Inflation Risk as Determinant of the Discount Rate in Tort Settlements

Abstract

The vield on long-term bonds has been cited as the most frequently used discount rate in tort settlements. Returns from long-term bonds do not change as interest rates rise in response to unanticipated inflation. Investors (plaintiffs) are thereby exposed to inflation risk the possibility that future investment returns may not keep pace with future increases in prices and wages. Future returns from short-term instruments will likely rise as a result of unanticipated inflation. Since short-term instruments reduce exposure to inflation risk, the yield on short-term financial instruments is the appropriate rate to use when discounting to present value. In injury cases a lump sum may be awarded plaintiffs to restore them to the position that would have existed had there been no injury. The determination of a lump sum award is importantly affected by inflation and by the discount rate. The plaintiff's exposure to inflation risk is reduced when lower return short-term interest rates are used to calculate a lump sum award. Unanticipated inflation implies that borrowers and lenders determine interest rates using estimates about the future that later prove to be incorrect. The result is that price level increases outstrip earned interest on fixed return financial instruments such as bonds. Thus, inflation risk refers to the possibility that future investment returns may not keep pace with future increases in prices and earnings.'