• Stuart Fowler

Solving problems in the retail investment market: the FSA consults

In January I went to see the head of the FSA Retail Distribution Reviewteam and some of her colleagues. The FSA set up this team to address the root causes and effects of problems in the distribution of long-term savings products. The fact that the FSA is on this case is good news. But the really good news is that it no longer needs persuading about the root causes. These were stated with surprising bluntness in FSA Chairman Callum McCarthy’s Gleneagles speech.

The Review team has set up various industry working parties. My contribution therefore focused on what I thought those might miss, knowing how hard industry people find it to think outside their business models and, when they do, to see the profit potential in disruptive models. What the FSA was particularly interested in was my views on the enabling roles to be played by ‘investment technology’. It is the key to a wide range of solutions: improving typical industry skills, lowering the need for advice, increasing ease of access to good products, reducing their costs, making the customer experience more relevant and engaging, encouraging greater personal responsibility.

A very important review The FSA launched its review in June last year with the aim of ‘identifying and addressing the root causes of problems that continue to emerge in the retail investment market’. It identified five key themes:

  • The sustainability of the sector

  • The impact of incentives

  • Professionalism and reputation

  • Consumer access to financial products and services

  • Regulatory barriers and enablers

The first four were what McCarthy chose to tie together in his speech to industry leaders at Gleneagles. The model for distributing long-term savings products does not work, he said. It fails to provide what the consumer needs at a price that makes sense. But neither is the industry earning enough return on capital to sustain the model. The manufacturers have made themselves more and more dependent on a separate advice industry (IFAs) to distribute their products, relying on commissions to attract IFA custom. Separate advice is a hugely inefficient business model: fragmented, under-capitalised and under-skilled and forced by high costs to move ever up-market, increasing the number of households with no access to advice.

The high costs of the business are of course one of the barriers that regulations contribute to – but the FSA probably needs no lectures on the need to relate the amount of regulation to the complexity of the product being sold or the process used to sell it.

We cannnot afford advisers I started the meeting by suggesting that as a nation we cannot afford the luxury of a separate advice market. From a committed independent adviser this may seem surprising but it follows logically from the overriding priority when making long-term savings: harvest the risk premiums markets offer and harvest them at the lowest possible cost.

The industry inserts a wedge between the market return and the investor’s return. Since individuals cannot obtain market returns without buying exposure to markets through some product or service created by the industry, some cost is inevitable. The actual costs are several times the minimum cost required both to provide exposure for the masses and to ensure efficient markets. The gap is not added value: it is wealth destruction.

The additional costs relate directly to the competition for distribution. This competition is based on claimed performance skills rather than on efficient delivery of the market return. Applying performance skills adds to the industry’s costs. Firms compete on the basis of past performance, as if a measure of the skill on offer. Because past performance is indistinguishable from a purely random process, there will always be a sufficiently large proportion of the total number of competing firms to suggest to consumers that the additional costs are worthwhile.

When a separate advice industry is inserted into the equation, as the means of distributing the products, the advisers have two options:

  1. tell the public to opt out and harvest risk premiums passively (via index trackers) or

  2. tell them there is added value worth paying for and they are the people who can deliver it – by taking on the job of selecting and changing active managers

The first is a service with limited economic earnings power (except for very wealthy households). The second is a service that creates both initial and continuous earnings power through the process of reselection, as the myth of performance predictability meets the reality of randomness. A separate advice industry therefore acts to perpetuate the myth of added value from selection and transactional activity.

In my testimony to the FSA I summarised very briefly the size of the wedge resulting from the distribution model and its impact on the product of the nation’s savings, quoting earlier analyses I have made – including a key chapter of my book.

The impact varies depending on whether savers hold equities or bonds. The wedge does more damage to bond holdings than to equity holdings because there is less systematic return to share with the industry. Even over very long periods of saving the effect is also sensitive to whether market returns adjusted for inflation are better or worse than the long-term average. Using a ‘typical’ asset allocation in line with the suggested default for the new national pension saving scheme (60% equities, 40% bonds), and allowing for different mean returns to a long-term plan, the cost wedge takes between 31 and 71% of the potential outcome for small regular savings plans. I suggested it would take a 25% increase in the rate of savings to close only half of the average loss of savings outcome.

The idea that reducing the cost of savings is both the easiest and surest way to increase the product of the nation’s savings is a powerful justification for the new National Pension Savings Scheme, whether or not you support the separate concept of ‘soft compulsion’.

What alternatives to advisers? Collection of regular savings via a central agency is the key solution in the mass market but it is not the only one. I have not altered my thinking that one of the original intentions of ‘depolarisation’, to re-engage the high-street financial institutions in the distribution of simple financial products, was also vital to improving access to services and products the mass market needs.

I believe the essential insight here is service rather than products. The nature of any long-term savings plan, which in the mass market is mainly about topping up a subsistence state pension entitlement, is a journey undertaken with specific objectives, involving trade-offs and compromises, and regular attention and effort. The experience of the journey will dominate the experience of the outcome itself.

I believe that it is the journey attributes that individuals can relate to, not the products or investments underlying the path and the outcome. Indeed, if like us you believe the investment journey requires dynamic management of the underlying asset allocation, and should take this into account when planning it, there will be an additional level of complexity about the products and vehicles that will further tax consumers’ understanding and willingness to engage.

Projections: the language of journey management I suggested in my evidence that the closest the industry has come to changing the language of long-term savings so it directly addresses the progress of a journey was something instigated by the FSA in response to the crisis in mortgage endowment plans: ‘reprojection letters’. The purpose of these letters from insurers was to tell policyholders whether they were on course to achieving their objectives and so needed to do anything to alter the original planning assumptions. The technical means of doing so was projecting probable outcomes given where the plan was at current market values and allowing for the time remaining.

It does not take a genius to see that, if you can ‘model’ and therefore forecast the probable paths and outcomes of a plan, this information will change the way you both plan and report the journey.

With Chris Drew, my fellow director of financial modeling business Lambda Investment Technology, I had tried over many years to persuade the FSA that its regulations restricting the use of probabilistic models (in favour of prescribed ‘normalised’ and representative projection rates) were harming the market. We were interested in debunking the FSA’s nonsense approach to reprojecting outcomes but we really wanted to focus on the benefits of a free market in investment modeling that captures the full probability distribution for uncertain future values.

As it turned out, it was the EU (in the shape of the new investment directive, MiFID) that came to the rescue by outlawing local rules that prescribe what advice is based on in favour of a general duty to justify and explain the basis.

Technology and the distribution business The change in the customer experience is the most important benefit of applying techniques that can quantify the journey attributes. However, they would be of little use if consumers do not have access to them. I wanted the FSA to see how applying advice skills residing in software programmes could tempt the easy-access firms like banks and building societies back into long-lasting relationship-based services, as well encouraging the life insurance companies back into direct relationships with consumers.

Regulatory risks and costs need also to be much lower if either of these natural distributors are to commit seriously to the opportunity. The use of decision processes driven by software applications can provide the risk reduction these firms need. There will still be training costs but the advice process itself can be made relatively low-risk by depending on distributed technology. Indeed, the process within a branch will essentially emulate remote applications that are accessed via the internet, but guided by a member of staff. Telephone-guided versions would share the same processes.

What the FSA can do If the FSA can be persuaded that the risks of consumer detriment are lower because of i) the underlying investment structure ii) the advice process delivery and iii) the continuing after-sales information, it should be willing to lower the burden (and cost) of regulating such services.

Otherwise I was sceptical of the FSA’s ability to influence the changes in the distribution models needed. It is doing the right things in the area of education and consumer help but this is a long-term plan. I have always chided the FSA for losing the opportunity with the polarisation changes to provide an economic incentive for IFAs to come off the commission drug and tried to demonstrate why the ‘menu’ approach to commission comparison makes matters worse rather than better. But the FSA has now acknolwedged this publicly.

The Review team members were curious to know why I thought disruptive business formats had not emerged, even without FSA encouragement. We both knew of one that Lambda was involved with that was a ‘nearly’ launch and the reasons why it was pulled (which were to do with problems in the core business). I had to admit to being rather depressed by the lack of firms interested in subverting existing industry structures, whether existing or new brands. But the National Pension Savings Scheme will at least fill one need for a simple, low-cost plan. I hope that it will load up its platform with the kind of decision-support technology and journey-management information I envisage. I hope that will in turn set an example others want to follow.



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