The Past As Prologue: On the Accuracy of Using Historical Averages in Discounting Future Lost Earnings to Present Value
Format of Original
American Academy of Economic and Financial Experts (AAEFE)
Journal of Legal Economics
A variety of methods are currently used by forensic economists to discount long-term future earnings losses to present value. Published surveys of forensic economics practice (Brookshire and Slesnick 1993; 1999) as well as an analysis of the forensic economics literature strongly suggest that the most common of these methods is the use of long-term historical averages of discount rates and earnings growth rates. These average discount rates and earnings growth rates are used, either separately or after first being combined into a net discount rate, to calculate the present value of the future losses. While this historical averages method evidently has been in use for some time, relatively little effort has been expended to assess its degree of accuracy in estimating the lump sum of money actually needed to replace the future lost earnings. The primary purpose of this paper is to provide such an assessment. The results of this study will be sobering to those who advocate the use of historical averages in calculating the present value of future losses. Both for 30-year and 20-year future loss periods, the use of investment returns and wage growth rates derived from past periods of varying lengths typically would have resulted in large absolute forecast errors and an overwhelming bias in favor of plaintiffs, at least over the 76-year period covered in this study. On the other hand, the results for 10-year future loss periods show smaller errors and less bias. The rest of this paper is laid out as follows. The next section briefly reviews some of the most significant contributions to the literature relating to the use of historical averages for estimating present value. This is followed by a discussion of the methods and data employed in the present study. The main results are then presented and discussed, and possible biases are considered. Finally, some concluding comments are offered.