Inflation and Present Value Discounting in Economic Loss Calculations
We are often asked how we account for inflation and present value discounting in the calculation of future economic losses. To answer this we must first understand the purpose of the present value discounting.
Present value discounting is done in order to determine “how much should you give a person today, to replace lost earnings, or pay for a required care cost, in the future”. Consider a future care cost of $1,000, to be incurred 5 years from now. If you were given $1,000 today, and invested that money and earned interest at 2.5% per year, you would have about $1,131 in 5 years, which is more money than you would actually need. Assuming you could earn 2.5% interest per year, you would only have to be given about $884 today, in order to have $1,000 in 5 years. Likewise, a person would only have to be given approximately $44,200 today to invest at 2.5% per year to replace lost earnings in year 5 of $50,000. Stated another way, the present value today of $50,000 in 5 years, assuming a discount rate of 2.5% per year, is about $44,200.
However, to determine the appropriate discount rate to be used in future economic loss calculations, we must also consider the effects of inflation. For example, if an item costs $1,000 today, it is likely going to cost somewhat more than that in 5 years, due to inflation. Assuming inflation of 2% per year, an item costing $1,000 today will cost about $1,104 in 5 years. Assuming you could earn 2.5% interest per year, you would have to be given about $976 today, to have $1,104 in 5 years.
Therefore, to determine how much you should give a person today to replace lost future earnings, or pay a future care cost, we must either: (a) estimate an appropriate future interest/investment rate and a future inflation rate; or (b) we can simplify the calculation, and just estimate the difference between the future interest rate and the future inflation rate. The difference between interest rates and inflation rates can be referred to as a ‘net discount rate’. In our example above, the net discount rate is about 0.5% (it is actually about 0.48% due to mathematical compounding). That is, assuming interest rates will exceed inflation rates by about 0.5% per year, you would need to give a person about $976 today for them to have enough money to pay a cost of $1,000 (in today’s dollars) in 5 years.
In Ontario, the net discount rate to be used for the calculation of awards for future pecuniary damages is determined by formula in accordance with Rule 53.09 of the Rules of Civil Procedure of Ontario. The discount rate to be used for the first 15 years following the start of trial is established based on safe long-term Government of Canada bonds. After 15 years, the discount rate is legislated at 2.5% per annum.
The discount rate to be used for the first 15 years of calculation is adjusted effective January 1st of each year, and is generally available sometime in September on the Attorney General website, www.attorneygeneral.jus.gov.on.ca. For trials scheduled to commence after January 1, 2018, a discount rate of 0.1% per annum for the first 15 years and 2.5% per annum thereafter is applicable.
However, when dealing with future amounts that do not increase with inflation (e.g. non-indexed company pensions, many long-term disability (LTD) benefits, or Income Replacement Benefits (IRBs)), a higher discount rate is warranted. The higher the discount rate used, the lower the present value of the amounts. That is, you would require less money today to replace an amount that does not increase with inflation, than you would to replace an amount that does increase with inflation. Based on the inflation rates suggested by Rule 53.09 of the Ontario Rules of Civil Procedure for trials scheduled for 2018 a discount rate of 2.1% per year for the first 15 years and thereafter would be used for amounts that do not increase with inflation.
Our Financial Services Advisory Team (FSAT) has significant experience preparing these calculations. If you have any questions or require assistance with a calculation, please contact a member of our team.