Vocational Economics Inc.
Vocational Economics Inc. staff
 

Use of a Total Offset

 

For litigation seeking recovery of lost earnings, “present value” refers to the amount of money needed today which, when prudently invested, will replace the future stream of those earnings.  The present value sum plus accumulated interest should provide periodic cash payments to replace the expected lost earnings over the plaintiff’s worklife expectancy, with no shortfall or overage.  Determination of the present value of a wage stream is dependent upon two key rates: the rate of expected annual increases in compensation and the rate of return at which to invest the lump-sum award.

Compensation Growth

Essential to the estimate of future compensation is an estimate of the rate at which current compensation levels will increase over the plaintiff’s worklife expectancy.  Many economists gauge this estimate by applying the average increase in wages over the past several years.  However, relying only upon average growth rates for wages when projecting future earnings will underestimate overall compensation growth because this growth rate ignores the importance of fringe benefits in an employee’s total compensation.

Data collected by the US Bureau of Labor Statistics demonstrate the increasing importance of fringe benefits to the average US employee.  Over the past 50 years, fringe benefits have grown considerably faster than wages, resulting in an average annual increase in total compensation roughly one percent larger than the growth rate in wages alone.  This is demonstrated in the chart below.  Therefore, average growth rates in total compensation are usually more relevant for computing present value than the average growth rate for wages alone. 

Discount Rate

In addition to a growth rate to reflect future increases in compensation, an expert needs to discount the future value cash flows to reflect the interest to be earned by conservative investment of the lump-sum award.  If plaintiffs invest to replace future losses in labor market compensation, then a safe, short-term government treasury, such as a 91-day Treasury Bill, is a logical investment vehicle because it provides the best return on investment with minimum risk. 

Use of the 91-day T-Bill is based in part on the decision by the U.S. Supreme Court in Jones and Laughlin Steel v. Pfeifer (462 US 523; 1983).  In this decision, the Court discusses appropriate discount rates for calculating present value for a future earnings stream:

The discount rate should be based on the rate of interest that would be earned on “the best and safest investments.”  Once it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-free stream of future income to replace his lost wage; therefore, the discount rate should not reflect the market’s premium for investors who are willing to accept some risk of default. 

Not only does this instrument offer the backing of the US Government, considered as the lowest default risk in the world, it offers the best protection against inflation risk.  For example, one could invest in a 30-year US Treasury Bond and get the same protection against default risk.  However, if inflation then rose significantly, the interest rate returned by those bonds would be rendered below market, perhaps even below the inflation rate, for the remaining duration of the bond.  Utilization of a short-term instrument like the 91-day Treasury Bill affords maximum flexibility to reinvest at the current rate as inflation changes.

Net Discount Rate

Once an expert identifies the appropriate data regarding growth and interest rates, the main issue is the relationship between the two, or the net discount rate.  One must exercise caution, however, not to be swayed by the current “spot” rates.  Our economy flows in cycles, and compensation growth and interest rates can vary significantly from period to period.  The graph below depicts the net discount rate derived from compensation growth rates and a 91-day T-Bill, and averaged on a 5-year rolling horizon.  It shows the post-world war years with a negative net discount.  That is, compensation growth exceeded the discount rate for these years as workers began to demand and receive more lucrative fringe benefit packages.  As the days of hyper-inflation and economic deficits hit in the 80’s the rates reversed, causing interest to exceed compensation by as much as 4%.  Recent fiscal and monetary controls have brought the net discount back below 0% (growth rate exceeds discount) for the past few years.

Using these same data, one can examine the average net discount rate for a period of varying lengths of time to the present day.  The chart below shows this rate for several such periods to 2005.

Long-term interrelationships between compensation growth and interest rates show that, overall, the average long-term return on a 91-day Treasury Bill has been roughly equal to average compensation growth rates.  Recent years show a decidedly negative discount.  However, one must be cautious in projecting current conditions over a long-term horizon.  The use of a pure offset method recognizes historical cycles and acknowledges the uncertainty in the future relationship between growth and interest rates.

Data Used

For more information on the data used in the analyses on this page, see the following links:

In addition, the Offset Bibliography page provides further research in this area.  For an illustration of the effects of varied net discounts rates on a present value calculation, see the Net Discount Comparison page.