Pure Offset Calculation

Pure Offset Calculation

Written by : Mike Swift

Economic language is sometimes very hard to understand. As a result, many attorneys believe that a present value calculation, requiring a “discount to present value” specific to earning capacity loss, must result in an amount less than today’s dollar value. This is a myth. Because the language used to provide a present value loss states that the sum of money must be discounted to present value, what is often not realized is that the sum need not be reduced in order to arrive at present value stated in terms of today’s dollars.

Discounting to present value may result in a sum of money that is the simple multiplication of an earning capacity dollar figure by a worklife expectancy value. This decision is made by the economist based upon his or her interpretation of two factors: a growth factor and a discount factor. A firm understanding of the concept of “present value” can lead to a substantial increase in the value of cases involving damages from loss of future earning capacity. Hundreds of thousands of dollars may be at stake for the wrongfully injured.

Present value, as defined by economists, is the current worth of a future sum of money or stream of cash flows given a specified rate of return. “Today’s dollars” is the best way to think of the term present value. In the case of a loss of future earning capacity, present value is the sum of money needed today that, if prudently invested, would replace the future stream of compensation for the wrongfully injured individual.

Consider the case of a three year-old female, Kathy, that has a severe traumatic brain injury and will never be capable of employment. We can assume, based upon her parent’s level of educational attainment and government data, that her ability to work and earn money absent the injury would have been $50,000 annually. Furthermore, we estimate that her worklife expectancy absent the injury is most reasonably represented by 40 years. Simple multiplication of the earning capacity figure and the worklife expectancy value leads to $2,000,000. The next step is to discount this figure to present value.

The objective in discounting this figure to present value is to empower the jury with the information needed to compensate the wrongfully injured individual for the future loss of earning capacity stated in terms of today’s dollars. In order to accomplish this, we must consider that Kathy would have received increases in her compensation over her lifespan due to increased productivity in the labor market as well as inflation. In addition, if Kathy received $2,000,000 today she could prudently invest this sum of money in order to gain interest. We must take these two issues into consideration. Economists term them the growth rate and the discount rate. These factors have an opposing effect on the present value sum. Namely, an increase of the growth rate serves to increase the present value sum and an increase of the discount rate serves to decrease the present value sum. The difference between the discount rate and the growth rate are of utmost importance. If the growth rate is equal to the discount rate a pure offset results because the arithmetic growth increase is set at the same rate as the arithmetic discount rate.

There are three distinct approaches to applying the present value methodology: (i) net positive discount, (ii) net negative discount, and (iii) net neutral discount or pure offset. If the growth rate is less than the discount rate, a net positive discount has been applied. In Kathy’s case, this means she would be receiving less than the $2,000,000 sum as it is assumed that her compensation increases would be less than the rate she could earn by prudently investing an award.
An economist can also utilize a net negative discount. This is rare in practice, but historical data is in support for utilizing a net negative discount for short-term awards (i.e. the plaintiff is to be compensated for a stream of income that would have accrued to him over the next 5 years of his worklife). In this case, the growth rate is greater than the discount rate. Kathy would receive more than the $2,000,000 sum because the economist believes that her compensation increases would be more than the rate she could earn by prudently investing an award.

Supported by historical data and trends, the net neutral discount is where the growth rate and discount rate are equal to one another. This is also known as a pure offset or total offset approach. Kathy would receive exactly the $2,000,000 sum in this case. The growth rate and discount rate are set equal in the present value formula, which is mathematically equivalent to using simple multiplication to multiply the annual earning capacity figure by the worklife expectancy value to obtain the product. Historical patterns of the appropriate growth and discount rates show that the two rates exhibit a convergence to an equilibrium. In addition, it is very difficult to forecast the behavior of the growth rate of compensation and the discount rate. The pure offset approach helps to mitigate this difficulty and causes the plaintiff and defense to share equally in a future risk that is unknowable. This approach has been mandated in several states such as Kentucky and Pennsylvania. For many years, the state of Alaska also mandated the use of the pure offset in arriving at present value.