Five Keys to Assessing Economic Damages

What does it mean to say that someone has suffered an economic loss? Although such losses can arise from a wide variety of criteria ' employment discrimination, personal injury, breach of contract and medical malpractice, to name a few ' the basic definition of economic loss remains the same. An individual is said to have suffered an economic loss when the pre-incident value of what s/he could have been expected to earn exceeds the value of what s/he can now be expected to earn post-incident. In other words, there are two broad components involved in calculating an economic loss. First, one must establish what the individual could have been expected to earn had the incident never taken place. This is commonly referred to as the 'but-for' earnings stream, because it is the earnings stream that the individual would have enjoyed 'but-for' the incident. Second, one must estimate what the individual can now be expected to earn, given that the incident has occurred. This is commonly referred to as the 'offset' earnings stream, because these earnings serve to 'offset' the loss suffered.

This definition of economic loss focuses on earnings. In fact, the terms 'but-for' and 'offset' also apply to a number of other streams that have economic value, such as employment benefits and non-market production. While the focus of this article is on earnings, these other elements are also an important part of damage estimation.

Key Number One

Future 'But-For' Earnings Must Be Properly Estimated

Labor economists have been studying the way in which earnings vary over one's work life since the early 60s. Research shows that real earnings increase most rapidly in the early years of working. While earnings continue to increase thereafter, the rate of growth falls as individuals move into the middle years of their work life. Finally, earnings 'flatten out', and may ultimately decrease toward the end of the individual's employment life. Labor economists term this relationship an 'age-earnings profile.' The precise shape of this age earnings profile, that is, how steep its positive slope in the early years, the age at which it peaks, and how steep its negative slope thereafter, tends to vary with the individual's education level, occupation, and labor-force attachment. There are a number of publicly available government data sources that provide information on these variables. An expert can utilize these government data to estimate an age-earnings profile specific to the plaintiff. Future 'but-for' earnings can then be projected using this profile.

Given this understanding of how earnings behave over one's employment history, it is usually inappropriate to simply assume a constant growth rate for earnings for every year of the plaintiff's work life. Naturally, there are exceptions to the age-earnings rule, such as when earnings are governed by a collective bargaining agreement, or when past earnings growth has been markedly different from that predicted by the age-earnings profile. In most cases, however, using an age-earnings profile is the most appropriate, and theoretically sound, methodology for predicting future earnings.

Key Number Two

Offset Earnings Must Be Taken into Account

The basic definition of economic loss discussed above brings us to the second key to accurate damage estimation. The expert must estimate 'offset' earnings. As elementary as this may sound, it is astonishing how many times damage estimates are prepared that solely evaluate the plaintiff's 'but-for' earnings ' completely ignoring what the individual in question can be expected to earn in the future. Naturally there may be instances where an individual is so seriously injured that s/he is not expected to ever be able to work again. However, in such cases the expert must make it clear why no 'offset' earnings stream was estimated. Even wrongful death cases require the estimation of a type of 'offset' stream. Though clearly the deceased will have no future earnings, what s/he would have consumed had s/he not died must be subtracted from the economic loss sustained by his or her survivors. In short, what the expert is called upon to estimate is the extent to which an individual (or an estate) has been economically diminished by a given incident. One could think of this as the 'net impact' of the incident. If all relevant 'offsets' are not properly taken into account, no such estimation has been performed.

Wrongful Termination: Offset Earnings Can Be Estimated

In wrongful termination cases, it is often the case that the plaintiff has not found new employment by the time the damage estimation must be prepared. Clearly, this complicates matters, as there are no current earnings on which to base the projection of 'offset' earnings. This does not mean, however, that it is appropriate to simply leave 'offset' earnings out of the calculation. As discussed above, the estimation of 'offset' earnings is critical to an accurate damage estimation.

When the plaintiff in a wrongful termination case has not yet found new employment, 'offset' earnings can be estimated using government data from the 'Displaced Workers Survey.' These data provide information on individuals who were displaced from their jobs at any time over the 3 years prior to the survey. Among the data provided by the 'Displaced Workers Survey' are the individuals' earnings prior to displacement; whether or not they had, by the Survey date, found new employment; and, if they had, their earnings on the new job. With these data, we can estimate the percent of pre-termination earnings that displaced workers were able to replace, by the Survey date, through new employment.

Two of the most important factors related to an individual's ability to reposition him- or herself are pre-displacement earnings level, and age. Selecting individuals who fall in earnings- and age-ranges similar to the plaintiff allows an expert to estimate an average replacement rate appropriate to a particular plaintiff. 'Offset' earnings can then be calculated by multiplying the estimated replacement rate by the plaintiff's 'but-for' earnings.

Key Number Three

Work Life and Life Expectancies Must Be Specified

Another key to accurate damage estimation is a proper adjustment for both work life and life expectancy. It is not appropriate to simply assume a particular age for either retirement or the end of life. There are published government data available on average work life expectancies by age, gender and education. There are also published government data on average life expectancies by age, gender and race.

Key Number Four

Source Documents Must Be Used Whenever Available

Any estimate of loss is only as good as the data that underlie it. Thus, it is critical to use source documents, such as tax returns, collective bargaining agreements and employee benefit statements, whenever possible. Unfortunately, good documentation is not always available, in which case the expert has no choice but to rely on individuals' best recollections. This approach, however, should only be used as a last resort. Since memory is often unreliable, it is crucial to always press for documentation. When source documents are available, there is simply no excuse for working without them.

Key Number Five

Estimates Must Be Present-Valued

The final key to accurate damage estimation is present-valuation. The basic idea behind present-valuing is that a dollar received today is worth more than a dollar received a year from now. If one receives a dollar today, one could put it in the bank, and earn the prevailing interest rate. Suppose that rate is 5%. In that case, by the end of the year, that dollar would be worth $1.05. Therefore, if the person who paid the dollar already owed money from last year, he or she will need to pay more today than what was originally owed ' the extra 5 cents on the dollar. Similarly, if he or she is paying now for a loss that will not occur until next year, he or she can pay less.

The expert often estimates losses that stretch well into the future, yet settlement on those losses will be made in the present. Thus, any losses that are projected for the future, beyond the settlement date, need to be discounted to the date of settlement. Similarly, any losses that were incurred prior to the settlement date need to have interest accrued up until the point of settlement (though often the court prefers to perform this last calculation). When estimates of loss stretch far into the future, the failure to present-value will result in a dramatic overestimate of loss in current dollars.

Amy Henderson, Ph.D, is Vice President and Senior Economic Analyst at Integral Research, Inc., an economic consulting firm based in New York. She provides economic and statistical analysis to both plaintiffs' and defense counsel in connection with a wide array of employment law cases.

The proper assessment of economic damages, once liability is determined, is one of the most crucial elements of the legal process. In fact, even before a case ever enters the courtroom, an accurate estimate of economic loss may pave the way for a settlement, saving both sides time and expense.

To estimate economic loss, we must make a number of assumptions, and wherever there are assumptions, there is room for reasonable people to disagree. That said, there are key elements to proper damage estimation that should almost always be followed. This article provides a basic blueprint for the proper approach to estimating economic loss, and the five key items that should be addressed in any damage estimate. Armed with this information, attorneys can more effectively interview a prospective damages expert. They will also be equipped to perform a quick first evaluation of an opposing expert's report, and to make sure that these key points are covered when deposing or cross examining that expert.

Economic Loss Defined

What does it mean to say that someone has suffered an economic loss? Although such losses can arise from a wide variety of criteria ' employment discrimination, personal injury, breach of contract and medical malpractice, to name a few ' the basic definition of economic loss remains the same. An individual is said to have suffered an economic loss when the pre-incident value of what s/he could have been expected to earn exceeds the value of what s/he can now be expected to earn post-incident. In other words, there are two broad components involved in calculating an economic loss. First, one must establish what the individual could have been expected to earn had the incident never taken place. This is commonly referred to as the 'but-for' earnings stream, because it is the earnings stream that the individual would have enjoyed 'but-for' the incident. Second, one must estimate what the individual can now be expected to earn, given that the incident has occurred. This is commonly referred to as the 'offset' earnings stream, because these earnings serve to 'offset' the loss suffered.

This definition of economic loss focuses on earnings. In fact, the terms 'but-for' and 'offset' also apply to a number of other streams that have economic value, such as employment benefits and non-market production. While the focus of this article is on earnings, these other elements are also an important part of damage estimation.

Key Number One

Future 'But-For' Earnings Must Be Properly Estimated

Labor economists have been studying the way in which earnings vary over one's work life since the early 60s. Research shows that real earnings increase most rapidly in the early years of working. While earnings continue to increase thereafter, the rate of growth falls as individuals move into the middle years of their work life. Finally, earnings 'flatten out', and may ultimately decrease toward the end of the individual's employment life. Labor economists term this relationship an 'age-earnings profile.' The precise shape of this age earnings profile, that is, how steep its positive slope in the early years, the age at which it peaks, and how steep its negative slope thereafter, tends to vary with the individual's education level, occupation, and labor-force attachment. There are a number of publicly available government data sources that provide information on these variables. An expert can utilize these government data to estimate an age-earnings profile specific to the plaintiff. Future 'but-for' earnings can then be projected using this profile.

Given this understanding of how earnings behave over one's employment history, it is usually inappropriate to simply assume a constant growth rate for earnings for every year of the plaintiff's work life. Naturally, there are exceptions to the age-earnings rule, such as when earnings are governed by a collective bargaining agreement, or when past earnings growth has been markedly different from that predicted by the age-earnings profile. In most cases, however, using an age-earnings profile is the most appropriate, and theoretically sound, methodology for predicting future earnings.

Key Number Two

Offset Earnings Must Be Taken into Account

The basic definition of economic loss discussed above brings us to the second key to accurate damage estimation. The expert must estimate 'offset' earnings. As elementary as this may sound, it is astonishing how many times damage estimates are prepared that solely evaluate the plaintiff's 'but-for' earnings ' completely ignoring what the individual in question can be expected to earn in the future. Naturally there may be instances where an individual is so seriously injured that s/he is not expected to ever be able to work again. However, in such cases the expert must make it clear why no 'offset' earnings stream was estimated. Even wrongful death cases require the estimation of a type of 'offset' stream. Though clearly the deceased will have no future earnings, what s/he would have consumed had s/he not died must be subtracted from the economic loss sustained by his or her survivors. In short, what the expert is called upon to estimate is the extent to which an individual (or an estate) has been economically diminished by a given incident. One could think of this as the 'net impact' of the incident. If all relevant 'offsets' are not properly taken into account, no such estimation has been performed.

Wrongful Termination: Offset Earnings Can Be Estimated

In wrongful termination cases, it is often the case that the plaintiff has not found new employment by the time the damage estimation must be prepared. Clearly, this complicates matters, as there are no current earnings on which to base the projection of 'offset' earnings. This does not mean, however, that it is appropriate to simply leave 'offset' earnings out of the calculation. As discussed above, the estimation of 'offset' earnings is critical to an accurate damage estimation.

When the plaintiff in a wrongful termination case has not yet found new employment, 'offset' earnings can be estimated using government data from the 'Displaced Workers Survey.' These data provide information on individuals who were displaced from their jobs at any time over the 3 years prior to the survey. Among the data provided by the 'Displaced Workers Survey' are the individuals' earnings prior to displacement; whether or not they had, by the Survey date, found new employment; and, if they had, their earnings on the new job. With these data, we can estimate the percent of pre-termination earnings that displaced workers were able to replace, by the Survey date, through new employment.

Two of the most important factors related to an individual's ability to reposition him- or herself are pre-displacement earnings level, and age. Selecting individuals who fall in earnings- and age-ranges similar to the plaintiff allows an expert to estimate an average replacement rate appropriate to a particular plaintiff. 'Offset' earnings can then be calculated by multiplying the estimated replacement rate by the plaintiff's 'but-for' earnings.

Key Number Three

Work Life and Life Expectancies Must Be Specified

Another key to accurate damage estimation is a proper adjustment for both work life and life expectancy. It is not appropriate to simply assume a particular age for either retirement or the end of life. There are published government data available on average work life expectancies by age, gender and education. There are also published government data on average life expectancies by age, gender and race.

Key Number Four

Source Documents Must Be Used Whenever Available

Any estimate of loss is only as good as the data that underlie it. Thus, it is critical to use source documents, such as tax returns, collective bargaining agreements and employee benefit statements, whenever possible. Unfortunately, good documentation is not always available, in which case the expert has no choice but to rely on individuals' best recollections. This approach, however, should only be used as a last resort. Since memory is often unreliable, it is crucial to always press for documentation. When source documents are available, there is simply no excuse for working without them.

Key Number Five

Estimates Must Be Present-Valued

The final key to accurate damage estimation is present-valuation. The basic idea behind present-valuing is that a dollar received today is worth more than a dollar received a year from now. If one receives a dollar today, one could put it in the bank, and earn the prevailing interest rate. Suppose that rate is 5%. In that case, by the end of the year, that dollar would be worth $1.05. Therefore, if the person who paid the dollar already owed money from last year, he or she will need to pay more today than what was originally owed ' the extra 5 cents on the dollar. Similarly, if he or she is paying now for a loss that will not occur until next year, he or she can pay less.

The expert often estimates losses that stretch well into the future, yet settlement on those losses will be made in the present. Thus, any losses that are projected for the future, beyond the settlement date, need to be discounted to the date of settlement. Similarly, any losses that were incurred prior to the settlement date need to have interest accrued up until the point of settlement (though often the court prefers to perform this last calculation). When estimates of loss stretch far into the future, the failure to present-value will result in a dramatic overestimate of loss in current dollars.

Amy Henderson, Ph.D, is Vice President and Senior Economic Analyst at Integral Research, Inc., an economic consulting firm based in New York. She provides economic and statistical analysis to both plaintiffs' and defense counsel in connection with a wide array of employment law cases.