The Appropriate Discount Rate In A Lost Earnings Claim

Damage experts don't always agree regarding the appropriate discount rate and underlying methodology for a lost earnings claim and certain commonly applied methods actually provide a windfall to Plaintiffs. The chosen rate can make a meaningful difference in the economic damages conclusion. A recent article, "Lost Compensation Settlement Tool Allows You To Assess Economic Damages Accurately And Efficiently, Under Various Scenarios", demonstrates the significance of the applied rate on damages.

Every few years, the Journal of Forensic Economics (JFE) publishes the results of its survey of National Association of Forensic Economics (NAFE) members regarding their methods, estimates, and perspectives on lost earnings calculations. One of the areas of inquiry is discount rates. In the most recent JFE survey, published in December 2015, the following question is posed:

"Assume the judge instructs that you MUST estimate a net discount rate (and use a fixed rate) in your forecast of total compensation for a 30-year period. The net discount rate may be based upon either nominal or real values. Please note that for this question the net discount rate is (approximately) equal to the interest rate minus the general rate of increase in total compensation for all U.S. workers. Complete the following sentence: "I would use _____% per year as the average net discount rate over 30 future years." (It is recognized that some respondents may not use a single, fixed rate, but the assumption of the question is that a single, fixed rate estimate is required. Because it is the judge's instruction, please answer in the box below. If you would not ordinarily use a single, fixed rate, provide an explanation in the "Comments" box...)"

Results of the 1999, 2003, 2009, 2012, and 2015 (current survey), are provided in the following table:

For the most current survey, the mean and median was 1.36% and 1.25% respectively. The range was between -1.00% and 5.60%. Approximately 12% of respondents thought the net discount rate was 0% or less (recall that the total offset rule dictates a net discount rate of 0% may be mandated by jurisdiction). Some survey respondents provided comments, but only selected ones were published. Thus, it is unclear how many survey respondents use a fixed rate versus a range or some other method. Absent this missing data, the table above suggests a consistent declining trend in the net discount rate employed by experts since 1999. Much of this decline is likely associated with the decline in U.S. government securities rates since the 2009 recession, as many damage experts simply apply those rates in personal injury matters.

In some jurisdictions, this method/rate is mandated, either by statute, case law, or jury instructions. The table at the end of this article provide some examples (note: the example relate to personal injury claims unless otherwise noted). However, many damage experts apply a fixed, risk-free rate even when the jurisdiction allows them to use their own expert judgment. For instance, California law requires that damages be awarded at present value, but does not dictate a rate. Section 3904 of the California Civil Jury Instructions (CACI), entitled "Present Cash Value" follows:

"If you decide that [name of plaintiff]'s harm includes future economic damages for [loss of earnings/future medical expenses/ lost profits/[insert other damages], then the amount of those future damages must be reduced to their present cash value. This is necessary because money received now will, through investment, grow to a larger amount in the future.

To find present cash value, you must determine the amount of money that, if reasonably invested today, will provide [name of plaintiff] with the amount of [his/her/its] future damages.

You may consider expert testimony in determining the present cash value of future [economic] damages."

A low discount rate benefits the Plaintiff as it results in a higher ultimate damages result (all else equal). The JFE survey article also reports that historically (since 1999), approximately two-thirds of survey respondents' earnings in forensic economics were derived from Plaintiff-side work. However, the surveys' published results do not allow analysis of the correlation between rates employed and Plaintiff versus Defendant work. In many instances, a risk-free government securities method/rate may be economically irrational. "Sources and Authority" of CACI 3904 provides additional guidance on the investment approach that underlies the selection of the discount rate:

"Exact actuarial computation should result in a lump-sum, present-value award which if prudently invested will provide the beneficiaries with an investment return allowing them to regularly withdraw matching support money so that, by reinvesting the surplus earnings during the earlier years of the expected support period, they may maintain the anticipated future support level throughout the period and, upon the last withdrawal, have depleted both principal and interest." (Canavin v. Pacific Southwest Airlines (1983) 148 Cal.App.3d 512, 521 [196 Cal.Rptr. 82])

Applying a risk-free rate does not follow these California legal instructions. In cases with longer damage periods, no competent investment advisor would invest 100% of anyone's long-term portfolio solely in risk-free investments. Instead, a proper investment approach matches the time horizon for the investment with the underlying use of the moneys being invested. The use of U.S. government securities is appropriate for (but only for) damage periods that are only a few years from the date of trial. If the lost income period is 30 years, then one should be investing moneys with a 30-year time horizon (and thereby discounting them to present value accordingly). Application of a risk-free rate over this length of time provides an impermissible windfall to a Plaintiff.

Fulcrum Inquiry performs economic analysis of injury and employment damages.

As discussed above, the following table provides examples of jurisdictions that mandate the discount method/rate, either by statute, case law, or jury instructions. These examples relate to personal injury claims unless otherwise noted.

David Nolte is a principal at Fulcrum Financial Inquiry LLP with over 30 years experience performing forensic accounting, auditing, business appraisals, and related financial consulting. He regularly serves as an expert witness.

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