In order to understand the

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1 A lifetime commitment Jennifer Stone, Nick Leech, Andrew Sands and Nick Martin reflect on the implications of the change in the discount rate Jennifer Stone, Nick Leech (pictured), Andrew Sands, and Nick Martin are Nestor directors An investor placing capital into ILGs and holding the investment until the redemption date (date of maturity) is at today s prices guaranteed to have less purchasing power with that money than they had at the time they first invested. In order to understand the current discount rate, it is useful to appreciate what has led us to this point. For a large portion of the last century, lawyers and judges were reluctant to utilise consistent calculations for the compensation for future losses. This created great uncertainty and arguably unfairness in awards of damages. As stated by Lord Diplock in Cookson v Knowles [1978]: The conventional method of calculating it (future loss) has been to apply to what is found upon the evidence to be a sum representing the dependency (multiplicand), a multiplier representing what the judge considers in the circumstances, particularly in terms of a deceased, to be an appropriate number of years purchase. In times of stable currency the multipliers that were used by judges were appropriate to interest rates of 4% to 5% whether the judges using them were conscious of this or not. The use of a 4 to 5% discount rate was based upon gross investment returns in equities in very different economic conditions to those we find ourselves in today. Lawyers who were in practice at the time state that a ceiling of 18 was thought by the judiciary to be appropriate to a whole life multiplier. As also stated by Lord Diplock: the likelihood of continuing inflation after the date of trial should not affect either the figure for the dependency (multiplicand) or the multiplier used. Inflation is taken care of in a rough and ready way by the higher rates of interest obtainable as one of the consequences of it, and no other practical basis of calculation has been suggested that is capable of dealing with so conjectural a factor with greater precision. The Ogden Tables, first published in 1984, thankfully provided a consistent approach to calculating future loss. Sir Michael Ogden QC stated the following: When it comes to the explanatory notes we must make sure that they are readily comprehensible. We must assume the most stupid circuit judge in the country and before him are the two most stupid advocates. All three of them must be able to understand what we are saying. The difficulties involved in calculating damages were perhaps best expressed by Lord Oliver in Hodgson v Trapp [1988]; Essentially what the court has to do is to calculate as best it can the sum of money which will on the one hand be adequate, by its capital and income, to provide annually for the injured person a sum equal to his estimated annual loss over the whole of the period during which that loss is likely to continue, but which, on the other hand, will not, at the end of that period, leave him in a better financial position than he would have been apart from the accident. The well-known case of Wells v Wells [1998] concluded that personal injury claimants should not be treated as ordinary investors and should invest in Index Linked Gilts, or ILGs, due to the greater security compared to equities. The House of Lords, as it then was, decided that the discount rate should be 3%. This was followed by the Lord Chancellor in 2001 exercising his power under the Damages Act and the Personal Injury Law Journal 11

2 discount rate was reduced to 2.5%. This was based on real yields on ILGs of 2.46%, rounded up to 2.5%, and the rate stayed in place until 20th March 2017, despite serious economic headwinds during that period. It has been clear to most practitioners that the discount rate has been incorrect for a long period of time. News of the Lord Chancellor s decision to reduce the 2.5% per annum discount rate to minus 0.75% per annum, did however come as a surprise to many involved in personal injury and clinical negligence litigation. Defendants are understandably concerned over the cost of the change and claimants are excited as they see their re-drafted schedules of future loss 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). The discount rate is based on real returns. A real return is the actual return on an investment after allowing for price inflation. Nominal returns are not adjusted for price inflation. For instance, a nominal return of 5.5% per annum, with inflation at 2.5% per annum, would result in a real return of 3% per annum. An example of a positive nominal return with a negative real return would be this; The discount rate is based on real returns. A real return is the actual return on an investment after allowing for price inflation. the lump sum is stark; 3,067,000 plays 7,825,000, a factor of On 30 March 2017, the Ministry of Justice launched an open consultation relating to the personal injury discount rate and how it should be set in future. The consultation closes on 11 May The core issues at stake are what principles should guide how the rate is set? How often should the rate be set, and; who should set the discount rate? The paper also considers whether sufficient use is being made of periodical payment orders. The ILGs market In the current investment climate, it does not follow that a claimant is fully protected against movements in the RPI if they invest in ILGs even with a discount rate at -0.75%. The claimant would only be fully protected if they purchased a portfolio of ILGs which matched their actual cash-flow requirements which it is not possible to do with ILGs, as: adding up to double digit millions, in many cases. The negative discount rate is derived from today s economic realities of investing damages in such lowrisk investments. ILGs have become expensive. An investor placing capital into ILGs and holding the investment until the redemption date (date of maturity) is at today s prices guaranteed to have less purchasing power with that money than they had at the time they first invested. To recite the Lord Chancellor (para 8 Discount rate: statement placed by The Lord Chancellor, in the libraries of the Houses of Parliament on 27 February 2017): 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 say an investor invested 100 today, which resulted in a maturity value of 150 in ten years time. If inflation is such that the 100 purchasing power at the beginning of the period would be reflected by an equivalent sum of 175 at the end of the period, the investor has enjoyed a positive nominal return to get to 150, but suffered a negative real return in that actually he needed 175 to purchase the same goods at the end of the 10-year period as he could at the start of it. Based on the new discount rate, the current assumption is that the lump sum, when invested in ILGS, will produce an annual return equivalent to -0.75% when measured against the Retail Prices Index (RPI). In other words, the lump sum would need to provide a positive nominal return after allowing for charges and tax when RPI inflation is in excess of 0.75% per annum. To put the change in the scale of lump sum damages in context, a simple example ought to assist. Consider a 26-year-old male with a normal life expectancy. Let us assume he has a future lifetime expenditure need of 100,000 per annum. Using a 2.5% discount rate provides a multiplier of 30.67, a -0.75% discount rate, a multiplier of The difference in it is not possible to predict the actual date of death of the claimant; the cash-flow requirements of a claimant are unlikely to follow an inflation index closely, as they will be influenced by the individual circumstances and health of the claimant; and many of the claimant s future costs will be wage related. There are currently 27 ILGs in issue (including two ILGs which mature in the same year). This is illustrated by information on the website of the UK Debt Management Office, which shows the nominal amount of ILGs in issue for each redemption year as at 1 March 2017 (the gilt market website is here: There are many individual years in which no ILGs mature, and it should be noted that no ILGs mature after 2068, which means that it is not possible to match the exact cash-flow requirements of a claimant with ILGs. 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) offer real yields in the range 12 Personal Injury Law Journal

3 -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 then hoping for the best is prudent financial advice. Looking at historic real yield data for the generic 10-year and 30-year maturity ILGs produce a three year simple average gross real redemption yield of -0.89% and -0.73% respectively. The methodology used to calculate the discount rate has been applied correctly to arrive at the -0.75% rate, however, to reiterate, it leaves a number of issues for claimant investors to contend with: Current real yields today are significantly below the three-year rolling average as at end of Dec 2016 with the 10-year at -1.86% real and the 30-year at -1.55% real. Clearly these will not be effective long-term solutions for an award based on achieving an outcome of -0.75%. The simple average will change quite dramatically over time, and especially when 2014 drops out of the data: assuming that the yield doesn t move from here, the three-year simple average at the end of 2017 will be -1.85% for the 10-year linker and -1.54% for the 30-year linker. A system that makes awards based on the three-year rolling average may need to update the discount rate quite frequently to keep up with changed market conditions. Implicitly, using the three-year rolling average to calculate the discount rate embeds an assumption that yields will revert to that average over time. A reversion of today s yields to the levels implied by the Lord Chancellor would result in significant capital losses for index linked gilts. For example, if the current generic 10-year linker (UKI 0.125% March 2026) reverted immediately from its yield today (-1.86%) to the three-year average calculated of -0.89%, that would result in a fall in value of around 8.5%. For the generic 30-year (UKI 0.125% 2046), a reversion from today s yield of -1.55% to the calculated three-year average of 0.73% would mean a fall in value of around 21%. In summary, even if it were the case that an investment portfolio made up of ILGs with five-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 longterm earnings capacity. While investors may consider that ILGs are low-risk assets, ILGs prices are extremely sensitive to shifts in the real yield. In reality, while Nestor is 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. Adopting a cautious and low-risk approach is usually advisable, but investing solely and directly in ILGs is impractical and unwise. Such an approach is 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 any deficit arising from purchasing accommodation in a negative discount rate scenario. Regardless of the ILGs market and its difficulties, the welcome fact is that the reduced discount rate has reduced the pressure on long-term gross investment returns. Under the 2.5% discount rate, in order to meet wage-related expenses, underlying investment returns before charges and tax needed to be in the region of 9-10% per annum. Utilising the -0.75% discount rate means underlying investment returns now need to be more like %, which ought to be achievable for a cautious investor. Practical considerations and periodical payments The calculation for the lump sum is still based on a multiplier that takes Utilising the -0.75% discount rate means underlying investment returns now need to be more like %, which ought to be achievable for a cautious investor. no account of the fact that carers wages and other earnings based losses will likely, over an extended period, increase faster than inflation as measured by RPI. A lump sum settlement for any element of earnings based future losses would therefore suffer from shortcomings in respect of an incorrect assumption about future inflationary impacts. This factor will inevitably expose the claimant to higher levels of risk, which is at odds with Wells v Wells. Therefore, with a conventional award, in order to ensure that the lump sum damages last, the claimant must make a return to match inflation (as measured by Retail Prices Index), a return to deal with the difference between wages and inflation if dealing with future wage costs, a return to deal with any investment charges that apply, and a return to deal with the tax bill. Only after each of those returns has been achieved, can allowance be made for the minus 0.75% pa discount rate. If this level of nominal return is not achieved, the damages will run out within the claimant s lifetime. Despite the reduction in the discount rate, meeting lifetime needs, especially earnings-related needs, is unlikely to be possible using Index-Linked Gilts and Personal Injury Law Journal 13

4 the claimant would most likely need to utilise low-risk multi-asset investments. Although a discount rate reduction makes a lump sum award more attractive on the face of it, all the advantages of periodical payments continue to apply. Achieving a secure, lifelong, tax-free, appropriately indexed annual income stream is arguably the best possible investment ever to have existed. Despite that, following the discount rate announcement, some personal injury lawyers have asked us whether this deals a fatal blow to the continued use of periodical payment orders (PPOs) for future recurring losses. If claimants are getting significantly more damages for future losses, why is it not sensible just to accept the increased lump sum and disregard a PPO? In our view, it is not that simple. Comparing a future loss lump sum (albeit bigger using a minus 0.75% as opposed to 2.5% discount rate) versus earnings linked PPO s, remains a complex decision, and one which will affect the lives of personal injury claimants for many years to come. Time for adequate consideration at the end of the litigation process is, in our view, still just as vital as it has always been. Tempting though a greater future loss lump sum will be, it would be inadvisable for those advising personal injury claimants to give just a cursory glance towards a PPO then disregard it. There is, and always will continue to be, significant advantages for a claimant to have part of their future loss damages paid by way of a PPO. As regards the reduction, the assumptions used when the Lord Chancellor made her decision still remain just that; assumptions. The new rate still ignores mortality, and lump sum awards cannot match the lifelong, There is, and always will continue to be, significant advantages for a claimant to have part of their future loss damages paid by way of a periodical payment order. 100k in decumulation tax free, inflation proofed certainty of a PPO. Although interest rates may rise in the short to medium term, which will improve ILGs yields, capital values will fall. As usual the answer lies somewhere in the middle: A periodical payment order, appropriately indexed, to meet certain recurring lifetime needs, alongside a suitable 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. Leaving aside the number crunching aspects of how awards ought best to be allocated between periodical payments and lump sums, there is the all-important issue of how the structure of an award impacts on post-settlement behaviour of claimants and/or their families. At Nestor, we work with many professional deputies around the UK, with several already expressing concern that lump sums may become more popular. We share that concern, as it is often the case that client expectations and budgeting become difficult to manage in the face of a large lump sum, which may need to last 60 years, and for reasons set out above, has more pressure on it than might be apparent at first blush. Periodical payments resolve many of the budgeting issues, and allow all concerned some peace of mind. From the defendant perspective, it is likely that periodical payments will become more attractive in the -0.75% discount rate environment than under the 2.5% discount rate. Historically, bodies such as the NHSLA and Motor Insurers Bureau have always been keen on periodical payments; insurers less so, as they recognised the onerous and more costly reserving implications of long-term usually wage related liabilities. It is likely that if the negative discount rate prevails, more insurers will be willing to negotiate to settle claims by way of periodical payments, which in our view, can only be a good thing. At the very least, it will make the system fairer such that those injured in road traffic accidents will have the same opportunity for a periodical payment order as those injured by the NHS. What should claimants invest in? We have been consulting with external experienced fund managers currently managing personal injury damages awards for our clients. 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 needed to address at first instance was this: given the reduction in the discount rate, why is it not sensible to invest claimants 14 Personal Injury Law Journal

5 awards into a portfolio of Index Linked Government Stock (ILGs)? After all, that is the essence of the calculation. After due consultation and consideration, and for all the reasons set out above, 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. 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 direct holdings in ILGs are far from risk-free, and will potentially be subjected to extreme price volatility, given the fact that ILGs have high current valuations. Future personal injury claimants will get greater lump sum awards and in theory those awards ought not to be invested in risk-based assets to get 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 five years, is at best impractical. There are many potentially suitable investment strategies that could be adopted by claimants. At Nestor, we have a range of solutions for our clients, and recommend an investment strategy only when we have established the client s needs, as well as attitude to risk. There is no such thing as one right answer. All of the external investment managers we recommend must meet our strict due diligence criteria, and are subject to quarterly scrutiny from Nestor s Investment Committee. There are many risks faced by personal injury investors due to the requirement to draw down on their investment over long periods of time. This is known as decumulation. Investors are subjected to random and unpredictable fluctuations in market returns. These can be felt acutely when there is a need to decumulate capital to meet ongoing expenditure needs. The graph on p14 shows an example of 100,000 invested, performance being in line with the MSCI World Index (source Morgan Stanley). There is an assumption of annual withdrawals at 5,000 per annum, increasing by 3% each year. The grey line shows the actual returns experienced between the years 1991 to If, however, it is assumed that the annual returns occurred in reverse order, we can see the effect that would have had on the fund, with it being totally depleted in the year Remember, investors have no control over market conditions; the only thing that can be influenced is where the money is placed. Perhaps one of the most high-profile and best-known funds in this market is the personal injury fund, run by Seven Investment Management. The fund, an open ended investment company (OEIC), was incepted in 2009 and all information relating to returns is in the public domain. It terms of risk, it sits towards the bottom end of the cautious risk profile, at times being on the cusp of a defensive strategy. The personal injury fund is used for some but by no means all of Nestor s clients, and it is important to document that it is not a one-size-fits-all solution. It may however shed some light on actual historic returns for cautious investors. The five-year performance to the end of December 2016 resulted in nominal returns of 4.5% per annum, after internal fund charges and platform charges. If this figure is converted into real net returns, it is necessary to take off the following: RPI inflation taking historic trends this would be 2.5% per annum; IFA charges say 0.5% per annum; tax as a proportion of the lump sum say 1% per annum; and wage inflation if future losses are earnings based the Financial Conduct Authority assumes a difference of 1.5% per annum between price inflation and wage inflation for preparing financial projections (Source COBS 13 Annex 2/4). To put this in context, the five-year performance results in a real net rate of return of 0.5% per annum for price based RPI future costs and a real net The magnitude of the shift in the discount rate has taken many by surprise, and it remains to be seen if it continues at minus 0.75% following the consultation. rate of return of -1% for wage related future costs. Summary In conclusion, we remain strong advocates of periodical payments; in most catastrophic claims, periodical payments for some of the future losses will be in the best interests of the claimant. We would welcome greater use of periodical payments, and equality between insured cases and those involving the NHS. The magnitude of the shift in the discount rate has taken many by surprise, and it remains to be seen if it continues at minus 0.75% following the consultation. Gaining positive nominal returns in the investment world other than ILGs is what most claimants choose to do, usually very cautiously. It is however not a one-way ticket to over-compensation, even with a minus 0.75% discount rate. Careful consideration needs to be given to the impact of price inflation, wage inflation, tax and investment costs on nominal investment returns. What is left in real terms for the cautiously invested claimant after all that is accounted for, is perhaps not what appears at first glance. Cookson v Knowles [1978] UKHL 3 Hodgson v Trapp [1988] UKHL 9 Wells v Wells [1998] UKHL 27 Personal Injury Law Journal 15