On Wednesday, we learned prices in June increased 9.1 percent over the prior 12 months. This is the largest 12-month increase since December 1981. Despite interest rate increases to the Federal Funds Rate by the Federal Reserve, inflation remains high and broad-based. In this post, we will discuss the implications of negative net discount rates and how they may affect you.
The net discount rate used to present the value of future cash flows is a function of interest rates (discount rates) and growth rates. Although these rates vary in the short term and can change quickly because of an economic shock, the long-term relationship changes slowly over time.
Discount and Growth Rates Since 2002
Experts that make present value calculations for litigation purposes ultimately use their judgment to determine an appropriate average net discount rate for the period. Shorter periods have less time for short-term rates to return to long-term relationships. Long-term periods allow more time for discount and growth rates to return to long-term averages. For this reason, an expert’s average net discount rate for a short period will be different than an expert’s average net discount rate for a long period.
From 2002 to 2021, prices increased at an average annual rate of 2.32 percent. The highest two rates were 4.1 percent in 2007 and 7.0 percent in 2021. The lowest rate was .10 percent and occurred in 2008. During the same period, the yield on 10-year U.S. Treasury securities averaged 3.00 percent. This results in an average net discount rate of .68 percent (3.00 percent less 2.32 percent).
Negative Net Discount Rates
Over the last two decades, the average gap between growth rates, such as inflation or wage growth, and interest rates have gotten smaller. As the 20-year average net discount rate continues to fall, the frequency of experts using negative net discounts in present value calculations for litigation has increased. For this reason, it is important to examine the economic implications of negative net discount rates.
At its most basic, a negative net discount rate means more money is needed today to fund a future cash flow than the current cost of that cash flow. For example, a negative 1 percent net discount rate implies that $105 is needed today to fund a $100 expense that will incur five years in the future. This is because price level increases will outpace the rate of return on today’s money. This could make sense if there is a specific item or service that has a long history of high price increases. An example is hospital services cited in a life care plan. From 2003 to 2021, the average price level increase for hospital services was 5.37 percent. This is approximately three points higher than overall price increases. Since hospital services are specifically identified and have a history of above-average price increases, the use of a negative net discount rate to fund future hospital services could be reasonable. This would be appropriate if it involved a future output of money (an expense), not a receipt of money (income).
Courts present the value of future cash flows to account for the benefit of an award occurring today for future losses. The award is discounted to present value because the Court recognizes the proceeds will be invested for the benefit of the awardee. A negative net discount rate implies the awardee will not benefit from a current award. Rather, the awardee is better off receiving the award in the future at the time of the loss. The logic is problematic since it implies the beneficiary of an award is better off receiving funds in the future instead of today.
Finally, negative net discount rates for lost earnings inappropriately insulate Plaintiff from inflation. Consumers everywhere are affected by abnormally high inflation since wages earned are not having the same purchasing power as they did a few years ago. Present value calculations are designed to account for normal inflation over the damage period. Present value calculations that use current abnormally high inflation to rationalize negative net discount rates for long-term calculations unreasonably insulate Plaintiff from inflation.
The use of negative net discount rates in present value calculations by experts is becoming more common. The implication of negative net discount rates should be examined closely to determine if it is reasonable given the expert’s theory of damages related to future expenses, lost wages, and the time period over which they would have occurred.
The team at Anderson ZurMuehlen is pleased to be a resource to you. Should you have any questions regarding the implications of negative net discount rates, please connect with us.
This article was written by Steven Johnson, CPA and Shareholder in our Helena office.