Growth and Discounting of Awards for Future Damages
Awards for future damages are discounted to reflect present value — that is, lump-sum awards can generate interest over time, so awards are discounted to account for the “time” value of money. The question is: how much money must be provided today in order to yield (through a safe investment) what the plaintiff will need in the future? The lump sum paid today is to be invested to provide for future needs.
The discount rate used to reduce damages to present value should be based on the yield from a safe investment. The rate of return on high-grade municipal bonds is often used as a discount rate because the bonds are not only safe but tax free. Some economists favor the rate of return on U.S. treasuries as a discount rate. It is important to bear in mind that a higher discount rate results in a lower present-value lump-sum distribution to the plaintiff.
Probable growth of future damages amounts, as well as the interest rate (yield) on a safe investment, must also be factored into the equation when calculating the present value of an award.
For example, earnings tend to grow due to price inflation, gains in personal productivity (the value of an individual worker’s experience and maturity), and national increases in productivity (e.g., technological advances such as the internet increase the gross national product).
The U.S. Supreme Court in Jones & Laughlin v.Pfeifer, 426 U.S. 523, held that “real rate of return” should be considered in the discounting process. The real rate of return is the difference between the growth caused by inflation and productivity and the discount rate (yield on a safe investment, such as the interest generated by bonds). This is a net discount when the interest rate (investment yield) is greater than the inflation and productivity rates, or a net growth rate when the inflation and productivity are greater than the interest rate.
For example, if inflation and productivity are assumed to be 6 percent and the interest rate is 4 percent, the real return is a net 2 percent growth rate. If inflation and productivity are assumed to be 4 percent and the interest rate is 6 percent, the real return is a net 2 percent discount rate.
An example of the effect of the interest (discount) rate on the present value of an award:
DAMAGES OF $30,000 ANNUALLY FOR 35 YEARS, ASSUMING A 4% INFLATION & PRODUCTIVITY RATE:
- Interest rate 8% (net discount 4%): present value = $570,000
- Interest rate 6% (net discount 2%):present value = $760,000
- Interest rate 4% (real return 0%):present value = $1,050,000
- Interest rate 2% (net growth 2%):present value = $1,589,829
The ‘Total Offset’ Method
Pennsylvania is the only state that uses the total offset method, as specified in Kaczkowski v. Bolubasz, 421 A.2d 1027. The total-offset method is based on the theory that, over time, inflationary growth in wages is equal to, and thus offsets, the interest rate, leaving only productivity in the equation. This makes the calculation of present value extremely simple — the present value of future wages is current earnings times the number of years the earnings will be received, increased by the rate of productivity. There is no explicit ‘reduction’ calculation. Certain other jurisdictions, such as Michigan, specify discount rates by statute. Other jurisdictions provide little or no guidance, leaving the discounting process as a matter of argument.