What rate of interest should be used to discount future earnings lost due to personal injury or wrongful death? Sometimes earnings are discounted using the return on short-term U.S. debt obligations (“T-bills”) as a proxy for the risk-free rate of interest. An alternative approach favors a discount rate reflecting the inherent riskiness of future pay. In this approach, earnings are discounted by a higher, supposedly riskier, market based rate of return. The two choices reflect a fundamental disagreement over whether successful plaintiffs ought to be forced to accept a level of risk in the replacement of future pay that is similar to the level of risk they would have faced actually earning that pay. However, recent research suggests that over a suitably long investment horizon, equity investments are likely to yield higher expected returns and be safer than T-bills. When discounting lost earnings that would have accrued sufficiently far in the future, a stock-based discount rate may be more suitable than Treasury rates regardless of whether those earnings should be discounted based on their riskiness.
In cases of personal injury or wrongful death, it may be appropriate to compensate the plaintiff for earnings that the victim would have received but for the legal violation. (As the plaintiff may be the victim’s estate or a relative, the victim and the plaintiff are not always the same person.) Future earnings are discounted to present value to estimate the award currently due. This award is intended to be just large enough to generate a stream of payments (including investment returns and withdrawals of principal) to replace the earnings stream the victim would have received but for the violation. If future earnings are discounted at too high a rate, the resulting award is likely to undercompensate the plaintiff relative to what the victim would have earned. If earnings are discounted at too low a rate, the award is likely to overcompensate the plaintiff.
The use of T-bill rates for discounting is frequently attributed to two U.S. Supreme Court decisions, Chesapeake & Ohio Railway Co. v. Kelly 241 US 485 (1916) and Jones & Laughlin Steel Co. v. Pfeifer 462 US 523 (1983). In Kelly the Court stated: “We do not mean to say that the discount should be at what is commonly called the ‘legal rate’ of interest — that is, the rate limited by law, beyond which interest is prohibited . . . compensation should be awarded upon a basis that does not call upon the beneficiaries to exercise [financial] skill, for where this is necessarily employed, the interest return is in part earned by the investor, rather than by the investment. . . it being a matter of common knowledge that, as a rule, the best and safest investments, and those which require the least care, yield only a moderate return.”
In Pfeifer the parties had agreed to assume away that “the [plaintiff] could have been disabled or even killed in a different, non-work-related accident at any time. The probability that he would still be working at a given date is constantly diminishing.” Consequently, the Court found that, “[o]nce it is assumed that the injured worker would definitely have worked for a specific term of years, he is entitled to a risk-free stream of future income to replace his lost wages.”
Some litigants and researchers appear to have interpreted these two cases to mandate the use of T-bill rates in all federal cases. Economists commonly use those rates to measure risk-free rates of return in the short run. Nevertheless, using T-bill rates to discount earnings that would have been earned in the distant future may overcompensate plaintiffs.
Assessments of the return and the risk on a security depend on the length of time over which they are measured. T-bills may be safer than stocks in the short term, but projections of earnings are often made over very long periods of time. Over longer terms, stocks not only yield more than T-bills, but by some measures they are safer, as was shown by a study of the behavior of risks and returns using data from 1802 to 2012. (While a potential concern is that some of these data are from many years ago, the inclusion of the very early data does not appear to drive this result.)
Turning first to yield, the average annual real (i.e., inflation-adjusted) return for stocks – as measured by broad-based indexes – between 1802 and 2012 was 6.6 percent, compared to 3.6 percent for bonds and 2.7 percent for T-bills. Stocks outperformed both long-term U.S. debt obligations (bonds) and T-bills in more than 90 percent of the 30-year holding periods occurring between 1802 and 2012. Even for much shorter one-year holding periods, stocks outperformed bonds and T-bills in close to 60 percent of all periods.
Now consider risk. Although T-bills are occasionally used as a proxy for a risk-free asset, they are not truly risk free. T-bills are more susceptible than stocks to inflation. Inflation has occasionally exceeded the return on T-bills and some long-term Treasury bonds. Consequently, these securities are not inflation risk free even if they are considered default risk free. Someone who invested in T-bills or bonds during periods when their returns were lower than inflation experienced a loss of purchasing power.
One common measure of financial risk is the standard deviation or volatility of returns over time. For holding periods twenty years or longer, the standard deviation of real returns on stock is lower than that for treasury bonds or T-bills. For example, for all thirty-year holding periods occurring between 1802 and 2012, the standard deviation of stock returns was less than 2% while the standard deviations of both T-bill and bond returns were greater than 2%.
Another way to assess risk is to consider the worst real or nominal return over a given investment period. Stocks are also safer than T-bills or bonds by this measure for sufficiently long holding periods. For example, since 1802, stocks have never had a negative real return if held for seventeen or more years. T-bills and bonds have each suffered real losses over holding periods this long.
When calculating the present value of a damages award, money that would have been earned in the distant future likely should not be discounted by T-bill rates. Over sufficiently long holding periods, stocks have exhibited higher returns and lower risk than T-bills when risk is measured based on volatility of real returns or the worst historical outcome. Consequently, a plaintiff whose award for losses occurring in the distant future was calculated based on a T-bill discount rate could reap a windfall by investing part of the award in readily accessible stock index funds without subjecting herself to unreasonable risk.