Accident and illness can take a life prematurely or render someone incapable of continuing in his job. Lawyers in personal injury or malpractice lawsuits often calculate future lost earnings due to a serious accident, negligence or illness. A lost earnings calculation usually includes the base salary, an annual growth rate and benefits. Costs for household services that can no longer be performed may also be part of the lost earnings calculation. The present value of lost earnings is the discounted value of the estimated future-earnings stream.
Project the expected annual earning capacity until retirement. Use the person's current salary. If this information is unavailable, use reasonable alternatives such as market rates for jobs that match the person's background and training. For example, if a 35-year-old female customer support officer earning $40,000 per year is no longer able to work due to a serious accident, calculate her future lost earnings for 25 years (60 - 35), assuming retirement at age 60.
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Get the benefit costs. Benefits include Social Security taxes, paid holidays and vacations, health benefits and 401k contributions. According to a U.S. Bureau of Labor Statistics report for September 2010, benefits in the private sector averaged 29.4 percent of compensation costs. In the example, the benefits are about $11,760 (0.294 x $40,000) at current-year salary levels.
Estimate the annual value of household services that can no longer be performed. These may include unpaid tasks that support others in the household, such as preparing meals, looking after the children, laundry, grocery shopping, driving the kids and the spouse to work, small household repairs and yard maintenance. The reason you have to put a value on these tasks is because someone may have to be hired to do them. In the example, if these tasks require 10 hours per week and the hired help costs $15 per hour, the annual value of these household services is $7,800 ($15 x 10 x 52).
Compute the total lost earnings per year. Add the salary to the benefits and household services. In the example, the lost earnings at current-year levels are $59,560 ($40,000 + $11,760 + $7,800).
Calculate the present value of the future lost earnings. Using discounted cash flow analysis, the present value of a future cash flow is given by C / (1 + r)^n, where "C" is the future cash flow in year "n" and "r" is the discount rate. The inflation rate may be used for the discount rate. If the earnings are expected to grow at a constant rate "g" each year, the effective discount rate may be approximated as r - g.
In the example, if the discount rate and the earnings growth rate are 4 percent and 1 percent, respectively, then the effective discount rate is 3 percent. Given that "n" equals 25 (for 25 years of lost earnings), the present value factor is 17.413, according to a present value of an ordinary annuity table (see Resources). To conclude the example, the present value of future lost earnings is approximately $1.037 million ($59,560 x 17.413).