Consider someone permanently injured or killed in their early 30s that:
- Had a remaining expected work life of 40 years.
- Would have earned $100,000 a year.
Undiscounted, that is $4.0 million in damages. Using the “risk-free” rates of today (some of the highest that have been seen in 20+ years), results in a damage payout of approximately $2.8 million. If you instead assume the “risk-free” rates will not stay at these historic highs, a more modest discounting results in damages of $3.7 million. Making a single change to the discount rates to reflect widely accepted and prudent investment practice damages drops by between 33% and 50%. This can be seen in the following chart:
Background
Economic damages will often continue into future periods. Absent the rare instance where specific statutory instructions preclude such, it is necessary to reduce economic damages in future periods to represent the time value of money. In practical terms, this reduction represents reasonable expected returns on the monies awarded. In effect, the monetary damages awarded in the now are assumed to appreciate over the lifetime of the damage period to cover total. To do otherwise (i.e., to not reduce future damages) would represent an impermissible litigation windfall to the plaintiff.
In personal injury lawsuits, damages continue into future periods if the plaintiff’s ability to find replacement work is adversely affected. Successful claimants are assumed to invest their lump sum award in appropriate asset classes and use the principal and the returns to offset their future losses. The damages payout, i.e., monies received in the now, will be invested and the damages payout plus returns from prudent investment should grow to cover the entire damage period. In an ideal world, the final withdrawal at the end of the damage period will have depleted both principal and investment returns.
Reducing future damages is generally referred to as “discounting” and is mathematically represented as a “discount rate”, which are expressed as a percentage.
The Problem
What is an appropriate discount rate? Discount rates are generally between zero and 40%, though circumstances occasionally make appropriate discount rates outside this range. And small changes to discount rates can produce wildly different results over the long periods of time that personal injury and wrongful death damages occur. If the discount rate is too low, it will overcompensate the plaintiff; too high and it will undercompensate.
The discount rates that would be appropriate for commercial damages are not usually appropriate for personal injury and wrongful death damages. Unlike personal injury and wrongful death damages, future damages for commercial damages are discounted based on the economic risk of the business, generally measured by equity, industry, size and specific risk factors. There are several methods widely accepted for calculating this for a business.
There are not as many widely accepted methods for personal injury and wrongful death damages. The perpetrator of future damages (generally the defendant in personal injury and wrongful death cases) should not benefit from the assumption of aggressive risk (i.e., higher investment returns) by the plaintiff. As a result, many of our contemporaries use risk-free or short-term investment returns for the entire damage period. This way of calculating damages heavily favors the plaintiff by minimally reducing future damages, if at all.
Using risk-free returns across all periods is inappropriate. Monies should be invested on time horizons comparable to the injury. Discount rates using only risk-free or short-term returns do not meet this expectation in the long term. It is more appropriate to discount monies that will not be used for longer periods at a higher discount rate to represent the returns over that longer holding period.
Historic Returns
It is reasonable to base projections using historic data. Financial planners do this routinely. The following summarizes historical investment return data. Among other things, the data measures returns of multiple investment classes over multiple holding periods. Analytics specifically looked at in how many periods there were losses under each class. The “Longest Holding Period” displayed below is the investment period for each asset class that was required historically being guaranteed a positive return:
As an example, there are no fifteen-year holding periods in the past 100 years where someone could have invested in large-cap stocks and have experienced a loss. This is true even during periods of economic downturn. The Longest Holding Period for less risky asset classes are generally shorter while more risky assets are longer. There is no Longest Holding Period for US Treasuries, indicating they generally never experience losses.
The Longest Holding Period is when each asset class would have been historically guaranteed returns. The chart does NOT show how long the asset classes need to be held before it would be reasonable to expect returns. The Longest Holding Periods include periods of significant economic downturns, including:
- The Great Depression, which is generally considered to take place from 1929 to 1939
- The Great Inflation in the 1970s, which peaked between 1973 to 1975, but affected the economy from 1965 to 1982.
- The Global Financial Crisis of 2007 and 2008, aka “The Great Recession.”
Because these adverse economic events are rare, most of the holding periods experienced positive returns. The following graphic puts this into perspective:
The asset classes with longer Longest Holding Periods receive greater returns. The following is the average returns by asset class for their respective Longest Holding Period:
Looking once again at US Treasuries, while they generally do not experience losses, they hardly receive any gains. Prudent investors are better served by investing in other asset classes when long holding periods are available; this is the widely accepted and prudent practice.
Recall that the objective is that the defendant does not benefit from assumption of aggressive risk by the plaintiff. It is equitable that plaintiffs in personal injury and wrongful death cases be expected to assume the use of investments that are considered ordinary and prudent by practically all investment managers. Consistent with such an investment approach, cash requirements for only the first few years of the damage period should be invested in risk-free assets.
Our Solution
The use of “risk-free” returns significantly overstates damages when applied to longer damage periods. To correct this error, Analytics uses a tiered method to apply discount rates. Broadly speaking, the returns of low-return investments are applied to earlier returns, with higher returns applied to damages in later periods where the longer holding periods mitigate the risks. We match investment returns against to periods where they can reasonably be expected to have positive returns. This method is conceptually sound in that it follows prudent and widely accepted investment strategies. It is equitable to both party because it provides for assumption of reasonable risk and investment returns.
What should I do?
Hire an expert (like us). As an expert, we will save you time and money because:
- We have the expertise to calculate and support appropriate discount rates for future damages.
- We know the sorts of financial information that are needed to calculate economic damages in personal injury and wrongful death cases.
- We are intimately familiar with the financial information upon which economic damages rely.
- We have experience defending these calculations in deposition and at trial.
We can provide expert witnesses testimony in a simple, efficient manner so that triers of fact can understand otherwise complicated subjects.