Economic Analysis in Employment Cases, Part 3

Business_Finance_14004The Main Components of the Analysis

Worklife

A statistical average of the number of years a person will be working. It factors out the probability of death, sickness, child rearing, and leaving the labor force.

Generally, the Worklife Expectancy Tables by the Bureau of Labor Statistics (BLS) were considered most authoritative but they are out of date (1986 has been the most recent). For instance, since 1986 worklife expectancy for women has increased. Subsequently, the few Worklife tables constructed by forensic economists using BLS employment data are reliable.

The flaws of using ‘retirement’ age or Social Security eligibility age are that these do not consider the above consideration of the expected worklife.

Including an analysis using worklife is absolutely necessary. BUT since worklife is a statistical average and plaintiff may exceed expected worklife, it is reasonable to consider an alternative scenario of ‘retirement’ age in addition to the worklife scenario.

There are other worklife expectancy tables that have been constructed that consider education levels, occupation and other aspects. Lately, I’ve been using the worklife tables in Journal of Forensic Economics 14(3) 2001, pp. 203-227. The authors’ are Hunt, Pickersgill & Rutemiller.

Discount Rate

The higher the (net) discount rate, the lower the present value of loss.

I use a twenty year historic average yield of 3-month Treasury Bills. Using Treasury securities is necessary because they are default risk free. Using some historic average is justified to smooth out cyclical fluctuations.

Using short-term securities is justified to remove inflation risk that may occur with longer term Treasuries (bonds). It is not always financially prudent to ‘lock-in’ to a T-Bond when future interest rates are expected to rise due to inflation. (This lowers the bond price of the previously issued bond).

Note: for a few months recently (Nov 2005 to March 2006 approx) the yield curve flattened and then became inverted. What this means is that the yield on long term Treasuries (bonds) was actually less than the short-term T-Bills. This rarely happens and when it does it makes the business news.

Typically, the longer the date to maturity the higher the yield because of the economic principle of forgoing liquidity.

The ‘controversy’ surrounding the selection of the (net) discount rate is ‘much to do about nothing.’

In actual fact, it is really the net discount rate that ultimately matters most (d-g).

There is no set method for ascertaining the appropriate discount rate; indeed, the parties are normally given great leeway in arguing how reduction of the award is to be calculated. [e.g., Noble v. Tweedy (1949) 90 Cal.App.2d 738, 747-748, 203 P.2d 778, 783] But until evidence is taken on the issue (or comparable judicial notice, below), no present cash value instruction may be given. [Wilson v. Gilbert (1972) 25 Cal.App.3d 607, 102 Cal.Rptr. 31]

Burden of proof?  No known reported California decision has squarely

resolved which side has the burden of proving the appropriate reduction to present value. The result could conceivably go either way:

* Under a view that the reduction ultimately benefits defendant (who thereby pays out a smaller lump-sum amount), arguably defendant should shoulder the burden of producing evidence on the issue.

* But to the extent present value may be viewed as an element of compensatory damages, plaintiff just as plausibly should have the initial evidentiary burden.

The National Association Forensic Economics peer-reviewed Journal of Forensic Economics devoted an entire issue (April 1989) to the discount rate controversy:

In the article by Colella, a net discount rate of zero (total offset method) is supported. He states Alaska and Pennsylvania have legislated this.

Article by Conley is in support of net discount rate of 1.

In Falero’s article, he supports the use of a variety of rates in his reports. Specifically, he supports the use of a short-term rate in all his reports. He suggests a 6-month T-Bill as the risk-free rate.

In the article by Fox, there is support for a weighted average discount rate that includes a 6-month T-Bill rate.

In the article by Ray, he argues against choosing a discount rate that has a maturity date that corresponds with the termination of future claims because this rate may change from the time of report to settlement. Plaintiff may incur loss. He suggests a twenty-year average for 90-day T-Bills may be ‘much more appropriate’ (p.95).

Slesinger in his article substantiates the disagreement among economists regarding the appropriate discount rate. He computes long-term average of the net discount rates for a variety of securities, representing a variety of risk levels including BAA rated corporate bonds. This range takes values from 1.35% to nearly 3%, representing different risk levels.

Continuing, in the article by Albrecht (Journal of Forensic Economics 6(3) 1993 pp. 271-272), support for a risk-free rate is given.

Further, in the article by Romans and Floss (Journal of Forensic Economics 5(3) 1993 pp. 265-266) the authors offer four guidelines in the selection of a discount rate in order to reduce the controversy. These are (1) the discount rate should be a default risk-free rate. This implies Treasury bond rates; (2) the discount rate should be inflation risk-free rate. This implies a fairly short-term rate, such as Treasury Bills;

TAX ISSUE: (3) the discount rate should be a tax-free rate. This implies a Treasury rate minus some effective average marginal tax rate (or use rate on low risk municipal bonds);

(4) the discount rate should be an average over some reasonable time period since the use of short-term rates require reinvesting. The authors state the averaging period should be identical to the earnings growth period. They argue that an average of three to five year Treasury bond rates would be at the high end of the band of discount rate selection. At the lower end, would be an average of Treasury bill rates or municipal bond rates. They favor fairly short term government rate with a tax adjustment and municipal bond rates which may, in part, account for this tax issue. (With either of these last two approaches, the discount rate is a lower value. The lower the value of the discount rate the higher the present value of future earnings.)

[See generally, Trevino v. United States (9th Cir. 1986) 804 F.2d 1512, 1519, cert.den. (1987) 484 U.S. 816; Jones & Laughlin Steel Corp. v. Pfeifer (1983) 462 U.S. 523, 541-546, 103 S.Ct. 2541, 2552-2555; Schiernbeck v. Haight (1992) 7 Cal.App.4th 869, 9 Cal.Rptr.2d 716, 721]

About George Jouganatos, Ph.D.

Professor of economics for over 18 years, taught economics, finance, and quantitative analysis at UC Davis and Santa Cruz, California State University, Sacramento, and University of San Francisco. Has written many economic impact, efficiency, cost, and feasibility studies; designed economic models, strategic plans, and performance measures. Has written and conducted seminars in the field of economics of development, political economy, economic history, environmental economics, public policy, operational analysis, and economic modeling and forecasting. Over 25 years of consulting services providing economic and statistical analysis for the private and public sectors. Specialties include, but not limited to, personal injury, wrongful death, wrongful termination, housing discrimination, employment discrimination, economic loss, business valuations, lost profits, divorce, general economic and public finance issues. Consultation and testimony for numerous attorneys in California, New York, Nevada, Iowa, Montana, British Columbia, Oregon, New Mexico, and Hawaii. Expert witness and article contributor for www.ForensisGroup.com

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