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  • Stuart Fowler

RDR: mixed blessings for consumers


After three years, the FSA’s latest consultation paper on the Retail Distribution Review (RDR), published 25th June, is close to the final word, incorporating the draft Handbook test that rarely alters much in subsequent consultation. It is time therefore to judge whether these changes in the way the advice industry works will lead to significantly better outcomes for customers. Superficially much will change for the better in the industry but it will probably not have a dramatic impact on key targets of the RDR: increasing access to advice, improving the value of advice and lowering its costs. The FSA concedes that the industry is not yet confident about the business models that would increase access to financial advice at the bottom end. We fear the RDR will actually damage consumer-friendly innovation at the top end, including our own business which is pretty ironic (putting it politely). It is only in the relatively well-served middle market that the long-drawn out RDR process stands to produce clear benefits. But even these will only be significant if customers make an effort themselves to face up to and engage with personal finance.

Scope of the reforms There are four areas where the FSA wanted to use the RDR to secure better consumer outcomes:

  • Commission bias

  • Clarity about adviser status

  • Adviser skills

  • Extending access to advice

We consider the likely impacts for each in turn.

Commission bias The banning of commission payments by manufacturers of financial products to agents who distribute them to investors alone justifies the RDR. It has taken far too long for the regulator to bite this bullet but let us be thankful it was finally up to the task, and that is has not wavered between last year’s feedback statement and the draft regulations.

The business model of virtually all financial advisers reflects two marketplace realities:

  • Most customers will not pay for advice but they will pay charges for a product

  • Product manufacturers will pay advisers to distribute their products

Put the two together and power over advice, in other words true ‘independence’, is effectively surrendered to the manufacturers, such as insurance companies and unit trust groups. The result has been disastrous for consumers whose monetary outcomes have been dramatically lower than in a properly functioning, independent and competitive advice market. Whilst some forms of bias resulting from this have been flagrant and despicable, the real damage has come from universal acceptance of practices that are more subtly biased but cause widespread loss of utility to individuals and the economy as a whole.

Past attempts by regulators to deal with the commission issue relied on changing the behaviour of buyers. By forcing full disclosure of charges and the impact on outcomes, the regulator hoped that people would shop around for genuinely independent advice and therefore end up being sold better-priced products. Some people may well have benefited as intended but the complacency and laziness of the vast majority of customers condemned them to more of the same. The fact that so many continued to trust ‘advice’ from their local bank suggests to me that disclosure was clearly not working.

The most powerful change in the marketplace has not come from regulation but the emergence of discount brokers like BestInvest and Hargreaves Lansdowne, who enabled clients to buy funds cheaper than they could directly from providers and even cheaper than through most IFAs! If proof were needed the investment industry was not functioning as a properly competitive market, this was it.

It is true that there has been growing public resistance to initial commissions but I believe this has mainly been driven by distributors changing their business models to emphasise ‘trail’ or continuing commissions. So-called ‘fee-based advice’, which relies on trail commissions paid by fund or product providers to IFAs out of the annual management charges of the products, generates a regular fee stream for ‘portfolio maintenance’. In practice, their regular client charges are ‘offset’ by commissions, so the client does not have to write a cheque.

Fee-based IFAs have been remarkably successful in claiming the moral high ground relative to front-end loaded initial commission. This is disingenuous. Financial planning costs are themselves front-end loaded and commission offset is just a subtler form of bias that still relies on using more expensive products that can generate the fee streams. The practical effects have been to perpetuate a bias to risky assets and a bias to active management. Both conflict with effective, objective advice.

So the FSA is to be congratulated for getting it right after everything else failed. It has effectively banned all commissions including trail commissions. Fees for service will instead need to be agreed with the adviser and must be justified by the provision of a genuine service. They may be collected, by arrangement, from the client’s investments with a provider (such as a fund manager) or a third-party service provider (such as a fund supermarket or platform) but these third-parties are not allowed to be involved in setting the rates.

The FSA has done what it can but it is consumers who will themselves determine whether they end up being much better off, by their engagement in valuing services, discerning different suppliers and negotiating fees. If they are not discerning, competitive and innovative business models will lack confidence and ‘new’ standard practices will develop that merely replicate the cost structures of the old distribution model.

Clarity about adviser status Throughout the three year RDR process the FSA has wrestled with the question of ‘independence’, as a label describing the status of a firm advising the public. What defines it and who can use it?

The importance accorded to status relies, like commission disclosure, on the public using information about agents to make better choices. Whilst the independent label clearly matters to IFAs, it is not at all clear that consumers have valued it. This may be because language was being asked more than it could deliver or just because consumers have not cared enough.

In its consumer research the FSA has consistently found that words do not perform the function they hoped. This is also true of the latest research undertaken by Oxera to test the distinction the FSA proposed in last year’s feedback statement between ‘independent’ and ‘restricted’ services.

Independence can mean ‘financially independent’, as in adviser not being owned by, controlled by, influenced by or dependent on services performed on their behalf by, product manufacturers. This tested well but unfortunately restricting ownership cuts across EU laws and may anyway cut across the other policy objective of engaging banks and insurance companies in advice to increase access.

Independence can mean ‘financially independent’, as in adviser not being owned by, controlled by, influenced by or dependent on services performed on their behalf by, product manufacturers. This tested well but unfortunately restricting ownership cuts across EU laws and may anyway cut across the other policy objective of engaging banks and insurance companies in advice to increase access.

The IFA industry trade body AIFA lobbied hard and successfully for a meaning for independence based on its existing use in the regulations, as advice based on researching the whole of the market: inclusive rather than exclusive. Advice that is not ‘whole of market’ and is selective in the products it offers is to be termed ‘restricted’. This distinction did not test so well with the public, however.

The main change in regulatory approach is that firms may be both independent and restricted depending on individual business lines. This is a challenging departure in an industry that has viewed independence as ‘all or nothing’, believing that that is how consumers themselves think.

For most IFA business formats this is not a big issue as they will continue to hold themselves out as independent across all business lines, even if their claims to comprehensive coverage are in fact spurious. The change may help banks to claim independence across some business lines, such as pensions and investment but not mortgages. We see the problems being with other firms who are brought into the RDR scope for the first time: wealth managers and stockbrokers. Our own business model, integrating goal-based portfolio management with lifetime financial planning, is potentially threatened too.

What does the FSA really mean? ‘Whole of market’ is not a good test of bias or breadth of skill or even of the presence of skills. This is because it assumes that knowledge needs to be constantly applied to assessing available alternatives whereas in reality knowledge needs to be applied on an initial and then occasional basis to eliminate alternatives so as to focus assessment time and money only on the most suitable alternatives.

Not to use knowledge this way leads to spurious research activity and wasteful costs, as somebody will have to pay for it. It is also, ironically, inconsistent with the FSA’s own research that has for many years argued that there are more products than an efficient market needs and that there is no evidence that researching them all will yield useful information such as better expected performance.

Lean solutions are by definition exclusive rather than inclusive. Though they presumably reflect the adviser’s beliefs, they are not as a matter of fact better than either others but they ought to be more cost-effective. Cost effectiveness matters in a marketplace where traditional solutions are too expensive to be rational choices and where most of the cost is associated with decision that have very little or no bearing on investment outcomes. These intimately-related observations about process and cost are to be found in the history of regulatory investigations that predates the RDR including the Sandler Report and the FSA’s own internal research publications. They even feature on the FSA’s consumer website.

Do the RDR proposals conflict with this? What the proposed Handbook says is: ‘A relevant market should comprise all retail investment products which are capable of meeting the investment needs and objectives of a retail client’. An adviser or manager who does not consider all such products will have to describe themselves, for that activity, as ‘restricted’ rather than ‘independent’. This means there is a lot at stake on the FSA’s intentions here.

It specifically itemises in its guidance notes active as well as passive funds, ETFs as well as tracker funds and structured products with asymmetrical, option-based payoffs. It could not be more inclusive. But while all of these alternatives may be ‘capable’ of providing a solution to a particular investment need, and may even all be ‘suitable’, they are not equivalent in either cost or expected performance attributes. Whereas some differences may be matters of fact (such as cost) others will reflect the adviser’s own generic investment beliefs.

Neither the paper nor the Handbook text gives any guidance as to how we in the industry are meant to interpret this. A key question is whether there is a difference, in terms of a decision hierarchy, between generic analysis of suitability, which may only need to be reviewed intermittently or as new innovations occur, or regular research and appraisal. Many advice processes are designed around a hierarchical order of decision making, where the order is determined by the amount of risk or outcome explained by a particular type of decision. Its most common manifestation is the ‘90% Rule’ that makes asset allocation decisions dominant in risk control and portfolio optimisation processes and trivializes selection choices (at the level of individual investments chosen to implement the asset allocation desired). The investment industry has this process upside down, in terms of an obsession with implementation choices but also in exposing investors to the much higher costs associated with implementation choices.

Since the FSA has made exactly the same observations in the past, does it really require continuing analysis of all individual products within a type even if prior research suggests they are fungible? Can ‘higher-order’ decisions, themselves independent, be allowed to restrict the individual products that are analysed for recommendation? If so, why should an independent firm not restrict itself by eliminating from its scope:

  • all active funds (eg following the FSA’s own long-standing views on active management)

  • all multi-asset class funds (eg because the adviser loses control of the asset allocation)

  • all structured products (eg because, like all forms of portfolio insurance, option strategies unless mispriced are zero-sum games)

Other issues for advisers with client-friendly business formats include: What does a financial planner who recommends third-party portfolio managers need to do to retain their vital independence?

  • Why do advisers who unitise their implementation choices have to treat that packaging as ‘restricted’ unless they advise on all similar third-party packages, even if the selection process meets independence tests? (In our case, for example, we know that we will be able to reduce implementation costs for clients by separately unitising the two different elements of our portfolios: a common risky asset portfolio and matched target-date pools of ILGs. Does that mean we could no longer describe ourselves as independent?)

  • If a manager who only invests in UK assets has to call themselves restricted, how geographically diversified do you need to be to prove your independence?

Implications for No Monkey Business We are financially and intellectually independent and we use our knowledge of investment theory and practice to simplify and restrict the building blocks we use in our portfolios, creating cost-effective services for our clients. I believe the FSA’s new distinctions about independence are counter-intuitive and counter-productive and have no logical foundation either in consumer research or investment practice. In the absence of clear guidance from the FSA to dispel our disquiet, we intend to promote our independence as robustly as ever.

Adviser skills The latest proposals contain no surprises compared with earlier drafts which require all advisers to be qualified to a higher level in every specific area they advise on by 2012 when the new rules take effect. Unfortunately, we still do not know what the actual scope of the exams will be but we know what level they will correspond to in terms of existing qualifications.

I am perhaps iconoclastic in calling for higher skills yet condemning the industry’s exam-based learning. My concerns mainly apply to investment skills but the effect of naïve or limited understanding of capital market behaviour on financial planning is barely understood within the IFA sector. I do not see how you can be a good financial planner without understanding economics and investment, although what I see as being good at economics and investment has nothing to do with guessing what will happen and everything to do with knowing what can happen.

I welcome exam-based tests of purely technical knowledge, such as pension rules, tax and trusts, but even here there is an unnecessary obsession with breadth of factual knowledge, largely redundant when reference sources are readily available, and little emphasis on testing comprehension of principles and effects.

I am therefore quite sceptical about whether the FSA’s objectives for lifting actual skill levels will be achieved or that more exam qualifications will make any detectable difference to consumer outcomes.

Increasing access to advice This is the toughest of the FSA’s objectives. The long game is education which has a fair chance of making a difference eventually. But the short game is all about economically viable business models and that is really tough to solve. The scope of financial advice in low-income families is fundamentally different from that of existing advice businesses and the risks of giving unsuitable advice are very high. Realistically it requires the involvement of high-street institutions who are the last people on earth I would trust to give good and objective advice.

I have to count myself a sceptic on this one too. As such, a better strategy for public policy makers would be to reduce the public’s need for advice. That requires simplification of the UK’s systems of benefits, tax and pensions. Unfortunately, what is screamingly obvious to everyone else remains an impenetrable foreign language to politicians.

#commissions #independence #regulation #skills

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