Many lawsuits, particularly personal injury cases, where the plaintiff suffers severe or permanent injuries, involve lost earning capacity and/or future medical expense damages. When seeking these damages, the plaintiff’s legal representation must reduce the amount of these future damages to their present value. While simple in principle, present value proves to be a difficult concept for litigation participants to comprehend. Often, attorneys turn to economic experts to calculate and explain present value damages to the court during expert witness testimony. In this article, we will explore the process of determining the present value of future damages.
The Knowles Group is one of the top litigation economics consulting firms in the United States, specializing in calculating economic damages in terms of present value. Since 1979, we have provided our services to plaintiffs and defendants across North America in state and federal courthouses. Contact us today to schedule your complimentary case consultation.
Understanding Present Value
Present value is a concept that determines the worth of future money in today’s terms. When a plaintiff claims the right to future economic damages, such as future lost earnings, loss of earning capacity, future medical expenses, etc., the amount of those damages must be reduced to their present cash value.
Determining present value is a crucial step toward determining fair settlement due to the fact that a dollar today, when reasonably invested, is worth more than a dollar tomorrow. Likewise, when reasonably invested, $100,000 dollars today is worth significantly more than $100,000 twenty years from now.
Is There A Formula For Calculating Present Value?
To calculate the present value of damages, one must determine the amount of money that, if reasonably invested, will compensate the plaintiff for their future damages. To do so accurately, expert forensics must consider a multitude of influencing factors, including the plaintiff’s past, present, and future earnings, their earning capacity before the event, the growth rate of those earnings, the appropriate discount rate representing inflation, the cost of future medical expenses, market conditions, and much more. As a result, there is no simple formula for determining the present value of damages.
The following is a simplified present value formula to demonstrate the value of $10,000 received five years from now at a discount rate of 5%
|PV = Present Value ($) FV = Future Value ($) r = Discount Rate (as decimal) n = Period of time (in years)|
|PV = FV/ (1 + r)n
PV = $10,000 / (1 + 0.05)5
PV = $10,000/ 1.2769
Present Value of $10,000, five years from today, at a 5% discount rate = $7,835.26
Factors to Consider When Determining Present Value of the Damages
To further illustrate the determination of present value, let’s compare three hypothetical personal injury cases of a 10-year-old plaintiff, a 30-year-old plaintiff, and a 50-year-old plaintiff. For simplicity, each has a fixed earning capacity of $40,000 per year, a work-life to age 65, a stable wage growth rate of 4%, and a discount rate of 6%. We also will not consider future medical expenses or market conditions.
Let’s take a look at each of these factors as they relate to our plaintiffs. Then, we will return to our hypothetical example to determine the present value of the damages. These factors include
- Loss of Future Earnings
- Work-Life Expectancy
- Wage Growth Rate
- Discount Rate (Inflation)
- Net Discount Rate
- Future Medical Expenses
- Life Expectancy
- Market Conditions
Loss of Future Earnings
Loss of future earnings, often referred to as “loss of earning capacity” or “loss of future income,” represents the money an individual would have earned if not for the damaging event. Calculating future lost earnings involves considering factors like the individual’s career trajectory, work life and overall life expectancy, potential promotions, inflation, and more.
In our hypothetical example, we assume that each of our plaintiffs has a fixed earning capacity of $40,000. In reality, that would not be the case. Each plaintiff would likely have the opportunity for career advancement, with the youngest plaintiff having the most extended work life and, therefore, the highest potential earning capacity. This increase in future earnings over time must be considered when calculating lost future earnings before determining present value.
Work-life expectancy refers to the estimated number of years an individual is expected to remain in the labor force, actively engaged in employment or self-employment. It considers factors such as the individual’s age, health, occupation, education, and historical workforce participation patterns.
Our hypothetical example assumes all plaintiffs will retire at age 65. This means the 50-year-old plaintiff has a work-life expectancy of 15 years, and the 30-year-old plaintiff has a work-life expectancy of 35 years. For the 10-year-old plaintiff, we assume they will begin work at age 18, giving them a total work-life expectancy of 47 years.
It’s important to note that while a longer work-life expectancy will result in more significant total damages, the relationship between work-life expectancy and the present value of future earnings is more nuanced because the farther into the future earnings occur, the more heavily they are discounted due to the ever-increasing rate of inflation. As a result, for example, the present value of damages for a plaintiff with a 20-year work-life expectancy will be higher than that of a plaintiff with a ten-year life expectancy; the value will not be 2x more.
Wage Growth Rate
Wage growth rate refers to the annual rate at which average wages or salaries increase over time due to inflation, general economic productivity, and individual productivity.
In our hypothetical example, we assume a consistent wage growth rate of 4% over the work-life of all three plaintiffs. In reality, this would not be the case. In reality, the rate at which wages increase is affected by many variables, including the mean and median averages of the years involved in the work-life, market conditions during those years, the treatment of fringe benefits, and other factors. This means that the wage growth rate for a 10-year-old, a 30-year-old, and a 50-year-old would vary.
The discount rate represents the interest rate used to determine the present value of future cash flows. While the wage growth rate determines how earnings might increase over time, the discount rate reduces those future earnings in compensation for the time value of money, inflation, risks, and uncertainties.
In our hypothetical example, we use a discount rate of 6%. In reality, expert forensics derive discount rates from historical data, current market interest rates, economic forecasts, and U.S. Treasuries. Discount rates are amongst the most controversial factors related to determining the present cash value of damages and can vary depending on how the rate was derived.
Net Discount Rate
The net discount rate is derived by subtracting the wage growth rate from the discount rate to simplify calculations. Rather than calculate the inflation of future earnings based on wage growth and then discounting those inflated earnings back to present value, expert forensics can directly apply the net discount rate to future earnings to fairly and accurately arrive at a present value.
In our hypothetical example, we’re assuming a discount rate of 6% and a wage growth rate of 4%, giving us a net discount rate of 2%. Once again, in reality, the net discount rate would vary for each hypothetical plaintiff based on the factors influencing their wage growth and the corresponding discount rate.
Future Medical Expenses
Future medical expenses refer to the projected cost of future medical care that an injured plaintiff is expected to incur over their total life expectancy due to an injury. Determining future medical expenses involves an assessment from a medical professional to determine what future treatments, surgeries, medications, therapies, etc. will be required. Just like individual earnings, the cost of medical expenses will inflate over time and must be discounted to represent present value.
In our hypothetical scenario, we’ve chosen to ignore future medical expenses for the sake of simplicity. The cost of future medical expenses would be added to the total present value of damages.
Life expectancy is the average number of years a person of a specific age, gender, and health status can expect to live, based on standardized mortality tables and sometimes adjusted for individual circumstances such as pre-existing medical conditions.
In our hypothetical example, we’ve assumed a fixed work-life expectancy. In reality, an injury often reduces a plaintiff’s work-life expectancy. The plaintiff’s life expectancy determines more precise lost earning values in these cases. Likewise, future medical expenses usually continue past a plaintiff’s work-life expectancy. Therefore, life expectancy is used to determine the total future medical expenses. Additionally, life expectancy affects wage growth rates and discounting durations.
Market conditions encompass a variety of external factors, such as interest rates, inflation, economic growth, technological advancements, and regulatory changes that influence the supply, demand, and pricing within an economy.
In the context of present value calculations, these conditions are crucial: interest rates and inflation directly affect the discount rate used to determine the current worth of future sums, economic growth can influence wage trajectories and profits, technological changes might alter future costs or earnings, and regulatory or geopolitical events can introduce unforeseen risks or opportunities. Market conditions shape the estimation of future amounts and the rate at which they are discounted to their present value.
Returning to Our Hypothetical Example
In our hypothetical example, we compare three personal injury cases of a 10-year-old plaintiff, a 30-year-old plaintiff, and a 50-year-old plaintiff. For simplicity, each has a fixed earning capacity of $40,000 per year, a work-life to age 65, a stable wage growth rate of 4%, and a discount rate of 6%. We also will not consider future medical expenses or market conditions. Based on the factors explained above, here is what the hypothetical present value calculations might look like
|10-Year-Old Plaintiff||30-Year-Old Plaintiff||50-Year-Old Plaintiff|
|Work-Life Expectancy||47 years||35 years||15 years|
|Wage Growth Rate||4%||4%||4%|
|Net Discount Rate||2%||2%||2%|
|Future Value of Damages||$7,277,798||$3,063,933||$832,981|
|Present Value of Damages||$1,054,652||$999,945||$513,971|
Expert Economic Damage Calculations for Present and Future Values
Calculating the present value of damages is a nuanced process where expertise and precision are essential. At The Knowles Group, we have decades of experience assessing and quantifying these damages, considering factors like work-life estimates and economic shifts. Serving attorneys and litigation firms nationwide, our forensic economic consulting provides meticulous analysis to determine accurate valuations in various legal cases.