Our response to FCA consultation on DB transfer advice
Who might be interested in this?
Our response to the FCA’s consultation of pension transfer advice, which can be read here, is mainly of interest to fellow pension professionals and pension journalists. It is far more technical, note, than individuals will need or value.
This broader investment context could be of interest to anyone working in private-client advice and wealth management and to personal finance journalists. The issues raised by transfer advice are, after all, common to the broader challenges of managing the process of living off capital. Though deferred spending is the most common purpose of private savings, the challenge of living off capital is generally poorly dealt met by the investment industry. Our response was not therefore limited to pension accounts but was placed in the context of effective techniques for managing money assigned to a stream of cash flows - in an industry where most investment techniques are designed for static capital stock. Our standpoint is that prescriptive regulation must not prevent and should support the development of more appropriate and effective investment techniques. It needs to be rooted in an accurate and internally consistent conceptual framework and we believe this is still work in progress for the FCA.
What's the background?
In June 2017 the FCA released a consultation paper proposing a number of changes that would improve consumer outcomes when seeking advice on whether or not to transfer rights to a Defined Benefit pension income to a personal pension where they could control how they turned it into an income stream. The paper was a response to ‘Pension Freedoms’ introduced two years earlier that encouraged personal control over what people did with their retirement savings. Those freedoms were only accessible to anyone with a final-salary, or Defined Benefit (DB) pension if they first transferred their capitalised rights into a personal pension plan. The Freedoms initiative had been partly responsible for a massive increase in demand for transfer advice, posing risks that the existing rules were either inappropriate or inadequate.
Advising on transfers from a pension arrangement that provides ‘safeguarded’ benefits (ie where the risks inherent in capital markets, inflation and longevity are borne by the scheme not the member) is a specific regulatory activity requiring FCA authorisation for a firm and specific qualifications for an individual adviser. The advice process was itself highly prescriptive, to an extent that is unusual given the way the FCA generally writes rules for how business should be conducted. Pension Freedoms posed a problem for these prescriptive rules because they assumed that the scheme member, having transferred deferred benefits as a capital sum prior to retirement, would then buy an annuity at retirement. Once the requirement to buy an annuity disappeared, so should the presumption that the person transferring would want to buy an annuity.
How did the FCA measure up?
The FCA has flunked this test. It instead is clinging to the idea that the value of the safeguarded benefits can be computed and communicated to clients based on a discount rate that assumes an attitude to risk that allows risk taking up to retirement and then somehow does not tolerate risk after retirement. This is a nonsense. Yet it is a component of the rules that partly explains the high costs of a transfer advice process, so it is also a wasteful nonsense. The 'true' measure of a risk-free pension at every stage, including before retirement, is easy and cheap to compute and is accurate enough, without knowing every detail of the scheme benefits, to serve as the message the FCA wants to see about the value (and cost) of being protected from risk. Considering the incoherence of the discount rate assumption, the accuracy required for the different forms of benefit is spurious. We know we are not alone in arguing this point in our response to the FCA consultation.
The consultation was more open in spirit when it invited opinions that were based on the use of stochastic models in transfer advice. Since stochastics are a core component of our drawdown model, our response deals with the conceptual and practical issues arising when showing outputs from both deterministic, static projection methods and simulations of dynamic outcomes subject to risk controls and constraints. I suspect we are one of few firms able to talk about this from experience as well as from a conceptual standpoint. Outcomes-driven, goal-based investing is what has differentiated the firm since we first started in 2005 and still places us in a minority of IFAs and wealth managers, let alone authorised transfer specialists. The FCA wanted opinions on how stochastic modelling affected clients' understanding and composure. We gave it to them: 'transformative' is the answer.
Most of the changes the FCA wants to make are in the form of guidance as to its expectations, rather than new rules. Most of these we support. However, the FCA needs to recognise that this raises the bar to access to advice by increasing the holistic and contextual scope of the transfer advice. This is a familiar regulatory problem: how to improve outcomes for those accessing advice without reducing the number able to access advice. I addressed this trade off in a blog post when the consultation paper first came out, as follows:
‘In terms of the competitive landscape we operate in, the proposals are probably grist to our mill. This is what our transfer business already looks like. But I doubt many others do. There is no area of transfer business we exclude that this consultation will make a safer harbour. The requirement to make the benefit comparison specific to the replacement investments, though logically faultless, rules out advising self-directed investors. The same principle when applied to transfers to QROPS in conjunction (as foreseen by the DWP) with a foreign local adviser means there is far too much overlap between the two firms to make advice safe. Outsourced transfer advice is also arguably incompatible with the holistic reach of the proposals. These are all genuine advice needs some firms are meeting today that are riskier in the light of these proposals.’
The problems arising from the involvement of two different firms mainly affects outsourcing. The FCA published last week a reiteration of its earlier findings of suitability tests carried out on sample recommendations over the past two years. There is a much larger incidence of reports not recording enough information to allow suitability to be tested in the case of DB transfers (over one third) than is the case for suitability tests generally (negligible). It does not elaborate on the extent to which this is based on file reviews for transfer specialists who have taken on outsourced reports for other advisers not qualified to advise on DB transfers. For these, we might expect the suitability to fall short of requirements when tested in isolation but not necessarily when taken with the recommendation of the replacement strategy or product by the introducing adviser. In other words, historically problems have probably arisen because the regulations force the two functions apart (not many firms employ transfer specialists so specialist transfer firms evolved) but also back together again (by making the suitability of the advice specific to the replacement strategy). The FCA is addressing this now but did not address it during the full period covered by its file reviews. It would be much more interesting to see tests of how the subsequent alerts and guidance have altered practices. Otherwise, the criticisms of the industry might justifiably be read as criticisms also of the regulator.
We also wanted to address the question of whether a firm complying with the guidance and new rules could expect to experience less negative bias from both Professional Indemnity Insurers and the Financial Ombudsman Service. Bias has risk impacts that raise costs for firms and therefore affect access. We doubt the changes will make any difference. They are very relevant to the issue of contingent charges: since the firm's liability somewhat illogically only arises if and when a transfer is the outcome, charges need to be made contingent on that. This conflicts with the principle the FCA wants to see applied that advice is indifferent to the outcome because it is charged for regardless of the outcome. We addressed this problem in an earlier post.
Here's our full response to the FCA consultation.