The retail financial advice market - a regulatory perspective
Speech by Clive Briault, Managing Director, Retail Markets
Money Marketing Live
5 May 2005
Thank you for the invitation to give the opening address at your annual Money Marketing Live event. You have put together an excellent programme that reflects the many important issues facing the retail financial advice market. So at the end of the election campaign I ask you this morning “are you thinking what we are thinking?” about this market; and I suggest that when we look “forward not back” we focus on “putting forward real solutions”.
Financial advice is critical to our society for a number of reasons.
First, advice plays an important role in ensuring that consumers have expert help in making a complex range of choices on important financial decisions. Consumers are being required to take greater responsibility for financial decisions, as income and wealth increase; as state provision is rolled back or fails to keep up with the increasing demands and expectations placed on it (and a recent OECD report ranks Britain's state pension as one of the lowest among the richest nations); as occupational pension schemes switch from defined benefit to defined contribution arrangements; and as - on average - we live for longer.
Alongside these challenges consumers have needed to adjust to a low inflation environment, and many need to take some very difficult personal financial decisions. For example, whether to contract in or out of the State Second Pension, how to make provision for their retirement, what to do if they end up with a shortfall on their mortgage endowment, whether to surrender poor-performing with profits funds, how to manage rising levels of consumer debt, and whether to repay a mortgage ahead of schedule.
Second, financial advice is also hugely important in practice. Yours is a substantial industry. Nearly 5,000 firms of all sizes provide independent financial advice as their primary activity, including 40 networks with 6,700 Appointed Representatives. The 30,000 financial advisers are generating over £3 billion a year in new business premiums. This is a diverse industry which plays an important part in local economies and is a source of healthy competition in the overall market for retail financial advice.
Third, a number of recent studies have suggested that many individuals are not investing enough for their retirement. Estimates of this gap range from 0 to 60, in billions of pounds. And many who are saving and investing might be able to do so more effectively if they took professional advice. So there is plenty of scope for the advice market to expand significantly. The challenge here for you as providers of advice is to demonstrate to more consumers that there is value to them in paying for your services.
No doubt I am preaching to the converted in stating the importance of what you do.
What do we want the advice market to provide?
Having acknowledged the vital importance of retail financial advice, it is helpful to take a step back and consider what outcomes we are looking to see. What would a well performing retail financial advice market deliver?
The FSA's three strategic priorities are: to promote efficient, orderly and fair markets; to help retail consumers to achieve a fair deal; and to improve our business capability and effectiveness.
Within this, our retail agenda focuses on delivering an effective and efficient retail market for financial services and products. This requires:
- Capable and confident consumers.
- Clear, simple and understandable information available for, and used by, consumers.
- Soundly managed and well capitalised firms who treat their customers fairly.
- And risk based regulation.
These components of an effective market apply as much to the market for financial advice as to any other part of the retail financial marketplace.
At the simplest level, the market should provide good quality, suitable advice to consumers. And consumers should be able to recognise when this is happening, and when it is not, and to respond accordingly.
The advice market as a whole (of which financial advisers are a part, but not all) should be healthy and sustainable, built on viable business models.
As a regulator, we do not want to prescribe how the advice market should be structured. Rather, we want to allow firms to choose what advice they provide, and to allow consumers to choose what advice they want to take and how they pay for it. And we want consumers to be able to understand the different types of advice that are available to them. We do not have any statutory requirement to ensure that there are a particular number or given size of firms offering particular services in different segments of the market.
Depolarisation will allow firms greater flexibility in developing their business models; it will provide consumers with more choice; and through the Menu it will provide greater transparency about how advice is paid for and how much it costs. From 1 June all firms will need to operate within the depolarisation rules. This means that all firms selling packaged products will need to make some changes and be ready to comply with new requirements. We want to see greater access for consumers to good value products and advice; greater clarity on what services and products are available, and at what price, for consumers seeking advice; a clear choice for consumers between paying fees or opting for commission; and more shopping around (including on the basis of costs).
State of the distribution system generally
The retail distribution market is clearly in a state of change.
There are a range of pressures at work affecting firms (both producers and distributors), consumers, and the FSA.
Despite some better results this year, product providers have faced a range of threats to their profitability in the last few years. These include weaker equity markets, reduced income, declining sales of with-profits policies and other products with relatively high charges, and the limited potential for profit from stakeholder products, to name just a few. And some have clearly been seeking – with some success – to move away from taking on “advice risk” themselves by limiting themselves to the manufacture of financial products, and to pass the advice risk on to others in the distribution chain, including in particular the IFAs. Of course this still leaves the product providers with a risk to their reputation if their products are mis-sold by others, so we would expect them to care about, and to monitor, the quality of advice given by others on their products.
IFAs and other intermediaries have faced an equally daunting range of challenges. These include having to deal with compensation costs arising from past poor advice, either in their own firms or more generally when this causes other firms to fail and to impose a cost on the rest of the industry through the Financial Services Compensation Scheme; the rising cost and limited scope of professional indemnity insurance; and sluggish demand for investment products in weak markets and where consumers have low levels of confidence. There are also questions about the sustainability of a large number of firms looking for business from a relatively small pool of customers, at least unless more consumers choose to take financial advice.
In response to these market pressures, we are seeing a range of different corporate structures and strategies emerging. Very broadly, in a market where most investment products need to be actively sold to consumers, product providers have to utilise some combination of direct marketing, third party distribution channels, or their own direct sales forces (including their own branch staff, where applicable). There has been considerable interest recently in attempts by product providers to secure distribution through the provision of financial support to networks and to IFAs intending to follow the multi-tied route, although our guidance on the provision of “golden hellos” and our insistence that any finance provided on non-commercial terms must be disclosed has restrained this approach by product providers.
Meanwhile, within the IFA community we see firms faced with choices about whether to remain independent or to become multi-tied under our new depolarisation regime. And we see a proliferation of “network” models, ranging from national IFAs at one end of the spectrum; through networks providing various combinations of compliance and other services to financial advisers; and recently at the other end of the spectrum networks seeking to distance themselves from taking on advice risk by offering a narrow range of services that avoids the need for the network itself to be a regulated firm. In all this we do not see any significant signs of consolidation.
Some commentators have suggested that we may see retail banks and other product providers becoming a greater force in the distribution of investment products, and there are some signs of the resurrection of direct sales forces from the ashes (but more on phoenixes in a moment). There are some very difficult strategic decisions for these firms to take, but they could have a considerable impact on the future of the distribution and advice markets. More large banks or product providers may decide that the way forward for them is through owning and running their own distribution channels, and that there is a viable and sustainable way of training, developing, monitoring, incentivising and controlling their staff in order to deliver advice that is both of a high quality and profitable. And the multi-tie route opened up by depolarisation may be a further important factor that encourages this. Of course this would take these firms straight into taking on advice risk, but I must say as a regulator that it would be very disappointing if our major financial services firms were unable to find a way to manage and control this risk effectively.
We have been criticised for imposing a greater regulatory burden on networks compared to directly authorised firms, and of failing to recognise the efficiencies and apparently higher standards of compliance the networks achieve. Our position here is that where networks are providing a service which includes responsibility for compliance then we would rightly expect them to meet – if not exceed – our regulatory standards. So they should expect close scrutiny. When we begin to see these higher standards operating in practice we are of course willing to recognise them and tailor our risk-based approach accordingly, including by reducing the intensity of our supervision of them.
Our primary objectives for the retail distribution system centre on the quality of advice available to consumers and the fair treatment of consumers by firms.
And since the taking of advice should be an important contribution to consumer protection, to consumer awareness of the benefits, costs and risks of financial products, and to market confidence more generally, then three of our four statutory objectives give us a strong interest in the impact of changes in market structure on the range and availability of advice.
One possible outcome of market pressures may be an increasingly stratified advice market: wealthier consumers having access to fully independent and 'whole of market' advice; a middle range of consumers using mostly multi-tied advisers; less wealthy consumers having access mostly to Basic Advice on Stakeholder products; and the most basic level being access to generic or workplace type advice. But this is by no means the only possible outcome. Indeed, it is up to each provider of advice to decide what represents for them an attractive and economic proposition, and for consumers to determine what advice they want to take. The market for each type of advice could be very different in years to come as these choices are played out.
Our own work on financial capability also has a role to play here. We, in partnership with others, have acknowledged and are attempting to tackle the current low levels of financial capability in the population as a whole, but this will take time to improve. This lack of understanding relates not just to products – which are often complicated, either inherently or because they are designed this way – but also to a lack of understanding of risk and the risk/reward trade off, and to the availability and benefits of advice. So one of the workstreams supporting the financial capability strategy is focussing on generic advice and the role that it could play within the overall provision of advice.
But there is a real risk that we end up with serious gaps in the provision of advice, with some consumers having no access to affordable financial advice. Some gaps already exist, but shifts in market structures could make the situation worse. Indeed, this is something that I am constantly reminded of when we at the FSA, or those in the media or in the financial services industry, recommend to consumers that they 'seek independent advice', without always fully considering if the market is willing and able to deliver this service.
What do we find in practice?
I turn next from market structure to what we observe from our work in regulating the retail distribution sector. It is a mixed picture.
Let me be clear at the outset that we do see many examples of well managed firms. When we visit firms we find the majority are making every effort to comply with our rules, and are keen to try to do things properly. We see firms who genuinely believe it is in their business interests to develop effective, long-term relationships with their customers, based on trust and fair treatment. And generally we have seen better standards of advice, better persistency rates, lower complaint rates, and higher quality staff among IFAs than among tied advisers.
Of course we deliberately focus our supervision and other monitoring efforts on problem areas and higher risk firms, so where we have negative perceptions of the sector this often arises from a less than fully representative sample. But our regulatory experience does nevertheless suggest that among some firms there are significant shortfalls against the standards set out in our rules and guidance, and that we would expect all firms to observe.
I begin with the quality of advice given to consumers. This is difficult to measure, and we would be the first to agree that this is not always capable of being assessed in black and white terms. There may not be any single right answer for what a consumer should do. Equally, however, it is often reasonably clear – and sometimes only too obvious – that a consumer is being advised to make an investment that is unsuitable for him or her, or where an inadequate attempt has been made to assess a consumer’s circumstances and risk appetite or to explain why a particular recommendation is suitable for that consumer.
For example, as (an incidental) part of our research on the filtering/sales process for the Sandler simplified products, we asked consumers not only to follow through a mock Basic Advice interview but also to complete a full financial fact find that was given to a fully qualified adviser. The results from these two processes were then compared with a benchmark derived from a computerised planning tool. Overall, 11% of product recommendations – and 18% of pension recommendations - made by the financial advisers in this sample through the full fact find were deemed to be “bad” outcomes, and this was a significantly higher proportion of such outcomes than were generated from the Basic Advice route. This is worrying, even if the results must be treated with some caution because the research did not seek to capture all the checks and balances that would be present in a real advice process.
The recent ABI report on commission also found that in a mystery shopping exercise based on a scenario where consumers had credit card debts, and where good advice would include the need to repay these debts, in 22% of cases for commission based IFAs and 15% for tied advisers, the consumers were not advised to pay off these debts as a priority. And the reported figures contain no information on how many advisers even considered the possible advantages to consumers of also paying off some of their mortgage. This is also a rare example of IFAs performing less well than tied advisers.
There have also been many other “mystery shopping” exercises undertaken by consumer organisations and the media, which have found worryingly large incidences of poor advice. These all tend to be based on very small samples, but the similarity of the results each time cannot easily be explained away.
We also see low standards of competence in some firms. At one firm recently we saw an individual who appeared to pay no regard to his customers' attitudes towards risk. When questioned about his treatment of a cautious investor's portfolio the individual replied that a portfolio could not be structured to reflect a cautious outlook and that he "didn't believe in it – what I might buy one day may not be what I'd buy another". The same firm had no training and competence procedures and only conducted yearly reviews. The firm was therefore unable to monitor the activities of their advisers and there are no records to determine their competency. Remedial action is being taken at our insistence.
Our work – whether on individual firms or on projects across the sector as a whole – also suggests that poor advice and mis-selling is by no means a thing of the past. Those past episodes will be familiar to you – the widespread problems with personal pensions, mortgage endowments and precipice bonds. Other examples are more recent.
We announced in March that we had been looking closely at Venture Capital Trusts (VCTs) – we saw an increase in activity in this market early this year, and indications that these products are no longer being aimed solely at high net worth individuals and that much less wealthy individuals were being targeted. Following our alert to the industry we are now aiming to establish a more detailed picture of the market, including data on what types of customers are investing in VCTs and through which distribution channels.
In the next few weeks we will publish the findings from work we have been undertaking on equity release and on income withdrawal from pension pots. Early indications from both projects suggest that here too, there has been some poor quality advice on what are very complex products.
For example, on equity release, we have seen consumers being advised to release more equity than needed and then to invest this capital in products such as with-profits bonds – so borrowing at high rates, and then paying high commission for very uncertain returns.
On income withdrawal we have seen consumers with relatively small pension pots (less than £100k) being advised to take out lump sums, and paying high charges without understanding fully the impact of this on their pensions. Indeed, this may only become clear to them when they receive their next pension statement.
It is also not clear to us that all of you stress test your advice and recommendations to consumers against a range of scenarios and possible changes in circumstance, either on a macro-economic basis (eg changes in the economy, interest rates, taxation etc) or micro-economic basis (eg changes to the individual's employment status, risk appetite etc).
We are absolutely not saying here that all IFAs have been giving poor advice. And we have been encouraged by finding some potentially-higher risk products (for example property funds) on which standards of advice and understanding seem good. But it is certainly interesting to observe that in each episode of mis-selling we see a polarised situation in which some advisers are pushing complex and risky products strongly while others are closer to the “I would not touch this with a bargepole” position.
We also see some examples of poorly managed and operated firms. This includes inappropriate governance structures (for example medium-sized advisory groups with no Chairman and inadequate NEDs); a lack of strategic direction; an absence of management information to support decision making; and poor systems and controls. A recent set of visits to 25 small firms in one area of the country revealed that almost all the firms had issues, for example in relation to record-keeping, provision of suitability letters and the charging of fees or commission. In four of these firms we judged that the failings in relation to the operation of their business put customers at serious risk.
The lack of strategic direction is supported by evidence from our risk assessment process, where strategy - or rather the absence of it - was the most frequently occurring risk we identified among retail investment advice firms in the last two years. And half of the attendees at our recent Retail Intermediaries sector conference quoted this as the most important issue they face.
We see firms with weak financial positions and inadequate capital resources, often because the directors have removed capital from the firm in the form of remuneration. This means there is little money in the pot for when things go wrong.
As a result of these various fundamental weaknesses we regularly see firms failing, or having to be supported by loans from product providers. And with the increasing numbers of failing firms come greater calls on the Financial Services Compensation Scheme and higher levies, creating the potential for a real downward spiral. This has an adverse knock-on impact on those among you who are doing the right thing.
And of course we see so-called 'phoenix' firms, those which seek to disappear then re-establish themselves without meeting their liabilities to customers from previous enterprises.
In one example, a firm had ceased trading and had applied to resign as it had considerable exposure to a collapsed fund in which it had been advising clients to invest. During our investigation it was discovered that the directors of the controlling firm had been buying small firms and then stripping out the assets and transferring the advisers, leaving a dormant firm with liabilities and no way of meeting these liabilities. The controlling firm, which is also regulated by the FSA, is now being investigated by us.
We have taken decisive action to tackle the question of phoenix firms. Our standard practice now is to ask directors to sign undertakings to honour the liabilities in relation to customer claims on their previous business; to encourage firms to 'ring fence' funds to be held by the departing firm to meet any further potential liabilities thus avoiding future claims; to refuse the application for authorisation of the new business where the directors of the departing firm will not make reasonable arrangements for claims arising out of their previous business; and, as a last resort, to refer individuals to Enforcement where their actions have actively disadvantaged customers. We have successfully thwarted twelve attempts at phoenixing in the last year.
More generally, we take enforcement action where appropriate. For example, over the last three and a half years one quarter of the 60 or so enforcement fines we have levied have been on IFAs/financial advisers, whether for mis-selling, misleading financial promotions, or other issues such as inadequate internal systems and controls.
In addition, we have a team dedicated to taking action against firms that do not meet the basic standards needed to carry out the activities for which they have sought authorisation – our so-called "Threshold Conditions". In the last year, 30 firms have had their permission to conduct investment business cancelled, and a further 120 have taken remedial steps to address breaches of the threshold conditions. Some of these breaches related to lack of adequate resources (including PII and financial resources) and failures to comply with Ombudsman awards, non-cooperation with the FSA and non-payment of our fees.
The last ten minutes may have sounded like the Icelandic weather forecast in the middle of the winter, but as I said at the outset, this is because as regulators we do tend to focus on the issues and areas where we see things going wrong.
So what do we want to see change?
I mentioned our Treating Customers Fairly (TCF) initiative earlier – it is one of the four key pillars of our retail agenda.
Much of our Treating Customers Fairly work so far has been focused on larger firms and predominantly those manufacturing products so it is understandable that small firms, including IFAs, find it more difficult to understand what we are expecting them to do. We are planning to do more work looking at the implications of TCF by sector and for smaller firms which we hope will be helpful to you. We continue dialogue with the industry – both individual firms and trade associations: AIFA are members of our TCF consultative group, and AMI have issued a TCF briefing note.
Ultimately it is the responsibility of the senior management of your firms to ensure that you comply with our high level principles, but perhaps I can give a few practical suggestions of what we mean that are relevant to the IFA community.
First, how do you incentivise and reward your staff? Clearly things like bonuses and commissions influence the way your staff behave - that is what they are meant to do - but have you thought what risks that creates for customers and what you could do to control those risks? Is there a conflict of interest here, that needs to be managed carefully, so that it is clearly demonstrable that you are working in the best interests of your customers? To what extent do you have in place any payments that depend on the quality of advice given, on customer satisfaction, and on establishing a long term relationship with your customers? Do you have systems that enable you to measure such outcomes?
The current commission structure is confusing and complex, creating a range of perverse incentives and potential risks, including commission-driven sales, churning and trail commission. But research suggests that most consumers tend to prefer commission. This may be a cheaper way of funding lower value transactions than fees (although consumers do tend to attach less 'value' to a service which they don't feel they are paying for). And we note the recent research undertaken for the ABI that concludes that commission bias may be not be as large a problem in practice as it is often deemed to be in principle.
I would hope that since you have a high level obligation to offer suitable advice, as well as a common sense incentive to offer treat customers fairly and offer good service, the issue of commission ought to be secondary, although I doubt that this can be relied upon in all cases.
Second, how well do you understand the products on which you are advising? I should say at the outset here that we regard it as a responsibility of product providers to consider, when designing their products, which consumers the product is likely to be suitable for, and equally important which consumers it is not likely to be suitable for. And providers should then pass this information on to their distribution channels, as well as explain clearly the risks as well as the opportunities that their products offer. This should help you as advisers to understand these risks and to tailor your advice accordingly.
But this does not remove your responsibility as advisers to understand the products on which you are advising. And to understand the wider contexts such as tax and state provisions.
Stating that you need to understand the products on which you advise may seem a statement of the obvious. But let me give you an example – an IFA attended our annual public meeting last year and asked whether he was seriously expected to understand the with profits products he had been advising on for the last ten years.
We have also done some work on the Principles and Practices for Financial Management (PPFM) documents issued by with profit funds which suggests that IFAs are failing to use these documents. PPFMs were introduced in April 2004. And while it is clear that they provide a valuable governance discipline - purely in terms of requiring life insurers to set out how they run their with-profits books of business - it is less clear that these documents have fulfilled their secondary function: to inform the advisory community. The results of some thematic work we carried out in 2004 indicated that for whatever reason, not enough of you are using these document to direct product recommendations. This situation must be addressed and we are working with AIFA to identify ways in which to do this.
Third, do you handle complaints fairly? Have you thought whether you could improve your processes to deliver a better outcome for your clients, for example by speaking to them to be clear you have understood what they are unhappy about? Do you learn from complaints? I imagine many of your firms will have had complaints over the last few years about poor investment performance. Some of those cannot be helped, but have you looked back at the way you explained products and the risks associated with them to see if the risks were explained as well as they might have been?
Fourth, we need to see a more robust approach to the provision of capital across the sector. Again, much of the solution lies in your own hands, by ensuring that sufficient capital is kept in the business to enable a reasonable amount of claims against your firms to be met if the need should arise. Our own capital requirements are not risk-sensitive in this way, but clearly one option would be for us to develop a back-book related capital charge.
Meanwhile, the PII market is generally easier than it has been for a while, although we still hear of some firms experiencing problems. Our experience is that firms which have good systems and controls, clear business models, are financially sound and have senior management that take risk seriously should find it easier to obtain cover that meets their needs.
Some additional TCF considerations include: the training and competence of your staff; the need to determine your customers' needs; to explain risks clearly and ensure as far as possible customers understand the advice they are given; the importance of good record keeping; and being clear what post sale service will be provided, including communications and future reviews.
What do we do about it?
A fair question in response to all this is to ask what have we the FSA done and what are we doing to work with you to help to tackle this range of issues, problems and risks?
First, we continue to manage the 'perimeter' between authorised and unauthorised firms. We carry out rigorous checks on firms and individuals seeking authorisation and we actively manage out, or remove, firms which do not meet the threshold conditions.
And this year we have been undertaking proactive work to enforce the perimeter of the new mortgage and general insurance regime. We are announcing today that we have visited almost 500 mortgage advisory firms, finding 11 firms whose business required them to be authorised by us but who had not applied. Seven of those have now applied for authorisation and the remaining four have stopped undertaking regulated activities. We are moving on next to general insurance intermediaries.
Second, we make policy and set the rules which regulated firms are required to comply with. We understand that the burden of regulation can be heavy, particularly for smaller firms. We are taking this issue seriously. We have work in hand to simplify the COB Sourcebook, we have produced a tailored Handbook for retail intermediaries, and we are doing work to understand more accurately the cost of regulation. Here we are actively looking to involve small firms, where costs are a particular concern.
Third, we adopt a risk-based approach to supervision: we will focus our resources on the higher risk firms/groups while minimising the regulatory burden for the lower-risk firms/groups. A good example is the issue of Client Money where we have identified a problem, developed a pragmatic solution, and will be working with the industry over the coming months to find practical solutions and new ways of working that will keep firms outside the scope of the Markets in Financial Instruments Directive (MiFID).
Fourth, we provide extensive industry training and support, including workshops on topical issues such as depolarisation and sector newsletters (the latest edition published in mid-April).
We have a dedicated Retail Intermediaries sector team for the investments side, and this will soon be extended to cover mortgage and general insurance.
We also recognise that we have more to do in deepening our understanding of the issues you face. We are recruiting more staff with industry experience, and for our existing staff we have put in place a series of secondments and shadowing of financial advisers by FSA staff.
Finally, for small firms we have, or are putting in place, a range of initiatives to make us easier to do business with. These include: the firms online system – a web-based tool for submitting secure applications and notifications to us (it is very important that you are registered to used this system); a programme of geographical Roadshows around the country – opportunities for us to make you aware of key issues and risks and a chance for you to ask questions; a major programme of improvements to the small firms section of our website, starting with a survey that we emailed to you today; and we announced this week that we are negotiating a way for you to be able to pay your FSA, FOS and FSCS fees and levies in instalments.
Conclusions
I hope I have managed to convey a little of the scale of the changes and challenges that face the retail financial advice market today.
These are difficult but exciting times and we see massive opportunities for you as financial advisers to shape the future of your industry and the services you provide. You play an increasingly important role in the financial health of our society. It is for you to decide where you really want to be, and to determine your own destiny. There is clearly more for some of you to do, including effective implementation of depolarisation and making the Treating Customer Fairly principle a reality and a core part of your business. We will continue to work together with you towards what I believe are our common goals.
Thank you for your attention.