The Risk and Reward of Investing a Lost Earnings Award
The discount rate used to compute the present value of lost earnings in a personal injury, wrongful death or wrongful employment termination lawsuit is a critical factor that can significantly impact the “bottom line” value presented to a jury as an award value. A plaintiff can invest the jury’s award in any of a wide variety of financial instruments, ranging from the stock market to U.S. Treasury securities to a mixture of stocks, corporate bonds, and Treasuries to a money market account. Although stocks offer potentially higher returns than can be earned from Treasuries, the latter form of investment affords significantly less risk than stocks. In other words, the probability of earning the higher return from stocks can be quite variable, even resulting in negative returns.
If the present value of forecast earnings is computed using, for example, the average return on stocks, the plaintiff’s award will be smaller than if computed using the interest yield on Treasury bills. To replace the stream of annual earnings lost due to the injury, the plaintiff would need to invest in and earn the average return on stocks. But the risk-return tradeoff inherent in investing in stocks implies there would be no guarantee the plaintiff would exactly replace the stream of lost earnings. Due to the variability of returns from stocks it is possible the plaintiff could fail to replace the lost earnings and face financial shortfall. Conversely, it is also possible the plaintiff could reap returns on an investment in stocks in excess of the stream of lost earnings. Further, if the plaintiff were to invest the award in a lower risk financial instrument with corresponding lower returns, it is probable the award would be prematurely exhausted and fail to replace the lost earnings.
Alternatively, if the present value is computed using interest yields on Treasury bills, the plaintiff’s award would be larger. If this award were invested to earn the same return as the Treasuries, the stream of earnings would be exactly replaced. However, if invested in potentially higher yielding stocks, it is possible the plaintiff could get windfall returns, more than replacing the lost earnings, or could suffer financial shortfall.
A recent article published in the Journal of Forensic Economics examines the risk-reward tradeoff faced by a hypothetical plaintiff awarded the present value of a stream of lost annual earnings. The present value is computed in eight different ways, each using a discount rate based on the average rate of return of an investment in a portfolio of financial instruments ranging from 100 percent investment in U.S. Treasury bills to 100 percent investment in the S&P 500. Assuming the jury awards the respective present value, the hypothetical plaintiff invests the award in the same portfolio used to compute the present value, where the annual rate of return is randomly drawn from a distribution of historical returns earned during the period 1965–2010. For example, if the present value was computed using a discount rate equal to the average rate of return on a portfolio consisting of 100 percent long-term corporate bonds, the plaintiff would invest in long-term corporate bonds and each year would earn a return equal to that randomly drawn from the distribution of historical annual returns for long-term corporate bonds. For each of these eight different discounting-investing scenarios, 10,000 simulations were run, thereby creating a distribution of results. The results of this exercise are illuminating.
For each of the eight different portfolios the award was prematurely exhausted in about 51 percent of the 10,000 cases. In other words, in slightly more than one-half the instances the plaintiff would suffer financial ruin prior to reaching the end of the original projection of his/her work-life, failing to replace the entire lost earnings stream. However, in those instances when there was premature exhaustion the median years to failure was substantially sooner for more risky portfolios (e.g., 100 percent S&P 500) than for less risky portfolios (e.g., 100 percent Treasury bills). In the latter scenario, “this implies that the plaintiff has a very high chance of successfully relying on the portfolio of replace his/her lost income.” In regards to a portfolio comprised of S&P 500 stock, in those instances when there was premature exhaustion the median years to failure was only slightly more than one-half the period of forecast lost earnings. Additionally, the earliest year of failure occurred many years earlier for more risky portfolios than for less risky.
On the other hand, generally the more risky the portfolio, the larger the percentage of simulations in which the plaintiff receives an “enrichment,” defined as a final balance in the “investment account” in excess of $1,000,000. In other words, by the chances inherent in investing in high risk, high return portfolios, the plaintiff will have been overcompensated. Enrichment is highly unlikely with an investment in 100 percent Treasury bills.
“The Risk and Reward of Investing a Lost Earnings Award: A Comparison of Stocks, Bonds, and Bills,” Michael L. Nieswiadomy, Journal of Forensic Economics, Vol. 23, No. 2, September 2012, pp. 199-207.