What is involved in setting an investment strategy aimed at ensuring that lump sum awards of damages last as intended? It is not entirely straightforward, given that investment returns can be limited by various factors, which do not feature within the assumptions made by the discount rate.
Periodical payments revisited
We have written extensively in this publication over the years explaining why, from a financial perspective, periodical payments make sense – particularly for personal injury claimants who are burdened with the very significant and lifelong risks related to investment and mortality in respect of lump sum awards. Periodical payments simply do away with all of that. Linkage to earnings related inflation and tax freedom make them a must consider in all high value claims. Unfortunately, not all claimants can benefit from that form of compensation – the Court can only order periodical payments if it is satisfied of the reasonable security of continuity of payment. Insurers which are Lloyds Syndicate members where the policies pre-date January 2004 cannot satisfy the Court for various technical reasons. Also, many employer and public liability policies have indemnity limits, often under £10,000,000. Periodical payments designed to keep pace with inflation, might, over a long life expectancy, add up to a sum that impacts upon the level of indemnity. Again, the Court would have difficulty with that as periodical payments would stop once the indemnity level is reached.
So, assuming periodical payments more or less look after themselves, we are left with managing the cases that settle on a lump sum basis and, of course, the lesser lump sums that accompany periodical awards.
Cash – safe but unrewarding
Wells v Wells states categorically that personal injury claimants are not ordinary investors. We would agree with that statement without qualification. A claimant with a lump sum award will need from the outset to draw down an annual income to meet needs on a sustainable basis. Simply leaving the award languishing in cash deposits, will be of little use. Price inflation (not to mention that related to earnings which is usually higher still), outstrips interest rates, resulting in an award held in cash, devaluing over time. The present very low interest rates when compared to inflation, underlines the point. Great for mortgage repayments, but awful if reliance on bank interest on a lifetime’s savings is a key income component. Cash holdings might be of minimal risk if managed properly, and would normally form a minor part of an overall portfolio to provide financial flexibility. However, deputies and trustees are under fiduciary duties which should steer them toward taking appropriate advice, thus avoiding the solely in cash scenario.
Risk – a crucial factor
As regards the longer-term investments (aside from some cash holdings), once the claimant’s capital and income needs have been ascertained, the remaining balance must be managed on a sustainable basis. One of the principal factors is establishing the attitude to investment risk of the claimant, trustees or deputy. Given the nature of the award, a cautious approach to investment is the most usual outcome. There are many definitions of caution in this context, the following being a flavour giving example:
The Cautious Personal Injury Investor is sensitive to short-term losses. Whilst recognising that investment values will change, they would feel uncomfortable if their investments rose and fell in value very rapidly. A Cautious investor’s aversion to losses could compel them to shift into a more stable investment if significant short-term losses occur. Analysing the risk-return choices available, a Cautious investor is usually willing to accept somewhat lower returns in order to assure greater safety of his or her investment.
As the spectrum of investment risk runs from the ‘biscuit tin under the bed’ approach up to the whole award chanced on the 3.15pm at Newbury, the above definition clearly sits at the lower end of that range. On the basis that a greater appetite for risk might produce better returns (and more significant losses), caution will limit potential volatility but, at the same time, restricting possible gains.
Perhaps this is a suitable point to consider what investment returns driven by a cautious approach might mean in relation to the discount rate. The present Lord Chancellor’s review process accepts that a 2.5% real return is not possible on the theory, which is based on returns from Index Linked Government Stock (ILGS). Hence the need for claimants to accept a level of risk which is unavoidable to achieve real returns – in spite of Wells, where the Lords recognised that claimants are not ordinary investors and should not be exposed to risk in order to obtain a real return on their awards. Real return, of course, means a return net of tax, price inflation and the costs of investment advice. Presently, that all adds up to a required gross return of about 8%, which is not at all easy to achieve, and difficult to reconcile with a cautious approach to investment risk.
Compare that with periodical payments – secure, lifelong, guaranteed, tax-free and appropriately indexed income. Good value indeed, which no doubt would prove remarkably popular if available to the wider public! A must consider option prior to settlement.
Once the risk profile is established, the investment strategy should take account of the following:
Security and continuity of income – where the claimant’s needs are concerned, investments should be sought that have a greater degree of protection than those that are available to ordinary investors. Unnecessary levels of investment risk should be avoided. Flexibility – the claimant’s situation will undoubtedly change over the course of a lifetime, and finances should look to accommodate changing income needs.
Tax efficiency – Income Tax and Capital Gains Tax may have a detrimental effect on the claimant’s financial situation, depending on the tax regime throughout the course of a possibly lengthy lifetime.
Cash holdings will provide flexibility, in other words, catering for contingent events which, in real terms, generates extra cost. The longer-term investments often meant to remain undisturbed for at least five years, are where the risk profile drives the make-up of the investment. Client portfolios based on caution will usually include a limited amount of riskier assets such as equities (stocks and shares). The larger part of the portfolio would usually be made up of fixed interest, a cover all term which includes income producing Government and good quality corporate bonds, providing a stabilising effect due to their lower risk characteristics. Other investment types are represented in small overall percentage terms, completing the portfolio and adding to the diversification process – in other words, spreading risk by eggs in different baskets. Overall, the aim is to achieve stable and sustainable income and growth with minimum volatility.
Once the investments are established, regular reviews form a crucial part of the adviser’s role. Lives change and the investment approach may need to take account of that. Often, after a flurry of immediate post-settlement activity, claimants’ circumstances settle, but crises or significant changes of plan in shattered lives are not unusual.
As discussed above, it is not straightforward to achieve a consistent real return based on a discount which pays no heed to the cost of ongoing investment advice – at least not without taking an approach based on greater risk, effectively treating claimants as ordinary investors. Investment and mortality risk are lifelong, the latter clearly by definition, and represent many years of concern for claimants and their representatives. Greater use of periodical payments is one way forward, both in relation to their usage in more cases and to compensate heads of loss other than care. It will be no surprise that we would support any changes to encourage that. The Lord Chancellor appears to have his sights in that direction, but there are considerable hurdles to overcome. It is therefore, essential to obtain specialist advice, both on pre-settlement format of the award and post settlement financial advice as to strategy and appropriate investment.