In this article, our Discount Rate Working Group outlines the elements that go into setting the rate and considers what may change for the next review.
The 2019 review only required the Lord Chancellor to consult the Government Actuary and the Treasury before setting the rate. The Civil Liability Act 2018 requires a more extensive consultation for the next review. The Lord Chancellor is required to consult the Treasury and an expert panel consisting of five people:
The MOJ has recently opened invitations to apply for the various positions with a deadline of 9 December. Identifying prospective experts and the merits of proposing them is beyond the scope of this article but there is an opportunity to help inform the discussion directly if credible, market leading experts can be found and persuaded to be involved.
Once constituted the expert panel will have to consider the various elements which go into setting the discount rate which on the last review consisted of:
Some of the assumptions that go into setting the rate are set by the legislation itself and cannot be altered. The assumptions are not the same in each of the three UK jurisdictions and it is useful to revisit which parameters are set by the legislation and those which might be capable of change.
The issues which are open to reconsideration by GAD and the expert panel include:
The Government Actuary's Department (GAD) considered the possibility of dual rates in their report to the Lord Chancellor of 25 June 2019 on the first review of the discount rate. GAD said that adopting a dual rate was likely to more closely match the pattern of expected future investment returns and lead to more equal outcomes between claimants investing over different periods. The report recommended a single rate largely because there were many ways in which a multiple rate could be set and that would be a significant departure from current practice. However, the recommendation then was for long term rate of +1.5% and a switching point from the short-term rate of 15 years. The short-term rate would be -0.75% before a further adjustment would be made to reduce the risk of under compensation. If the Lord Chancellor wanted to reflect the same risk of under compensation as under the current rate, then the short-term rate would be -1.5% as that achieves a 65% likelihood that claimants would meet 100% of their needs. In GAD’s view the long term rate did not need to be adjusted so the dual rate would be -1.5% for the first 15 years of loss and +1.5% for loss beyond that period.
When setting the rate in 2019 the Lord Chancellor said:
The MOJ was expected to issue a call for evidence on single/dual discount rates in October 2022 but this has been delayed as a result of the turbulent political climate. The MOJ is currently holding a number of stakeholder events before finalising the questions for the call for evidence, so there will soon be a direct opportunity to have input on that discussion. Whilst it is inescapable that those investing over a longer period can achieve a better return than those investing over a short period, additional issues around the practical implications of any change will need to be carefully considered to avoid the potential for unintended consequences. For now though, our expectation is that a dual rate is very likely to be adopted.
Verdict: highly likely to change
In Scotland and Northern Ireland, the investment portfolio is defined in the legislation and not subject to reconsideration. That is not the case in England and Wales. The portfolio must reflect the nature of the hypothetical investor specified in the legislation which is someone who will accept “More risk than a very low level of risk but less risk than would ordinarily be accepted by a prudent and properly advised investor.” As long as the portfolio reflects that level of risk it can consist of any investments and in such proportion as GAD or the experts consider appropriate.
In their 2019 report GAD considered three low risk portfolios with different fund allocations: cautious, central, and less cautious. GAD recommended that the Lord Chancellor adopt the returns on the central portfolio which had 57.5% allocation to lower risk assets of cash, gilts, and corporate bonds and 42.5% allocation to growth assets of equities and other investments. The portfolio set in the Scottish and Northern Ireland legislation has a lower risk portfolio with 70% in lower risk assets and 30% in growth assets. As a result, it produces a lower return hence the difference in the rates in the different jurisdictions.
The Institute and Faculty of Actuaries carried out some portfolio modelling of its own in late 2021 and concluded that GAD’s portfolio was not optimal in terms of getting the best return for the level of investor considered. Adopting an “efficient frontier and risk neutral portfolio” produced a return 0.5% higher than the 2% above CPI that GAD found the return to be.
Importantly GAD and the experts are obliged by the legislation to consider the actual investments made by personal injury investors, not just the hypothetical portfolios constructed by GAD. The challenge will be to get evidence of those real investments that are held by claimants and those advising them.
Verdict: modest possibility of change, higher if details of real investments provided
The period of investment is not set in the England and Wales legislation. It is set at 30 years in Scotland and 43 years in Northern Ireland. GAD adopted a 43 year period on the first review on the basis that the Call for Evidence established that the average duration of loss for personal injury cases was between 40 and 45 years. The 30 year period set in Scotland appears unduly low and we do not expect that GAD will move from the 43 year period already used unless a dual or multiple rate is adopted.
Verdict: unlikely to change except as part of a move to dual rates
The return that is produced over the period defined is inevitably a direct result of the portfolio chosen less CPI over the same period. It would therefore seem that the return cannot be influenced other than by the choice of the portfolio and the period over which the investment is considered. However, GAD and the experts are required by the legislation to consider the actual returns received by personal injury investors. If that real-world data were available to the expert panel it would act as a sense check for whether the returns on the notional portfolio reflected actual returns. The rate could then be adjusted up or down to reflect the reality of the situation.
Unfortunately obtaining data as to the returns actually achieved by claimant personal injury investors is extremely difficult. Those that advise claimants on their investments have that information but have not previously made it available to those setting the rate. The justification has been that the data they have is not representative of the hypothetical claimant investor because with the DR set too high (at 2.5% from 2001 until 20 March 2017 when it changed to -0.75%) claimants had to take much greater risk on their investments in order to have enough money to pay for their outgoings. That reasoning made sense at the last review in 2019, when claimants had to try and achieve a 2.5% net return until 2017 and we only had two years' data for claimants trying to beat a much lower risk return of -0.75%. The justification holds less water a further 3 years down the line with claimants only having to beat either -0.75% or -0.25% for the past 5 years. Even if we can only get data on actual returns achieved by claimant PI investors over the past 5 years there is a real opportunity to make a difference on the next review as at least we are starting with a real-world outcome rather than a purely hypothetical one.
Verdict: modest chance of change, higher if data on actual returns provided
There are two elements that need to be considered, inflation in the form of CPI or RPI and also the extent to which damages inflation differs from those measures.
When considering inflation as a whole (CPI/RPI) GAD is looking at the change in inflation over the entire investment period, currently 43 years, so a short-term rise or fall in inflation has an impact but it is not as dramatic as the recent swing in CPI from 2% to 11%. The main difference between the GAD reports in 2019 and 2022 was that inflation had risen by 0.5%, returns had been static, so the DR had dropped by 0.5%.
The England and Wales report used CPI as the measure of inflation but then reduced the return over CPI by 1% on the basis that damages inflation was thought to be 1% higher than CPI. The Scottish and NI reports used RPI as the measure of inflation and there was no additional reduction on the basis that damages inflation was thought to be the same as RPI.
The assumption that damages only rise by 1% over CPI may not be valid and is clearly open to challenge. The majority of damages for future losses consists primarily of care followed by earnings, case management and equipment. The first three of those are influenced mostly by changes in earnings rather than CPI. This point was made by Edward Tomlinson (financial planner at IM Asset Management - subsidiary of Irwin Mitchell) in a recent article in the Journal of Personal Injury Law. His view was that care costs were rising by 2% above CPI not 1% as allowed for by GAD. That assumption alone would reduce the DR by a very significant 1%.
Verdict: high chance of change
On the last review a figure of 0.75% was taken off the return after inflation to reflect the effect of tax and the cost of investment advice. The tax figure was thought to be between 0% on a £100k invested award, 0.2% on a £1m award and 0.5% on a £3m award. Financial adviser fees were expected to be 0.25% to 0.5% pa as were fund management fees. Additionally the platform fee was expected to be 0.1%% to 0.2%. The total deductions are set out in the report:
The deduction should therefore between 0.6% as a minimum and 1.7% at the most. GAD adopted a figure closer to the lower figure and four reasons are given for this including that claimants would shop around for the lowest fees and that fees are lower on a static asset allocation with an unchanging investment objective.
Edward Tomlinson argues the deduction is too small, pointing out that The Forum of Complex Injury Solicitors provided data from 389 claimant investors whose average charge was 1.77% before tax. If that were accepted then we would see a further 1% reduction on the DR.
Verdict: high chance of change
The Scottish and NI Legislation requires a further reduction of 0.5% to the discount rate to give claimants an additional margin of safety to reduce the risk of under-compensation. That margin is not specified in the English legislation so might be capable of being challenged. In their 2019 report GAD’s logic was that a DR of +0.25% would correspond to 50% of claimants meeting their needs and 50% not. They went on to say that it might be appropriate to adjust the rate downwards to increase the likelihood of claimants meeting their needs.
They included a graph demonstrating the percentage likelihood of the representative claimant with a 43 year investment period meeting their needs which is actually better summarised as a table:
Any shift of the DR from a 50% risk of under compensation inevitably also increases the risk of overcompensation, particularly for those with longer term awards. IFOA's analysis last year established that with a single discount rate of -0.25% claimants with compensation periods of less than 15 years ran the risk of being under compensated by 5% but conversely every claimant with compensation periods over 18 years was overcompensated by at least 5%. The longer the damages period the greater the overcompensation. For 20 year losses, overcompensation was 10%, 26 year losses had an extra 15%, and 33 year losses an extra 20%.
Despite the obvious bias towards overcompensation, Edward Tomlinson argues that the reduction of 0.5% to reduce the risk of under compensation is too small, arguing that the aim is to achieve 100% compensation, not give claimants a 66% chance of achieving 100% compensation. Our own view is that this adjustment is unlikely to shift further.
Verdict: very low chance of change
The assumptions that will have a negative effect on the rate and are most likely to change are:
The assumptions that will have a positive effect on the rate and are most likely to change are:
Of these, the biggest impact will be from the adoption of a single or dual rate, which will be the subject of one of our next articles.