Category: Laura Weir

ACTLA Presentation – Income Replacement Benefits

Posted on By economica

ACTLA Lunch & Learn

Prepared by:

Laura J. Weir, MA

Economica Partnership

March 25, 2021

Income Replacement Benefits

In the sections below, I provide the notes I used to discuss various types of income replacement benefits and issues that may arise with respect to these benefits when estimating a plaintiff’s loss of income. Please note that these are brief, somewhat informal, point-form notes.

1 Injuries outside of motor vehicle accidents

Typically, income replacement benefits (such as long-term disability benefits from an employer-sponsored plan) are not taken into account as it is assumed the plaintiff will need to repay these benefits. We also assume the insurer will not pay benefits into the post-trial period (i.e., once an action has settled), although this should be confirmed.

An exception to this is a retirement pension benefit from an employer-sponsored plan. This income source may arise when a plaintiff retires earlier than would otherwise have been the case, and will therefore begin receiving retirement pension benefits earlier than they would have without-accident. When this situation occurs, it is best to provide your expert with the annual pension statements, one from just before the accident and then the most recent statements (particularly if the plaintiff is already receiving their pension).

2 Injuries arising from motor vehicle accidents

Injuries arising from motor vehicle accidents differ in that the loss of income is estimated on an after-tax basis. Further, income replacement benefits (including those from an employer-sponsored plan) are deducted from the loss as the right to make a subrogated claim for these benefits has largely been eliminated. Below is a list of the income replacement benefits I have encountered when estimating a loss, and a discussion regarding some of the issues surrounding these benefits.

2.1 Section B benefits

These are usually fairly straight forward. The maximum benefit as of November 1, 2020 is $600 per week, $31,200 per year for two years (up from $400 per week prior to this time). These benefits are not subject to tax and therefore, this benefit is equivalent to approximately $38,550 in regular, taxable earnings. Due to the non-taxable nature of this benefit, this may lead to negative pre-trial losses, particularly if the plaintiff was receiving other wage replacement benefits in addition to the section B benefits (as coordination between plans is not always perfect).

2.2 Regular sick-time pay & short-term disability benefits

Regular sick-time pay (and often short-term disability benefits) are typically included with regular T4 earnings and can be deducted accordingly. However, I have been advised by some of the lawyers I work with that if a plaintiff has used vacation pay to fund additional sick leave as a result of the accident, and they would have otherwise received this vacation pay as a payout when their employment ended (most commonly occurring when plaintiffs work seasonally or on a project basis), then they are entitled to be compensated for this.

In order to account for this type of wage replacement, you will need to give your expert the amount of the vacation pay used to fund an accident-related leave of absence (either directly as a dollar value or with specific dates over which the vacation pay was used). This is because vacation pay will be included in the regular earnings and it will be very difficult for your expert to differentiate between it and other T4 earnings.

Indeed, anytime that it’s possible to provide your expert with documentation regarding pay received prior to the accident, and pay received after, it is very helpful (for example, paystubs from the time of the accident typically have this information).

2.3 Lump-sum severance payout

This type of benefit refers to a lump-sum payment that a plaintiff may receive from their employer if they are terminated from their position as a result of the accident (over-and-above pay for vacation, pay in lieu of notice, and other statutory payments). Often, the payment is structured as X weeks/months of salary for every Y years of service. While this appears to be rare (I have personally only seen it in a handful of cases), when it does occur the amounts in question tend to be significant.

The legal question is, of course, whether or not the defendant is entitled to benefit from the plaintiff having access to a severance payout. From an economic standpoint, this is income received as a result of the accident and would therefore be included in the calculation. However, if the plaintiff would have received this payout upon retirement in the absence of the accident, this should be taken into account in the calculations as well (i.e., a severance payout should be included in both the without- and with-accident calculations in this case).

When this replacement benefit occurs, you will need to provide guidance to your expert with respect to whether or not you think the payment should be included. If it is to be included, you will need to provide your expert with the documentation for this payout (usually included with the termination release documents).

2.4 Canada Pension Plan (CPP) disability benefit

This is usually a straight-forward deduction as these benefits are taxable and are indexed for inflation. However, there are a few things to watch out for.

First, the initial lump-sum payment (once the plaintiff is approved) may be made directly to the long-term disability (LTD) insurer, even though it will be reported as income by the plaintiff on their tax returns. It is therefore helpful to have the acceptance paperwork from the CPP (if not the actual file) and not just rely on the amounts reported on the tax return. In this case, deducting both the entire past LTD benefit and the lump-sum payment from the CPP would be double-counting.

Second, plaintiffs with children will receive both a disability benefit for themselves and one for each of their children. In 2021, the CPP children’s disability benefit is $3,090 per year, per child. Thus, the presence of children does have a significant effect on the total CPP disability benefit received (and therefore on the resulting loss).

I have not received guidance from counsel as to whether or not the CPP children’s benefit is deductible (and therefore usually provide two losses – one deducting the benefit and one not). However, I would note that from my experience, LTD plans typically do not deduct the children’s benefit from the LTD benefit payable.

While this situation is not common, I have had a case where the child benefit made the difference between a loss of income and a gain. The plaintiff was a relatively low income earner but had multiple children. Once the children’s benefits were added to the plaintiff’s, she was receiving more in CPP disability benefits than she would have earned through her job. Given the size of the CPP children’s benefit, and particularly if there is more than one child, the issue of whether or not the CPP child’s benefit is deductible from the loss of income is an important one.

Third, the CPP disability benefit is typically deducted from the monthly LTD payment (leaving the total disability benefit relatively unchanged). Again, I would note that the children’s benefit is not usually deducted. If the LTD benefit is both taxable and indexed for inflation, then the total disability benefit may be used without really differentiating between the two payments. However, if the LTD is not taxable or is not adjusted by inflation, then the LTD and the CPP benefits should be calculated separately (and your expert will require the documentation for both benefits).

2.5 LTD benefits

It is helpful to have the LTD file (or at a minimum the acceptance letter) to determine not only the benefit amount, but also whether or not it is taxable and how long it will be received. Under a typical employer-funded plan, the LTD will usually be received until age 65 (although this should be confirmed). Further, the LTD file should provide your expert with information regarding any deductions being made (such as for insurance premiums or pension contributions as discussed below).

One of the main issues with some LTD plans is that they fund the continuation of an employee’s pensionable service while they are on disability. That is, where the plaintiff may have contributed (say) 10% of their salary to the pension plan for each year of service, the plaintiff now receives that year of service at no cost. Therefore, while their pensionable salary (used to estimate their retirement pension) usually remains unchanged from the time they went on disability, the ability to accrue pensionable service at no cost will often more than compensate for this. In addition, most LTD plans run to the plaintiff’s age 65. If they would have retired earlier than age 65 in the absence of the accident, the plaintiff may end up with more years of service (at no cost) with-accident than without-accident. Again, when a plaintiff participates in an employer-sponsored pension plan, it is helpful to provide your expert with the annual pension statements from both before and after the accident.

2.6 Employment insurance (EI) & Workers’ Compensation Board (WCB) benefits

EI benefits are a straight forward deduction and I cannot really think of any issues surrounding this replacement benefit. However, WCB benefits are definitely not a simple deduction (in fact, are not a deduction at all).

It is my understanding that the WCB has retained the right to make a subrogated claim for any benefits paid. Therefore, these benefits are treated in the same way as benefits for non-motor vehicle accidents in that they are not to be included in the calculations. However, care should be taken to get a complete list of wage loss payments from the WCB.

I have had cases in which WCB benefits were paid both to the plaintiff as a direct wage replacement, and to the employer as reimbursement during a return-to-work program. However, the WCB will claim for the entire amount (i.e., both the payments made to the plaintiff and those made to the employer). If your expert has only the plaintiff’s tax returns to work with in this situation, they will underestimate the WCB benefit (and overestimate the regular earnings) as a portion of the benefit (the part paid to the employer) will not appear on the tax returns. Indeed, in several of the cases I have had with this payment scheme, the WCB benefits paid to the employer were also not included in the employee’s WCB file. Therefore, the list of wage loss payments from the WCB will be very important for properly dealing with these benefits.

2.7 Veterans Affairs disability pensions

This is a benefit that will only be encountered when the plaintiff is entitled to benefits from Veterans Affairs as a result of the accident (so, RCMP officers and members of the military). However, what makes this pension significant in these cases is that it is non-taxable, it is indexed for inflation, and it is payable for life (regardless of whether or not the plaintiff is working because it is related to the injury, not level of disability). Thus, even a relatively small Veterans Affairs pension may result in a non-taxable, accident-related benefit that will have a significant effect on the future loss of income (potentially leading to a gain in income, depending on the estimated annual loss).

For example, suppose that a 35-year old male is entitled to a Veterans Affairs disability benefit of (say) $500 per month, $6,000 per year. The present value of this pension over the course of this man’s life will be approximately $159,000. Thus, even a relatively small benefit will have a significant effect on the future loss of income.

2.8 Supported employment

It may be the case that a plaintiff has been rendered effectively competitively unemployable but has been given a “job” by a friend or family member, or by a charitable organization. In this case, the plaintiff is not performing actual productive work that an employer may reasonably profit from, but they are still receiving some form of pay or stipend by a benevolent individual or group.

This type of potential replacement income is quite rare in my experience. It is of course a legal question whether or not this type of income should be included in the calculations, and you should provide this guidance to your expert, but in my view it should likely not be included. It appears unreasonable to me to assume that a friend or family member is responsible for offsetting part of the plaintiff’s loss of income by providing supported employment.

Thank you for the opportunity to discuss these issues with you today.

Yours truly,

Laura J. Weir, MA

For a PDF version of this presentation, click here.

Notes-regarding-Laura-Weirs-March-25-2021-ACTLA-talkDownload

Summer 2019 issue of the Expert Witness newsletter (volume 23, issue 1)

Posted on By economica

Contents:

In this issue of The Expert Witness, we present two articles:

From the Desk of Christopher Bruce: Farewell

Christopher Bruce publishes his final Expert Witness newsletter. In this article, Chris writes about his achievements and the founding of Economica.

Selecting the Productivity Factor

In this article, the economists discuss the real rate of growth earnings, methods of predicting the real rate of growth earnings, and how to select a forecast.

We would also like to share; A Word from the Consultants of Economica.

A Pdf. version of the Newsletter can be found here.

A Word from the Consultants of Economica

Posted on By economica

We would like to say thank you to Dr. Christopher Bruce. You have been a great mentor for us throughout our careers with Economica. You have provided direction, leadership, advice, and have groomed us to be one of the leading firms in the industry. Your knowledge, guidance, and support throughout the years have been a major contributor to our success, and we truly appreciate everything we have learned from you.

We are thankful for the opportunity you have given us, and we will strive to maintain the level of professionalism, integrity, and service that Economica is known for, and continue to be one of the leading firms in this industry.

Thank you and enjoy your retirement Chris.

 

Selecting the Productivity Factor

Posted on By economica

One of the most important determinants of the plaintiff’s future earnings is the rate at which those earnings will grow. There are two broad determinants of this rate. First, each individual benefits from increases that arise from gains in experience, promotions, and job changes. Second, as the economy grows, the earnings of all individuals rise with it – the source of the popular aphorism “a rising tide lifts all boats.” The purpose of this article is to summarise the most recent research concerning the latter rate, which economists call the real rate of growth of earnings, and which the courts often refer to as the productivity factor.

We divide our discussion into three parts: In the first, we define what we mean by real rate of growth of earnings. In the second, we provide two types of statistical evidence concerning that rate. Finally, we argue that the most reliable projections of that rate are obtained from agencies that specialise in making such projections. We conclude that those projections indicate that real earnings will grow at approximately 1.25 to 1.50 percent per year in the long run.

1. Definition: Real rate of growth of earnings

Assume that it has been observed that economy-wide earnings have increased at five percent per year. This “observed” rate is referred to as the nominal rate of growth of earnings. Economists divide this rate into two factors: those due to increases in the average level of prices, the rate of price inflation, and those due to increases in the purchasing power of wages, the real rate of growth of earnings.

For example, if the rate of price inflation has been two percent per year, the first two percent of a five percent nominal increase will be needed just to allow individuals to buy the same set of goods that they had been able to purchase before the price increase. The remaining approximately three percent will be available to purchase additional goods. That three percent is called the real rate of growth of earnings.

As there is a strong consensus in the financial community that the long-run rate of price inflation will be approximately two percent, the forecast of wage growth can focus on the real rate of growth. [The financial community widely believes that the rate of inflation will be two percent because (a) that is the rate that the Bank of Canada has targeted since 1996; and (b) the Bank has managed to maintain the actual rate of inflation near its target since the latter was introduced.]

 

2. Methods of predicting the real rate of growth of earnings

In the long run, if workers are to be able to purchase more goods with their earnings (that is, if real wages are to rise), they must produce more goods. Hence, it is commonly argued that long-run increases in average real earnings must approximate long-run increases in average output per worker. As the latter is often called the rate of growth of productivity, the terms “real rate of growth of earnings” and “rate of growth of productivity” are often used interchangeably in the courts. Although this conflation could be misleading in the short run, when deviations between the two are common, if we are concerned with lifetime changes in a plaintiff’s earnings, projections of productivity growth can substitute for projections of real wage growth.

In this section, we provide two types of data concerning the growth of both real earnings and productivity. In the first, projections assume that past growth rates will continue into the future. In the second, models of the growth of the economy are used to derive predictions concerning growth of wages and productivity.

2.1 Historical data

In Table 1, we compare Alberta wage and price inflation, from 2001/2002 through 2017/2018. It is seen from this table that over the 2012-2018 time frame, which coincided with a considerable economic downturn in the Alberta economy (2014-2016), price inflation was higher than wage inflation. However, a longer-term perspective finds that wage inflation averaged approximately 0.78 percent higher than price inflation over the ten-year period 2008-2018; and approximately 1.0 percent higher than price inflation over the seventeen-year period 2001-2018.

 

If it is assumed that the experience of the last two decades or so is indicative of what will happen in the next few decades, then the data in Table 1 suggest that the real rate of growth of wages will be approximately 1.0 percent per year.

The data reported in Table 2, obtained from Statistics Canada, suggest that Canadian labour productivity has increased at an average annual rate of approximately 1.23 percent over the past 37 years (from 1982 through 2018), and 0.88 percent over the last five years (2014-2018).

Again, a forecast of 1.0 to 1.25 percent seems to be supported by the data.

 

2.2 Forecasting Agencies

We have identified five reputable, independent agencies that provide public projections of either real wages or labour productivity. We summarise their long-run projections in Table 3, below.

Table 3 suggests that reputable forecasting agencies are predicting that real wages will grow at approximately 1.25 to 1.50 percent per year over the next two or three decades.

3. Selecting a forecast

Our experience is that most financial experts have relied on historical figures, such as those we reported in Tables 1 and 2, to project the rate of growth of real wages/productivity. For two reasons, we caution against acceptance of this approach.

First, there is no theoretical basis for assuming that what has happened in the past will continue into the future. For example, advances in computer technology are introducing changes to the economy that may differ in significant ways from those that have occurred in the past; the wave of “baby boomers” is about to retire from the labour force; and interest rates have fallen to historical lows.

Second, with very few exceptions, the financial experts who testify in personal injury cases have not devoted significant amounts of time to the analysis of long-run changes in labour productivity. Given a choice between the testimony of individuals whose primary expertise is in the preparation of personal injury reports and that of individuals who devote their professional lives to the forecasting of long-term trends in the economy, it seems to us clear that it is the latter that should be preferred.

Accordingly, we recommend that the courts rely on the forecasts of the five agencies identified in Table 3, and on others with similar expertise, when determining the “productivity factor” to be employed in personal injury and fatal accident actions.

 

 

 

Selecting the Discount Rate (2017)

Posted on By economica

by Christopher J. Bruce, Derek W. Aldridge, Kelly Rathje, Laura Weir

When calculating the lump sum award that is to replace a stream of losses in the future, it is first necessary to determine the rate of interest, or discount rate, at which the award will be invested. In Canada, this rate is set equal to the real rate of interest, that is, to the nominal (or “observed”) interest rate net of the rate of inflation.1

Whereas most provinces mandate the discount rate that is to be used when calculating the present value of future losses, Alberta has left the determination of that rate to the courts. Accordingly, the testimony of financial experts on this matter has become an important element of most personal injury actions.

Over the last forty years, Economica has made important contributions to the debate concerning the choice of a discount rate. These contributions have come in the form of chapters in our textbook, Assessment of Personal Injury Damages (now in its fifth edition), articles in this newsletter, and submissions to reviews of the mandated rates in Ontario, Saskatchewan, and British Columbia.

In this article, we argue that whereas virtually all financial experts (including ourselves) have implicitly applied what we will call here the active management approach to the determination of the discount rate, it can be argued that an alternative technique, which we will call the annuity approach, is often more appropriate.

In Section I of this article, we describe these two approaches and investigate their relative merits. In Section II, we employ the principles developed in the first section, to examine how numerical measures of the discount rate might be obtained when discounting two types of future costs: medical expenses and losses of earnings. Finally, in Section III, we summarise our findings.

In that Section, we argue that:

  • if the plaintiff chooses to self-manage the investment of his or her award, the appropriate discount rate (net of inflation) is 2.5 percent; whereas
  • if the plaintiff chooses to purchase a life annuity, or have the defendant purchase a structured settlement, the appropriate discount rate (net of inflation) is zero percent. We argue that it is to the advantage of plaintiffs to make this choice in most cases in which their losses are expected to continue into ages of high mortality (usually after age 75 or so).

I. Two Approaches to Selecting the Discount Rate

There are two broad approaches to the determination of the discount rate, the annuity approach and the active management approach. In the former, it is assumed that plaintiffs will use their lump sum awards to purchase annuities. In the latter, it is assumed that they will invest their awards in a portfolio of stocks, bonds, mutual funds, and other financial assets.

In this section, we define the two approaches and investigate their relative merits. We conclude by identifying the circumstances in which each approach might be preferred to the other.

1. The Two Approaches Defined

The Annuity Approach

If the plaintiff has been awarded a lump sum award to replace a stream of losses from the date of trial until some specified termination date – most often the plaintiff’s projected date of retirement or date of death – he or she will be able to replace the future losses by purchasing an annuity, usually from a life insurance company. This purchase can take the form of either a life annuity or, under the auspices of the court, a structured settlement. In either case, the plaintiff will receive a specified stream of benefits until the termination date.

The purchase price of the annuity will be determined by three main factors: the value of the annual payments, the number of years to the termination date (which will, in part, be determined by the life expectancy of the plaintiff), and the rate of interest at which the insurance company is able to invest the funds received from the plaintiff (or defendant, in the case of a structured settlement).

It is this rate of interest that is known as the discount rate. In the case of an annuity, the discount rate is determined primarily by the requirement (arising both from regulation and accepted accounting practices) that the stream of payments the insurance company has contracted to make is matched by the stream of income that the company will receive from its investment. That is, at the time the annuity contract is signed, the insurance company will invest a sufficient amount, in secure financial instruments, that the income generated from that investment will be sufficient to fund the stream of payments the company has contracted to pay.

What this implies is that for each promised future payment, the insurance company will, implicitly make a separate investment that will generate sufficient returns that it will be able to cover the contracted payment at the appropriate date. For example, if it has contracted to pay $50,000 per year for ten years, it will make ten separate investments, each of which has a maturity value of $50,000.

The discount rate applicable to the payment that must be made one year from now is the interest rate currently available on one-year investments (such as one-year bonds); the rate applicable to the payment to be made two years from now is the interest rate currently available on two-year investments; etc. Thus, there could, in principle, be as many discount rates as there are time periods in the plaintiff’s stream of losses. (In practice, however, investments for more than ten or fifteen years tend to have the same interest rate, so a thirty-year annuity might require ten discount rates.)

Note, first, that there is not “a” discount rate. Rather, there is one rate for each year over which the stream of payments is to be made into the future.

More importantly, note also that it is not necessary to “predict” the discount rate(s). As the investments are to be purchased today (i.e. at the date of settlement), it is the interest rates that are available today that are to be used – and these rates are readily available.

Structured settlement: If it is assumed that a structured settlement is to be purchased, the argument concerning choice of a discount rate is similar to that for a life annuity. Again, the insurance company will place the lump sum received from the defendant in a series of investments, each of which will mature on the date that the payment is due. As the insurance company can be expected, once again, to purchase secure investments, the rates of return that are currently available on such investments can be used to determine the discount rate(s).

The Active Management Approach

Alternatively, the plaintiff might use his or her award to purchase a mixed portfolio of financial assets – for example, stocks, bonds, and mutual funds – selling and buying components within that portfolio as changes occur in financial markets. Because the individual is continuously selling old investments and purchasing new ones, the returns on those investments will reflect rising (and falling) rates that are available in the financial markets.

The complication that this approach introduces is that the rates of return that will be available at the times the plaintiff reinvests his or her funds are not known at the time that the court award is made. These rates must be predicted – in contrast to the rates employed in the annuity approach, which are known at the time the award is made.

2. Comparison of the Two Approaches

As the plaintiff’s award is intended to replace an ongoing loss, it is important that the income the plaintiff receives from investment of that award is sufficient, in each period, to provide the desired compensation. In turn, this requires that the rate of return on that investment be as predictable as possible. The less predictable is the rate of return, the less certain can the courts be that the award will be sufficient for its purposes.

The predictability of the rates of return obtained under the annuity and active management approaches differs with respect to three characteristics: volatility of the rate of return on the invested funds, uncertainty concerning the plaintiff’s life expectancy, and protection against unanticipated increases in the rate of inflation. In this section, we compare the two investment approaches with respect to each of these characteristics in turn.

Volatility

The volatility of a class of investments refers to the variability in the rate of return earned on those investments over time. According to one source:

… volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time. [investopedia.com, emphasis added]

The more volatile is the price of a security, the more likely it is that the rate of return on that security will deviate from its long run average. In some periods the return will rise above the average and investors will experience a windfall; but in other periods, the return will fall below average and investors will experience a shortfall.

In the very long run, high returns and low returns may average out, and the rate of return obtained will trend towards the long run value. However, many plaintiffs do not invest for a period long enough that they can be confident that the rate of return on investment of their awards will settle on the long run average. This will particularly be true if plaintiffs are unlucky enough to make a major investment shortly before markets enter a sharp downturn such as was experienced in 2008, (or lucky enough to invest shortly before an upturn, such as in 2010).

To avoid the uncertainty that may result if the plaintiff’s award is invested in volatile financial instruments, it is often recommended that they concentrate their investments on secure, non-volatile stocks, bonds, and mutual funds. The Canadian courts have confirmed this recommendation. For example, in its seminal decision in Lewis v. Todd (1980 CarswellOnt 617), the Supreme Court of Canada approved of an expert witness’s use of “high grade investments [of] long duration.” [para. 17]

Investments in life annuities offer the lowest volatility possible: essentially, the rate of return is guaranteed as long as the insurer, and its re-insurers, remains viable.

Investments in an actively managed portfolio experience two forms of volatility that are not found with annuities. First, all but the most conservative, high grade investments experience variations in returns from year to year.

Second, even if a sophisticated investor could avoid most year-to-year variations in the rate of return, no investor can protect him- or herself against variations that occur due to long-term changes in the economy. For example, assume that it had been anticipated that the plaintiff would be able to obtain a two percent rate of return on investment of his/her award, because the economy was expected to grow at that rate. If broad economic fundamentals should change, such that long run growth fell to one percent per year, it is unlikely that the individual investor would be able to maintain a two percent return on investments.

To conclude, if the goal is to minimize volatility in the returns on the plaintiff’s investments, life annuities and structured settlements are superior to active management, especially in the long run. For short periods of time, perhaps five or ten years, an actively managed “portfolio of high grade investments” may offer almost as much security as an annuity.

Life Expectancy

Assume that a plaintiff will require medical expenses of $50,000 per year for the rest of his life. In a personal injury action, his award will be calculated to ensure that if he invests that amount in a fund composed of secure investments, it will provide $50,000 per year for the lifetime of the average Canadian of his age and sex. For example, if he is a 50-year-old Canadian male his life expectancy is approximately 31 years, to age 81. Thus, his award will be calculated to ensure that he can remove $50,000 per year until his age 81, at which point the award have been drawn down (approximately) to zero.

This puts the plaintiff in a quandary: that the life expectancy of 50-year-old males is 31 years implies that (approximately) half of 50 year old males will live longer than 31 years (and half less than that). Thus, if the plaintiff spends $50,000 per year on medical expenses there is a 50 percent chance that his investment fund will be exhausted before he dies.

Alternatively, if he spends less than $50,000 per year, to leave money in the fund for the possibility that he will live beyond age 81, he will have insufficient funds in every year to pay for his required expenses. Even if it happens that the plaintiff lives less than 31 years, he will have been inadequately compensated for his necessary expenses, because he will have been taking the (reasonable) precaution of spending less than $50,000 per year to create a buffer for the possibility he will live longer than average.

In short, if plaintiffs invest their awards in actively managed investment funds, it is virtually certain that their awards will be insufficient to compensate them fully.

Furthermore, it can easily be shown that this outcome also arises when the amount to be replaced is a loss of income – although the shortfall will be less in this case than in the case of most medical expenses, because the impact of mortality is much lower when the loss continues only to retirement ages (when mortality rates are still low) than when it continues to the end of life.

If the plaintiff’s award is placed in a life annuity or structured settlement, however, payment of the desired annual compensation will be guaranteed from the date of settlement to the end date of the compensation period.

In short, whereas a life annuity will pay the plaintiff an amount equal to his or her loss in every year, an award invested in a portfolio of funds will, in most cases, undercompensate the plaintiff. This under-compensation will often be less when the award is intended to compensate for a loss of earned income than when it is to compensate for long term costs of care. Thus, on this ground, life annuities are slightly preferred to mixed portfolios of investments when there has been a loss of earnings; but annuities are definitely preferred when there is a long-term requirement for payment of medical expenses.

Unanticipated Inflation

A drawback to the annuity approach is that the stream of income that it provides may prove to be inadequate if inflation rates rise unexpectedly. For example, if an annuity provided for $10,000 per year, increasing each year at two percent (to allow for anticipated inflation), it would pay $12,190 in year ten. But if inflation proves to be four percent per year, the plaintiff will require $14,800 in year ten to buy what $10,000 would have bought in year one. The annuity will pay $12,190 when $14,800 is required.

It is often possible to buy annuities whose annual payouts increase with the actual rate of inflation. However, as the risk facing the sellers of annuities is quite high in this case, the price of these annuities may be higher than many buyers are willing to pay.

An alternative method of protecting against the effect of unanticipated inflation is to invest in an actively managed portfolio of assets. Under this approach, the individual is assumed to buy and sell financial assets on a continuing basis, replacing low-earning assets with higher-earning ones as market conditions change. If inflation increases, so will the returns on investments, particularly bonds, allowing the plaintiff to maintain a real rate of return (i.e. a rate net of inflation) that is consistent over time.

On this ground, if the rate of inflation cannot be predicted easily, the active management approach may be preferred to the annuity approach. However, central banks around the world have become convinced that one of their primary functions is to maintain a steady, low rate of inflation. The Bank of Canada, for example, has successfully targeted a rate of two percent since the early 1990s. This policy has been so well received that virtually all financial analysts expect this rate to be maintained well into the future.

As there is no reason to expect that the future rate of inflation will deviate significantly from the rate that has been experienced for the last twenty years, there is little reason to base the selection of the investment approach on the need to protect against unanticipated changes in the rate of inflation.

We conclude, therefore, that the ability of the active management approach to provide protection against unanticipated inflation does not offer a compelling reason to choose that approach in preference to the life annuity approach.

3. Summary

We summarise this section by investigating the merits of using the two investment approaches to replace (i) costs of medical care and (ii) losses of earnings.

Costs of Medical Care

For two reasons, if the plaintiff’s award is intended to provide compensation for medical expenses, particularly expenses that extend well into the future, we recommend that the award be invested in a life annuity (or structured settlement). First, as medical expenses are often required for the plaintiff’s entire life, it is important that the award is able to provide benefits should the plaintiff live beyond the average life expectancy. Whereas this can be achieved easily using a life annuity, it cannot be done through the active management approach.

Second, as the requirement for medical expenses often extends many decades into the future, the returns on awards invested in actively managed funds may be subjected to significant volatility, hence placing the risk of inadequate compensation on the plaintiff. The returns on a life annuity, however, are guaranteed by the insurer, thereby removing the risk of volatility from the plaintiff.

The contrary argument, for using the active management approach to the funding of future medical expenses, is that this approach allows for protection against unanticipated inflationary changes. We have argued, however, that such changes are not expected to be so large as to counter the arguments for use of life annuities. Furthermore, if the courts decide that inflation is likely to become an important factor, they can require that plaintiffs purchase inflation-protected life annuities.

We conclude that, in most cases, it should be assumed that when the plaintiff’s award is to provide for medical expenses, it will not be invested in actively managed funds but will, instead, be used to purchase life annuities. The exception occurs when medical expenses are required for only a short period of time.

Loss of Earnings

When the purpose of the plaintiff’s award is to replace a future stream of lost earnings, the argument in favour of life annuities is weaker than it was with respect to medical expenses. The reason for this is that earnings losses will generally end at an age at which the annual rate of mortality is still quite low.

For example, as we argued above, if a 50-year-old man has a life expectancy of 81, there is (approximately) a fifty percent chance that he will live beyond that age and will exhaust any award for medical expenses. Assume, however, that that individual had planned to retire at age 60, bringing any loss of earnings to an end at that age. As the probability of dying before age 60 is very small, the difference between an award that allowed for that probability and one that did not would also be small. Thus, any “error” that arose from using the active management approach might be compensated by other factors.

If we assume again that the risk of unexpected changes in inflation is small, then the primary difference between the annuity approach and the active management approach (with respect to losses of earnings) will arise with respect to volatility. On this basis alone, the annuity approach will be preferred as it offers less risk that an unanticipated fall in interest rates will leave the plaintiff’s award inadequate.

However, it is possible that this uncertainty concerning the rate of return on investments might be offset if the active management approach provided higher average rates of return. For example, if those rates were two or three percentage points higher than those offered by the sellers of life annuities, plaintiffs might prefer to manage their own funds rather than rely on an annuity.

For this reason, we suggest that the active management approach be employed only if it is clear that the plaintiff does not wish to invest his or her award in an annuity (as, in this case, the plaintiff has signaled that the rate of return on actively managed assets is high enough to compensate for the increased risk).

II. Evidence Concerning the Value of the Discount Rate

1. The Annuity Approach

If it is assumed that the plaintiff will purchase a life annuity, the appropriate discount rate will be the rate(s) of return that life insurance companies use when pricing those annuities. In this section, we argue that these rates will approximate the rates of interest that are available on Government of Canada bonds of the appropriate durations.

In Table 1, we summarise those rates for five-year, ten-year, long-term, and real rate of return bonds and for GICs of one-year, three-year, and five-year terms. In this table, the term “long-term bond” applies to government bonds with maturation dates of fifteen years or more. “Real rate of return bonds” are bonds whose rate of return is specified as a fixed value (the real rate of return) plus the actual rate of inflation. Thus, for example, if the fixed value is 1.0 percent and the rate of inflation proves to be 2.5 percent, the bond will pay (approximately) 3.5 percent.2

Table 1 reports both the nominal (observed) and real (net of inflation) rates of return on five- and ten-year bonds, long-term bonds, and GICs. In each case, the real rate has been calculated by reducing the nominal rate by the expected rate of inflation, two percent.3 As the interest rate on real rate of return bonds is reported as a real rate, we report only the real rate of return on those bonds.

In Table 1 it can be seen, first, that the real rates of return on government bonds increase as the duration of those bonds increase; thus confirming that there is not a single discount rate but rather a different rate for each length of investment.

Second, it is also seen that the real interest rates on secure bonds have not recently risen above 0.5 percent for investments of any duration; and have risen above 0.0 percent only on real rate of return bonds.

Our contention is that these rates can be used as indicators of the rates at which life insurance companies will invest the funds they receive for life annuities and structured settlements. We can test this contention by comparing the interest rates employed to determine the prices of structured settlements against the rates reported in Table 1.

This we have done by obtaining quotes for several alternative structured settlements. From these we have been able to determine the interest rates that were employed to obtain those quotes. In Table 2 we report six such structured settlements, for males receiving $1,000 per month ($12,000 per year).4

Three scenarios represent payments that end at age 60 and three represent payments that continue to the date of the plaintiff’s death. (Those that end at age 60 are assumed to be typical of awards for loss of earnings; and those that continue for life are assumed to be typical of awards for medical expenses.) The assumed ages for the plaintiffs, at the date of trial, are, respectively, 20, 35, and 60. Furthermore, in each case we report quotes for both the situation in which the annual payment is to increase by two percent per year and for that in which it will increase by the actual rate of inflation.

Column (4) of Table 2 reports the quotes we received, assuming that the annual payment was to increase by the actual rate of inflation; while column (6) reports the quotes assuming that the annual payment was to increase by two percent per year. Columns (5) and (7) then report our calculation of the implied interest rates that were used to obtain the costs of the various annuities.

For example, the first figure in column (4) indicates that it would cost $489,176 to purchase an annuity that paid a male plaintiff $12,000 per year, indexed for inflation, for the next 40 years (i.e. from age 20 to age 60). The first figure in column (5) then indicates that the insurance company that quoted this amount had implicitly assumed that its investments would earn an average real rate of interest, (i.e. nominal interest net of inflation), of -0.27 percent over the 40-year period in question. Similar costs and real interest rates are reported for the other eleven scenarios.

Notably, in every case in which the payments were fully indexed for future inflation (column 5), the implied real rate of interest was negative – between -1.24 percent and -0.27 percent. It is only when the payments did not provide full protection against inflation – column 7, in which increases were limited to two percent per year – that insurers offered a positive real interest rate. Even then, rates were less than one percent.

We would note that the implied discount rates of the annuities presented in Table 2 are consistent with the implied discount rates of annuities offered  by private insurance firms such as Sun Life Financial and RBC Insurance. For example, the Sun Life Financial annuity calculator indicates that as of April 2017, a $1,000,000 annuity for a 50-year old female will provide an annual income of approximately $41,819 per year (with no inflation adjustment). This implies a discount rate of approximately 0.13 percent. The annuity calculator provided by RBC Insurance indicates that as of April 2017, a $1,000,000 annuity will provide a 55-year old male with annual payments of approximately $50,931 (with no inflation adjustment), for an implied discount rate of 0.15 percent.5

It is informative to compare the rates employed in the calculation of structured settlements (and private annuities) with the rates reported for government bonds, in Table 1. The two annuities with the shortest durations – ten years, from age 50 to 60 – had implied discount rates of -1.24 and -1.02 percent, both very similar to the figure of -1.23 percent reported in Table 1 for five-year bonds in 2016. Similarly, the two annuities with the longest durations – from age 20 for life – had implied discount rates of -0.57 percent and +0.65 percent, with an average very close to the figure of -0.08 percent reported in Table 1 for long-term government bonds.

We conclude from Tables 1 and 2 that, in cases in which the plaintiff purchases a life annuity or structured settlement – particularly one that is fully indexed for inflation – the discount rate can be estimated with some accuracy from the real rates of return currently available on Government of Canada bonds of appropriate durations.

2. Active Management Approach

In the active management approach, it is assumed that plaintiffs will re-allocate funds within their investment portfolios as conditions in financial markets change. Because these changes will be made in the future, the active management approach requires that estimates of future rates of return be calculated.

In this section, we first identify the type of financial instrument in which we assume the plaintiff will invest. We then contrast two methods of forecasting the rates of return on those instruments. Finally, we provide estimates of those rates of return.

Selection of the Appropriate Financial Instrument

The courts have been clear that, as the lump-sum award is intended to replace the plaintiff’s lost earnings, the investments in the plaintiff’s portfolio must not expose the plaintiff to unreasonable risk. For example, in its seminal decision in Lewis v. Todd (1980 CarswellOnt 617), the Supreme Court of Canada approved of the expert’s use of “high grade investments [of] long duration” [para. 17].

As the rates of return on investments in the stock market have historically been very volatile, it is usually recommended that plaintiffs do not restrict their investments to equities. Table 3, for example, reports the value of the Toronto Stock Exchange composite index for July of each year since 2000. It can be seen there that rates of return have been highly volatile, indicating that the rate available to an individual whose investments tracked the market would have depended importantly on the year in which those investments were made. For example, whereas the nominal return on investment in such a portfolio would have averaged 2.2 percent per year between 2000 and 2015, a similar investment would have averaged 6.2 percent per year between 2002 and 2015.

In light of this issue, two approaches might meet the court’s requirement that plaintiffs invest in high grade investments: it could be assumed that plaintiffs will purchase long-term Government of Canada bonds; or that they will invest their awards in financial instruments that offer higher yields than government bonds, but with greater risk – for example, in a mixed portfolio of “blue chip” stocks, corporate bonds, and mutual funds. In the discussion that follows, we will consider both.

Forecasting the Returns on Government Bonds

Two methods have commonly been used to forecast the rate of interest that will be available on government bonds. The first of these, the historical approach assumes that future rates will equal those that were observed in the past. The second, the efficient market approach, assumes that the rates that are currently available in the market reflect the rates that investors believe will prevail in the long run. We explain here why we prefer the efficient market approach.

The historical approach: A fundamental problem with the historical approach is that real interest rates have varied significantly over the last sixty years. As can be seen from Table 4, real rates were as low as 1.50 percent in two decades (1951-1960 and 1971-1980) and as high as 4.70 percent in two others (1981-2000). From this record, it would be possible to find support for almost any long-run rate between 2.0 and 5.0 percent.

More importantly, as indicated in Figure 1, real rates of return have declined virtually continuously for the past twenty years, from approximately 5.5 percent to -0.5 percent. Even if it was to be argued that real rates of interest will return to, say, 3.0 percent over the next twenty years, most plaintiffs will experience rates of return well below that over most of the period in which their award is invested.

A third problem with the use of historical rates is that there is no theory to support it. Adherents simply assume that because real rates took some value in the past, rates will return to that value in the future. Furthermore, they make this assumption in the face of the long run decline in real interest rates reported in Figure 1. If the markets expected the real rate of interest to return to “long-run” levels soon, sophisticated investors would not continue to purchase financial instruments that paid long-run rates as low as -0.08 percent (Table 1).

Finally, the evidence is not just that the real interest rate has declined significantly; this decline is consistent with theoretical predictions. Importantly, as central banks have adopted a policy of maintaining inflation within a narrow band of rates (in Canada, between 1.0 and 3.0 percent), uncertainty about the rate of inflation has been minimized. This reduction in risk has led to an increase in demand for bonds, and an associated reduction in real interest rates.

The Congressional Budget Office of the United States also predicts that interest rates will be lower in the future than in the past, resulting in part from slower growth rates of both the labour force and of productivity, thereby reducing the rate of return on capital; and in part from a shift of income to high-income households who tend to have high savings, thereby increasing the supply of money to the bond market.

The efficient market approach: The second source of information concerning future real rates of interest is the money market. When an investment firm that believes that inflation will average two percent per year purchases twenty-year Government of Canada bonds paying three percent, it is revealing that it expects the real rate of interest on those bonds will average approximately one percent over those twenty years. Thus, if the rate of inflation that investors were forecasting was known, that forecast could be used to deflate the nominal rates of interest observed in the market to obtain the implicit, underlying forecasts of real rates.

A strong case can be made for using an expected inflation rate of two percent. The reason for this is that in the last decade the Bank of Canada has not only made this its target rate of inflation, it has been successful in keeping the actual (long-run) rate of inflation very close to that target (which, in turn, has led most financial institutions to predict that future inflation will average two percent).6

Furthermore, in choosing to target a low rate of inflation, the Bank has been following a view that has achieved widespread acceptance in the economics community – that is, that control of inflation, at a low level, should be one of central banks’ primary roles.

On this basis, at the end of 2016 the real rate of interest on long-term government of Canada bonds appeared to be as little as 0.00 percent. (See the figures for long-term bond rates in Table 1.)

An alternative approach is to rely on information concerning bonds whose rate of return is denominated in terms of real interest rates – called real return bonds, or RRBs. By observing the rates of return at which these bonds sell, the risk free real rate of return that investors believe will prevail over the long run can easily be determined. That is, even if plaintiffs do not purchase RRBs, the real rate of interest that is observed on those bonds provides an unbiased indicator of the rate of interest that is expected by sophisticated investors. In Table 1, it is seen that the return on these bonds has recently fallen to as little as 0.41 percent.7

Forecasting Returns on a Mixed Portfolio

Forecasting the returns on a conservative, mixed portfolio is complicated by the fact that there is no common agreement about what the components of such a portfolio should be. Hence, not only is it difficult to obtain the current rates of return on conservative investments, there is also very little information about how such returns have varied over the past. Both issues complicate the forecasting process.

An approach that we suggest might mitigate this problem would be to rely on the rates of return that have been available on conservative portfolios offered by Canadian banks. We have been able to obtain information about four of these: the RBC Select Very Conservative Portfolio, CIBC Managed Income Portfolio, TD Comfort Conservative Income Portfolio, and ScotiaBank Selected Income Portfolio-Series A. Although these funds differ from one another in their details, they all have investment objectives similar to those stated for the RBC portfolio:

To provide income and the potential for modest capital growth by investing primarily in funds managed by RBC Global Asset Management, emphasizing mutual funds that invest in fixed-income securities with some exposure to mutual funds that invest in equity securities. The portfolio invests in a mix of Canadian, U.S. and international funds.

To achieve this goal, RBC invests primarily in bond funds. The result, seen in the first columns of Table 5 below, is that since 2011 this fund has consistently earned a nominal rate of return between 2.5 and 5.0 percent – with one deviation, to 6.74 percent, in 2014 – suggesting a real rate of return over that period of approximately 1.0 to 3.5 percent. Table 5 reports similar results for the other three portfolios (again, with 2014 being the only year that each of them achieved a nominal return that exceeded 5.00 percent).

The volatility in the rates of return on all four portfolios reported in Table 5 is considerably less than that on investments in the Toronto Stock Exchange, as reported in Table 3.

But that does not necessarily mean that plaintiffs would be advised to invest in a conservative mixed portfolio. Although the returns on such portfolios may be higher than that on life annuities, the returns on the latter are fixed once they are purchased, and hence have lower (zero) volatility than the returns on all other investments. The question remains: do the higher rates of return on mixed portfolios compensate the plaintiff for the higher volatility of their returns? This is a question that cannot be answered by financial experts, but only by the courts or government regulators.

What Table 5 does suggest, however, is that if plaintiffs had purchased mixed conservative portfolios in the last five years they would have achieved average nominal returns of between 3.5 and 4.5 percent per annum – or approximately 2.0 to 3.0 percent in real terms. This suggests that 2.5 percent represents a conservative estimate of the real rate available to plaintiffs seeking conservative investments.

III. Summary

In personal injury and fatal accident actions, the plaintiffs are assumed to invest their awards in such a way as to provide streams of returns that will replace their future annual losses. Two factors may intervene to hinder plaintiffs’ ability to achieve this goal. First, they may live longer than average. Second, the rate of return on investments may fall below the level that was anticipated when calculating their awards. In both cases, the award will be exhausted before the plaintiff’s death.

One approach plaintiffs can employ to avoid these problems is to invest their awards in life annuities or structured settlements, as these instruments guarantee a specified annual payment for life, and as the rates of return available on them are fixed.

The drawback to annuities is that the interest rates that insurance companies use to price their products are much lower than the rates of return that have been available on conservative mixed portfolios of financial assets. We showed in Section II that, whereas the implicit interest rates on life annuities are similar to the rates available on long-term Government of Canada bonds, or approximately 0.0 to 0.5 percent, the interest rates available on conservative portfolios of assets have been approximately 2.0 to 3.0 percent.

If a loss will not continue into the years beyond which mortality rates begin to rise substantially, the advantage of buying a life annuity may be relatively small compared to investing in a portfolio of assets. In that case, it may be appropriate to assume that that the discount rate can be estimated from the return on a portfolio of assets.

If the loss will continue into years of high mortality, however, the benefits of a life annuity (protection against exhaustion of the award) may exceed the costs (a lower rate of interest).

As it is only the plaintiff who can determine whether the benefits of a life annuity exceed the costs, it seems appropriate that the discount rate be chosen based on the plaintiff’s decision whether to self-manage the investment of his or her award or to use that award to purchase a life annuity (or structured settlement).

  • If the plaintiff chooses to self-manage his or her award, we recommend that the discount rate be set at 2.5 percent.
  • If the plaintiff chooses a life annuity or structured settlement, we recommend that the discount rate be set at zero percent.
  • We anticipate that plaintiffs will make the latter choice in virtually all cases in which their losses will continue into years of high mortality.

 

Estimating the Income of an Aboriginal Plaintiff: Recent Evidence

Posted on By economica

by Laura J. Weir

One of the more difficult problems facing the courts in personal injury actions is determining the future earning capacity of aboriginal plaintiffs 1 . In this article, I report on data concerning aboriginal earnings that Statistics Canada has made available from the 2011 census – now known as the National Household Survey.

Note that the discussion below examines statistics for those individuals who fall within the “aboriginal identity” classification, as defined by Statistics Canada. That is, this is a general discussion and care should be taken, on a case-by-case basis, to ensure that the adjustments applied are relevant to the specific aboriginal identity and situation of the plaintiff.

1. Aboriginal incomes

The “all workers” figures outlined in Table 1 (which consist of full-time and part-time workers, as well as individuals who were unemployed for part of the census year) indicate that aboriginals earned annual incomes that were equal, on average, to 79 percent of those of non-aboriginals. The difference is larger for males (at 77 percent) than for females (at 82 percent). When hours of work and unemployment are accounted for, the difference between aboriginal and non-aboriginal incomes becomes smaller, with aboriginal income equal (on average) to approximately 85 percent of non-aboriginal income. Again, the difference is slightly larger for males (at 84 percent) than for females (at 88 percent).

Four factors appear to explain most of the differences between aboriginal and non-aboriginal incomes:

  1. educational attainment,
  2. unemployment rates,
  3. labour force participation rates, and
  4. whether the individual lived on or off of a reserve.

I discuss each of these factors in the sections below.

2. Educational attainment

As shown in Table 1, the difference between aboriginal and non-aboriginal incomes varies by level of education. Education affects this differential in two ways.

First, as shown in Table 1, aboriginals earn less than non-aboriginals at each level of education. Second, as shown in Table 2, aboriginals (on average) have less education than do non-aboriginals.

The data in Table 2 indicate that, on average, aboriginal individuals are much more likely to be non-high school graduates than are non-aboriginals. This is significant given that the average income of a worker with a high school level of education is approximately 28 percent higher than the income of a worker without a high school education. Further, aboriginals are much less likely to complete an education at the bachelor’s degree level than non-aboriginals. Again, this is important given that the average income of a worker with a post-secondary education is approximately 81 percent higher than that for a worker without high school.

3. Rate of unemployment

In addition to differences in educational attainment, aboriginals were more likely to be unemployed than non-aboriginals.

In Table 3, I outline the unemployment rate of aboriginal and non-aboriginal Canadians at each level of education.

As shown in Table 3, the unemployment rate experienced by aboriginal Canadians is significantly higher (at about twice the rate) than for non-aboriginals.

Educational attainment mitigates some of this effect, with aboriginal and non-aboriginal Canadians at the bachelor’s degree level or higher experiencing similar rates of unemployment. However, an unemployment rate for aboriginals that is approximately twice that of non-aboriginals appears to hold for levels of education below that of a bachelor’s degree.

4. Participation rate

In addition to difference in the unemployment rate and educational attainment of aboriginals, participation in the labour force is lower for aboriginals than for non-aboriginals. In Table 4, I outline the participation rate of aboriginal and non-aboriginal Canadians, at each level of education.

As shown in Table 4, approximately 74 percent of non-aboriginal males (with no high school education) participate in the labour force, while only 61 percent of aboriginal males at this level of education participate. This decreases to 52 and 44 percent for non-aboriginal and aboriginal females respectively.

5. Living on or off a reserve

The discrepancies in education, unemployment and participation rates discussed above become even more pronounced when comparing aboriginals living on reserve with aboriginals living off reserve.

Interestingly, the difference between the participation rates of aboriginal and non-aboriginal Canadians decreases as education level increases.

For example, for men with a bachelor’s degree or higher, the participation rates are about the same for aboriginals and non-aboriginals. For women with a bachelor’s degree or higher, aboriginal women actually have a higher participation rate than non-aboriginal women.

First, as shown in Table 5, the level of education is lower for aboriginals living on reserve than for those living off reserve. Again, a lower level of educational attainment will, on average, lead to a lower level of income, all else being equal.

Second, the unemployment rate experienced by aboriginals living on reserve is significantly higher than the rate of those living off reserve.

As shown in Table 6, males living on reserve experienced an unemployment rate that was approximately twice that of aboriginal males living off reserve, and this holds true regardless of education level.

Women living on reserve fared slightly better than males, experiencing an unemployment rate that was higher than, but not twice as high, as those living off reserve. Educational attainment mitigated this effect to some extent, at least for the level of bachelor’s degree or above.

Third, participation rates decreased for aboriginals living on reserve, when compared to the rates for aboriginals living off reserve.

As can be seen in Table 7, participation in the labour force is higher for individuals living off reserve than for those living on reserve. However, educational attainment is a significant mitigating factor, with the difference in participation rates on and off reserve becoming smaller as the level of education increases.

6. Conclusions

In large part, these figures explain why the ratio of the earnings of aboriginals and non-aboriginals was much lower for “all workers”, 79 percent, than for “full-time” workers, 85 percent. And, when education level and work behavior are controlled for, aboriginal earnings are actually similar to non-aboriginal earnings. For example, at the high school level, the aboriginal income was equal to 94 percent of the non-aboriginal income for males, and 96 percent for females.

For example, male aboriginals with no high school diploma, living on reserve, had a participation rate that was 14 percent lower than those living off reserve, while the participation rate of males on reserve with a bachelor’s degree was only four percent lower than those living off reserve.

Notably, at the non-high school level, aboriginal females working full-time earned slightly more than non-aboriginal females (with aboriginal income equal to approximately 101 percent of the non-aboriginal income).

I believe that the conclusions outlined below can be drawn from the information discussed in this article.

  • If nothing was known about a plaintiff except that he or she was aboriginal – for example, if the plaintiff was a child – it would be appropriate to assume that they would earn approximately 77 percent as much as a non-aboriginal for males, and approximately 82 percent as much as a non-aboriginal for females.
  • If the education level of the plaintiff is known (or has been predicted), but the individual had not yet established a work history, then it would be appropriate to reduce the full-time figures for males by six percent for non-high school and high school, and by 14 percent for post-secondary. For females, there would be no adjustment necessary at the non-high school level, a four percent reduction at the high school level, and an 11 percent reduction at the post-secondary level.
  • Further, in the above case, the unemployment rate would have to be adjusted upwards to equal twice that of an average worker for each education level except bachelor’s degree and above (as these levels of education do not require an adjustment).
  • The adjustments described above would likely double for a plaintiff living on a reserve. That is, the unemployment rate of an aboriginal person living on reserve is approximately twice that of an aboriginal person living off reserve. Further, participation rates decrease significantly when a person lives on reserve, and educational attainment is much lower on reserve than off reserve.
  • If the plaintiff had completed his/her education and had established a consistent work history, however, that history should form the primary determinant of the forecast of future earnings. The forecast would not require the application of adjustments related to the average aboriginal Canadian, as it would be based on the plaintiff’s demonstrated (i.e., actual) work history.

Footnotes:

    1. Aboriginal identity is defined by Statistics Canada as including “persons who reported being an Aboriginal person, that is, First Nations (North American Indian), Métis or Inuk (Inuit) and/or those who reported Registered or Treaty Indian status, who is registered under the Indian Act of Canada, and/or those who reported membership in a First Nation or Indian band. Aboriginal peoples of Canada are defined in the Constitution Act, 1982, section 35 (2) as including the Indian, Inuit and Métis peoples of Canada” (see Statistics Canada’s website, www.statcan.gc.ca).

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Laura Weir is a consultant with Economica and has a Bachelor of Arts in economics (with a minor in actuarial science) and a Master of Arts degree from the University of Calgary.

The Discount Rate Simplified

Posted on By economica

by Christopher Bruce, Laura Weir, Derek Aldridge, and Kelly Rathje

In every personal injury or fatal accident case in which the plaintiff’s loss continues into the future, it is necessary to calculate the rate of interest at which the damages will be invested. This interest rate is commonly called the discount rate, and it is calculated as the nominal (or observed) rate of interest net of the expected rate of price inflation.

As Alberta has no mandated discount rate, the determination of that rate is left to the courts. In this article, we propose to offer a simple technique for identifying this rate.

We proceed in two steps. First, we discuss the criteria that we believe must be met when selecting the discount rate. Second, we apply these criteria to the relevant data, to make that selection. In a separate article following this one, Derek Aldridge and Christopher Bruce contrast the rates that we propose with those that are available on structured settlements.

1. Criteria

The first step in selecting a discount rate is to recognise that the plaintiff is expected to invest his or her award in such a way that the stream of income generated from that award will exactly reflect the stream of losses that the plaintiff has suffered. If the plaintiff has lost $50,000 per year for twenty years, investment of the lump-sum award should produce $50,000 per year, with the principal being exhausted by the end of the twentieth year.

As this stream of investment income is intended to replace a significant portion of the plaintiff’s lifetime earnings, the courts have ruled that the lump-sum should be invested in low-risk financial instruments. Hence:

The discount rate must be based on an investment portfolio that is of low risk.

Although this requirement does not mean that the plaintiff must put all of his or her award into government bonds or guaranteed investment certificates (the lowest-risk investments available), we argue that the interest rate available on those investments provides the most reliable indicator of the rate of return required by the courts.

The plaintiff may well include in his/her portfolio non-government or non-guaranteed investments, such as corporate bonds, mutual funds, and blue chip stocks; but, that the returns on such investments are higher than those obtained from government bonds results primarily from the higher level of risk associated with them – as was seen with devastating results in the post-2008 stock market crash.

The difference between the rate of interest on a government bond or a GIC and, say, a corporate bond is a measure of the compensation that investors demand for accepting a higher degree of risk on the latter investment than on the former. Once that level of “compensation” is deducted, the net, risk-free, interest rate is approximately the same on both. Hence:

The rates of return on Government of Canada bonds and GICs represent reliable indicators of the rate of interest sought by the courts.

Once it has been decided that it is government bond and GIC rates that are to be used, it is necessary to select from among the various options that are available to the plaintiff. Financial advisors recommend that, in order to reduce risk, investors should purchase a mix of bond durations. In that way, if interest rates should rise, investors can sell their short-term bonds and purchase newly-issued bonds at the higher rates; and if interest rates should fall, although investors will have to accept reduced interest rates on any new investments, they will still experience relatively high rates on their long-term (locked-in) investments. Hence:

Plaintiffs should purchase a mix of short-, medium-, and long-term investments.

If the duration of the plaintiff’s loss is less than ten years, the plaintiff will minimize risk by purchasing investments that have durations that mature on the dates on which the losses are incurred. For example, a one-year bond might be purchased to replace the loss one year in the future, a two-year bond to replace the loss two years from now, etc. Hence:

For losses that will occur in the next ten years, the relevant interest rate for any year is the rate of interest on a Government of Canada bond (or GIC) that has a term equal to that number of years.

But if the plaintiff’s loss extends for more than ten years, it will be wise to adopt an investment strategy in which bonds are purchased for shorter terms than the duration of the loss, and then re-invested periodically. To replace a loss twenty years from now, for example, the plaintiff might purchase five-year bonds today and re-invest the returns every five years until the funds were needed. If a similar practice is followed for every duration of loss, the risk that interest rates will rise or fall, relative to what is expected at the time of the initial investment, will be minimised.

Such a strategy, of rolling over short-term investments in order to generate a long-term return, means that the effective discount rate over the term of the investment will be determined not only by the rates that are available today but also by rates that will become available in the future. Thus, the court must predict what those future rates will be.

Contrary to what many experts argue, this prediction can be made simply and with confidence: the most reliable prediction of the rate of interest that will prevail in the long-run is that it will equal the rate of return currently available on long-run bonds. For example, if the current rate on 15-year government bonds is 3.0 percent, the best prediction of the rate of return that will prevail over the next fifteen years is 3.0 percent.

The argument for basing the prediction on this rate can most easily be understood by showing that the contrary cannot be true. For example, it might be argued that “as interest rates are unusually low today, it can be expected that they will eventually rise above current rates.” If this argument is correct, then individuals who wished to invest their funds for long periods of time (for example, individuals who are saving for their retirement) would not purchase long-term bonds today – they would purchase short-term bonds while waiting for interest rates to rise, and then purchase bonds at the new, higher rates once the interest rate had risen.

But if investors behaved this way, the demand for long-term bonds would decrease; and when demand for a bond decreases, its interest rate rises. (Issuers have to raise the rate of return in order to attract investors.) That is, if investors predict that the long-term interest rate will exceed the rate currently available on long-term bonds, they will act in such a way as to drive up the interest rate on long-term bonds. A bond rate that is less than the expected rate cannot be maintained.

Similarly, if investors believed that interest rates were about to fall, they would sell their short-term bonds and purchase long-term. But this would decrease the demand for short-term funds, driving up short-term interest rates, and increase the demand for long-term funds, driving down long-term interest rates.

In short, if the rate of interest that is currently available on long-term bonds is different from the rate that investors expect will prevail in the future, the long-term bond rate will change “towards” the rate that investors predict. As a result, the interest rate available on long-term bonds will always adjust until it equals the rate that investors predict will prevail in the long run. And, as investors have a strong incentive to make correct predictions about the bond market, it is likely that their predictions are the best that are available. Hence, we conclude that:

The best predictor of the rate of interest that will prevail in the long-run is the rate of interest that is currently offered on long-term bonds.

Finally, as we noted in the introduction to this article, the discount rate is found by netting out the forecasted rate of price inflation from the observed nominal rate of interest. Hence, before the discount rate can be determined:

The long-run rate of price inflation must be forecast.

Fortunately, there is a clear consensus that the long-run rate of inflation in Canada will be two percent. This consensus has developed because, since the early 1990s, the Bank of Canada has not only set two percent as its long-run target, it has both met that target and expressed satisfaction with the results of its policy.

That participants in the “money markets” have come to accept that the Bank will achieve this goal over the long-run is seen in two surveys of business leaders that have been conducted annually since 1994. Consistently, respondents have reported that they expect the long-run rate to be 2.0 percent. Indeed, not only has the average, expected rate been 2.0 percent in most years that the surveys were conducted, the variation of responses “around” 2.0 percent has decreased continuously. Hence:

There is a strong consensus that, in the long run, the rate of inflation will average 2.0 percent in Canada. Hence, the discount rate can be found by reducing the forecasted nominal rate by 2.0 percent.

2. Data

In Figure 1 and Table 1 we report the annual rates of return that have been available since 1995 on five Government of Canada bonds: 2-, 5-, and 10-year bonds, long-term bonds (an average of bonds with a maturity date longer than 10 years), and “real rate of return” bonds (bonds whose rates of return are stated net of inflation). It is seen there that both nominal and real interest rates on Government of Canada bonds have decreased almost continuously since the Bank of Canada introduced its policy of targeting a two percent rate of inflation. Whereas real interest rates were between 4.5 and 7.5 percent in 1995, they have fallen below one percent on most bonds, and even below zero percent on some, in recent years.

 

 

What these figures indicate is that investments in government bonds are unlikely to provide real rates of return above zero percent over the next five years; that bonds of five to ten year durations are unlikely to produce rates in excess of 1.0 percent; and that the market expects long-term real interest rates on government bonds to be less than two percent.

Nevertheless, in recognition of the fact that current rates are at a historical low, we have left our assumed rates at the same values we have employed for the past five years. Those rates, which we report in Table 2, are: 1.8 percent per year on funds invested for three years or less; rising in equal increments to 3.0 percent per year on funds invested for more than fifteen years.

 

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Christopher Bruce is the President of Economica and a Professor of Economics at the University of Calgary. He is also the author of Assessment of Personal Injury Damages (Butterworths, 2004).

Derek Aldridge is a consultant with Economica and has a Master of Arts degree (in economics) from the University of Victoria.

Kelly Rathje is a consultant with Economica and has a Master of Arts degree (in economics) from the University of Calgary.

Laura Weir is a consultant with Economica and has a Bachelor of Arts in economics (with a minor in actuarial science) and a Master of Arts degree from the University of Calgary.

The Discount Rate Revisited (Spring 2008)

Posted on By economica

by Laura Weir, Derek Aldridge, Kelly Rathje, and Christopher Bruce

This article first appeared in the spring 2008 issue of the Expert Witness.

Our readers will recall that every year or two we review our standard discount rate assumptions and publish our findings. It is time to repeat this exercise.

In the Summer 2006 issue of the Expert Witness, we reported that real rates of interest (that is, the rates of return net of inflation) had increased slightly from those outlined in our Summer 2005 article. We responded by increasing our forecast of the short-term (one to six years) real rates of interest. Our forecasted interest rates for the medium to long-term (seven to 15 years or more) remained unchanged – although these rates were slightly higher than the observed real rates of return on Government of Canada bonds, long-term real rate of return bonds, and the long-term rate mandated in Ontario. (Higher rates lead to lower present values, so our estimates can be considered conservative.)

In our 2006 article we specified our assumptions for real interest rates for periods ranging from one-year to 15 years or more. Our assumptions were based on the observed rates of interest on Government of Canada bonds of various terms. We now have more rates to observe and we see that these rates have continued their long-term downward trend. Real rates of interest for five bond series over the last 14 years are depicted in the figure below (with the rates for 2008 estimated using an average of the January through June interest rates).

Figure 1

From the figure we see that real rates have decreased slightly from their 2006 and 2007 levels. However, the decrease in real interest rates is not sufficient to warrant a change in our discount rate assumptions. In particular, we note that the average real rates for the past 12 and 24 months are very similar to the corresponding averages at the time we wrote the previous article. One exception is the long-term rate, whose 24-month average (2.23 percent) is a third of a percent less than the corresponding 24-month average at the time of our previous article.

Although we do not show the comparable interest rates on guaranteed investment certificates (GICs), we have examined them and they are consistently lower than the rates of return on bonds. For example, the rate currently offered for 5-year GICs is approximately three percent, corresponding to a real rate of only one percent.

Our discount rate assumptions, unchanged from our 2006 article, are shown in the table below.

Table 1

Over the years, our approach to forecasting an appropriate discount rate has been criticized by other economists who prefer to rely on historical interest rates in making their forecasts. Below, we address some of these critiques and provide support for our approach.

Our approach, often called the “conservative investment” approach (which assumes a plaintiff will use his damage award to purchase a financial instrument with an appropriate term to maturity and hold that instrument to maturity), has been criticized by other economists who argue for a “market-based” approach (that assumes a plaintiff will buy and sell bonds as interest rates vary instead of holding the bond to maturity). One of us (Bruce) addressed this issue in an article written for the Spring 2007 issue of the Expert Witness entitled “Forecasting the long-term interest rate on Government of Canada bonds: “market-based” versus “conservative” investment“. We summarize his conclusions here as this issue continues to arise.

Some economists suggest that our approach ignores the price changes resulting from changes in the interest rate within the bond market, arguing for the market-based approach that assumes the plaintiff can earn a higher rate of return by actively buying and selling bonds as interest rates change. As a simple example, suppose a plaintiff will incur a loss of income of $100,000, 20 years from now. The conservative approach assumes that he will purchase a 20-year bond, paying five percent in interest per year, for $37,689 and redeem it at maturity for $100,000 to fund his loss in that year.

Assume, however, that the interest rate decreases to four percent one year after purchase. The market-based approach suggests that at four percent, the plaintiff could sell his bond (that has 19 years left to maturity) for $47,464 (= $100,000/1.0419) and earn $9,775 (= $47,464 – $37,689) in profit, for an effective rate of return of 25.94 percent in one year. However, this is actually not a profit because the plaintiff still has to purchase a 19-year bond (at a cost of $47,464) to fund his $100,000 loss of income 19 years from now. Thus, there is no real benefit to actively trading bonds as the interest rate changes.

In addition to the fact that the effective rates of return under the market-based approach are illusory, effective rates of interest are extremely variable. For example, a publication by the Canadian Institute of Actuaries entitled Report on Canadian Economic Statistics 1924-2005 indicates that the 10-year average (1996-2005) effective real rate of return on long-term Government of Canada bonds was 7.36 percent. However, the standard deviation was 9.01 percent, suggesting an average effective real rate of return that could fluctuate between -1.65 percent and 16.37 percent. This suggests that the plaintiff will almost certainly earn a rate of return different from the average long-term rate. Further, while a “profit” can be made by selling a bond when the interest rate decreases, a “loss” would occur if the interest rate increased (say) to six percent, where the 19-year bond would now only cost $33,051, for a net loss of $4,638 (or an effective rate of return of -12.31 percent).

Finally, if we were to rely on an average of past effective rates of interest then what period should we rely on? For example, the Canadian Institute of Actuaries report noted above indicates that the real effective rate of return on Government of Canada long-term bonds averaged -1.31 percent for the period 1956-1980, +8.74 percent for the period 1981-2005, and +6.79 percent for the period 2001-2005. There would be no justification for relying on any one of the above periods over the others, or for averaging these periods together, in attempting to obtain a forecast of the rate of return in the future.

We use the observed rates on government bonds as an indicator of the rates that are anticipated by large institutional investors, with billions of dollars at stake. While one might find that a forecaster is suggesting that (say) 3½ percent is the appropriate real long-term rate, this prediction is contradicted by the fact that the Government of Canada is presently able to sell its long-term bonds which offer a real return of less than three percent. (If expert institutional investors anticipated that real rates on secure investments will average, say 3½ percent over the next ten years, then they would not buy bonds that pay only 2½ percent, and the Government of Canada would be forced to adjust its bond rates.)

Other economists suggest that it would be simpler to assume that a plaintiff will hold a long-term security and then liquidate portions of this security to fund his/her losses in each year. This is simply another version of the market-based approach and, as discussed, there is a great amount of risk inherent in this strategy. Under our approach, if a plaintiff purchases a 5-year government bond with a value at maturity of $10,000, then in five years he is virtually guaranteed to receive $10,000 after redeeming his bond. However, if he were to buy a 20-year bond with the idea that he would liquidate portions of it to fund losses in each year, then he would be at the mercy of the bond prices available in each year. That is, he would be selling portions of his bond (as opposed to redeeming bonds for the guaranteed maturity value) and so, would be relying on the price of bonds attainable at the date he needed to fund his losses. As our discussion regarding the “conservative” versus “market-based” approaches illustrates, a plaintiff trying to fund his losses during periods of high interest rates would likely be selling portions of his bond at prices lower than his original purchase price and so, may not be able to fund his losses in each future year. If there is pressure on interest rates to increase in the next few years, as many economists feel is the case, then it is likely that plaintiffs investing awards from trials occurring in the next year or two would find themselves in this situation. We do not believe it is reasonable to impose this level of risk on a plaintiff.

Over the last ten years our prediction concerning the long-term interest rate has gradually declined from 4¼ percent to three percent. This decline has been in step with the observed rates, which can be seen in the above chart. Other economists have commented on our changes, with the implication that these changes demonstrate a weakness in our methodology. Our response is that the long-term rate has been changing over the past ten years, and it is important to reflect these changes in our calculations. To do otherwise would result in us using interest rates that are inconsistent with the rates that are actually available to plaintiffs.

Even if one finds that over the past few decades, long-term real interest rates have averaged 3½ percent, that rate is not now available to plaintiffs. Today’s plaintiff seeking secure investments simply cannot obtain a guaranteed long-term rate as high as the rates that were available 10 or 20 years ago. Even if the long-term rate rises to 3½ percent in five years, it does not follow that today’s plaintiff will be able to earn a long-term rate of 3½ percent, since he will be limited to the lower rates for the first five years.

Finally, many economists argue that plaintiffs should invest in equities, as well as bonds, and argue that this would result in a portfolio that is less volatile than investing in bonds alone. We find it difficult to justify the assertion that a portfolio that includes equities would be less volatile, given that the value at maturity of Government of Canada bonds is virtually guaranteed. Remember, the purpose behind the plaintiff’s investment of an award is to fund his losses in each future year and this is much different from investing for (say) retirement. The plaintiff must be able to fund his future losses in each year, whereas retirement can be delayed (or retirement plans changed) if there are insufficient funds. A plaintiff who invests in a series of bonds that provide the amount needed to fund his loss in each year, will receive the necessary amount with little to no risk of default. The same can not be said of equities, which carry a very real risk of default. The inclusion of equities can only increase the risk that a plaintiff will not be able to fund their future losses in each year.

We will re-examine our assumptions next year, and expect that some minor adjustments in our shorter-term rates may be warranted, depending on the movement of rates between now and then. As noted, minor changes in our assumptions regarding short-term interest rates will typically lead to negligible changes to our present value estimates. The assumed longer-term rates have a greater influence on our calculations, and if the rate on long-term bonds remains significantly below three percent (as it has since 2004), it may be appropriate to adjust our long-term rates as well.

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Laura Weir, Derek Aldridge, Kelly Rathje, and Christopher Bruce are consultants with Economica.