The discount rate: seeking to square the circle

Last August, to fend off threatened judicial review proceedings from the Association of Personal Injury Lawyers (APIL), the Lord Chancellor issued the consultation paper ‘Damages Act 1996: The discount rate – how should it be set?’. Oddly, it raised the prospect of departing from the current approach of fixing the discount rate according to yields on Index-Linked Government Securities (ILGS) towards a calculation based on a mixed portfolio of investments. This move would only be countenanced, however, if it could be regarded as being in principle consistent with the House of Lords’ decision in Wells v Wells [1998] UKHL 27.

Known as the principle of full compensation, the objective of damages is to place the claimant in the same financial position as he would have been in had the accident not occurred.

Imprecise science

The assessment of damages is not, however, an exact science and imprecision is particularly inherent when calculating future losses.

Here multipliers, discounted for contingencies and obtained from actuarial tables, facilitate the calculation of the present value of the lump sum award. It is assumed the award will be invested to produce a return over the period of loss. In 2001 the Lord Chancellor, then Lord Irvine of Lairg, set the assumed rate of return at 2.5 per cent according to average gross redemption ILGS yields. As the consultation document acknowledged, by last summer pre-tax average yields had declined to 0.2 per cent. Accordingly, it is argued, the full compensation principle is not being met and claimants lose out substantially. In the meantime defendants, principally insurers, the NHS and Ministry of Defence enjoy a windfall. The consultation paper endeavours to reassure us that it is only the effect on awards to claimants that will inform the choice of methodology for setting the rate. This chimes with Wells where Lord Lloyd said he could not “see anything unjust in requiring the defendant to compensate the plaintiff in full, however burdensome that may prove”. I have yet, however, to detect the collective sigh of relief the paper’s assurance seeks to induce.

What then are the principles of Wells that the Lord Chancellor will be guided by and can they be reconciled with fixing the rate according to an expected return from a mixed portfolio?

Beyond those already mentioned, other notable principles include an endorsement of the concept of the notional annuity: that when arriving at the lump sum the aim is to reach a figure that will fund an annuity from which both capital and income may be drawn, providing sufficient annual funds over the period of loss.

The law lords also determined that claimants are not to be treated in the same way as an ordinary investor in the expectations made of them in terms of how they employed their damages.

Cautious investors

Lord Steyn’s opinion distinguishing between plaintiffs and ordinary investors (see box) illustrates the dangers posed by the MoJ proposal and readers will no doubt observe the parallels that can be drawn with recent market turmoil. Lord Steyn went on to say that plaintiffs should be treated as cautious and conservative investors, before observing that insurers also invested annuity funds in ILGS.

Prior to Wells the courts had taken care of inflation in a rough and ready way by assuming claimants invested in mixed assets, including equities, and would therefore enjoy the higher rates of interest assumed to be attainable in times of high inflation. This method was applied by Lord Diplock in Cookson v Knowles [1979] A.C.556. The House of Lords observed in Wells that when Lord Diplock did so, however, he said “no other practicable basis of calculation has been suggested that is capable of dealing with so conjectural a factor [as inflation] with greater precision”.

Available since 1981, ILGS are tied to the retail prices index and thereby protected against inflation. Investment in such instruments meant inflationary risks could be dealt with precisely, rather than imprecisely, coinciding neatly with the drive for greater precision in the assessment of damages and the quest for full compensation. Before Wells the merits of this approach had been highlighted by the Ogden Working Party, the Law Commission (that in 1994 recommended the use of ILGS be enshrined in law) and by David Kemp QC. In Lord Lloyd’s view those opinions were entitled to great weight.

Investment patterns

In Wells the question of how claimants actually invested their damages was deemed irrelevant to the calculation. Despite this the consultation paper seeks evidence of the investments typically made by claimants with lump sum awards. Empirical research conducted by the Law Commission in 1993 indicated claimants tended not to invest in stocks or securities and favoured deposit accounts.

It remains to be seen what evidence will now emerge but one must question how useful any data indicating a trend for more risky investments would be at a time of depressed deposit account rates, and when investment decisions will be influenced by the fact awards are made according to yields not attainable in ILGS. That aside, the pertinent issue, applying the principles of Wells, is whether the damages should be calculated on the basis that a claimant is obliged to invest even part of his damages in equities. The answer to this question, given by the Lords in Wells, is a resounding no.

As Lord Hope put it:

“The plaintiff who is receiving the amount of his future loss in the form of a lump sum is not an ordinary investor. The amount awarded under each head of his claim is calculated on the assumption that this part of his loss will have to be met entirely out of the relevant portion of the lump sum. So in his case the only form of investment which could be described as a prudent investment is one which will as nearly as possible guarantee the availability of the money as and when it is required. He cannot afford to wait until the market moves in his favour, or sustain the loss of capital which would result if he were forced to sell at a price which did not match the inflation rate. In any event the discount rate is to be selected not by forecasting what the plaintiff will actually do with the money but by identifying the return which the market will give for forgoing the use of capital. The availability of ILGS provides the best guide to what is required. It is the best tool for this exercise which is available.”

Neither this passage, nor for that matter the other quoted from Lord Steyn, can be read consistently with the setting of the discount rate according to expected returns on a mixed portfolio of assets. Wells represents not only a clear endorsement of the ILGS methodology, but also the rejection of an approach based on mixed investments. This position is not undermined by the mismatch risks associated with ILGS (in other words, the risk that the product purchased does not enable the investor to meet his need for available funds at specific times in the future). Irrespective of those risks ILGS are a safer long term investment for claimants than the alternatives presented.

Recently Lord Hope, sitting in the Privy Council, reconsidered the issue in Simon v Helmot [2012] UKPC 5 and said of ILGS: “It is tailor-made for investors who want a safe investment for the long term. In practical terms it is risk free. As nearly as possible, it guarantees the availability of the money to meet costs as and when it is required. It may not be perfect, as buying and selling gilts in the short-term may result in a gain or loss of capital. But it is the best tool that is available.”

In my view, setting the discount according to returns from a mixed portfolio of assets cannot be in principle consistent with the decision in Wells. It would neither protect the claimant from the risks presented by inflation, nor can it get as close as ILGS in guaranteeing the availability of funds when they are needed. On any reading that is so; but at a time of record low deposit rates unable to keep pace with rising inflation, a domestic economy facing uncertainty and vulnerable to shocks from an ever precarious eurozone, instability and simmering tension in the Middle East, and intractable squabbling in the US giving fiscal cliff II, what is already an incontrovertible argument assumes even greater force.

Richard Edwards is head of personal injury at E Rex Makin & Co, Liverpool, a solicitor-advocate and APIL fellow (www.erexmakin.co.uk)