The Discount Rate Decision: Right or Wrong, Gilt Edged or Double Edged?

In this post Henry Charles of 12 King’s Bench Walk considers the implications of the recent change to the discount rate.

Minus 0.75%.

The initial reaction: claimant nirvana …and if so for how long?

The Lord Chancellor’s statement heralded the new rate with the assertion that minus 0.75% was the only answer on a gilts based assessment:

“The discount rate was last set in 2001, when the then-Lord Chancellor, Lord Irvine of Lairg, set the rate at 2.5%. This was based on a three year average of real yields on Index Linked Gilts. Since 2001, the real yields on Index Linked Gilts has fallen, so I have decided to take action.

Having completed the process of statutory consultation, I am satisfied that the rate should be based on a three year average of real returns on Index Linked Gilts …”

The use of gilts as the vehicle for setting the discount rate was of course confirmed in Wells v Wells [1998] 1 AC345.  A number of questions arise.

Question 1: What is the Discount Rate trying to achieve?

The aim of damages is to put the Claimant back into the position s/he would have been in but for the defendant’s negligence.  That is a largely passive exercise for the claimant in that the medical and other evidence drives an assessment of needs, and together with actuarial evidence a more or less reasonable stab can be made at what the future would have held.  The claimant’s role becomes active when considering the present value of the future loss – is the claimant expected to put the money under the bed or invest it, and if it is to be invested what is the likely rate of return.  Get that wrong and the claimant will, at the extremes, make a mint or lose everything on the horses.  Where is the balance to be struck?

In Wells the House of Lords had the challenge of ruling on a prescribed discount rate pursuant to the Damages Act, no rate having been set, but against the background of a practice of a prevailing discount rate in the 4%-5% bracket.  The House of Lords noted that index linked government stock –gilts – appeared to be the best vehicle for claimants to secure their damages safely and against inflation.  They set the rate at 3%.

That rate was a compromise.  There was a recognition that there were multiple factors at work.  Stuart-Smith LJ noted In Warren v. Northern General Hospitals NHS Trust (No. 2) [2000] 1 WLR 1404, which pre-dated the 2.5% discount rate imposed by Lord Irvine in 2001:

“Although the logic of these figures might support Lord Lloyd’s view that there should be a bracket for the discount rate, for example 3.5% for funds up to £100,000, to 2.5% for those over £3.5. million, the House of Lords came down firmly in favour of an overall rate of 3%, save in very exceptional cases. This must mean as it seems to us that funds which fall within 0.5% of the norm of 3% should not be regarded as exceptional, let alone very exceptional. The chart does not go above £3.5 million, so we do not know where the 2.5% net return applies.”

So, as Stuart-Smith LJ noted, the House of Lords in Wells prioritised consistency above accuracy.  Later, in Helmot v Simon [2012] UKPC 5 the Privy Council settled on two discount rates in an appeal from Guernsey. Thus the judicial position, at the highest levels, developed along the lines of nature of loss – earnings and non-earnings related losses as a differentiator for the rate of return.  The evidence in Helmot was provided by Christopher Daykin, the Government Actuary from 1989 to 2007.  The guiding principle remained the same, recovery in full for the Claimant, use of gilts as the vehicle, but evidence drove a different conclusion as to whether there should be one rate, or not.

Of course, in Wells the Court had been operating in a very different environment: gilts were the safest investment vehicle in terms of security and providing a bulwark against inflation.  Life expectancy was significantly lower both for the general population and for the disabled who would obtain the higher awards.  So the fact that the discount rate was based on a claimant investing in gilts when in fact a younger claimant could not even purchase a gilt of long enough length to protect (maximum availability of gilts – 50 years) perhaps did not matter so much.  The other big difference was lack of ability to enforce a PPO.  It may also be argued that the financial sector was a deal less developed in the 1990’s and that save for a comparative handful of people – principally the self-employed – for most people investment advice and strategy was something that rarely bothered them directly.  Indeed evidence received in Wells was to the effect that most claimants put their damages award into bank accounts.

Question 2: are the considerations for setting the discount rate tethered to the common law, in particular Wells? 

When the 2.5% rate was set in 2001, Lord Irvine, the then Lord Chancellor did not feel he was bound by Wells v Wells ([1999] 1 AC 345) and he expressly referred to the real world investment strategy of claimants to invest in equities, and the approach of the Court of Protection when investing funds.  There is statutory force for that view because section 1 of the Damages Act 1996, the source of the Lord Chancellor’s power to set the discount rate by way of statutory instrument provides for consultation with the Government Actuary and the Treasury.  The Damages Act does not require observance of Wells, it does not require the Lord Chancellor to focus on gilts, indeed it makes no mention of gilts.  It does give the Lord Chancellor the option of setting multiple rates.

Where does that leave Wells?  Lord Steyn, in Wells, said that:

“My Lords, until the Lord Chancellor takes action under his statutory powers it is essential that there should be a firm and workable principle. It should be general and simple in order to enable settlement negotiations and litigation to be conducted with the benefit of a reasonable degree of predictability of the likely outcome of a case. While acknowledging an element of arbitrariness in any figure, I am content to adopt about 3 per cent. as the best present net figure. For my part I would derive that rate from the net average return of index-linked government securities over the past three years. While this figure of about 3 per cent. should not be regarded as immutable, I would suggest that only a marked change in economic circumstances should entitle any party to reopen the debate in advance of a decision by the Lord Chancellor.”

So once the Lord Chancellor sets the discount rate pursuant to the Damages Act, or perhaps if the Lord Chancellor refuses to set a rate, that is the end of Wells in terms of rate setting.  That is reflected in the case law since Wells: save for the first instance decision in Warrener (overturned on appeal) the Courts have declined to depart from the 2.5%.

However, the principled basis of Wells v Wells is critical.  Lord Steyn:

“The premise of the debate was that as a matter of law a victim of a tort is entitled to be compensated as nearly as possible in full for all pecuniary losses. For present purposes this mainly means compensation for loss of earnings and medical care, both past and future. Subject to the obvious qualification that perfection in the assessment of future compensation is unattainable, the 100 per cent. principle is well established and based on high authority: Livingstone v. Rawyards Coal Co. (1880) 5 App.Cas. 25 , 39; Lim Poh Choo v. Camden and Islington Area Health Authority [1980] A.C. 174 , 187e, per Lord Scarman. The technique employed to achieve this result is to provide an annuity of an annual amount equivalent to the streams of future losses of earnings and cost of future expenses: Hodgson v. Trapp [1989] A.C. 807 , 826d-e, per Lord Oliver of Aylmerton.”

And as he observed, the issues derived from a changed economic landscape.

Question 3: so how should the Lord Chancellor act in principle? 

Rationally.  Or findings of breach of human rights or a finding of Wednesbury unreasonableness will ensue.  But what is rational here? The Damages Act tells the Lord Chancellor who must be consulted, but leaves the door open for others to be consulted.  That leaves the question of primary purpose of the exercise of setting the discount rate.  That must be to ensure that claimants receive the full value of their award taking into account accelerated receipt and assuming a prudent attitude to risk.  We are back to the real ratios of Wells and Helmot.

The oddity of last week’s announcement was not limited to the professed purity of reliance on gilts, but the setting up of what amounts to an inquiry into how the rate might be set better or differently.  Pressure to reduce the 2.5% discount rate had been gathering speed in the first decade of the century underpinned by the relative lack of performance of gilts.  Consultation was eventually launched in the August 2012 and then again in February 2013, with a panel being set up in 2014 to advise on how claimants invested their awards.  Moreover the reasons for the delay in announcement from January are unclear, but may relate to the need to provide additional funding for the NHSLA.

Further comment from the Lord Chancellor this week indicates that she believes that a wholly victim centred approach is unbalanced.

Question 4: are gilts the answer?

In Wells it was noted that over a longer period equities performed better than gilts but that gilts provided the best short-term security.  The Court of Protection looked upon gilts as a suitable vehicle for up to five years.

However the notional claimant was expected to be a prudent claimant.  There must be three aspects to that prudence: protection from fraud, protection from failure of the financial institution where the money is invested, and protection from the vicissitudes of equities versus inflation.  The first two are dealt with to some extent by the Financial Services Compensation Scheme for equities, although there is clearly a case for some form of extension to the limits in respect of monies on deposits and investment schemes.  The volatility of equities is more difficult, but would a prudent claimant put money into gilts given their rate of return undershooting monies on deposit with a bank?  Gilt returns have been adversely affected by quantitative easing, it may be the case that at some point in the future they will look more attractive, but that is hardly an answer to the appropriate destination for short term funds security.

In the meantime the results of -0.75% are not perhaps an unqualified success for claimants.  Yes, the new rate dramatically increases multipliers: if we take the example of a 35 year old woman who loses a leg by reason of negligently treated cellulitis then the lifetime multiplier at 2.5% was 29.31 but is now 68.56 – against a life expectancy on 56.36 on ONS 2013-2015 data.  However if that amputee needs accommodation then the Roberts v Johnstone calculation no longer works (and was under pressure anyway).

That also has serious ramifications for periodical payments.  The new discount rate clearly diminishes the attractiveness of periodical payments where life expectancy is relatively clear, yet periodical payments probably achieve the restitutionary intent of tort law better than any other method.  More concerning though is the position in cases with liability issues where life expectancy is variable, or where there are some contingencies for the future best met by a variable order.  In these cases there is a need for capital to provide some cushion, and to meet immediate needs.  It may be said that loss of earnings on the new multipliers will do that.  If we take the example of our 35 year old claimant the problem becomes apparent: Assuming a retirement age of 68 and GCSE standard education the earnings multiplier but for injury rises from 17.25 at 2.5% to 28.44 at -0.75%.  Leaving aside any arguments as to adjustment of the residual earnings multiplier (which is now 12.40 as opposed to 7.52) at a net £10,000pa the claimant gets £160,400 as opposed to £97,300.  At 2.5% on a property of say £250,000 the Roberts award would have been £183,187.  Clearly it will be possible to capitalise some future losses but overall it is going to be more difficult to justify PPO’s where there is any issue as to liability.  It is also clear that this situation will hit those on low earnings pre-accident more than those on higher earnings.

There is also of course the problem of what to do with applications for interim payments made on an Eeles v Cobham [2009] EWCA Civ 204 basis given the apparent effect of the new discount rate on Roberts v Johnstone accommodation claims[1].

The press reaction to 0.75% has been predictable.  Moves are afoot to examine how the discount rate should be set (the terms of reference are unclear).  In the meantime there will be uncertainty and a probable diminution in the well of goodwill towards claimants.  That will potentially push further into tariffs or even no fault compensation.  Neither of which would favour claimants, nor indeed necessarily insurers.

In short the detailed gilts based outcome of Wells v Wells is probably a museum piece and arguably it has not been appropriately catalogued.  However the core principles remain not only good law but good practice, the question given the collapse of gilts is what should take their place. 

Question 5: What might be the answer?

Some possibilities present themselves:

  • Extension of the Financial Services Compensation Scheme to provide additional protection
  • Another look at providing funds for investment advice as part of damages
  • Providing different rates, whether based on value (taking into account the greater returns on larger investments) and/or category of loss (per Helmot)
  • A move away from gilts – which really do not look to be prudent investments in terms of returns compared with equities – but the rate set perhaps on the basis of a certain proportion of damages held in gilts or other less volatile investments
  • The wider societal trend has been to investment in equities, whether by pension schemes or ISAs, and it may be time to recognise that it is not possible or indeed a good use of resources to future proof the position of a handful of claimants using gilts when the vast majority will in fact perfectly responsibly invest in equities. Is it possible any longer to overlook the fact that the Court of Protection, hardly the investment equivalent of parachuteless skydivers , put 70% of funds in equities?
  • A more transparent method of setting the rate, perhaps based on some form of panel, committee or council formally and openly advising the Lord Chancellor and formed of the various stakeholders in the litigation process. A development of the Ogden committee?  Who gets appointed, on what basis?  How political is this all becoming? At what point do the politicians have to stop sub-contracting the decision-making?  Or can the industry become self-regulating?
  • There will undoubtedly be issues as to whether the Damages Act is now damaged goods in need of replacement by new primary legislation. That may not be necessary at law – although Wells post-dates the Damages act it pre-dates the setting of a discount rate by the Lord Chancellor pursuant to the Act, and Lord Irvine explicitly took into account returns on equities.  Politically, and for the purposes of finality though, primary legislation might be the best bet, tacked onto upcoming legislation.
  • In the meantime insurers and the courts may feel that periodical payments are the way forward.

And the answer to the questions posed in the title?

  • -0.75% is probably the wrong answer, for the wrong reasons: for a while now gilts have not been the appropriate main driver of the discount rate.
  • Whilst -0.75% may lead to short term gain for claimants, in the long term for all claimants and already for some claimants, it may not be in their best interests.
  • Perhaps -0.75% is more a case of light the blue touch paper

[1] And note that (i) the Roberts v Johnstone formula was a Court of Appeal decision specifically approved in Wells v Wells, so displacement is not going to be easy or rapid

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