FSA to review use of projection rates on investment products

Projection rates are used by firms to give retail consumers illustrations of potential future returns from packaged product investments, including pensions, ISAs and investment trust savings schemes, and in stakeholder pension decision trees, statutory money purchase illustrations and comparative tables. The rates are also used in the re-projection letters that indicate the extent of any potential fall in the maturity value of mortgage endowment policies.

The current regime within which projection rates are used has been in place for around 15 years and the context in which they were introduced has moved on. The Financial Services and Markets Act has improved the wider regulatory regime, greater emphasis is now placed on senior management responsibility within regulated firms and many firms' asset mixes have changed significantly. So the FSA will take a fundamental look at its role in setting projection rates and the standards it expects the industry to adopt in illustrating potential returns to its customers.

The FSA has also today announced that it will not be changing the projection rates that it currently requires firms to use. This decision follows a report on long-term market conditions undertaken by PricewaterhouseCoopers (PwC) which is being published today.

The prescribed projection rates, before charges are taken into account, will therefore remain at:

• for untaxed products (for example, pensions and ISAs): 5%, 7% and 9%

• for taxed products (for example, collective investment schemes and mortgage endowments): 4%, 6% and 8%.

It is important to recognise, however, that these rates assume a significant weighting of equities within the packaged investment product. Accordingly, where a firm considers that these rates would overstate the investment potential of a particular product - for example, where its asset mix contains a higher element of bonds - then, under FSA rules, it must use reduced rates.

Michael Folger, Director, Conduct of Business Standards said:

"For their financial planning, consumers can find it useful to have some idea of potential returns but it is important that they appreciate the uncertainties. No-one can predict the future. Projected returns are not promises. The report we are publishing today raises some questions about consumer understanding of the risk-return trade-off, especially over shorter investment periods. We will be undertaking an in-depth review of the FSA's role in setting projection rates and examine this as part of that work."

"In the meantime, we intend to maintain the rates at the current levels, as supported by the independent analysis that we are publishing today."

Key finding of the research The decision not to change was made after considering the results of detailed and independently peer-reviewed research into current and future market conditions, carried out on behalf of the FSA by PwC. The study recommends that projections be made on the basis that equities will, on average over the longer term, outperform government bonds by 3% to 4% annually, implying long term annual growth averaging between 7% and 8%.

Review of projection rate rules In their report PwC drew attention to the uncertainties inherent in any projection of investment growth. It suggested that a more sophisticated approach to setting the rates could be helpful in improving consumers appreciation of investment risks, in particular of actual returns falling outside the standard bands.

Endowment re-projection letters The projection rate used by a firm is particularly important where people are investing with a specific target return in mind, such as with mortgage endowments.

Firms should ensure that the rates they use in their endowment mortgage re-projection letters do not overstate the investment potential of the contract. The FSA is therefore today writing to remind them of their responsibilities in that context. A copy of the letter is attached.

For with-profits funds such as endowments, projection rates assume an asset mix of some 70% held in equities and 30% in bonds, and also reflect the effects of taxation. Although this has been the commonly-held mix over the last 15 years, many funds are now holding significantly less in equities.

Some firms may regard a switch from equities as a relatively temporary one, in which case the FSA-specified rates continue to reflect long-term investment potential. However, reduced rates of return must be used if the firm considers that those rates overstate the products investment potential.

APPENDIX : COPY OF LETTER TO BE SENT TO LIFE INSURERS

23 June 2003 Dear Chief Executive

Projections With particular reference to mortgage endowment re-projection letters we think it important to remind Chief Executives of life companies and friendly societies of the FSA's requirements in relation to projections. For about 15 years with profits funds have been commonly invested at least 70% in equities and other 'real assets' (such as land and other property). However, the asset composition of many with-profits funds, both open and closed to new business, has recently shifted away from equities towards fixed interest investments. When the asset mix of a fund changes in this way firms may need to consider whether the assumptions they make about rates of return for endowment re-projection letters and other purposes remain appropriate.

If a fund is expected to remain heavily weighted towards fixed interest then the prospective returns for investors will be more bond-like than equity-like. The returns will be expected to be less volatile on average but lower than from a predominantly equity fund. This affects the growth rate assumptions that should be used when an investor is provided with an illustration of the potential return from an investment product.

Our Handbook prescribes the basis on which illustrations must be prepared. It includes standard return assumptions for different types of product. For taxed products such as endowments these are annual rates of return of 4%, 6% and 8%. Our Board has recently confirmed the continuing appropriateness of these rates for with-profits funds invested mainly in equities and property.

But, our rules also provide (Conduct of business sourcebook 6.6.49R(2)) that if a firm expects the specified rates to overstate the investment potential of a contract, then reduced rates of return must be used. With gross gilt yields currently at about 4% (3.2% net of tax) this is likely to be the case for funds heavily invested in bonds.

Where a firm decides to use reduced rates of return this will also affect its decision about the red, amber and green classifications used for mortgage endowment re-projection letters.

A failure to have regard to COB 6.6.49 R (2) and the consequent use of inappropriately high rates of return could, for example, lead a consumer to an incorrect conclusion that an endowment policy is on track or to underestimate the extent of a projected shortfall. Our rules provide a framework in which it may be necessary for firms to make a judgement as to whether the standard rates of return are likely to overstate the investment potential of their contracts. This rule reflects an underlying general principle that communications with consumers should in all cases be clear, fair and not misleading. We shall be contacting selected firms over the next few months to review how they are complying with these regulatory requirements.

ENDS

Notes for editors

1. Firms prepare illustrations (projections) to give investors an indication of what they might get back from their investment over the long-term and the effect of charges on that return. The two main components of that return are the underlying growth in the investments themselves and the firms charges. The projection rates that the regulator sets are the maximum rate of underlying investment growth that a firm may assume when preparing its illustrations. The regulator sets three rates, a central rate and two flanking rates, one 2% lower and the other 2% higher than the central rate. The higher rate is the maximum rate that may be used but the lower flanking rate is not a floor if the investment potential of a particular product points to use of a lower rate.

2. The FSA appointed PricewaterhouseCoopers to provide an opinion of the expected future rates of return for different classes of investment and an indication of the range of variability of the annualised total returns.

3. Peer reviewers appointed by the FSA reviewed the analysis and the conclusions drawn up in the report. This comprised Martin Weale (Director, National Institute of Economic and Social Research) Professor David Miles (Imperial College) and Andrew Claringbold (Principal and Actuary, Aon). The panel is in broad agreement with the opinions reached by PwC and their comments are published in the same volumes as the report.

4. The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection of consumers; and fighting financial crime.

5. The FSA aims to maintain efficient, orderly and clean financial markets and help retail consumers achieve a fair deal.