How the FSA has undermined ‘independence’
By historical accident rather than by design, financial planning and private wealth management grew up independently of each other and are rarely fully integrated in a single business. The resulting differences have turned out to matter a lot as a consequence of the FSA’s decision that the reform of the distribution of packaged investment products should embrace not just independent financial advisers but also private client portfolio managers (many of whom are aghast at the idea that they distribute products).
Because of this, the FSA needed to adapt the previous clear distinction between the two advice models of ‘independent’ and ‘tied’. This distinction took its logic from objective economic facts, such as ownership of the firm and contractual distribution agreements.
This no longer held when wealth managers who also use packaged products as part of their portfolio solutions for customers were drawn into the RDR net, because many or even most are just as economically independent of distributors as an independent financial adviser even though the scope of their investment offering is typically less broad. This may only be because they often complement rather than replace financial planners. Indeed, many IFA firms refer clients to wealth managers to look after part of their wealth.
The FSA therefore found itself driven away from an economic logic for independence to one based on comprehensiveness of scope. The various stages of RDR consultation threw up three levels of scope that it has ended up dealing with rather differently. The result is a loss of clarity and logic that will pose problems for firms, consumers and the regulator itself. The industry’s response has been to see this as a loss to wealth managers at the expense of independent financial advisers. I believe that is wrong and that the real loss is to the relevance of independence, which used to mean something and now will not.
Different levels of restrictions
At a high level, if customer needs might be equally met by packaged investments either inside or outside a pension or other wrapper, a firm that restricts itself to one type not the other cannot call itself ‘independent’ but must instead refer to itself as ‘restricted’. This will force many wealth managers who use packaged products but do not do financial planning to use the same term to describe their business as firms who are economically tied by ownership or distribution contracts, such as St James’s Place.
Similarly caught at this high level are firms who do offer financial planning and can recommend life, pension and any other packaged products, who are economically unfettered in their research scope but who then unitise the portfolios (two effects of which are to make them cheaper and more tax-efficient).
A case in point is Towry Law. The act of packaging the portfolios makes them restricted, even though in theory no other element of their process altered.
The next level of restriction applies to firms who use packaged products across the whole of a relevant market, are unfettered in their research scope but choose nonetheless to limit the use they make of different types of product. Whereas before RDR this restriction might have been explained largely or entirely by commission bias, RDR will remove this explanation leaving, we can assume, the differences in opinion that exist in any healthy market about generic suitability, reliability or cost-effectiveness.
Here is what the FSA has to say on restrictions resulting from deliberate elimination: ‘While concerns have been expressed about how a firm can document whether reviews of the market have been sufficient, this will differ between products and is not, therefore, an area where we feel it would be appropriate to provide guidance. A firm might feel it was difficult to sufficiently review a particular market because of, for example, an absence of data or lack of transparency with products within the market.
‘This could be one of the reasons, though not the only one, for considering that these products were not appropriate for their client base, although we would expect the firm to be able to demonstrate why it did not feel the market for those products should be reviewed. If a firm concludes that certain products, such as structured products or unregulated collective investment schemes, are not suitable for its clients, it will not then need to review the market for that product for each client.”
Logically, there is a difference between generic products making up a relevant market and the further, lower level of restriction where a proportion of the products of a type is judged representative of the market as whole.
This difference is not explicitly addressed by the FSA. The more homogenous the products are, the smaller the sample size that is representative of the entire population. The FSA has made a rod for its own back here because it has for all of its existence railed against the bias of the industry to active management on the theoretical and empirical grounds that active funds fishing in the same pond are essentially homogenous commodities. If so, literally comprehensive analysis may yield no more information than selective analysis.
The problem of how representative the sample is, as a test of restrictions, will arise particularly when advisers and wealth managers use platforms, as these necessarily restrict scope but do not necessarily restrict how representative the scope is.
The risk of misrepresenting your status
The FSA has said it will monitor whether firms are misrepresenting their status so we have to hope that the penalties for ‘error’ will take account of their own reluctance to provide guidance. Unreasonable sanctions invite a legal nightmare for the regulator.
This explanation should serve to highlight the flaws in the FSA’s approach to a new polarisation between independent and restricted firms. The question therefore arises, which will suffer as a consequence, or will both suffer?
My judgement is that the distinctions are so counter-intuitive as to be meaningless to the ordinary customer and irksome to those that know a bit.
I shared the first response of wealth managers that this was a problem for them. But restricted is a newly-made up category and so has no meaning with customers to lose. And when it comes to investment credibility, I doubt this new label can ever have the power to damage the image of wealth managers relative to IFAs.
Independence, on the other hand, which does mean something economically and does imply something really useful about the best interests of consumers, has just been rendered impotent. That in my opinion is a regrettable loss.