72 CBJ 375. Present Value Analysis in Estimating Damages in Torts.

• Author: By WARD S. CURRAN (fn*)

Connecticut Bar Journal

Volume 72.

72 CBJ 375.

Present Value Analysis in Estimating Damages in Torts

375Present Value Analysis in Estimating Damages in TortsBy WARD S. CURRAN (fn*)I. PRINCIPLES OF PRESENT VALUE

In principle determining damages in torts is a straight forward proposition. Whether the plaintiff has suffered loss of earnings or earning capacity, incurred medical and other out of-pocket expenses, it is customary to divide the computations into past and future losses. There are usually data underlying past losses of earnings and out-of-pocket expenses. Future losses, however, must be estimated within a reasonable probability. (fn1) The methodology employed to determine the value today of future losses is present value analysis.

It is universally recognized that a sum received in the future is worth less than an equal sum received today. (fn2) For example, an amount, x, which is less than $100, can be invested at a rate of interest, r, so that a year from today

x(l+r) = $100

If r is 6 percent then

x(l.06) = $100

$100

X

1.06 x = $94.3396

As computed, $94.3396 will earn 6 percent interest resulting in $100 at that time. Similarly the present value or value today of $100 received at the end of two years at an interest rate of 6 percent compounded annually (fn3) is:

376 x (1.06)2 = $100

x = $88.9996

By analogy the present value of $100 received at the end of year one and at the end of year two is the sum of the present value of each so that

$94.3396 + $88.9996 = $183.3392 = $183.34

Although the principle of present value is well established, its application to standard torts cases can differ among jurisdictions. Connecticut, for example, remains open to any acceptable approach. In a 1988 decision the Connecticut Supreme Court noted . . . . we recognize that economics is an inexact science and we hesitate to adopt any particular method for computing the present value of lost compensation and future Costs. (fn4)

The complete freedom an economist enjoys in Connecticut state courts is circumscribed in a federal action in the Second Circuit. Here, the presumption is that future damages will be discounted at a real or inflation-adjusted interest rate of two percent. (fn5) If the economist were testifying in Alaska, damage awards would not have to be reduced to present value. More precisely the interest rate at which future losses are compounded equals the interest rate at which they are discounted. (fn6)

377 In addition, in several jurisdictions, the trier of fact determines the discount rate using the "safe investment" or unskilled investor" standard. Under this standard the trier of fact is expected to employ a discount rate that can be anticipated from "reasonably safe investments" which a person with no particular financial experience or skill could make. (fn7)

Finally, in cases governed by federal law, the U.S. Supreme Court has stated that [it is] clear that no single method for determining present value is mandated by federal law and that the method of calculating present value should take into account inflation and other sources of wage increases as well as the rate of interest. (fn8)

In the conclusion of this article we shall return to these disparties in court interpretations of the discount rate and how courts could in light of recent developments in the financial markets be better focused.

2. PRESENT VALUE METHODS: THE NECESSARY COMPONENTS

   That there is no single method for determining present value is correct, for there are essentially three. I shall refer to them as: 1. The current (nominal) dollar earnings and current (nominal interest rate method.

   2. The real earnings and real interest rate method.

   3. The total offset method.

   Although each method may be applied to any measurable element of damage, I shall employ them on the most common element, loss of future earnings or earning capacity. An 18-year-old who dies in an automobile accident a month after being accepted to college has a future earning capacity as does a 55-year-old tenured full professor of chemistry killed in a plane crash. Because they were at different stages of life, the central factors that determine future wages would affect each differently. The 18-year-old would not have embarked on a career path but a reasonable approach to his or her earning capacity would be the life-cycle pattern of earnings of col

   378 lege graduates. The tenured full professor of chemistry would not likely shift careers or employment. Hence, his future earning capacity would be based on his expected earnings as a professor at the institution where he was tenured. A factor determining future wages, promotion, would be captured in the life-cycle pattern of earnings for the 18-year-old but would no longer be relevant issue for a 55-year-old full professor of chemistry.

   A second factor determining wages, how' they are associated with inflation, will affect all workers, as will a third factor, the general growth of the economy. To illustrate, suppose a lawyer in a given city who started in 1960 at $7,000 per year as an associate would, in 1998, start at $56,000. A fair amount of that difference would be consistent with a general rise in prices. In 1997 the price level as measured by the Consumer price Index (CPI) had risen about 5.5 times over the level prevailing in 1960. (fn9) However, $7,000 in 1960 is equivalent to $38,500 ($7,000 x 5.5) not $56,000. The difference can, in part, be attributed to economic growth in which we all share. (fn10) How the three general factors, as well as any case-spe

   379cific factors pertaining to wages, are treated varies with the present value method employed. Before turning to that issue, however, we must deal with the factors underlying the other half of any present value technique, the interest rate or discount rate.

   As interest is the price for borrowing money, what general factors determine that price? In principle there are again three: the rate necessary to equate the demand for with the supply of funds, a premium for expected loss of purchasing power, and a premium for the loss of some or all of the principal. These factors are often characterized as the real rate of interest, the inflation premium, and the premium for the risk of default. Briefly an observed or nominal interest rate is comprised of all three factors. Moreover, conceptually one can view these factors as additive so that:

   nominal interest rate (i) = real rate (r) + premium for inflation (f) + premium for risk of default (d)

   In symbols: i = r + f + d

   As presented (fn11) one can observe any interest rate and see in it a real rate, a premium for risk of inflation, and a premium for risk of default. U.S. government securities are accepted as free of risk of default. They are, however, not free of risk of loss of purchasing power. Thus, while d is presumed to be zero, f has since the end of World War II been positive. Moreover, the longer the time period to maturity and hence to repayment of principal, the greater the uncertainty about the impact of inflation. Therefore, one would generally expect shorter term U.S. government securities to have a lower

   380rate of interest than U.S. government securities that mature further into the future. (fn12)

   Consistent with the legal notion of "reasonably safe investments," U.S. government securities are often used as the benchmark for determining the discount rate.

3. PRESENT VALUE METHODS: AN ILLUSTRATION

   As risk of default is absent in U.S. government securities, then:

   i=r+f

   The current dollar earnings and current interest rat projects future earnings with inflation built into them. Moreover, earnings are discounted at i, that is, at the current rate of interest. By contrast the real earnings and real interest rate method projects future earnings absent inflation and discounts those earnings at r. Under the total offset method it makes no difference whether inflation is included or excluded. The rate at which one compounds earnings equals the -rate at which one discounts earnings.

   It is helpful to illustrate each approach with a stylized set of facts. Thus 1. John Smith, single, is seriously injured in an automobile accident on his 55th birthday.

   2. John Smith is a state employee earning $50,000 per year on the date of the accident.

   3. Plaintiffs attorneys will introduce testimony from a qualified medical expert who will show that John Smith's injuries are so severe that he is permanently disabled.

   4. The trial is held exactly three years after the date of the accident.

   Plaintiff's economist prepares a report, on lost earnings, benefits and the cost of future custodial care and medical ex

   381penses. As the trial is in the Superior Court of Connecticut, he or she is free to use any acceptable method for determining future losses. From his or her analysis of tax records and pay scales the economist concludes that 1. John Smith's wages have consistently been about 1 percent above the historical rate of inflation of 3 percent per year.

   2. After allowance for federal income taxes, interest rates on short and intermediate term U.S. government securities are currently about 5 percent per year. The historical record and the Livingston Survey suggest that a real rate of interest of 2 percent after federal income taxes is reasonable. (fn13)

   3. Federal and state taxes average about 25 percent of gross income.

   4. Fringe benefits directly applicable to the plaintiff, i.e., pension contributions, insurance, etc. are 15 percent of adjusted gross...