Recently, you may have heard a lot of people having a lot to say about the so called discount rate but what is the current discount rate and what difference does it make?

On 27 February 2017, the Lord Chancellor, Liz Truss, announced a change in the discount rate from 2.5% to -0.75%. The announcement was covered in an article by Cari Sowden-Taylor that can be found here.

But what is the discount rate?

The discount rate is a percentage used by lawyers to calculate future losses in personal injury and fatal accident claims. It is particularly important in serious and catastrophic injury cases. However, the same discount rate is used to calculate all future losses in all levels of claim.

In 2001 the discount rate was set by the Lord Chancellor at 2.5% with reference to Index Linked Gilts and it has remained at 2.5% ever since. From 20 March 2017 the discount rate will change to -0.75%. You can read the statement issued by the Lord Chancellor at the Ministry of Justice here.

The logic behind the rate is quite simple. It is to discount a lump sum for future losses on the assumption that that money can be invested and earn interest for the future.

Take for example a claim for future loss of earnings. If as a result of an accident a claimant is no longer able to work or is forced to reduce their hours of work, they may include a loss of earnings claim as part of their claim for compensation against the defendant.

Had the accident not occurred, the injured person would have continued to work until their retirement and received an income on a regular basis. However, when calculating that loss as part of a claim, the fact that the claimant is receiving all their future earnings in one go and years before they would otherwise expect to earn their wage, a discount rate is applied. The logic of a discount rate is that a claimant is receiving a lump sum at the conclusion of their claim that can, and in most cases should, be invested at that time to provide an income over the course of the loss. More information on post settlement investments can be found here.

What difference does a change from 2.5% to the current discount rate of -0.75% make?

The short answer is a big difference!

In a worked example, a 25 year old woman, Katie, suffers catastrophic injuries in an accident that leaves her unable to work. Before the accident, Katie had been earning £22,000 per year after tax. Assuming Katie would have continued to work until her state retirement age of 68 and at the same level of income, she would have expected to work for a further 43 years receiving £22,000 per year.

If the accident hadn’t occurred, Katie could have expected to earn a total of £22,000 x 43 years = £946,000 in her lifetime.

However, we cannot simply award £946,000 because Katie would be receiving it all now rather than over the course of her working life. She could therefore invest it and earn interest over the next 43 years. Therefore, a discount rate is applied. In this example, taking a 2.5% discount, the actual multiplier would be 26.1 instead of 43. Katie would therefore be entitled to claim £22,000 x 26.1 = £574,200.

When we adjust the discount rate to -0.75%, the multiplier becomes 49.66 and the loss is therefore £22,000 x 49.66 = £1,092,520.

This can be summarised as follows:

Loss of earnings from 25 to 68 years old:

Discount rate Multiplier Annual loss Total loss
0% (no discount) 43 £21,000 £946,000
2.5% (old rate) 26.1 £21,000 £574,200
-0.75% (new rate) 49.66 £21,000 £1,092,520

In this example, changing the discount rate by 3.25% from 2.5% to -0.75% has resulted in an almost doubling of the value of the loss of earnings; a total increase of £518,320.

In the same example, an annual loss of £30,000, that may be used to pay for nursing care and assistance with day to day living for the rest of Katie’s life, would look like this:

Loss for life:

Discount rate Multiplier Annual loss Total loss
0% (no discount) 65.48 £30,000 £1,964,400
2.5% (old rate) 31.88 £30,000 £956,400
-0.75% (new rate) 85.75 £30,000 £2,572,500

A £30,000 loss per year for life would increase by £1,616,100 with the new discount rate.

These examples show the staggering difference of changing the discount rate from 2.5% to -0.75%. Bearing in mind that in a case such as this there would almost undoubtedly be a claim for ongoing professional care and assistance, a loss of pension and possible future surgery costs, the change of the discount rate could result in millions of pounds of difference in calculating the value of the claim.

In part three we will look to answer the most common questions that we get asked about the discount rate.