. But what if the choice is $1,000 now or $1,100 next year? $1,000 now or $1,200 next year? $1,000 vs. $1,300? At what point do you take the future value? Does your preference change if the pot increases to $1 million now or $1.1 million next year? Or $1 million vs. $1.2 million?

Here's another scenario: You win a lottery that pays you either $100,000 today or $1,083,471 on your retirement in 25 years. Which would you choose?

Discounting your future
It's human nature to "discount" the future, whether we're buying overpriced snacks from a vending machine or spending $300 for an iPod instead of opening an IRA. The more we prize the present value (bird in the hand), the higher our discount rate on the future (two birds in the bush). The financial concept of the "time value of money" could help our thinking, except that the mere mention of it causes most people's eyes to glaze over. But here goes: If the risk-free rate of return is 6%, then selecting a guaranteed 10% return in one year is the right choice for most people, whether the gain is $100 or $100,000. Unfortunately, this concept ignores the now factor, our urge for immediate fulfillment -- the adrenaline surge of the impulse buyer, the opiate of the shopaholic.

Not only do people discount the future, but they also apply inconsistent discount rates. (Remember, a discount rate is merely the interest rate that is used in calculating the present value of a future sum of money). We're influenced by the amount at stake, by the length of time to pay off, and especially by our patience -- our ability to defer gratification, at least occasionally, for a greater benefit in the future. We instinctively apply the highest discount rates to small sums and distant payoffs, which is a huge problem for retirement planning. For most people, a happy retirement requires exactly that -- saving small sums over decades.

The poster boy of want it now! was the biblical Esau, who returned home famished after a day of hunting and traded his birthright -- a secure retirement, if you will -- for a bowl of beans. How's that for shortsightedness!

On the want it now! scale, Esau was off the chart: future discount equals 100%. But behavioral economists tell us that many households have irrationally high future discount rates. They are "hyperbolic consumers" who spend all their earnings on immediate wants and arrive at retirement with little or no savings. They will face decades of financial misery, supported only by a teetering Social Security system. In contrast, households with similar incomes but lower future discount rates will control spending and build a nest egg. They defer some consumption today to ensure consumption during retirement.

Smoothing the way to retirement
Few of us get the choice of a single lump-sum $100,000 today vs. $1,083,471 in 25 years (the future value of $100,000 at 10% compounded annually). Instead, we must make an equivalent series of small choices throughout our lives, contributing to our 401(k)s, IRAs, and other long-term investments. The prudent approach, to use the economist's phrase, is one of "consumption smoothing" across our financial life cycle, saving in the early years so we can spend later.

The question is, how do we lower our future discount rate so that we invest early and often? We're tempted at every turn by flashy ads for "must have" items. And lenders encourage our spending with creative mortgages, revolving lines of credit, teaser loan rates, and mailboxes stuffed with credit card offers. We're kids in the candy store of life with an unlimited charge account.

Follow the golden "retirement" rule
There's one solution for funding the golden years that pre-empts the temptations of overconsumption: Fund your future first. Treat retirement savings as non-disposable income -- money that never hits your checkbook. Your disposable income is what's left after taxes are withheld. But think about that for a moment. Uncle Sam's at the front of your earnings queue, demanding a privilege you deny yourself. That would be fine if your Social Security taxes completely funded your retirement. But if you want more for your golden years than a struggle to make ends meet, then you should treat retirement savings as non-discretionary, just like your taxes.

If you're not doing so already, you owe it to your future to take the following steps -- immediately.

• Invest in your company's 401(k) or similar tax-deferred plan, at least to the amount of any employer match.
• If you're eligible for a Roth IRA, open one and arrange automatic monthly funding.
• When you get a raise or bonus, designate a portion for your tax-deferred savings.
• Figure out how much you should be saving for retirement and increase your investments by that amount.
• If you're a late starter or far below your savings target, do what it takes to bridge the gap with "catch-up" funding.

The key requirement for all these steps is to fund them off the top of your paycheck, just like your taxes.

The grasshopper and the ants
If your household has a dangerously high future discount rate, consider this contemporary update of Aesop's fable about the grasshopper and the ants. The industrious ants have all maxed out their retirement accounts, while the carefree grasshopper has no 401(k) and no IRA. His retirement, which never crosses his mind, will be a rude awakening. But until then, he's one happy critter, hip-hopping to the tunes on his iPod.

Uncertain about your retirement prospects? Sign up for a year of the Motley Fool Rule Your Retirement service, where you can learn the ins and outs of retirement planning from knowledgeable Fools who've been there and done that.

One of Fool contributor Doug Short's favorite pastimes is hanging out on the Rule Your Retirement discussion boards. Doug also welcomes visitors to http://dshort.net where, among other things, he posts his favorite travel pix. You can reach Doug at [email protected]. The Motley Fool is investors writing for investors.