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The "Income-Variance" Risk Factor and Jones & Laughlin v. Pfeifer Guidelines for the Calculation of Present Value

Papers that discuss the appropriate discount rate to be used on calculating the present value of future losses are so numerous that writing such papers could be characterized as a cottage industry. For a smattering of contributions, see for example, Havrilesky(1988), Pelaez (1989 and 1997), Albrecht and Moorhouse (1989), Nowak, (1991), Bell and Taub (1990 and 1999), Haydon and Webb (1992), Bonham and La Croix (1991), Haslag, Nieswiadomy, and Slottje, (1994) and Ewing, Payne, and Piette (2001). Related articles discuss projected earnings growth rates and the “net” discount rate that is the residual of offsetting an earnings growth rate against a discount rate. There is also the issue of “real” or inflation-free discount rates versus “nominal” discount rates. A recent exchange in the literature directs our attention to the variance and not just the level, of inflation forecasts and implications for the consideration of risk. This exchange suggests a consideration of the variance of income itself over the course of a typical worklife and the question arises: Has the existence of potential year-to-year variance in projected earnings of an injured victim been sufficiently understood and accounted for in our calculations of present value? Believing the answer to this question to be in the negative, this paper attempts to state and clarify issues regarding this “income-variance” risk factor. The proximate cause of the comments ventured here was an exchange in the Fall 1999 number of the Litigation Economics Digest between Professors Bell and Taub (comment) on the one hand, and Professor Ireland (response) on the other hand. The issues revolved around “risk adjustments” in damage calculations of present value. Ireland (1997) had argued that since inflation risk involves both upside and downside exposure (unanticipated variance in actual inflation over forecast period), then unanticipated variance in actual inflation over the time period of the forecast merely increases the variance, not the mean, of future returns and hence does not require any adjustment to the discount rate. Ireland further argued that a default premium for termination of the income stream needn’t be considered in present value calculations because such calculations already contain an adjustment for survival and workforce attachment probabilities. To additionally burden expected future earnings would involve double counting. Bell and Taub take issue with both of these