Considering the “total Offset” method may not be as crazy as many forensic economists believe. Current inflation rates are so high that cost increases are not fully set off by wage growth. Also, the increase in risk-free interest rates seems to be below the inflation rate. Therefore, in the short term, (i-g) may be negative for a while. Even though it is probable that (i-g) in the farther future may be positive, many future earnings streams discounted to present value may need to show a wash. Therefore, the Total offset methodology (Supreme Court of Pennsylvania decision in 491 Pa. 561 (1980) 412 A.2d 1027 Kaczkowski v. Bolubasz) may not be that inappropriate after all.
In tort cases involving the loss of future earning capacity is solved by a lumpsum necessary to compensate the injured party. The award depends on the future behavior of two variables: an appropriate interest rate and an appropriate wage growth rate.
Several historical studies show that the Future Net Discount Rate (FNDR) is not stable. Methodologies typically use low-risk US Treasury Securities such as 91 days, 6-months, 1-year, 3 years, 10-years, and 30 years. They contrast that with the percentage growth of average weekly earnings as reported by the Bureau of Labor Statistics. The studies show that the FNDR is not very stable and varies quite a lot though the variability is less than of the nominal rates. As a result, economists have different approaches that they believe will give them the most accurate amount of lost earning capacity.
During the COVID period, short-term US Treasury Securities rates edged towards zero (or below in some foreign regions). Inflationary pressures result from increased demand for durable goods, supported by monetary easing, and cost pressures resulting from product shortages and recently the war in Ukraine. Wage growth, even though substantial, has trailed inflation. Thus, it is reasonable to question discounting methods. Now that economies are recovering, the Federal Reserve worries about economies overheating and trying to put upward pressure on the interest rates.
The Dilemma, long term and short term FNDR
Let’s consider some data: Over the past year, the CPI-U increased 8.3% annually (April 21- April 22, bls.gov) and increased between March and April 0.6%. The average weekly earnings increased by 5.5% (April 21- April 22, bls.gov). Real Average Weekly earnings decreased by -3.3%. Treasury security Interest rates (https://home.treasury.gov/):
It is generally theorized that US Treasury securities are the most risk-free securities and therefore are the best investment vehicle to use for discounting lost earning capacity calculations. As a result, the yield rates are quite low compared to other investment vehicles. Though free from liquidity and default risk, they are not free of inflation risk. Assuming that inflation in June is 0.6%, the risk premium is 0.17%. However, if we look at the long run and consider the past year’s inflation rate of 8.3% and purchase a 1-year Treasury Security, at 2.16%, we lose 6.14% if the inflation remains the same for the next year.
Economists involved in a personal injury, medical malpractice, or wrongful death case, typically do not compare interest rates to inflation growth rates but interest rates to wage growth rates. There is a logic that these are related. In Kaskowski vs Bolubasz (1980), …” This Commonwealth now joins the growing number of jurisdictions which consider inflation and productivity as integral factors to be included in computing lost future earnings.” Similarly, calculating a Net Discount Rate using wage growth, we find an NDR of .27 using a monthly rate but a negative 3.34% annual rate.
The Federal Reserve Bank of St. Louis current data show that the 5-year Break-Even Inflation rate, which is a good indicator for future expected inflation, seems to be a little below 3%. This is similar to the Treasury security rates for the longer term. We probably may not need to conclude that the economy will be turned upside down.
If we look back on how well the treasury bonds predict future inflation and give a positive yield, we find the following. In 2016 the 3-month interest rate and 3-month average inflation are closer than the 3-year ones. This is also true for the 3-year interest rate and the 3-year wage growth rate.
In conclusion, to stay ahead of inflation and based on the limited data set used here, the only investment that makes current sense is short-term investments, such as the 1-month or 3-month bonds.
Certainly, the Overnight Bank Funding rate is changing rapidly from .07% to .82% in a few months. This makes predicting future interest rates and discount rates not easier.
Intuitively, it makes sense to believe that a discount rate should always be positive. After all, a negative discount rate would mean that the present value of future earnings stream is higher today than at the future date for when this stream is calculated. The notion does not seem logical, one should expect a positive return on an investment taking inflation into consideration. Yet, the Pennsylvania court does not discount the award to its present value but assumes that the effect of the future inflation rate will completely offset the interest rate. This is not against what actual data show.
The Pennsylvania Rule
The “offset present value method” in Pennsylvania was developed in Feldman v. Allegheny Airlines, 382 F. Supp. 1271 (D.Conn. 1974), aff’d, 524 F.2d 384 (1st Cir. 1975). In Feldman, a surviving husband brought a wrongful death action as the administrator of his wife’s estate. The court was faced with the inflation component and the task of discounting the award to its present value. The court developed a formula known as the “offset present value method” in which it subtracted the estimated inflation rate from the discount rate to calculate the inflation-adjusted or “real” rate of interest.[1] Each year’s earnings were then discounted to present value by this “real” discount rate. The “real” discount rate employed by the court was 1.5%. The Alaska Supreme Court in Beaulieu v. Elliott, 434 P.2d 665 (1967) described the offset method earlier and refined it in State v. Guinn, 555 P.2d 530 (1976) In this case the inflationary component’s impact on lost future earnings and the effect of future interest rates on lump-sum payment, the Alaska court applied that “total offset method.” Under the total offset method, a court does not discount the award to its present value but assumes that the effect of the future inflation rate will completely offset the interest rate, thereby eliminating any need to discount the award to its present value. The court excluded as speculative evidence the “non-scheduled salary increases and bonuses that are granted as one progresses in his chosen occupation in terms of skill, experience and value to the employer.” Productivity increases were allowed since, “Automatic step increases keyed to the length of service are by their very nature certain and predictable at the time of trial” and the court takes them into account when estimating the lost future earnings. State v. Guinn, 555 P.2d at 546. However, from an analysis of the formula involved, it appears that predicting prospective interest rates is as difficult as forecasting future inflation.
Inflation and productivity increasingly demand judicial attention, particularly with respect to personal injury action damages for lost future earnings. Traditionally, evidence of future inflation and productivity increases have been deemed too speculative to be included in calculating future damages even though inflation and productivity increases may drastically reduce an initially generous award.
If we look back on how well the treasury bonds predict future inflation and give a positive yield, we find the following. In 2016 the 3-month interest rate and 3-month average inflation are closer than the 3-year ones. This is also true for the 3-year interest rate and the 3-year wage growth rate.
In conclusion, to stay ahead of inflation and based on the limited data set used here, the only investment that makes current sense is short-term investments, such as the 1-month or 3-month bonds.
Certainly, the Overnight Bank Funding rate is changing rapidly from .07% to .82% in a few months. This makes predicting future interest rates and discount rates not easier.
Intuitively, it makes sense to believe that a discount rate should always be positive. After all, a negative discount rate would mean that present value of future earnings stream is higher today than at the future date for when this stream is calculated. The notion does not seem logical, one should expect a positive return on an investment taking inflation into consideration. Yet, the Pennsylvania court does not discount the award to its present value but assumes that the effect of the future inflation rate will completely offset the interest rate. This is not against what actual data show.
Bibliography
Brush, B. C. (2011). On the relative accuracy of discounting based on risk-free and risky portfolios. Journal of forensic economics, 59-74.
Brusk, B. C. (2011). Using historical simulation to compare the accuracy of nine alternative methods of estimating that present value of future lost earnings. Journal of forensic economics, 1-20.
Cushing, M. J., & Rosenbaum, D. I. (2006). Historical averages, unit roots and future net discount rates: a comprehensive estimator. Journal of forensic economics, 139-161.
Cushing, M. J., & Rosenbaum, D. I. (2007). How much confidence do we have in estimates of future net discount rates. Journal of forensic economics, 1-14.
Linke, C. M. (1997). Another perspective of the (i-g) differential for discounting future earnings. Journal of forensic economics, 243-254.
[1] The Fisher Effect is an economic theory created by economist Irving Fisher that describes the relationship between inflation and both real and nominal interest rates. The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation.