Setting the discount rate

Cutbacks iStock 000013353612XSmall 146x219A Ministry of Justice consultation paper could lead to a change in the Discount Rate for personal injury damages and have a significant impact on those paying compensation. Christopher Malla examines how it should be set.

The Ministry of Justice recently published a consultation into the methodology used by the Lord Chancellor in setting the discount rate for personal injury damages. A second consultation is to be published in the autumn to review the present legal basis for setting the discount rate.

Any reduction in the discount rate will lead to an increase in claimants’ damages and vice versa. This potentially has an impact on all local authorities with large value claims with significant future losses. It will not affect those cases where damages are awarded for pain, suffering and loss of amenity (general damages) and past losses, as the discount rate is not required on such claims.

The consultation is not intended to assess the level of the current discount rate of 2.5% but is focused on considering two broad methodology options when setting the discount rate. It asks whether Index Linked Government Stocks (ILGS) is the appropriate methodology or should the return on a mixed portfolio of appropriate investments be the starting point?

Whichever methodology is selected, the aim is to produce a discount rate which gives effect to the full compensation principle “on the basis of investments that would be made under an appropriate low risk investment strategy”.

The consultation sets out the view of the Government Actuary, which raises the following issues:

  1. Averaging the ILGS yield of the last three years (as was done by the previous Lord Chancellor in 2001) was likely to be misleading as an indicator of future returns.
  2. Calculating the real yield is dependent on assumed inflation for the period between indexation and payment.
  3. Using a simple average of all ILGS places a relatively high weighting on the yield of ILGS with a short maturity date, which is inconsistent with the need for payments over a longer period of a claimant’s life.
  4. The switch from retail to consumer prices index (RPI/CPI) inflation for the uprating and indexation of some benefits and pensions calls into doubt the reliance on real yields and real returns calculated by reference to RPI.

Although the Government Actuary acknowledged the possibility ILGS yields may rise, there is an argument that current rates should be adopted when setting the discount rate. Adjustment can be made, as necessary, rather than trying to second guess the markets as to the future. That said, the Government Actuary did consider expected future increases in yields on longer dated bonds should be taken into account.

The consultation asks whether it could be more efficient for claimants to invest in assets with a higher return if such investments have a similar level of risk as ILGS – i.e. would a mixed portfolio of investments satisfy the low level of risk identified by the House of Lords in Wells v Wells [1999]?

A number of portfolio types are identified as potential options for “claimant investors”, including mixed investment 0%-35% shares, sterling fixed interest and money markets. The option of 100% ILGS held to redemption appear to be considered risk free - providing a return at or above inflation and with no risk to capital value. However, some risks are unavoidable even to this investment vehicle, for example, it may not be possible to construct a portfolio of ILGS which mature when the claimant’s financial needs arise.

Any reduction in the discount rate will significantly increase the payment of damages by defendants, particularly in catastrophic injury claims with large future losses. Whilst the consultation will not take into account the consequences on those paying damages, a move away from ILGS as the methodology for setting the discount rate is likely to be good news for defendants. If the Lord Chancellor will continue to be guided by the principles set out in Wells v Wells, he will need to ensure any alternative mixed investment portfolio is low risk to the “claimant investor”. “Low risk” should not mean “no risk”.

Christopher Malla is a Partner at Kennedys. He can be contacted on 20 7667 9194 or by This email address is being protected from spambots. You need JavaScript enabled to view it..

Kennedys will be taking an active part in canvassing views of its interested parties to ensure an informed and appropriate response to the Consultation is submitted by the closing date of 23 October 2012. To find out more, please visit: http://www.kennedys-law.com/discountrate/