Compensatory Damages in Lost Wages Claims: The Relevance of Unemployment Trends AdjustmentsBy Josefina V. Tranfa-Abboud
March 27, 2012 | Download PDF
When claims of lost compensation arise, the role of the economic expert is to provide a reasonable estimate of the potential damages. The economic damages model designed should be tailored to the claim and its jurisdiction, but should also incorporate the effect of the economic environment and the effect of potential unemployment on the estimation of expected compensation. A simplified hypothetical example highlights the impact of the probability of unemployment on the lost compensation estimate.
See Josefina's article originally published in Employee Relations Law Journal, March 2012.
Claims of lost compensation arise from any circumstances or incidents that may have limited or completely eliminated an employee's ability to work and earn income. The role of the economic expert is to construct an economic model of damages that is tailored to the claim, to the individual whose damages are being evaluated, to the specifics of the employment and occupation of the individual, and to the reality of the economic environment. The central goal of an economic damages model in a lost compensation dispute is to provide a reasonable estimate of the difference between the net compensation "but-for" the disruptive event, and the net compensation that is possible given that an event has allegedly interfered with the individual's ability to work and to receive compensation for his or her work. Key to providing such a reasonable estimate is the importance of considerations regarding the risks and uncertainty associated with employment and earnings.
An economic damages model can provide a reasonable estimate of an individual's lost compensation only after proper consideration has been given to the probability that earnings may occur, a factor that carries even more weight under the current economic environment of continued significant challenges facing the labor market. Data regarding the unemployment rate and the discussion in the recent jobs reports provide insight into the necessary adjustments to achieve a reasonable estimate of a plaintiff's potential economic damages. The relevance of unemployment risk adjustments is highlighted in the sections that follow through a hypothetical example and a simplified economic model of lost compensation.
In December 2005, XYZ Corporation lays off Mary D, a 29-year-old female account manager. A short while later, she sues XYZ, claiming wrongful termination.The case is due to come to trial in January 2012.
Mary D. seeks to recover "past losses" – defined as her potential or alleged losses from the date of termination to the date of the trial.She also seeks to recover "future losses" – potential or alleged losses from the date of the trial forward. Mary D. claims that, as a result of her termination, she lost wages as well as her "ability" to obtain and maintain comparable employment with comparable compensation for the remainder of her work-life years.
The point of departure for the analysis of Mary's alleged lost wages claim is her prior earnings history, which is as follows (Figure 1):
Mary D. returned to the work force in January 2010, earning a salary of $35,000 per year.Further, job search specialists opine that Mary should be able to reach earnings comparable to her pre-termination compensation within four years of the date of trial, or by 2015.
The economic expert retained through Mary's attorneys uses these figures as the basis for the estimation of Mary's economic damages by projecting her pre-termination earnings in 2005, assuming annual increases of $2,000 from the date of her termination forward. The expert factors in her assumed new hire date and wages in order to compute the amount claimed for past and future losses.
Is the claim accurate?Does it fly in the face of economic reality to assume that Mary D. would in fact have earned her 2005 wages plus "typical" increases from 2005 forward with 100 percent certainty? Or would she have been affected – like millions of others – by one of the most prolonged downturns in economic history? Does her claim represent fair compensation or a potential windfall?
The underlying questions are these:
- How can a model be properly designed which will estimate the alleged earnings losses in Mary D.'s case?
- What are the relevant components in constructing a reasonable estimate of the alleged earnings losses?
- Is the economic environment pre- and post-termination a relevant factor to consider in the analysis?
- What role do unemployment trends play in a case such as this?
Claims of lost wages can arise as a result of several possible circumstances, for example:
- Termination from Employment: Suppose an employee is terminated either individually or as part of a broader reduction in force. Such a situation may lead to a claim of termination on the basis of discrimination. The plaintiff will likely claim lost wages as well as an inability to return to the pre-termination level of earnings and compensation.
- Failure to Promote: Suppose an employee was expecting to be promoted to a certain job title, but this promotion did not occur at the time when the employee was expecting it. Such circumstances may lead to an allegation of failure to promote. If the employee's compensation would have changed as a result of the promotion, there will be a claim of lost earnings and other supplemental compensation tied to base wages or job title.
- Personal Injury: A physical injury – one that prevents an individual from being able to return to a pre-injury occupation, or limits the individual's ability to earn pre-injury wages – is likely to provoke a claim for those lost and/or diminished wages.
- Wrongful Death: A claim of lost earnings and other compensation may arise as a result of an individual's death due to a third party's liability, whether related to an accident, medical malpractice or even a tragic accident. Beneficiaries or next-of-kin will cite the impact of the deceased's lost wages on their ability to live a life comparable to the one they enjoyed before the death.
The objective of a lost compensation analysis is to provide an estimate of compensatory amount that would make a plaintiff whole, or in other words, that would restore the plaintiff's pre-incident earnings-related conditions. It is the role of the economic expert to provide an estimate of the compensatory amount that would satisfy this objective. Lost compensation analyses are not "one-size-fits-all". Jurisdiction, type of claim, and employment and economic data are factors that play a key role in the design of the lost compensation model that fits the case. The economic model designed for each particular case should be based on data and information resulting from considering the following:
- The period of alleged lost compensation: The type of claim (particularly in employment discrimination matters) and the jurisdiction may affect the length of the future damages period.
- Compensation structure and potential increases in compensation: Certain jurisdictions, such as the State of Pennsylvania, do not allow inflationary increases to be considered in lost future compensation projections.
- Fringe benefits: Fringe benefits vary in nature, eligibility rules, and required contributions on the part of an employee. Also, fringe benefits not always convert into actual monetary value to the employee. Such is the case of life insurance and disability insurance, which result in monetary income only if death or disability actually occurs.
- Eligibility for bonuses, stock options, and other forms of compensation: Certain components of compensation may be tied to an employee's position and job title, as well as to the performance of the employee's pre-incident organization. Compensation components that are more closely tied to company performance carry greater risk than a base salary or other forms of basic earnings.
- Tax liability: Certain jurisdictions do not allow for the inclusion of tax effects on compensation, particularly in personal injury and wrongful death matters. Such is the case of New York State courts, which is extended to social security and Medicare taxes.
- The probability of continued employment and compensation: Company-specific turnover, occupation-specific turnover, and/or industry and geographic location-specific unemployment trends may affect this probability.
- Potential or actual mitigating employment and compensation: The employee's actual or potential employment and compensation opportunities should be considered in the analysis and should be accompanied by accompanying fringe benefits, if any, and adjusted for potential risks and any other applicable consideration as made in the estimation of pre-incident compensation.
- Disability benefits in personal injury claims: Actual income replacement benefits, such as social security disability income or a disability pension, may be potential offsets to certain components of lost compensation. However, the inclusion of such income replacement benefits in pre-trial lost compensation analyses is contingent on jurisdiction rules. Such is the case of the State of New York, where consideration for income replacement benefits such as social security disability income can only be considered post-trial.
In order to maintain the focus on the effects of the probability of unemployment in lost compensation claims, the discussion presented in the sections that follow is conducted by presenting a simplified hypothetical example of lost earnings, one that does not include most of the factors just described.
Maintaining employment - and consequently the stream of earnings that is expected to accompany it - does not carry a 100 percent certainty. The probability that someone may face periods of unemployment or under-employment is an important factor in estimating lost wages and/or other compensation. Any analysis that involves the estimation of lost compensation, whether due to a wrongful termination claim, a claim of personal injury or a wrongful death matter, needs to incorporate the probability that expected earnings may not have occurred.
This is a factor of particular importance as the U.S. economy moves through times of almost unprecedented economic challenge. Despite some evidence of a turnaround – the Business Cycle Dating Committee of the National Bureau of Economic Research declared the recession that began in December 2007 "officially" ended in June 2009 – by many accounts, job recovery in the United States continues to be slow.
One of the most astonishing characteristics of this most recent recession and its unprecedented slow recovery is not just massive job loss but the continued and protracted unemployment of many workers.In particular, 2008-2011 has proven to be a period of high anxiety over job retention for millions of workers across all industries across the country, evidenced by the significant upward trends in unemployment experienced in all 50 states. According to many analysts, an average of 150,000 jobs need to be added every month in order for the unemployment rate to begin a downward trend and to show consistent positive signs of job recovery.
The risk of unemployment, however, is an always present factor, not just relevant during periods of upsurge in the rate and the duration of unemployment. Estimations of lost wages based on equations that assume continuous, uninterrupted employment and a steady earnings stream with 100 percent certainty will generally be incomplete and upwardly biased. Given the events of the recent years and the current state of recovery of the U.S. economy, adjusting for the probability that employment and earnings have a less than 100 percent chance of occurrence is even more relevant.
Counsel retained by both the plaintiff and by the defense should consider the value of economic damages models that include adjustments for risk – and particularly give consideration to the unemployment trends of the last three years – as a key element in estimating lost wages for 2007-2010 and in the upcoming years.
The Business Cycle Dating Committee of the National Bureau of Economic Research declared on September 20, 2010 that the recession that began in December 2007 officially ended in June 2009.By many accounts, the 2007-2009 recession has been characterized as the deepest economic downturn since World War II, and the deepest on record since the Great Depression, particularly in terms of job losses.
Financial services firms that had been considered pillars of Wall Street were brought to their knees as a result of the collapse in the real estate markets, which led to widespread downsizing, restructuring, and bankruptcy of both large and small corporations across the country and across all industries. More and more workers both in private organizations as well as in government agencies and municipalities found themselves either unemployed or forced into part-time arrangements or mandatory furloughs or facing salary freezes.
The continued lack of sustained employment recovery continues to be at the heart of the political debate, and the discussions regarding the increased risk to employment over the last three years have only intensified since the last recession officially ended in June 2009.
The greatest increase in the rate of unemployment was experienced in 2009, with the unemployment rate for the U.S. economy almost doubling from 5.8 percent to 9.3 percent during the period 2008 to 2009. This upward trend continued in 2010 and, so far, 2011 has shown little or no signs of changes in the unemployment picture with very few indications from the monthly jobs reports of a potential change in trends. According to the September 2011 jobs report, while more employment increased by more than 100,000 people, the unemployment rate picture remained unchanged, and the number of people are "involuntary part-time employees" increased in September. Those considered as "long-term unemployed", defined as workers who have been unemployed for more than 27 weeks, represent 44.6 percent of the unemployed.The average work-week remained at similar levels to be 34.3 hours for all workers and 33.5 hours for non-supervisory production workers. The following chart (Figure 2) shows the available historical annual rate of unemployment over the last 20 years for the U.S. as a whole and for selected states:
The upward trend in the rate of unemployment has been coupled with an equally disconcerting upward trend in the number of weeks spent in unemployment. According to the U.S. Department of Labor, Bureau of Labor Statistics, the average number of weeks unemployed increased from 19 weeks in 2008 to 29 weeks in 2009.
Statistics also show that certain industries have been more affected than others. The following chart (Figure 3) shows statistics released by the U.S. Department of Labor, Bureau of Labor Statistics, regarding the rate of unemployment for certain industries:
According to these statistics, government workers have historically experienced the lowest rate of unemployment, while workers in the construction industry have experienced unemployment rates above the national average.
As indicated by reports published by the Monthly Labor Review in April 2011, the significant increase in unemployment experienced during the December 2007-June 2009 recession represents the deepest decline in employment since World War II. However, the recent years do not constitute the only time during which workers have faced the likelihood of unemployment. While the rate of unemployment varies across industries and states, even at levels of frictional unemployment (a level of unemployment that is considered necessary for continuous flow in the job markets), a certain percentage of workers will experience idleness and no earnings.
The objective of an analysis of lost compensation is to determine, within reasonable economic certainty, the accurate value of wages and fringe benefits that someone would have likely earned and received but-for a disruptive incident. A reasonable estimate of an individual's lost wages and fringe benefits has to be based on the likelihood that such earnings would in fact have occurred. The opposite is also true.If earning wages does not carry a 100 percent certainty, then an adjustment has to be made.
Ideally, accounting for the likelihood of compensation in a lost compensation claim should be based on measuring attrition rates specific to the pre-incident organization, industry and occupation. Such information, however, is not always available, and an alternative to such measures should be considered. While historical data regarding the unemployment rate is not tailored to any particular organization, State-level and industry-level data on unemployment can provide valuable insight regarding the trends and employment outlook of the locality and the industry, and into the likelihood of continued employment and earnings. The use of historical unemployment rates is a generally accepted approach in analyses conducted to provide an estimate of lost compensation.
The approach to the use of historical data regarding the unemployment rate varies among economic experts. Economic experts conducting analyses of employment trends generally consider different dates and spans of time for the unemployment rate. Some economists may argue that the "past damages period", defined as the period from the earnings disruption incident to the date of trial, should not incorporate any adjustment for the possibility of unemployment. Other economists may consider that the average rate of unemployment over a 30-year span should be used as the best predictor of future unemployment on the basis that such period of time should capture enough business cycles to provide a reasonable adjustment. Some economists consider that the risk of unemployment should not be a component of the analysis implicitly assuming pre-incident earnings would have been "certain".
These different views, however, may not constitute an appropriate approach to the estimation of lost compensation. Suppose an incident in 2007 caused a worker to be out of work during years 2008, 2009 and 2010. One approach would consider that the individual's wages for those years would have occurred with 100 percent certainty. The assumption that compensation would have been certain for this individual during years 2008-2010 does not capture reality.
Given what we know of the extreme nature of the 2007-2009 recession – how radically it differs from the period immediately before, how it radically changed the employment landscape for 2008-2011, and the possibility of permanent changes for the structure of the work force beyond 2011 – it's clear that an accurate analysis requires that unemployment data be taken into account. Any analysis of lost compensation requires consideration for the following facts:
- The unemployment rate doubled in 2009;
- The rate of unemployment has not yet returned to "normal" levels (in spite of the fact that the recession has been declared officially over by the Business Cycle Dating Committee of the National Bureau of Economic Research); and
- The rate of unemployment would not return to a steady level overnight, but will likely take a few years for the unemployment rate to "reverse" to something closer to its historical average.
In what follows, and in order to keep the discussion simple and to the point, only the risk of unemployment will be considered as the only main element in the projection. As discussed earlier, a complete model of lost compensation includes the effect of many factors, the probability of continued employment and earnings being just one of them.
The hypothetical example of Mary D serves as a means to illustrate how the adjustment process works, and the effect of considering the probability of unemployment in the estimation of lost compensation. In the hypothetical example, Mary D is a 29-year-old account manager who claims to have been wrongfully terminated in December 2005, and the trial has been scheduled to take place in January 2012. The basis of her economic damages claim is her pre-termination annual earnings, which escalated from $42,000 in 2002 to $48,000 in 2005, with an increase of $2,000 each year.
She claims both past losses (from termination to trial date) and future losses (from trial date forward). In this hypothetical example, it has been determined that the plaintiff could have obtained employment as of 2010 and could have earned wages of at least $35,000 per year. Following are two alternatives to the estimation of Mary D's potential lost compensation:
Approach 1: Ignoring the possibility of unemployment
This approach only takes into consideration the fact that Mary D, the plaintiff, received $2,000 increases in each of the four years of employment prior to termination, and assumes that her employment, as well as historical increases, would have continued to occur with 100 percent certainty. Accordingly, Mary's past increases are simply projected forward to the end of the damages period, resulting in the following projection (Figure 4):
Approach 2: Adjusting for the risk of unemployment
Incorporating the rate of unemployment into our estimate requires the following:
- An appropriate review of the available statistics for the past period; and
- An appropriate estimate of the rate of unemployment for future years – years for which data is not yet available.
The figures for 2006 through 2010 are drawn from Table 1 (Figure 1) which reports the U.S. rate of unemployment back to 1991. An assumption has to be made to account for the possibility of unemployment in "future" years (2011 to 2015). The table below (Figure 5) reports the unemployment rate that will be used in the estimation of Mary D's lost earnings, and it is based on the assumption that the rate of unemployment will not return to its pre-recession historical levels overnight. Rather, given the current state of the recovery on the job front, the unemployment rate will likely slowly reverse to its historical normal levels. Further, according to recent commentary by the U.S. Department of Labor, it is expected that attritional unemployment will likely be considered to be 6 percent:
Applying these past and hypothetical future unemployment-rate figures results in the following adjusted estimate of what Mary D. might have earned during the post-termination and post-trial periods (Figure 6):
Additional information is now factored in to account for Mary D's replacement earnings starting in 2010 of $35,000 per year, and to account for the fact that job search specialists have opined that Mary D. would be able to reach earnings levels comparable to what she earned in her pre-termination employment within four years after the trial.
Once the plaintiff becomes re-employed, the calculation of earnings loss becomes a "net loss." That is, since the plaintiff is earning a salary again, allegedly at a lower rate than would have been the case if she had been continually employed, the losses are estimated as the difference between her pre-termination earnings and her post-termination earnings. Post-termination earnings are also referred to as "mitigating earnings".
A new projection of the plaintiff's alleged lost earnings is developed, one that includes Mary's new earnings and the opinion of the job search specialists as well as the fact that the risk of unemployment is present for Mary's post-termination employment which would affect the estimation of Mary's post-termination earnings in similar fashion as it affected Mary's pre-termination employment and earnings. The adjusted, and more complete, estimation of net lost earnings in Mary's hypothetical case is as follows (Figure 7):
As can be noted, once it is considered that the plaintiff's pre-termination employment did not carry a 100 percent certainty, and that the probability of unemployment also plays a part in the projection of Mary's post-termination employment and earnings, a significant adjustment takes place both to pre-termination and post-termination earnings. The value of the impact on earnings depends on the levels of assumed potential unemployment risk.
By applying real-world unemployment figures and adjusting accordingly, this process has produced a radically different estimate of lost wages - $326,273, or 44.7 percent lower than the original estimate of $590,000 that did not take into account either post-termination earnings or the relevance of unemployment risks.
Our review of the hypothetical case of Mary D demonstrates how an economist can arrive at two different conclusions regarding the value of a lost earnings claim, depending on the assumptions made regarding the impact of external factors and the likelihood of employment on the estimation of lost compensation.
Many external factors play a role in the determination of someone's but-for compensation, and some of these factors are not quantifiable or cannot be predicted with certainty. As a result, any projection of lost compensation represents only an estimate and should be constructed based on assumptions that capture the surrounding economic realities as well as case-specific facts and information.
One key element in providing a reasonable estimate of lost compensation is accounting for the probability of realization of "but-for" (if the incident had not occurred) expected earnings. Incidents that lead to legal claims should not be considered as the only factor that could have potentially impacted the likelihood of someone's expected earnings. Rather, the general economic conditions, the economic conditions of the particular industry and occupation in the pre-incident scenario, factors specific to the pre-incident employer as well as to the individual's potential circumstances independent of the claim, are to be considered in providing an estimate.
Any economic analysis is generally conducted under incomplete and asymmetric information; not all factors can be fully accounted for and estimates require a certain degree of speculation. However, some undisputed realities should be considered as such information is available and is relevant, and which move the analysis away from undue speculation and into reasonable economic certainty. The realities of the employment landscape are to be considered, and when specific employment fluctuations affecting the individual whose earnings are to be estimated cannot be readily captured, publicly available statistics related to the unemployment rate should also be considered in order to provide a reasonable picture of the potential damages.
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Tranfa, Josefina V., Paul F. White and Frederick M. Holt. “Reply to ‘Comments on ‘The Use of Attrition Rates for Economic Loss Calculations In Employment Discrimination Cases – A Case Study’”, Journal of Forensic Economics, Volume XVIII, Number 1.
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© Wolters Kluwer Law and Business.
All Rights Reserved. Reprinted with permission from the Spring 2012 issue of the Employee Relations Law Journal.
About Josefina V. Tranfa-Abboud
Josefina V. Tranfa-Abboud Ph.D., CFE, MAFF, is a Principal in the Financial Advisory Services Group at Marks Paneth LLP. Dr. Tranfa-Abboud has extensive experience in economic analysis related to labor and employment disputes such as employment discrimination and other employment disputes, as well as claims of product liability, personal injury and wrongful death. Dr. Tranfa-Abboud also has extensive experience in the analysis of damages in commercial disputes involving claims of breach of contract business interruption and professional malpractice.... READ MORE +