about 18 basis points. The year-to-year differences never amount to more than $359. If bonds could be purchased in fractional amounts, a perfect fit could be attained, but it is difficult to conceive of greater accuracy being needed for most real-world circumstances.
Assuming that the balance of her portfolio, rounded off to
$580,000, is invested in an S&P 500 index fund, it would grow untouched, earning a total return over the 10-year period. At the average of 11 percent, it would reach $1,646,864. With 4 percent infla- tion, her initial withdrawal of $36,000 would grow to $53,289. This will represent only about 3.2 percent of her portfolio at that time, assuming the 11 percent total return. Because her withdrawal rates are below 4 percent, Sophie’s portfolio should be self-sustaining indef- initely. She has achieved what she wanted to do and can easily afford to continue with her cruises every other year if her health permits.
him unable to work at his job as a mechanic. He could no longer stand, bend, or twist for any length of time. At age 52, he still had at least 10 years of worklife left.1
There was no question as to legal liability, and the other driver’s insurance company made an offer to settle without going to court. As a victim, Tom was entitled under law to compensation for the damage he had suffered. General damagesis the term used for damages for which there is no objective way to assess dollar values, such as pain, suffering, or grief. Special damagesare those that can be equated (or at least estimated) directly with dollar values, such as lost wages and earning capacity, the cost of replacing Tom’s car, and his medical and rehabilitation costs. The focus here will be on the lost earning capac- ity to illustrate how asset dedication could play a role, but similar rea- soning would apply to the other elements of special damages.
Lost earning capacity is usually estimated as the difference between what someone would have earned over his lifetime had he continued in his current or planned occupation minus whatever he would now be able to earn in an acceptable alternative occupation recommended by a vocational therapist. Under the American judi- cial system, everyone is assumed to have the responsibility to miti- gate the damage from any accident. If you can avoid a car coming at you by getting out of the way, you must do so. The same is true for future damages, meaning that Tom cannot simply retire at age 52 and refuse any further employment at the expense of the other dri- ver’s insurance company.
Tom hired an attorney, who would get 30 percent of the award.2 His attorney thus had an incentive to maximize the award. The other driver’s insurance company also hired (or assigned) its own attorney, whose job it would be to minimize the total amount that Tom received. Defense attorneys usually work by the hour. Their incen- tive to do a good job is the hope of getting future cases from the same or other clients. The standard joke among attorneys is that you will never get rich working the defense side of the street, but the pay is steadier (does this sound sort of like stocks versus bonds?).
The insurance company’s offer to settle without going to court would save legal expenses for both sides. It also avoided the risk of either side’s ending up a big loser. However, Tom’s attorney thought the offer was too low. Tom was an experienced mechanic who had worked at the same automobile dealership for a number of years, and Tom had been earning about $100,000 per year, including wages and benefits. The job recommended by the vocational thera- pist would pay him only $40,000 per year. The $60,000 per year dif-
ference over his expected working lifetime formed the basis for his claim of economic damages.
An intuitive estimate of his loss would be to simply multiply the $60,000 times the 10 years to get $600,000. But this fails to fac- tor in present value or the expected increases in his wages as a result of inflation. Assume both sides agree that 4 percent is a rea- sonable inflation hedge.
Table 9.4 illustrates Tom’s projected wages plus 4 percent inflation, assuming that he would get only cost of living increases.
They total $720,366. But these are future values and must be dis- counted back to present value.
Disputes often arise at this point. What is the appropriate dis- count rate to use for computing present values? Both sides may hire independent economists to estimate the present value of lost wages.3 Theoretically, present values should be based on the inter- est rate, but there is no single interest rate, so the issue often comes down to which interest rate or what combination of rates to use.
Plaintiff ’s economists tend to argue for low rates in order to maximize the present value of the loss, while defense economists tend to argue the reverse in order to minimize the present value.
Both sides can cite historical evidence to support their figures because data for short-term, intermediate-term, or long-term bonds are readily available. Some argue that only interest rates on U.S.
Using Asset Dedication for More than Steady Retirement Income 181
Table 9.4
Estimated Earnings Losses over the Next 10 Years
Loss plus 4%
Year Loss Inflation 1 $60,000 $60,000 2 $60,000 $62,400 3 $60,000 $64,896 4 $60,000 $67,492 5 $60,000 $70,192 6 $60,000 $72,999 7 $60,000 $75,919 8 $60,000 $78,956 9 $60,000 $82,114 10 $60,000 $85,399
$600,000 $720,366
Treasuries should be used, and others argue that AAA-rated corpo- rate bonds are appropriate. Occasionally, the expected return on a generic portfolio with a conservative but arbitrary asset allocation including stocks is used. The jury must attempt to cut through the arcane economic arguments to decide what present value to use in reaching its conclusions as to the final award.
Assume that the plaintiff ’s economist uses 6 percent as the discount rate and the defense’s uses 8 percent. Table 9.5 shows that the plaintiff ’s rate leads to a present value of $551,537, and the defense’s, to $509,264. The obvious compromise would be to split it down the middle and use $530,401. The plaintiff would receive
$21,137 less than he wanted, and the defense would pay $21,137 more, but the result appears fair.
But better solutions are available with asset dedication, which can play a role in at least two ways. First, a 10-year portfolio con- sisting of U.S. Treasuries or corporate bonds could be set up, using the web site. It turns out that, because of the low interest rates on bonds as of this writing (late 2003), even the plaintiff ’s 6 percent is too high for government or corporate bonds. Table 9.6 shows the Scenarios screen from the web site, which indicates that $579,397 would be needed to buy a sufficient portfolio of U.S. Treasury and
Table 9.5
Present Values of Earning Losses at Two Discount Rates
Plaintiff Defense Loss plus Discount Discount
Inflation Rate Rate
Year Loss 4% 6% 8%
1 $60,000 $60,000 $60,000 $60,000 2 $60,000 $62,400 $58,868 $57,778 3 $60,000 $64,896 $57,757 $55,638 4 $60,000 $67,492 $56,667 $53,577 5 $60,000 $70,192 $55,598 $51,593 6 $60,000 $72,999 $54,549 $49,682 7 $60,000 $75,919 $53,520 $47,842 8 $60,000 $78,956 $52,510 $46,070 9 $60,000 $82,114 $51,519 $44,364 10 $60,000 $85,399 $50,547 $42,721
$600,000 $720,366 $551,537 $509,264