Developments in the Retail Financial Services Market
Speech by Dan Waters, Asset Management Sector Leader, FSA (given by Bruce Robson)
at the PIMA Conference
1 November 2006
Introduction
Good afternoon ladies and gentlemen. It is my privilege to be addressing you today amongst such a distinguished group of speakers.
There are many topics which I could speak about today, but I will focus my talk principally on the FSA's view of the general state of the market for the distribution of savings and investment products in the UK – its underlying problems, and some thoughts on initiatives we and the industry are undertaking to try to rectify the situation. I will also share some thoughts with you on the FSA’s developing views on platforms - often referred to as wrap platforms - and discuss our current regulatory stance in respect of them.
The State of the Retail Distribution of Savings and Investment Products
In September at the Gleneagles Savings and Pensions Industry Leaders' Summit, Callum McCarthy, the FSA chairman delivered a speech entitled "Is the present business model bust?". He analysed the state of the distribution system to retail customers for savings and investment products, focusing on its effects on the principal participants in the market: product providers/manufacturers; distributors/advisers and consumers.
The analysis is in some respects extremely depressing, but it represents the FSA’s considered view of where we have got to in retail financial services in the UK. In our view, it is better to be honest with ourselves and with you about where we think the problems are, as that will enable you and us to come up with realistic proposals for improvements of the situation.
The analysis bears repetition in the context of this audience, and I will spend a few minutes laying out what Callum said. As industry participants with a keen interest in the long-term, retail savings and investment market, many of these issues will not be new to you, and will, I trust, be of significant concern.
Callum articulated 2 examples of incentive-driven behavioural change. The first dealt with the way in which mortality rates of convicts being shipped to Australia in the late 18th century, dramatically improved when shippers were paid only for convicts delivered alive, rather than convicts shipped. The second relates to the way in which door-to-door energy-market salesmen in the late 1990's were only paid commission once documentation, which had often previously been fraudulently completed, had been verified with the consumer. Both examples vividly illustrate the rather simple, but often overlooked, point that incentives matter and can change behaviour, sometimes very significantly.
Callum's basic premise is that, against a backdrop where incentives matter and can change behaviour, we have a retail distribution system for savings and investment products which does not properly serve the interests of any of the three key sets of players in the markets: the provider/manufacturers, the distributor/advisers and the end consumers. It may seem counterintuitive or paradoxical that this could be the case, yet the profound market failures that underlie the market for retail financial services create the circumstances in which just such an outcome could occur.
So let's take a look at each of the 3 key players in this situation.
What about the Provider?
From the perspective of the provider
From the perspective of the provider, the rational assumption would be that the producer of a retail financial service would wish his or her brand to be associated with qualities of reliability, trustworthiness and good performance, and to establish and develop a long-term relationship with customers. This should benefit the provider both during the times of a customer's life when he or she is accumulating wealth, but also, and increasingly in the future, in those periods when wealth is being decumulated through other financial arrangements.
If this is an accurate summary of the aim, the distribution system seems to be failing to achieve it. Where there are cases of either mis-selling or mis-buying, the frictional costs associated with such transactions will inevitably take value out from the system. In turn, this will diminish, and may eliminate entirely, returns for providers and customers. It is likely that distributors will suffer as well. Overall, the situation hinders the development of either a reputation for the industry as a whole, or a brand reputation for individual companies.
From the perspective of the consumer
The consumer does not do much better than the providers under the present remuneration model. This model suffers from product bias, provider bias and churn.
Product bias - in other words, the customer not being advised to take action consistent with their priority needs - is arguably the most detrimental. Consumers are not always advised on transactions which fail to remunerate the adviser, or which offer little by way of commission to the adviser. So, for instance, there is a shortage of advice on paying off debt or the course of action to take on With Profits policies, and national savings, investment trusts and exchange-traded funds are neglected. Provider bias is clear: we are struck by the prevalence of examples of providers managing demand up or down by adjusting commissions which can lead to less suitable or even unsuitable sales.
Linked to provider bias is churn, with the potential for significant consumer detriment from paying unnecessary commissions, charges or fees when induced to switch from one product to another; this despite the benefits of such a move (if they exist at all) only materialising after a long period during which the switch has been to the consumer's detriment. So the consumer does badly from the present business model too. Please note that I am not saying that commission as an incentive is necessarily bad – but at present it is clear that the way in which firms are managed when the commission model applies frequently fails to mitigate these high risks of inappropriate advisory and transactional activities taking place.
From the perspective of the intermediary
The belief exists that the beneficiary of the present model is the intermediary who advises on the sale. This proposition undoubtedly requires further probing. The present system, with its in-built encouragement to churn and its product and provider bias, is not one which is naturally robust to claims for mis selling, and the associated compensation liabilities. It appears that as at May 2006, the top 21 IFAs had an overall operating loss. As a result, we don't think that one should assume that the present model is good for even the intermediaries.
What can the Industry and the FSA do about this?
We believe that the solution to the problems outlined above rests principally with the industry, and I will have some thoughts in respect of that to offer today. We also acknowledge that the regulatory policies of the past twenty years may not have helped to change the underlying model for the better. Indeed one could argue that the FSA Sourcebook on Conduct of Business may reflect and cater for the distortions in the market rather than tackling the underlying problems. I am pleased to say that we have embarked on a dramatic overhaul of our Conduct of Business Sourcebook, and just yesterday published our Reforming Conduct of Business Consultation Paper, which will get rid of half of the Sourcebook and greatly simplify our requirements. But more on that in a moment.
Let me focus on three major initiatives that the FSA is taking, which we hope will have a positive impact on the difficulties we face in this market.
Financial Capability
The first is our effort on promoting financial capability. One of the fundamental problems of the retail market for financial services – for providers, distributors and consumers – is the information asymmetry between customers and those who provide and distribute financial services and products. The underlying asymmetry, which cannot ever be fully removed, is exacerbated by the often woefully deficient levels of financial capability among the UK adult population. For instance, the FSA's recent, ground-breaking, comprehensive survey, which established a baseline for the level of financial capability in the UK, found that people take on financial risks without realising it, because they struggle to choose products that truly meet their needs. When faced with an overwhelming array of complex choices, they may abdicate and rely totally on the adviser. Underlying levels of financial competence are also low - for example, from our work so far, we have discovered that 40% of people who actually own an equity ISA are not aware that its value fluctuates with stock market performance, and 15% of people who own a cash ISA think its value does. Remember too that the performance of savings and investment products may not be known for an extended period of time, and it is difficult for consumers to learn lessons about the appropriateness or not of their choices in such circumstances.
We and our partners in the national strategy for financial capability are now implementing a programme that focuses on laying firm foundations for sustainable improvement in people's financial capability across a range of groups. This work includes financial education seminars in the workplace and piloting a guide for new parents on subjects such as savings and planning ahead. But these programs are not likely to yield major improvements for some years, more than likely a decade and more in the future. What else can be done more immediately?
Treating Customers Fairly
The second major strand of work involves the FSA seeking to find ways to provide incentives to firms to develop a business model for the retail financial market which works better than the present model. There are a number of initiatives, all of which derive from the treating customers fairly (TCF) programme. We are concerned about what we have called the ‘product life cycle’. One of the elements of this cycle, for example, involves the remuneration practices which we have found in many firms which profess to have embraced the principle of TCF, but where the practice appears to run counter to the principle. Our recent thematic work on the quality of advice at financial advisers also found that:
- for non sales personnel, at and above managers, bonuses are often linked solely to growth and profit targets, unadjusted for customer issues;
- for sales personnel, there are many detailed sales commission practices which, taken in the context of overall performance management frameworks, do little to encourage and may in fact discourage the fair treatment of customers.
So we want to encourage firms to develop practices which reinforce, rather than undermine, the principle of treating customers fairly and to take steps to mitigate the risks of unsuitable advice as a result of inappropriate management of performance and reward.
Aligned with this, we are also working to establish a better recognition of the responsibilities which exist between different parts of the distribution chain, and in particular between product providers and distributors. In our recent Discussion Paper (DP 06/4) on Product Provider Responsibility which was published on 28 September, we propose some ways in which the industry might improve its practices, encouraging providers to:
- design their products with greater care;
- provide higher quality information;
- monitor distribution channels more effectively at a high level, and,
- undertake better post-sale analysis of the performance of products.
We also encourage distributors to:
- take a closer look at the information they receive from product providers, and
- satisfy themselves that specific products are suitable for specific consumers.
We believe that by promoting a TCF approach and greater interaction between producers, distributors and clients, the result will be fewer cases of unfair outcomes for consumers. It is worth mentioning here that the suitability requirements under the Markets in Financial Instruments Directive enters into force next year. MiFID (as it is universally known) specifically requires that firms take into consideration the target consumer for particular types of products, an approach that closely corresponds to the emphasis we are putting on knitting the value chain together to achieve better consumer outcomes.
Retail Distribution Review
The third major stream of work I would like to mention is the Retail Distribution Review announced by our Chief Executive John Tiner in June. With this review, we are seeking to address the root causes of the problems I have mentioned today. We need to have a better understanding of the costs and the profitability of the retail financial services distribution business, the sustainability of the current structure, and assess how far those costs are associated with regulation. This will take into account our earlier work on the costs of regulation. I don't want to prejudge the results of this wider review, but, for example, we do need to identify regulations in this sector whose costs outweigh their benefits, in which case we will seek to change them.
I digress for a moment in this context to mention our Reforming Conduct of Business CP alluded to earlier. Our aims in radically simplifying the Sourcebook (having in mind of course the relevant European requirements) are; first, to assist firms in identifying those outcomes that really matter to the regulator; and second, to provide firms more freedom and flexibility to deliver those outcomes in the context of their particular business models. The focus on outcomes underpins the entire simplification exercise, and should help firms to identify where their business models are not yielding optimal consumer outcomes or indeed leading to actual detriment. We thereby hope to address root causes of the current failure of the system, rather than obsessing about procedural niceties.
But back to the Retail Distribution Review. In approaching the Review, we are focusing on improving market efficiency as a means of achieving better levels of consumer protection. We are certainly not seeking to dictate market structures. Rather, we are keen to enable the market to identify its own solutions as far as possible, while recognising that regulatory requirements might also need to change. During the initial phase of the Review, we have been meeting relevant stakeholders, including The Treasury, some trade bodies and our Panels, to understand the issues from their perspective. We are also working closely internally with colleagues undertaking associated projects (for example on financial capability), and will use the findings and conclusions of those initiatives appropriatly.
The scope and priorities for the Retail Distribution Review will be announced in a speech by Clive Briault tomorrow, so look out for that on our website. We aim to publish the findings of the Review including any recommendations in a Discussion Paper during the second quarter of 2007.
Industry Solutions
I mentioned earlier that the solution to the 'broken' business model must lie principally with the industry. We understand that many in the industry are frustrated by what is described as the "commission stranglehold" that the advisory community enjoys, but so long as providers continue to compete over the attractiveness of their commission proposition, the fundamental flaws in the present business model will remain. Industry must take responsibility for the business model that it chooses to operate under and the implications of the attendant incentives.
Platforms
In speaking to industry leaders and tracking developments in the market for retail savings and investment distribution, we have been struck by the emergence of ‘platforms’, by which I mean “online services used by intermediaries, and sometimes their customers, to view and administer portfolios” (as described on our website). This includes a whole range of services and offerings – anything from fund supermarkets, to some life insurance company extranets, to complete wealth management platforms. It is important to map the range of these services and to consider the regulatory implications of their various forms, to ensure that our rules do not inadvertently stifle competitive and innovative developments in the market for these services. In doing so, our intention is not to pick the regulatory ‘winning model’, but instead to provide a regulatory framework in which competition, the best insurance of genuinely good consumer outcomes, flourishes.
We have picked up a growing excitement about platforms, a marked change from the sort of conversations we were hearing even 18 months ago. I also note that platforms were responsible for 75% of all ISAs sold by IFAs in the first quarter of this year . There are myriad opportunities here, and indeed some industry leaders have suggested that some of the problems with the current distribution model could be overcome by intelligent use of platform technologies and structures. For distributors, they have the potential to open up a new set of opportunities, including helping firms that want to change the way they are remunerated. For product providers, they are a potential new avenue for distribution, which might involve rethinking the way that they deal with intermediaries.
For our part, we have already started to work with different firms that are in, or thinking of entering, the platform market, to check if there are areas where we are not providing the level playing field they are looking for. This work needs to go on, and in the coming months, we will be looking for input from across the industry. We have been approached by a number of you who want to open a regulatory dialogue on the underlying issues and I say today that we are more than willing to do this.
What might portfolio platforms mean for retail distribution?
In my mind, platforms have the potential to support a range of positive features for both providers and distributors. For advisers, platforms can provide assistance in organising and administering customers' accounts; they might offer access to new tools for assessing and recording clients' needs and wants; or they could even be a means for firms to gain access to discounted - or perhaps customisable - products. Also, some platforms are currently being marketed as a tool to assist advisers in providing ongoing advice – or even discretionary management - to their clients, instead of focusing on single transactions, and the churning patterns that sometimes accompany these.
For providers, it is possible that platforms could provide a meaningful balance of incentives to distributors other than the simple use of commission incentivisation with its acknowledged shortcomings. In addition, they may enable providers to capitalise on scale advantages in portfolio administration services and middle office service functions that some advisers would find beneficial, enabling them to focus on the advice elements that are perhaps the territory where they have a natural advantage.
I am not asserting that platforms are the answer to all of the retail market distribution problems that I have referred to above. What I do believe is that platforms are one example of industry participants seeking to innovate to create new solutions to current difficulties.
The different possibilities are great – but it is not yet clear whether firms will have the imagination, or take the care, needed to assess them all. We believe the common factor between the different services on offer is that they present firms with the potential to try to improve the service that their customers receive: by improving administration of customer portfolios, information available to customers and access to products and services. Of course, whether platforms – or other developments - deliver any of this in practice will depend on all the firms in the supply chain. Intermediaries and product providers, as well as platform providers need to have a common understanding of what it is their new services are trying to achieve.
Platforms of course bring their own challenges from the point of view of consumer protection, to which I now turn.
Are platforms good for consumers?
The flip side of all this opportunity is risk to consumers. For firms that want to see it that way – or perhaps just lack the imagination to see it otherwise – platforms, or some forms of them, could be an excuse for searching out new, short-term sources of funding, without any consideration for how they are going to build value into their business in the longer term. It is depressing to read in the trade press that some firms see these platforms as a way of taking more commission without offering additional services, or even – in one recent article – a way of circumventing checks that networks put in place on their advisers.
This sort of approach shows that not all intermediaries are willing or able to think seriously about what value for consumers their businesses create, or indeed to take responsibility for their own compliance in the absence of detailed rules. I do not think it will come as a surprise to you that I want these platforms to be regulated through high-level rules, leaving firms to work out their own methods of ensuring that their customers are treated fairly when they take up services provided through a platform. The issues can become acute when we are talking about a platform that is essentially little more to the customer than a product wrapper with a new name. A cynic might say that platforms are simply a smoke screen to disguise what is just another device for taking more money off clients through the intermediation of yet another structure in the value chain. If this is the outcome that is achieved, we will be a long way from treating customers fairly through the use of these structures.
What are the current issues of regulatory concern with portfolio platforms?
As you would expect, the regulator will want to be satisfied that platforms operate in a manner that delivers the regulatory outcomes that we seek to achieve. In particular, we will want to ensure that customers are treated fairly, that adequate disclosure of material information is made, that charges and the impact of them are transparent and easy to understand, and that where advice is held out to be independent, it is in fact independent. This last issue has been a particular concern in recent months as many of you will known, so let me just say a few things about the state of play on this issue.
Platforms and adviser independence
We recently published some material on our website in response to queries from firms about how our independence rules work where advisers use platforms. In the absence of a platform structure, the rules operate in a straightforward manner. An advisory firm holding itself out as independent must look across the whole of the market for products within the product services it offers – for example pensions, unit trusts or investment bonds. Post depolarisation, they must also offer their customers the option to pay by fee. Questions have arisen in the context of platforms which offer access to only a restricted selection of products, for example, a single investment bond or single pension, with linkages to a range of underlying investments.
Some of these platforms do not offer only 'plain vanilla', competitively priced wrappers or products that are suitable for all. This can be problematic from the point of view of an advisory firm that wants to use a single platform to offer a whole-of-market service, as the structure of the platform may limit the ability to do that. In dealing with platforms, we are clear that the independence rules must still be taken into account. This means that advisers cannot assume that, if a single investment bond or pension is available on a platform, this will necessarily be appropriate for all their customers. So independent advisers will need to continue to look across the whole market to provide independent advice, and this may mean that they end up using more than one platform for their customers, or that they also need to recommend products available through other channels. Going forward, platform providers should be conscious of this when considering which products advisers are going to want to be able to access.
Overall FSA stance on portfolio platforms
As we have seen, platforms take myriad forms and each of them has different issues and challenges from the point of view of the FSA. I believe that the right thing to do is to rely on our principles and high-level rules in responding to these challenges.
We have seen some very positive examples, over recent months, of firms thinking carefully about whether and how they want to incorporate platform services into their businesses, in order to offer the best possible services to their customers that they can. I want those examples to become the norm.
Conclusion
We recognise that the view we take of the sustainability of the current retail distribution model is severe. But it is a view that we believe is increasingly widely held in the industry itself. Indeed Callum’s speech was met by a constructive rather than a defensive response by the industry, which we consider a very positive development. There are encouraging signs that industry participants, including some key players, are taking these issues seriously and looking to develop business propositions that take a long-term view of customer services and firm profitability, rather than being locked into a cycle of sub-optimal, churn-driven, product pushing, through manipulation of commission incentives to distributors.
The FSA is doing its part to encourage those developments that lead to treating customers fairly being more than a slogan; that challenge consumers to take more responsibility for their financial needs and planning, and deter firms that take the low road of short-term profits at the expense of customer value and service. It is our view that the retail financial services industry in the UK is at a crossroads. We need to take the high road, the road that leads to sustainable business models, competitive and innovative forces driving up performance and long-term benefits to consumers of financial services. I trust that working in cooperation with the industry we will be able to chart and pursue that path.
Thank you for you kind attention.