November 2012

When calculating damages covering future periods, the future amounts must be reduced to present value to account for the time value of money. In the majority of cases, economic damage calculations in personal injury, wrongful death, and employment cases use discount rates that are too low. Consequently, the calculated damages pertaining to future periods are too high.

In some states, statutes provide specific instructions as to the discount rate to be used. In other states, economic conditions dictate how the discount rate is to be selected. For example, in California, 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.”

Further, the section “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])

Risk-Free Investment Returns Do Not Follow these Legal Instructions

When performing these calculations, many economists use U.S. government securities, which are widely viewed as being risk-free. Yet, with longer damage periods, no competent investment advisor would invest 100% of anyone’s long-term portfolio in this way. 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.

Stated otherwise, if the injured party is being compensated for a long-term injury, the investment time horizon is as long as the compensated injury. This is precisely what the above quote from Canavin v. Pacific Southwest Airlines describes. For example, if one’s lost income is estimated to last 30 years, then one should be investing moneys with a 30-year time horizon. As shown below, historical investment returns instruct us as to what investment returns are reasonable, and what securities would reasonably be expected to achieve such results.

Experts using risk-free and/or short-term rates for longer investment holding periods provide no rational justification for doing so, other than (i) an unsubstantiated claim that the law requires this, or (ii) it is “fair” to do so because the plaintiffs should not be forced to invest in risky assets. These claimed justifications ignore that an economic damage analysis is supposed to fully compensate the plaintiff for his injury. A too-high discount rate lowers damages in a manner that under-compensates the plaintiff. Similarly, a too-low discount rate provides an impermissible windfall to the successful plaintiff.

Past Investment Results

Although it is always difficult to predict the financial future, the best method available in most circumstances involves the intelligent use of past data and the lessons that such data provides. Such analysis makes the following lessons apparent:

  1. Over all holding periods, bonds have fewer loss periods than stocks. This is the conventional wisdom. But, the difference between the frequencies of loss periods for stocks vs. bonds is surprising, particularly when the holding period increases.
  2. Although a bond portfolio faced fewer loss periods, the bond portfolio generally significantly underperformed stock returns. This can be seen by visually comparing the larger blue lines with the shorter purple lines. This comment describes the conventional wisdom, although the above online graphic demonstrates this powerfully.
  3. With a holding period of more than ten years, the only time when stocks incurred a long-term loss occurred because of the stock declines during Great Depression. With a longer holding period, stocks are not nearly as risky an investment as some damages analysts would lead one to believe.
  4. There have been few periods when bonds beat stock returns. We are currently in one of those rare times when a long-term bond portfolio beats a long-term stock portfolio. History instructs us that this will not continue. This is easy to imagine in the current low interest rate environment. An increase in interest rates from their currently-low historic levels will cause the market value of fixed income securities to drop, which in turn will bring us back to the normal situation when stocks outperform bonds.
  5. At a 15-year holding period for stocks, there is never a period when losses occurred.

One could also create portfolios that include a mix of stocks and bonds. With a mixed bond and stock portfolio, the returns are an average of the bond and stock returns using an approach called “passive” investing.

The bottom line of the above is that the damage analyst should create a conservative model portfolio and identify historical investment results that would have been achieved with that conservative portfolio. The rate of return actually earned in the past is the proper basis for a discount rate over a similarly long period in the future. Such a discount rate should be used for longer-term periods over which the plaintiff is being compensated. Short-term compensation periods should use an investment that does not face principle fluctuations.

Damage analysts often use a “net discount rate”. A net discount rate is the difference between (i) the discount rate (or investment rate of return) shown in the above interactive graphic, and (ii) the growth rate in the future cash flows. For example, if the injured party’s income would be expected to grow in the future because of inflation or increased earning capability, the expert has the option of either growing the future earnings, or deducting the rate of earning growth from the discount rate. By using this smaller net discount rate, the calculation is simplified. Net discount rates are appropriate when one believes that inflation will increase required rates of return, as measured by the gross discount rate. Under this simplifying assumption, whatever future inflation occurs, the present value calculated using a net discount rate will remain correct.

The instructions contained herein do NOT apply to business or commercial damage calculations. Calculations involving business lost profits should be calculated based on the riskiness of the lost profits that are being discounted. There are a number of well-established methods of determining discount rates for businesses, but these methods are based on different concepts than discussed above.

Fulcrum Inquiry performs economic analysis on commercial damage, injury and employment damages, business valuation, and forensic accounting services.