The 27th February decision by the Lord Chancellor to reduce the discount rate to -0.75% has caused a bit of a stir, the like of which has not been seen for many years in personal injury litigation. Defendants are up in arms over the cost of this change, and claimants are excited as they see their re-drafted future loss schedules adding up to double digit millions, in many cases.
We are also hearing from many practitioners, that Periodical Payment Orders are dead in the water. Indeed, we wrote on this subject last week, in our article The Death of Periodical Payments is greatly exaggerated. If you want to read this click here.
The Truth about Gilts
Since the announcement, we have been consulting with our experienced fund managers, many of whom manage personal injury damages awards for claimants. We use a number of specialist investment managers, given our independent status. Most of our personal injury clients’ portfolios are very cautiously invested, an approach that we have been championing for many years, as we recognise that personal injury investors are not ordinary investors.
The issue we have been discussing is this: Given the reduction in the discount rate, why is it not sensible to invest claimants’ awards into a portfolio of Index Linked Gilts? After all, that is the essence of the calculation. To recite the Lord Chancellor:
The principles in Wells v Wells led me to base the discount rate on the investment portfolio that offers the least risk to investors in protecting an award of damages against inflation and against market risk. I take the view that a portfolio that contains 100% index-linked gilts (ILGs) best meets this criterion at the current time. A portfolio of ILGs, comprising stocks spread across a range of redemption dates guarantees the investor an inflation-adjusted income, known with certainty at the time of the award. Basing the discount rate on the real redemption yield of ILGs is consistent with the approach taken by the House of Lords in Wells v Wells and by the then Lord Chancellor, Lord Irvine, when he last set the rate in the Damages (Personal Injury) Order 2001 (S.I. 2001/2301).
– Para 8 Discount rate: statement placed by The Lord Chancellor, in the libraries of the Houses of Parliament on 27th February 2017.
After due consultation and consideration, it is our view that larger awards based on the new discount rate will still not eliminate the effects of long-term inflation risk. This is because the new discount rate is still higher than the real yields available on ILGs. Further, there is also the additional risk that care and other wage related costs will rise faster than inflation as measured by the Retail Price Index. ILGs will never be able meet wage cost inflation. Also, lump sum awards will always carry mortality risk, a crucial factor somewhat lost in the recent excitement.
Continued Need for a Positive Return
It is still therefore desirable that personal injury investors aim to target a return greater than inflation, if they want their damages to last, in the context of larger lump sum awards. Investment portfolios made exclusively of ILGs are far from risk-free, and will potentially be subjected to extreme price volatility, given the fact that ILGs’s have high current valuations. Yes, future personal injury claimants will get greater lump sum awards and yes, in theory those awards ought not to be invested in risk-based assets to achieve greater returns. However, the very notion that personal injury claimants will be able to invest entirely in a portfolio of ILGs with maturities of at least 5-years, is at best impractical.
More Gilty Secrets
Current market pricing of ILGs does not support the reduced discount rate. ILGs currently offer real yields of -2.45% (for the 2022 maturity) and -1.60% (for the 2046 maturity). The current range of ILGs (going out to 2068) offers real yields in the range -1.6% to -1.8%. It is therefore clear that an investment strategy relying solely on ILGs will fail to meet a claimant’s long-term needs, even putting aside the very substantial effects of care cost inflation and the costs of managing such a strategy.
Today’s yields on ILGs are certainly less negative than they were in the third quarter of 2016, but are still close to the lowest ever seen for this asset type. It is therefore not clear that expecting a personal injury investor to simply build a portfolio of ILGs and hoping for the best is prudent financial advice.
Even if it were the case that an investment portfolio made up of ILGs with 5-years plus maturities would meet lifelong needs, there is a significant risk that claimants would suffer capital losses over the life of the gilt. This is due to significant fluctuations in the real yield, and has a significance for personal injury claimants, if they need staged capital withdrawals to replace equipment etc. If such capital is needed at a time when real yields are higher, then any withdrawal may be extremely destructive for an ILGs portfolio’s long-term earnings capacity. Whilst investors may consider that ILGs are low-risk assets, ILGs prices are extremely sensitive to shifts in the real yield.
It’s not as simple as that…
In reality, whilst we are very supportive of the discount rate reduction, and believe that it is long overdue, claimants should not be under any illusion that adopting a simplistic ‘basket of ILGs portfolio’ approach to investing is free of danger or risk. Yes, it is as cautious and as low a risk as possible, but investing solely in ILGs is impractical and unwise, and will be unlikely to be able to meet a claimant’s needs, and even more unlikely to build up reserves to guard against mortality risk, or to help with restoring the deficit arising from purchasing accommodation in a negative discount rate scenario.
As usual the answer lies somewhere in the middle: A Periodical Payment Order to meet certain recurring lifetime needs, alongside an appropriate lump sum award, with the latter wisely and cautiously invested, is the tried and tested approach. The all eggs in one basket approach of investing solely in ILGs carries far more risk for claimants than the theory might imply.
In our next article, we will look at how personal injury claimants can actually invest, in the new reduced discount rate world.
As ever, discussion on this issue is most welcome.