Valuing Losses of Pension Benefits

Valuing a Pension as a Percentage of Lost Earnings

A substantial number of economic reports I have seen, and a sizable number that I have written myself, value the loss of fringe benefits as a percentage of lost earnings. Many of these reports rely for this purpose on the Chamber of Commerce or Department of Labor statistics cited at the beginning of this paper. The first issue that needs to be addressed is the question of when is it appropriate to value the loss of pension benefits as a percentage of lost earnings.

If all employers offered defined contribution plans under which each employer contributed 3% of each employee’s gross earnings to a pension plan account in the employee’s name, the task of valuing pension plans would be easy. To each estimate of earnings loss one would just add 3% for the pension plan. But a substantial number of employers do not offer pension plans, and those that do offer a variety of plans, as described above. Hence, the duration of employment that a worker would have had with a particular employer and the type of pension plans offered by other employers for whom worker might have worked become matters of concern.

The circumstance in which use of a percentage of earnings to value pension benefits seems most compelling is the case of an injury of a young person who has not yet entered the labor force. There is no employer and no track record of earnings. Use of U.S. Chamber of Commerce or U.S. Dept. of Labor statistics cited at the beginning of this paper to estimate the loss of pension benefits would seem to be the only recourse. These statistics include employers who have no employee pension plan and cover all types of employers. The future labor market experience very much a blank slate for this person and average statistics for a sample of employers spanning all industries and occupations in the labor force would seem to be the best way of obtaining a measure of the pension benefit loss.

Another circumstance where the “percentage of earnings” approach might be the best procedure is where it is known that the person was employed at the time of the case-causing event but nothing is known about the fringe benefits. Use of a percentage to measure all relevant⁹ fringe benefits, including a pension plan, is a stop-gap, temporary solution that may be remedied at a later time if and when more information becomes available.

Based on the discussion of pension plan trends presented above, it is clear that, while the chances of a randomly-selected worker being covered by any type of pension plan have stayed about the same, the chances are getting greater that, given coverage, the worker will be covered by a defined contribution plan, or by a cash balance plan. For both of these types of plan–in sharp contrast to defined benefit plans, as emphasized below–valuation of pension losses as a percentage of earnings is appropriate. Hence, to take yet another situation where use of a “percentage of earnings” may be a reasonable approach, if a worker randomly selected from the working-age population is unemployed at the time of the case-causing event, it is more likely today than in 1980 or 1990 that the next job the worker gets will be a job with a defined contribution pension plan.¹⁰

When the Percentage of Earnings Approach Is Inappropriate

If a worker is employed at the time of the case-causing event and is covered by a defined benefit plan, the details of which can be determined, it is inappropriate to use a percentage of the estimated loss of earnings to measure the worker’s loss of the pension benefits arising from the reduction in earnings. With a defined benefit plan, there is no separate account set aside for each specific worker. The amount the employer contributes to the defined benefit plan each year is determined by a variety of factors considered by the plan actuary, as described above, such as the age distribution of employees and their mortality, the amount of employee turnover which affects the percentage of employees who are vested in the plan, and the level of interest rates and the rate of return on other assets in which the funds of the plan are invested. When all of these factors influencing a firm’s contributions to its pension plan are considered, it become obvious that the link between the firm’s contributions to its pension plan per employee in any given year, or over the last X years, would bear only a very loose and uncertain relationship to the present value of the employee’s loss of pension benefits during the time of retirement.

An argument that might be made for using the percentage of lost earnings approach to value the pension loss when a person is covered by a defined benefit pension benefits is based in the KISS (Keep it simple, stupid) principle. The use of the percentage of earnings approach simplifies a damage report in several ways. For one thing, it avoids making the loss period reach any further into the future than the end of the person’s working life. Valuing the pension losses by computing the present value of future pension benefits but for and given the case-causing event and deducting the latter from the former means extending the loss period out to the end of the worker’s life expectancy. This duration is virtually always longer than the projected age of retirement. As Gerald Martin (year?) has noted, “Most economists seem to claim the loss over the worklife as a loss of benefits because this avoids the need to push another 20 years or so further into the future” (p. 4–16.2). A simpler damage report and opinion is easier to present in testimony and it takes less time to prepare. It is therefore less expensive. The loss of wages itself may in many cases be sufficiently high to exceed the applicable insurance limits for the case. Incurring additional expert fees for the time to undertake a relatively elaborate computation of the pension loss may be an expense that fails the attorney’s cost-benefit test. If some cheaper proxy for all lost fringe benefits, including the pension loss, are available, well and good. Do it poorly and cheaply, or, in the alternative, don’t include an estimate of the pension loss at all.

Given a world where nine in 10 cases settle without trial, using inappropriate methods to compute damages is a calculated risk. Use of inappropriate methods makes the using side vulnerable to an effective attack that exposes the error in the proffered estimate. Depending on the particular context, such an exposure could call into question the entire damage appraisal.

Valuing Losses of Benefits from Contributory vs. Non-Contributory Defined Benefit Plans

With many, if not most, defined benefit plans workers covered by the plan are required to contribute some percentage of pay toward the cost of the plan. For the same level of pension benefits at retirement, a plan that requires contributions from the worker is worth less to the worker than would be the case if no contributions are required. When valuing the pension loss arising from a reduction in earnings, care must be taken, therefore, to reflect this obvious fact in the valuation of the pension loss. The most straightforward way of doing this is to deduct the worker’s pension contribution from the estimate of the pension loss or the estimate of lost earnings.

A Double Counting Mistake to Avoid

It would clearly be inappropriate to value the loss of pension from a defined benefit plan as a percentage of earnings and also by computing the present value of the loss of future benefits. Such double counting may occur because of sloppy work: the pension loss is estimated as the present value of the loss of future pension benefits paid after retirement; a “percentage of earnings” approach is used to value the loss of all other fringe benefits except the pension loss, with the expert forgetting to remove the component of the fringe benefit percentage representing retirement plans before multiplying it by the loss of earnings.

Having discussed some issues and ideas that apply to the valuation of pension losses in all kinds of cases, I provide some examples and discuss some additional issues that arise in the context of particular kinds of cases.

DC Savings Plan with Employer Match

First assume that the discharged employee had a DC savings plan wherein the employer matched 50% of the employee’s contribution up to 4% of pay. Suppose the employee had pay of $30,000 per year, and assume that pay would have increased by 3% per year over the 5-year loss period. Suppose further that the employee had a history of contributing the maximum of 4% of pay to the DC plan each year. Under these assumptions, and discounting of future losses to present worth at 5%, the mortality-adjusted present value of the pension loss would be $3,158, as shown in Part A of Table 1. The present value is computed as of 1/1/03. For simplicity, the assumption being made that pay is received at the end of the year. The mortality adjustment (based on mortality data for all persons in the U.S. in 2000) makes little difference: without the adjustment, the loss is $3,184, only $26 more. The adjustment is included for extension to the estimate of the loss with a DB plan, discussed below.

DB Plan Funded 100% by the Employer with No Early Retirement

Assume alternatively that the employee was covered under a DB plan. Assume that the plan’s benefit formula is such that annual retirement benefits equal to 1% of salary during the year before the date of retirement multiplied by years of service. The retirement age under the plan is age 65 with no provision for early retirement. Assume that the pension is solely funded by the firm with no contribution required of employees. Suppose at the time of the wrongful termination, the employee had 30 years of service and would have been eligible to retire at 65 with 35 years of service, but for the wrongful termination. Assume a salary of $30,000 per year and a 3% pay increase each year. But for the wrongful termination, the person would have had retirement benefits of 1% x $34,778 x 35 years = $12,172 per year. Given the wrongful termination, the person will be able to draw benefits, at the normal retirement age, of 1% x $30,000 x 30 years = $9,000 per year. The annual loss of pension, therefore, is $3,172 per year. Using the 2000 United States Life Tables, cited in Table 1, the life expectancy of a person exactly 60 years old is 21.6 years to age 81.6. Assuming a 16.6-year life expectancy beyond retirement at age 65, the present value of this loss using a 5% discount rate would be $31,185, as shown in Table 1. If, instead of using this “annuity certain” approach, the “life annuity” approach is used to compute the present value of the pension loss, that loss would be $29,599, also shown in Table 1.¹²

DB Plan with Early Retirement Provision

Now consider a modification to this example wherein the employee is allowed to begin drawing a reduced pension immediately at the time of termination due to an “early retirement” provision that allows employees to retire as early as age 60, with at least 25 years of service. Suppose further that the penalty for “early retirement” is 5% for each year the employee is under age 65. The loss of pension due to wrongful termination is computed for this scenario in Table 2. The early retirement option reduces the size of the pension loss to $22,339 using the annuity certain approach and to $18,390 using the life annuity approach. More generally, the smaller the penalty for early retirement, the smaller the pension loss. If there was no penalty for retirement at age 60 or later, the pension loss from retiring at age 60 rather than age 65 would be negative, meaning that retiring with a pension of $9,000 at age 60 has a higher present value as of age 63 than waiting to age 65 and retiring with an annual pension of $12,172.

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Note that it would be difficult if not impossible to determine the value of the employee’s pension loss by computing the employer’s contribution to the plan on behalf of this particular employee. As noted above, with a DB plan the employer does not make contributions on behalf of particular employees. Even if the amount the employer contributed in the years after the termination could be determined and divided by the number of employees in the plan, the resulting average contribution per employee would have only a minuscule chance of measuring the employee’s pension loss. It is also worth noting that the average percentage of employee pay that employers spend on retirement and savings plans–6.6% using the U.S. Chamber of Commerce survey, and 4.2% using data from the U.S. Dept. of Labor in the year 2002–would provide poor estimates of the DB pension loss computed in Tables 1 and 2. For example, in Table 1, the life annuity pension loss of $29,599 is about 18.6% of the loss of earnings of $159,211. Using either of these employer cost percentages to estimate the pension loss as a multiple of lost earnings–either 6.6% or 4.2% of the loss of earnings of $159,211–significantly understates the loss of pension benefits. Similarly, in Table 2, the life annuity pension loss of $18,390 is about 11.6% of lost earnings of $159,211.

DB Plan Funded Partly by the Employer and Partly by the Employee

Take the same scenario as that depicted in Part B of Table 1, with one change. Assume that employees are required to contribute 5% of earnings to the DB retirement plan. The correct valuation of the pension loss when the employee is required to make a contribution is to deduct the amount of that contribution from the loss. The contribution is a cost to the employee of participating in the plan and makes the plan less valuable than one with the same benefits that is totally financed by the employer. Hence, the pension loss would be the Table 1 loss of $29,599, as above, less 5% x $159,211 = $7,961. The pension loss is therefore $21,638 = $29,599 - $7,961.¹³

Valuing the Loss in A Cash Balance Plan

As a final alternative, suppose the employer provides employees with a cash balance pension plan. Assume that at the time of the employee’s termination, the amount in the employee’s hypothetical account is $250,000. Suppose further that additional credits are added thereafter to the employee’s hypothetical cash balance through annual credits computed as 4% of employee pay. Furthermore, assume that employee balances grow based on interest credits that are not conditioned on continued employment. Under these assumptions the loss in the value of the cash balance plan is simply 4% of the loss of back and front pay. Continuing the above example, the loss would be 4% x $159,211 = $6,368. Because the interest credits are not conditioned on continued employment, those credits would not be part of the loss.

Estimating the Loss of Social Security Benefits

Social Security provides a type of defined benefit pension plan under which retirement benefits depend on years spent working in covered employment and the amount of earnings in all those years. This record of earnings is summarized in the employee’s “average indexed monthly earnings” (AIME). As I have argued elsewhere (Rodgers, 2000), multiplying the employer’s FICA tax “contribution” 5.3% (the part of the FICA tax of 7.65% that funds the retirement portion of the Social Security program) by the lost earnings virtually always provides a poor estimate of the employee’s loss of Social Security benefits.

To continue with the above example, the loss of the last five years of the terminated employee’s working life could have the effect of reducing the employee’s AIME, which would result in a loss of Social Security retirement benefits relative to what those benefits would have been but for the termination. The loss depends on the terminated worker’s earnings history in covered employment. The loss can be as low as zero if the earnings the worker would have received but for the wrongful termination would not have been used to compute the worker’s AIME–a situation that would arise if those earnings were not among the highest 35 years of indexed earnings used to compute AIME.

The maximum loss that the worker could sustain would be the total loss of Social Security retirement benefits from being denied coverage because the loss of the five years of work was enough to keep the worker from being “fully insured.” This would be an unusual situation where the worker had attained less than 40 quarters (credits) of coverage up to the time of the wrongful termination at age 60. The situation where a worker begins working full-time after age 50 and has obtained no quarters of coverage prior to that date is probably very rare indeed. But in such an instance, the wrongful termination could render the person ineligible for any benefits. If this person was “on the cusp” of becoming fully insured and never became so due to the wrongful termination, then the loss of social security retirement benefits could be substantial.

A somewhat more likely scenario where there could be a substantial loss of Social Security retirement benefits would be the situation where a person had worked for many years as a Federal civilian employee (being hired prior to 1984) and then took a job in the private sector in 1994 at age 54. Such a worker would have obtained 24 quarters of coverage by age 60–less than the 40 quarters of coverage required to be eligible for Social Security retirement benefits. But for the termination, the worker, using the assumptions above, would have obtained an additional 20 quarters of coverage over the five years of employment during the period 2000 through 2004, allowing the worker to be eligible for a Social Security pension.¹⁴

Table 3 shows an example of the calculation of the loss of Social Security benefits in two scenarios. In the first, It is assumed that the terminated worker had earnings prior to 1999 that bore the same relationship to average covered earnings in those years as earnings of $30,000 in 1999 bore to average covered earnings in that year. The worker’s AIME based on the highest 35 years of indexed earnings from age 22 to age 64 is computed, but for, and given the termination. As can be seen, AIME is $2,652 but for the termination and $2,638, given the termination, so the effect of the termination on AIME is very small. The effect of the termination on the primary insurance amount (PIA) is therefore very small, reducing the amount from $1,192 to $1,188, or by $4 per month. The reduction is the same for the age 65 monthly benefit, from $1,152 to $1,148 per month.¹⁵ This reduced monthly benefit will have a smaller present value than the present value of the 5.3% OASI portion of the FICA tax paid by the employee on the lost earnings, which, from the example above, is 5.3% x $159,211 = $8,438. The net loss, as shown in Table 4, is a negative $7,860.¹⁶

Table 3 Estimating the Loss of Social Security Retirement Benefits

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In the second scenario, it is assumed that the worker began working in covered employment in 1994 at the age of 54. Therefore, at the time of the termination, insufficient quarters of coverage (24) were held for being “fully insured and no Social Security benefits would be collectable, given the termination. But for the termination, the worker would have had sufficient quarters of coverage. Hence, the entire present value of benefits, but for the termination, would constitute the worker’s loss of benefits. Table 5 computes the present value of the gross loss of benefits as $44,359, and the net loss after OASI FICA taxes as $35,921.

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It is worth noting that multiplying the employer’s 5.3% tax “contribution” times the loss of earnings of $159,211 produces a number equal to $8,438. This number is a not a good estimate of the Social Security pension losses in either of the two scenarios depicted in Tables 4 and 5. This illustrates the point noted above that what might be termed the “FICA tax method” of estimating the employee’s loss of Social Security benefits does not accurately estimate such losses.

Same Scenarios but Involving a Younger Employee

The previous situations were couched in terms of an older employee close to retirement. Let us examine the loss of pension for a case of a younger employee, but otherwise in the same circumstances.

For the DC Savings Plan with Employer Match scenario, the loss remains the same, namely, $3,184, as shown in Table 1. For the DB Plan Funded 100% by the Employer, there is a difference in the loss. To fix the difference, assume that the younger terminated employee was 40 years old with 10 years of service at the time of termination. Assume, as before, that there are three years of back pay losses and two years of front pay losses, with the same pay structure.¹⁷ But for the wrongful termination, the retirement benefits would have been computed as 1% x $34,778 x 15 years = $5,217 per year. Given the wrongful termination, the person will be able to draw benefits, at the normal retirement age, of 1% x $30,000 x 10 years = $3,000 per year. The annual loss of pension, therefore, is $2,217 per year. Assuming a 15-year life expectancy beyond retirement, the present value of this loss using a 5% discount rate would be $7,867, as shown in Table 6. The loss is much smaller due to the effect of discounting a loss occurring further in the future. In the scenario, DB Plan Funded Partly by the Employer and Partly by the Employee, a deduction of an employee contribution of 5% of lost earnings would result in no net loss of pension, as the present value of the employee contribution to the pension plan of $7,961 would exceed the present value of the pension loss of $7,867. In Valuing the Loss in a Cash Balance Plan, the loss would continue to be the same with the same credit of 4% of employee pay, and the loss would be the same as in the earlier example, namely, $6,368. Estimating the Loss of Social Security Benefits for a younger person would entail the same type of issues as for an older person, but with the added uncertainty created by the much longer time period for market work and earnings before retirement. The likelihood of a net loss of benefits arising would be smaller due to the nearness in time of the employee’s 5.3% “contribution,” compared to the possible loss of benefits is a distant, more heavily discounted future.

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Age at the time of injury

A key aspect in the valuation of pension losses in personal injury cases is the age of the person at the time of the injury. At one extreme the plaintiff may be a young person who has not yet completed his or her education and entered the labor force. At the other extreme, the injured person may have already retired from the labor force and be drawing one or more pensions. Or the person may be somewhere in between in his or her 20’s, 30’s, 40s or 50’s. For the very young person not yet in the labor force, there is no employer and no track record of earnings. As noted above, this is a situation where the strongest case can be made for using the U.S. Chamber of Commerce or U.S. Dept. of Labor statistics cited at the beginning of this paper to estimate the loss of pension benefits. The future labor market experience is very much a blank slate for this person and average statistics for a sample of employers spanning all industries and occupations in the labor force can be used to provide a rough measure of the pension benefit loss.

Once a person enters the labor force after completing his or her education, more is known about the likely career. Even so, young people are more likely to change jobs than older people. Indeed, one of the main reasons for the rapid rise in earnings at younger ages, as observed in age-earnings cycle data, is the wage increases that come with a change in employers. If a person would have had several employers over a career, each offering a different type of pension plan, the problem of estimating the loss of pension becomes formidable. However, the pension plan offered by the employer at the time of the injury may provide some guidance about the time of plan the person may have for the remainder of their career, and the details of that plan can guide the estimate of the pension component of the fringe benefit loss. For example, if the person has begun a career as a public school teacher, it is may be reasonable to assume a career with employers who offer the type of defined benefit plan the person held at the time of the injury. Appraisals for persons who have an established career and track record of employment allow more to be known about the type of pension benefit plan the person will likely have over their working career. The older the person, the more likely the person is to stay with their longstanding occupation due to the cost of changing to a new one. Employers offering jobs to persons in that occupation may provide similar benefit packages including pensions. When a person nears retirement, it should be possible to compute the stream of pension benefits after retirement and how that stream of benefits will be affected by an injury that causes a loss of earnings. Once the person’s working life is mostly over, an injury that diminishes earnings has fewer years to adversely impact the future stream of pension income, which is already largely determined by years of service accumulation and/or the accumulation of retirement assets in tax-sheltered DC plans. After retirement, an injury to a retired person that left the person alive and with the same life expectancy (or mortality risk over future ages) would not alter the flow of pension benefits.

Severity and duration of the injury

A number of types of situations can be distinguished.

1. In personal injury cases with the smallest economic losses, the injured person is able to continue working at the same employer in the same job, after a short recovery period of a few weeks. In this type of situation, the loss of wages and fringe benefits will be zero or very small.

2. More severe is the case where the injury requires a change in job duties but which allows the person to remain with the same employer with the injuries accommodated in a job that carries a lower rate of pay. Here there will a loss of pension benefits whose value is a function of annual earnings. However, to the extent that the employee’s own contributions to the cost of the plan are correspondingly reduced, the size of the pension loss is also reduced.

3. The injury may require that the employee change employers because no work is available at the old firm that can be performed by the employee, given the injuries sustained. In this situation, there will be a pension loss due to the loss of wages and a reduced employer contribution to a DC plan, or, for a DB plan, a loss of service credits during the time interval off work between the pre-injury and the post-injury job. Furthermore, the pension plan, if any, provided by the new employer may provide for pension benefits having a higher or lower value than those provided by the pre-accident employer. If wages are lower in the new job and pension benefits depend on wages, the pension benefits are likely to have a lower value than those provided in the old job. This is obviously true, a fortiori, if no pension plan offered by the new employer.

4. The injuries may be so severe as to require a substantial period of recovery, during which the person is out of the labor force, followed by the capacity to engage in work on a more limited basis, perhaps allowing only part-time work. Part-time employment may offer no employer-provided fringe benefits of any kind, except for those benefits which are legally mandated.

5. Finally, the injuries may be so severe as to render the person totally and permanently disabled, thereby qualifying the person for a disability pension from Social Security, worker’s compensation and/or an employer-provided disability pension. The disability pension may be treated as a collateral source that cannot be mentioned in trial testimony or used to offset other economic losses of wages or fringe benefits. However, there may be subrogation claims by disability insurance carriers against a court award or settlement received by the injured person. When earnings are reduced to zero, this will, of course, generate pension losses for any retirement pension whose amount is a function of earnings. In the Social Security program, this impact is mitigated by the existence of both disability and retirement pensions and by the fact that payments are indexed to the increases in the CPI-W. Should a person become totally and permanently disabled, disability payments continue until the person is eligible to retire, after which the payments changes from being labeled a “disability pension” to being labeled a “retirement pension.” If the person is relatively young when disabled, there will likely be a loss of Social Security pension benefits during the retirement years because the person is denied the earnings increases associated with economy-wide and personal productivity increases over what would have been his working life cycle and only experiences increases tied to the cost-of-living indexing. However, the extra Social Security taxes the person would have paid on these productivity enhanced earnings may more than offset the extra Social Security benefits that would have been received during retirement, but for the disabling injuries.

The duration of tenure with a particular employer and pension plan type

Because employers do not offer defined contribution plans under which each employer contributed x% of each employee’s gross earnings to a pension plan, the task of valuing pension plan losses in personal injury cases is made more difficult. A substantial number of employers do not offer pension plans, and those that do offer a variety of plans, as described earlier in this paper. Hence, the duration of employment that worker would have had with a particular employer and the type of pension plans offered in other jobs the worker might have had become matters of concern. How long the person would have remained with that employer even if the injury had not occurred? The implicit or explicit assumption made in many forensic economic damage reports is either that, but for the injury, (i) the injured worker would have continued working at the same firm until retirement from the labor force, or (ii) any changes of employer would have resulted in the worker receiving a wage and fringe benefit package comparable to that provided by the employing firm at the time of the injury. The specifics of the case may allow a reasonable inference to be made about the probability that the injured person would have continued work in the same job and for the same employer, but for the accident or incident requiring the change in employers. The older the worker at the time of injury, the more likely it is that one or both of these statements will be good prediction. For example, a 50-year-old public school teacher with 25 years of service for a particular school district and 10 years away from retirement is likely, but for a totally disabling injury, to have continued working as a school teacher until retirement. The loss of future retirement benefits under the defined benefit plan is relatively easy to calculate as the benefit reduction occasioned by the reduced years of service and the reduced level of pay, given the injury, that will be used in a DB formula that uses income and years of service as the two variables for determining retirement benefits.

By contrast, it may be reasonable to assume that a younger worker would have changed employers many times, even if an injury had not occurred. The significance of employer change in regard to the valuation of pensions is that job change can cause a pension loss for at least two reasons. First, if the job change occurs before an employee becomes vested, all pension benefits are lost. Second, there is a pension loss because pension benefits accrue more rapidly as the retirement age under the plan is approached. Leaving a job prior to this point causes the participant to miss this period of most rapid accrual (Copeland and Coronado). This feature of plans is, of course, a way a reducing employment turnover. (Cash-balance plans have more evenness in the rate of benefit accrual, meaning that the pension loss arising from changing employers is smaller than with a conventional DB plan.) Of course, the specifics of the situation must be examined to determine whether an injured employee who was forced to change employers has sustained such pension loss. If the defined benefit pension plan loss is determined in the manner suggested in Table 1, the accrual rate of benefits is automatically taken into account.