Julian Chamberlayne discusses the factors that need to be considered when setting the new discount rate. Longevity, prices and earnings inflation all compound the investment risk that claimants face under the MoJ’s planned change to setting the discount rate.
On 7 September 2017, the Lord Chancellor, David Liddington, laid draft legislation before Parliament incorporating a proposed new methodology for setting the discount rate by which future losses for those with long-term injuries will be compensated. In the first of this two-part series I considered what proportion of seriously injured claimants should we as a society be prepared to accept will be under compensated while still claiming to maintain a framework of laws that provide for 100% compensation (NLJ, 29 September 2017, p 8). Here, I look at some of the key factors beyond investment risk that ought to be considered by the Lord Chancellor when setting the new rate.
The Ministry of Justice’s (MoJ’s) new methodology is said to be based on how claimants actually invest, derived from evidence gathered during the consultation. However, that evidence appears to be largely anecdotal and there remains no published body of evidence to prove how seriously injured claimants do invest. Section 4(2) of the draft legislation published last month states that the rate of return should be the rate that, in the opinion of the Lord Chancellor, a recipient of relevant damages could reasonably be expected to achieve. Under s 4(3)(d) it is assumed that the relevant damages are invested using an approach that involves more risk than a very low level of risk, but less risk than would ordinarily be accepted by a prudent and properly advised individual investor who has different financial aims. At cl 4(5) the Lord Chancellor is to have regard to the actual investments made by investors of relevant damages, although there is no requirement for him to publish any evidence he considers of such investor behaviour.
It is fundamental to understanding the rationale behind the Wells v Wells methodology that the index linked government stocks (ILGS) benchmark was only ever a proxy, to avoid the inherently speculative exercise of trying to guess at a combination of future investment returns and the rate of future inflation. As David Westcott QC persuasively argued before the Court of Appeal in Bermuda in Thomson v Thomson and Colonial Insurance Limited  CA (Bda) 2 Civ, the adoption of a discount rate based on ILGS does not lead to a single claimant being ‘over-compensated’. Rather, claimants may choose to take investment risks so as to improve their financial position. However, to require them to do so would make them the only class of investor required to take risks so as to advantage some other party, ironically the person who committed the tort against them. Why does MoJ propose 0%–1%?
The Government Actuary Department (GAD) paper, which accompanies the draft legislation, appears to be the key evidence by which the proposed 0%-1% discount rate is justified. However, it comes with some important caveats. The first is that it had only assessed the investment return risk, whereas claimants in real life are exposed to at least five other significant risks. These are set out in table 2 of the GAD’s paper (Personal Injury Discount Rate Analysis, 19 July 2017, page 7).
As the GAD report acknowledges, a mixed portfolio provides claimants with no protection against the risk of inflation, and so, unlike periodical payments, leaves that risk with them rather than with the insurers. Inflation risk was one of if not the main driver behind the courts adopting the Wells v Wells methodology in the first place. Sumption JA (as he then was) commented at para  in the Court of Appeal decision in Helmot v Simon  UKPC 5 that ‘the reason for calculating a lump sum award on the footing that the lump sum will be invested in index-linked gilts is that it achieves an automatic adjustment for future increases in the general level of prices’.
A second and important component of the inflation risk is the fact that a number of the largest heads of future loss (notably loss of earnings and care costs), do not rise in line with RPI, as assumed in the GAD analysis, but rather rise in line with earnings inflation, which over longer periods of time typically involves a significant differential of 1.5%–2% pa. That differential compounds over those long periods of time to make a large difference. Every time the court has been unconstrained in the consideration of that issue, that differential has been accepted. Hence, post- Thompstone v Tameside  EWCA Civ 5, this has been the accepted norm in relation to periodical payments. In common law jurisdictions unconstrained by the Lord Chancellor’s fixing of the discount rate it has also been accepted and resulted in a minus 2% adjustment to the discount rate in Helmot and Thomson.
The GAD report also acknowledges that a claimant might be forced to take more investment risk to protect against longevity. A similar point has been made to me on a number of big occasions by investment managers who have worked with seriously injured claimants I am representing. As there as a significant chance that the claimant will outlive the life expectancy projection, any prudent investment adviser has to tailor their advice on that basis. This involves the difficult choice between the claimant either reducing their expenditure, and consequently not applying the damages as anticipated to meet their needs, or taking a greater investment risk, which is quite obviously double-edged.
At section 4(5), a number of factors relating to investment return and investment behaviour must be considered by the Lord Chancellor. Section 5(7) requires the Lord Chancellor to give reasons for his decision, but only in relation to the allowances for taxation, inflation and investment management costs. If the MoJ proceeds with this approach and its draft legislation, it is crucial that it is amended to require the Lord Chancellor to actively consider the proportion of claimants who would be under-compensated by the rate he sets, publish the evidence he has relied on and give reasons for all aspects of his decision-making. The Lord Chancellor also ought to set a second discount rate for earnings related heads of loss, as defendants/insurers are frequently unwilling to offer to settle on a periodical payment basis and some would not pass the security of funding test if the matter were put before the courts.
To further address this problem, Pt 36 of the Civil Procedure Rules should be amended to require any offer to settle in cases involving significant injuries and future losses to be put on periodical payment orders (PPO) terms as well.
This article first appeared in the New Law Journal, the original can be found here (subscription required).