NAPF Investment Conference
17 March 2004
Speech by John Tiner

Introduction

I am delighted to be here today to give a keynote address at the opening of your conference. There is a lot going on in the Pensions and Investment Management markets and today I thought I would cover, briefly, five of the current issues: The Pensions Bill; Investment Projection Rates; soft commissions and the bundling of research; market timing and late trading; and finally, unlocking pensions.

But, first, a word on the financial scene in Scotland, one of the top 10 European centres for banking, life and pensions and investment management. The industry here has continued to thrive contributing roughly 8% of GDP and providing one in ten jobs, either directly or through support activities. Scottish-based life assurance offices have around £250 billion of funds under management. Growth in the financial services sector between 1998 and 2003 averaged 8%, compared with 2.4% in the economy as a whole. Of course the banking industry hosts two of the market leaders, not just in the UK, but at a global level as well. And there is an extensive network of advisers throughout Scotland, meeting the financial advisory needs of the public. So there is much to be proud of in the development of the financial services industry here.

A word, too, on mutuals as this has become a topical issue – not least in Scotland. The stakeholder structure of any business is entirely a matter for its Board and its members. Both mutual and proprietary structures co-exist in the landscape of the financial services market and I am sure this enhances the choices available to consumers. The FSA has a statutory obligation to have regard to competition and innovation in all its work, and I believe that the diversity of choice that mutuals bring is consistent with these principles. At the same time, it's clear that many life assurers – especially those heavily involved in selling smoothed with-profits policies – need considerable capital to back their business. And that a mutual has a different, and sometimes more limited, range of choice as to how to respond to any capital shortfall.

At the FSA we have to satisfy ourselves that all regulated firms, including mutuals, meet their regulatory obligations and will continue to do so. Over the years we have seen quite a number of mutuals who have decided to propose an alternative structure to their members, and our concern has been to ensure that it has considered its policyholders' interests properly, and that the mutual will treat its customers fairly during any demutualisation process and that – if there are any potential conflicts of interest within the executive or board – these are properly handled.

Pensions Bill

I turn now to the first of my five main headings: pensions. The world of pensions never seems to stand still. It’s constantly changing – no more so than at the current time - and presents challenges and opportunities for the pensions industry and regulators on a regular basis. But more importantly, it presents challenges for consumers. The new Pensions Bill and the simplification of the pensions tax regime mean radical and welcome change that we will all have to get to grips with. The changes put even more emphasis on the need for consumers to take advice or increasingly to make their own well informed decisions. So consumers will need to understand what the changes mean for them. We have highlighted this in two recent documents – our Financial Risk Outlook for 2004 and our Business Plan for 2004/2005.

On the specific proposals in the Pensions Bill, we welcome the proposal to create a new pensions regulator that will adopt a pro active role and a risk based approach in supervising workplace pensions. The FSA has shared its own risk based experience with DWP and Opra and is co operating fully in building the new regulator. Going forward, it will be important that the respective regulatory responsibilities of the FSA and the new regulator are clearly understood by both the pensions industry and consumers, as well, of course, by the two regulatory bodies themselves. We will continue to work closely with the new regulator to ensure this happens.

The other main plank of the Pensions Bill is the creation of a Pensions Protection Fund. This has few direct implications for the FSA, and I do not propose to say much about it. As a regulator, we do of course welcome measures to increase consumer protection and so we will be interested in the Fund as it develops.

The Government's proposals on Informed Choices for Working and Saving have rightly emphasised the importance of the workplace in encouraging employees to buy financial services products, whether pensions or other investment and savings products. The Government is assessing the best ways of using the workplace to promote pensions through a pilot exercise scheduled for later this year. The FSA is helping the DWP to develop the Employer Pack to be used in this pilot. And we have provided further assistance and support for the Government's plans through the Employer Task Force on pensions and its Advisory Group.

Our research into the effectiveness of our regime for regulating Stakeholder pensions has shown that employers have a key role in getting the pensions message across to employees. However, we know that employers are not entirely confident about promoting personal pensions or Stakeholder pensions to their employees for fear of breaching the Financial Services and Markets Act. That's why we published, in April 2002, an updated guidance note for employers, setting out what they can do, and how they can do it without exposing themselves to regulatory risk.

We drew attention to the constraints which our legislation places on employers who wish to promote the benefits of their own pension arrangements. We suggested that the solution might lie in amending the Financial Promotion Order, and I am glad to see from recent Government announcements that this looks likely to happen.

As well as the Pensions Bill and all that goes with it, there are the Government’s proposals to simplify and rationalise the pensions tax regime. The proposals mark a radical and welcome simplification of the various existing pensions tax regimes. Simplification has the potential to benefit both consumers and the pensions industry.

But this very day, in his Budget Speech in London, Gordon Brown has signalled his decision on the way forward . So much further comment from me this afternoon is rather beside the point. I should just say, however, that radical change is bound to bring with it one or two wrinkles that a regulator needs to watch out for. Removal of the link between the time of leaving employment and drawing an occupational pension would give consumers welcome flexibility. However, we are alive to the fact that the associated proposal to raise from 50 to 55 the earliest age at which pension benefits can be drawn might lead advisers to encourage pension scheme members of a certain age to bring forward their retirement, possibly to their disadvantage. We have already updated the "Consumer Help" part of our website to draw attention to the proposed change and the need for consumers to factor this into their retirement planning.

And some people may be persuaded to take action to avoid tax penalties on surplus pension funds in excess of any lifetime limit. For example, people may be tempted to retire prematurely, perhaps switching into income drawdown contracts immediately before the proposed tax rules take effect. Firms will need to be sure that their advice in this area is of a high standard.

Whatever the shape of the tax changes, there is no doubt of the growing need for consumers to plan for their own financial futures, especially to plan for their retirement. For our part, we will need to reflect the new tax regime and the Pensions Bill in our consumer literature and the information on our consumer website. Retirement planning and retirement saving will also be a key consideration as we take forward our longer-term initiative to improve financial capability so that consumers have the education, information and generic advice they need to make their financial decisions with confidence.

Projection rates

We decided last year that we would carry out a fundamental review of the framework under which we prescribe the rates of return for the illustration of potential returns from pensions and other packaged products. The rules we have now were carried over from the previous regulatory regimes. They are relatively crudely structured and rely on the FSA specifying fixed annual rates of return, based on a broad brush view of asset mix and pay little attention to particular consumers' time horizons.

Last year we went through an exercise to review the rates and other assumptions that we set out in our rules. We decided not to change the rates; but, in reviewing the work that had been done to get to that point I began to ask myself why we were doing it in the first place. Why are we, the FSA, telling firms how to portray potential performance of their products? What market knowledge do we have that others don't and what if anything do consumers do with the information?

So, I wonder why we are intervening in such a detailed and prescriptive way in matters that firms should be better placed to deal with. On the other hand the genesis of the regulator's involvement in this area tracks back to the late 1980's, when the SRO's of the time found that firms were unjustly inflating rates in illustrations, creating false expectations among investors. But life has moved on since those days and I am keen we consider this issue by going back to first principles.

The FSA need intervene in firms' affairs in such a detailed way only when this is clearly necessary. A market failure analysis approach will help us decide whether rules like these are helpful or just an unnecessary complication. In other words: does regulation here add value?

There are some broad options. We cannot discount the extreme option of prohibiting projections altogether. If giving consumers this extra information does not lead to better decision-making then from the regulator's perspective it has very little value. Similarly, there is no point in the FSA telling firms how to go about providing an illustration, if just leaving firms to get on with it would lead to exactly the same volumes of money going into the same products.

Of course, matters are not as simple as that. One size fits all rates do not take sufficient account of key variables such as asset mix, which as we have observed can change materially in the space of a year or two. But consumers need some idea of how much they should be saving towards retirement and what sort of pension they might have built up. So, before proposing to delete parts of our Handbook, or telling firms to do things differently, we need to have a debate about the basic issues. So far, we have carried this on informally with some of the key players. We will shortly move into more public mode and look to publish a Discussion Paper in June on what we see as the key issues and challenges. Our minds are open and we look forward to some creative ideas emerging from this consultation.

Soft commissions and the bundling of research

One of our other more controversial initiatives over the last twelve months has been our proposal to reform the way in which soft commission and bundled brokerage arrangements operate in the UK market. Since our consultation ended in October, we've been analysing responses, and engaging in extensive discussions with firms and their trade bodies, including the NAPF. We are now reaching the final stages of our deliberations and decision-making process and, as the FT reported this morning, I shall be taking a set of proposals to my Board tomorrow. But I would like to recap why we are looking into this difficult subject, talk about how we think it affects pension funds and to give you some insight into our thinking at this stage.

As we said in our consultation paper – CP 176 – we don't think that soft commissions and bundled brokerage operate in the best interests of investors, such as pension scheme trustees. Customers are not getting enough information about how much of their money is spent on commission, and what services the fund manager gets in return.

We need to improve transparency and accountability in the fund management sector, so that trustees can exercise effective scrutiny over how the scheme’s money is spent and can have a better dialogue with their fund manager about how costs are managed.

We had nearly 150 responses to CP 176 from a very diverse range of respondents who – not surprisingly – had equally diverse and often conflicting views. However, there does seem to be a consensus that softing and bundling lack transparency with regard to costs, and that fund managers have not been properly accountable to their clients in the past. But there is less consensus on how to solve these problems. In CP176 we said that it is difficult to see a case for preserving the practice of softing goods and services not linked directly to trade execution. Responses to consultation, together with our discussions and subsequent analysis suggest, however, that the softing and bundling of investment research has a different set of considerations attached to it.

Many respondents felt that market-driven initiatives can deliver the necessary transparency and accountability. They urged us to allow time for the voluntary Disclosure Code developed by NAPF and IMA to become fully operational, and to consider enhancements to the Code as an alternative solution to the CP176 proposals.

Whatever solutions we adopt, we will promote greater transparency of fund management costs. We have had discussions with NAPF and IMA about the possibility of enhancing the Code to provide comparative disclosure of those costs. The basic idea would be to show, on a fund by fund basis, the breakdown of commission payments between the costs of execution and the costs of additional non-execution services, principally investment research.

That kind of approach could be promising in providing a basis for establishing market prices for investment research from both brokers and independent providers. That in turn could drive more efficient research purchasing decisions by fund managers, over time. However, disclosure by itself would not necessarily address all the conflicts of interest we identified in CP176. That is a point the NAPF have registered strongly with us. A crucial issue is how far trustees and their advisers could – or would – use the extra information to challenge their fund managers to exercise greater discipline, to ensure they get good value for money in the services they buy on behalf of their clients.

Our consumer protection objective requires us to consider whether investors have accurate information that meets their needs. However, that must be balanced against the general principle that consumers should take responsibility for their decisions. The next phase of consultation will give you the chance to help us reach a proportionate and broadly supported outcome.

Market timing and late trading

You will need no reminding that this is another aspect of fund management to which we have been giving close attention through recent months. Towards the end of last year, we undertook a review to determine whether the types of abuses uncovered in mutual funds in the US were a significant problem here, specifically in FSA-authorised Collective Investment Schemes. Our focus was on the activities of market professionals, who identify and exploit arbitrage opportunities but have no interest in long term asset holdings. Short-term trading in funds by such players can create dilution for continuing investors. Such investors can include pension funds as well as private individuals. Whether there is a problem in practice depends largely on the vigilance of fund managers and the effectiveness of their controls.

Let me deal first of all with late trading. This is the wholly unacceptable practice of permitting a customer to enter an order, or withdraw an existing order, after a fund's valuation point. In this scenario the customer is allowed to trade in a way which profits him, to the clear detriment of long-term investors. We found no evidence of late trading in UK CIS, and we think that the important controls provided through our trustee and depositary structures, make UK funds less susceptible to this practice.

In our recent work we have looked too, for any evidence of market timing. This practice has market professionals trading on the basis of stale prices, again operating to the detriment of long-term holders who lose out as a result of the dilution of the fund. An example of this is where an investor is able to buy exposure to US assets through a UK-based fund at noon today at prices based on yesterday's New York close. There will clearly be advantages in doing this if subsequent economic news has made it a virtual certainty that the prices of the underlying assets – and hence of the units – will increase at the next valuation point for the fund. Market timers don't need to be using any non-public information to do this, and they're not breaching any of our rules by 'timing'. However, we believe this activity is capable of causing real detriment – which is why we feel strongly that fund managers must ensure it doesn't happen.

Our review of fund managers' practice has been quite extensive. We have information from the 31 firms in our sample, 25 of whom we have visited. These firms account for about £160bn of funds under management, or around three quarters of the authorised Collective Investment Scheme industry in the UK. And we have generally been pleased with the level of co-operation we have received from the firms involved. We found some evidence of market timing in UK authorised CIS, but no evidence that market timing is widespread or that it has been a major source of detriment to long-term investors. We will publish a statement tomorrow that goes into a little more detail.

At the root of these issues is how fund managers deal with conflicts of interest. Open-ended funds are a feature of our industry, but in running them fund managers need to be aware of the potential for market timers to make profits at the expense of long-term investors. Fund managers need to monitor the activity in their funds so that they can manage the effect on their funds. They need to ensure that potential conflicts of interest are identified and are managed in accordance with our Principles-based regime. In particular, fund managers need to balance carefully the financial rewards resulting from increasing the amount of funds under management against potential dilution if trading occurs on a significant scale. We will increasingly be looking to fund managers to demonstrate to us - and their investors - that any potential conflicts have been managed effectively.

Unlocking pensions

I would like to end where I began – with pensions. A small number of firms have been actively encouraging consumers to "unlock" their benefits in occupational pension schemes through aggressive and unbalanced advertising and without adequate knowledge of the consumer's financial and personal circumstances.

So what is unlocking? "Unlocking your pension" is marketing jargon for taking your pension benefits before your retirement age. Members of occupational pension schemes can transfer their benefits to a personal or stakeholder pension plan – usually in order to get hold of an immediate, tax free, lump sum.

The downside is that consumers will lose out on investment growth between unlocking and their retirement date – so their pension will be smaller but will have to last longer! To make matters worse, some firms have been targeting vulnerable consumers, such as people struggling to service debt, without making them fully aware of the long-term implications.

Some firms were also purporting to act as IFAs but in many cases were restricting their advice to one product and not considering other products or, indeed, other aspects of pension planning. Too often, the firms were giving little, if any, consideration to possible alternative ways of raising funds such as loans or re-mortgaging.

We therefore published a consumer alert on our Website outlining the risks attached to unlocking pensions. We backed this up by press coverage and appearances on TV.

Going forward, we have worked with firms to get them to improve their sales practices. We have also made firms identify – and pay compensation to – consumers who have been disadvantaged by inappropriate advice.

In addition, we have taken disciplinary action against firms whose failings show a blatant disregard for consumers' interests. In February we fined one firm £ 175,000, for misleading advertising and inappropriate advice. That firm has also set aside £ 1 million to cover compensation costs and the costs of the review.

We have also been actively searching for misleading advertisements. Where we have concerns, we make the firm withdraw or amend their adverts. In February we hosted a seminar for Senior Management of firms in this market with the specific aim of improving the content of 'Financial Promotions'. We have also produced a factsheet for firms that have had to amend their Financial Promotional material to send to consumers until the firm has fully amended the material. We shall not hesitate to take disciplinary action against any firm that we find is producing misleading material.

Conclusion

As you can see, it's another busy year and next year will be too. However, our new organisational structure, which comes into effect in April, will help us become an organisation which is focused on delivery and which firms, consumers and others find it easy to do business with.

But our approach to those management challenges is perhaps a subject for another day.

Through these remarks this afternoon I have touched on just a cross-section of our current policy and supervision work relevant to pension funds and to the fund management industry. Investment conditions and securities markets throw up challenges enough for long-term investors. From the regulator, we look to set clear requirements on the rules of the game so as to promote clean and efficient markets. That way all of you in this hall should be better placed to discharge your crucial responsibilities.

Thank you.

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