The Discount Rate – Onwards and Upwards

The Lord Chancellor has announced the government’s response to the consultation process on the discount rate. How the rate will be set in the future, when and by whom, is now much clearer.

Draft legislation, inclusive of an assumption that claimants invest their awards with 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, has been published with a request for feedback from interested parties. The proposed increased level of investment risk is a distinct move away from Wells, and is said to reflect the approach actually taken by the majority of claimants. Claimants over the years have always had to take a greater level of risk, as the Wells approach is theoretical and impossible from a practical perspective.

The Lord Chancellor considers that the new methodology, if applied now, would result in a discount rate of between 0% and 1%. As claimants are now assumed to take some investment risk, it follows that they should be appropriately advised, hence the cost of investment advice will be included in the calculation process.

The definition of risk in the draft legislation is vague, to the extent that it would be unlikely to meet the requirements of the Financial Conduct Authority. A charitable view would be that the expert panel appointed to advise the Lord Chancellor every three years, would apply a more stringent approach to defining investment risk – hence the above definition is simply guidance.

Many years of experience shows that the vast majority of claimants want to take a very cautious approach towards investment risk. In the past, they have been forced to take investment risk, given years of being undercompensated under the old 2.5% rate. It now seems that the not a penny more, not a penny less principle involves forcing the claimant to take investment risk, just to meet this principle. A significant departure from Wells.

Within the documents published last week, is the Government Actuaries Department Personal Injury Discount Rate Analysis which can be viewed here.

This makes for interesting reading. For example, if we assume the current -0.75% discount rate, and also assume that the claimant adopts a typical ‘low risk’ investment strategy, as the consultation response suggests, that would result in a 4% probability of under-compensation by 5% or more. If, however, the discount rate moved up to a 1% rate, use of the same ‘low risk’ investment strategy increases the probability of being under-compensated by 5% or more to 30%, and the probability of being under-compensated by 10% or more to 22%.

It is clear that whatever rate is set, investments must make a positive nominal return in order to provide for the claimant’s needs throughout life.  Nominal returns are not adjusted for inflation.  For instance, a gross nominal return of 5% per annum (which would be a fair assumption for a very cautious approach), with price inflation at 2.5% per annum, investment charges at 1.5% per annum and tax at 1% per annum would result in a real return of 0% per annum.  If the difference between wage costs and price inflation is also factored in at say 1.5% per annum, the real rate of return in this example would be minus 1.5% per annum. It appears that the Lord Chancellor’s initial indication of a range between 0% and 1% is on the basis of future costs rising in line with price inflation, and no difference between earnings and prices.

Finally, it is well worth restating that periodical payment orders avoid all of the investment risks and headwinds associated with a lump sum award. The consultation process, despite containing many questions on periodical payments, has perhaps missed an opportunity to encourage their wider use.

Please get in touch if you have any queries.