The Ministry of Justice has published a Consultation into the methodology used by the Lord Chancellor and his counterparts in Scotland and Northern Ireland in independently setting the discount rate for personal injury damages in their respective jurisdictions. The Consultation ends 23 October 2012 and it appears to be a two part process. A second Consultation is to be published in the autumn to review the present legal basis for the setting of the discount rate and to seek views on whether the restrictions imposed by the present law on the factors that can be taken into account in the setting of the rate are still appropriate.
Any reduction in the Discount Rate will lead to an increase in claimant’ damages and vice versa. The Consultation is not intended to assess the level of the current Discount Rate of 2.5% but is focussed on considering two broad methodology options when setting the Discount Rate. It asks whether Index Linked Government Stocks (ILGS) is the appropriate methodology or should the return on a mixed portfolio of appropriate investments be the starting point?
The Consultation confirms the consequences for defendants of paying awards are not a matter to be taken into account in setting the Discount Rate and the rate can only be set at a level which fairly compensates claimants. Whichever methodology is selected, the aim is to produce a Discount Rate which gives effect to the full compensation principle "on the basis of investments that would be made under an appropriate low risk investment strategy".
The Consultation sets out the view of the Government Actuary, which raises the following issues:
- Averaging the ILGS yield of the last three years (as was done by the previous Lord Chancellor in 2001) was likely to be misleading as an indicator of future returns, as the return to investors (who hold their ILGS to maturity) will be the yield on the day they invest, not the yields available in the past.
- Calculating the real yield is dependent on assumed inflation for the period between indexation and payment (as there is a time lag between collection of prices data, publication of the inflation index and indexation of bond).
- Using a simple average of all ILGS places a relatively high weighting on the yield of ILGS with a short maturity date, which is inconsistent with the need for payments over a longer period of a claimant’s life. That said a weighted average would place greater weight on longer dated ILGS yields, as there are more in issue.
- The switch from retail to consumer prices index (RPI/CPI) inflation for the uprating and indexation of some benefits and pensions calls into doubt the reliance on real yields and real returns calculated by reference to RPI.
Although the Government Actuary acknowledged the possibility ILGS yields may rise, there is an argument that current rates should be adopted when setting the Discount Rate. Adjustment can be made, as necessary, rather than trying to second guess the markets as to the future. That said, the Government Actuary did consider expected future increases in yields on longer dated bonds should be taken into account.
The Consultation asks whether it could be more efficient for claimants to invest in assets with a higher return if such investments have a similar level of risk as ILGS – i.e. would a mixed portfolio of investments satisfy the low level of risk identified by the House of Lords in Wells v Wells ?
A number of portfolio types are identified as potential options for "claimant investors", including mixed investment 0%-35% shares, sterling fixed interest and money markets.
The following table sets out the assumed future return of those portfolio types with levels of extra return relative to ILGS and the market risks a "claimant investor" would have to bear (page 38 Consultation paper).
Click here to view table.
It appears from the above table that the final option (100% ILGS held to redemption) is risk free providing a return at or above the inflation and with no risk to capital value. However, some risks are unavoidable even to this investment vehicle. For instance, it may not be possible to construct a portfolio of ILGS which mature when a claimant’s financial needs arise. In addition, inflation measured by RPI may not match the inflation applicable to the costs actually borne (i.e. costs of care).
These issues go to the real heart of the Consultation and reflect the Ministry of Justice’s interest in going back to basics and identifying whether ILGS is the appropriate methodology. Alternatively, should the return on other "low" risk investments be the starting point when setting the Discount Rate?
Any reduction in the Discount Rate will significantly increase the payment of damages by defendants, particularly in catastrophic injury claims with large future losses. Whilst the Consultation will not take into account the consequences on those paying damages, a move away from ILGS as the methodology for setting the Discount Rate is likely to be good news for defendants. If the Lord Chancellor will continue to be guided by the principles set out in Wells v Wells, he will need to ensure any alternative mixed investment portfolio is low risk to the "claimant investor". "Low risk" should not mean "no risk".