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Speech by Clive Briault, Managing Director, Retail Markets, FSA
Cazalet Consulting Conference
2 November 2006

Introduction

Today provides me with a good opportunity to announce the scope and priorities of our review of retail distribution.

So this morning I will:

• set out our initial thoughts on what the review will cover;
• explain how it fits with our other key retail priorities and initiatives; and
• set out how we would like to engage the industry in the review.

Background

We launched our review of retail distribution in June. Since then many of you have been involved in discussions with us about the areas on which we should focus. Our specific aim was to consider the root causes of the problems that have emerged in the distribution of retail investment products, and to see if they can be fixed at source. We will look at distribution by – not just advice from – banks, building societies, life insurers, fund managers, financial advisers, and platforms. Our focus is on the investment sector, but we will also consider whether there is any read-across for the mortgage and general insurance sectors.

When Callum McCarthy addressed the Gleneagles summit in September, he made some hard-hitting points about the present business model and its ability to serve the interests of the provider, intermediary, and most importantly the consumer. In particular, Callum focussed on:

• the commission structures that exist in this market;
• the resulting focus on business volume over quality;
• the likelihood therefore for product bias, provider bias and churn;
• the lack of persistency for life and pensions policies; and
• the low profitability of the sector overall.

Callum did not claim that his observations were either new or original. Indeed, judging by the response, his remarks reflect the concerns that many of you share about the way in which the retail investment market operates. It is precisely these concerns that led us to launch this review. They centre around the incentive structures that exist between and within firms; the ability of firms and consumers to recognise and to manage the inherent conflicts that arise; the apparent inability of many firms in this sector to create or retain value in their business; the indicators that some products and some advice are of poor quality; and the impact of regulation on this market.

An alternative way for me to express these concerns is to return to my roots as an economist and to consider what is likely to happen in a market in which consumers lack both the capability and the willingness to act as a strong force contributing to an efficient and effective competitive market, especially where products are complex and long-term in nature. Our recent Baseline Survey of financial capability confirms this unfortunate state of affairs.

We would then expect to find a market characterised as one in which products and services have to be actively sold rather than bought; in which the focal points for competition may not be the characteristics that are in fact those most important to consumers; and in which the incentives facing firms may not be aligned to the fair treatment of their customers. So the market may find itself stuck in a sub-optimal state of affairs, with no obvious way of breaking out of this.

And, in turn, an economist will tell you that if we begin in a third-best position then even well-intentioned regulatory intervention may have all sorts of unintended consequences and may not necessarily improve matters.

In turn, these concerns lead me to ask whether the market structure is such that it will always lead to adverse behaviour by some to the detriment of others? Is the current business model capable of change? Could that change result in a fairer and longer term relationship between firms and customers and a more sustainable business? Are the players in the market capable of coping with the inherent conflicts that exist because of the incentive structures? And does the regulatory framework really protect those it is designed to protect without stifling innovation and without restricting access to new providers, distributors, products and consumers?

These questions are not easy to answer but they are fundamental to the future of retail distribution in the UK. At the end of the day we all share the objective of delivering investment products to retail consumers in a way that meets both their needs and your commercial imperatives. We want to seize this opportunity for change and to work with you to deliver it.

It is not, and should not be, the job of a regulator to dictate business models or market solutions. But we are clear that to deliver a fair deal for consumers the market needs to operate more effectively, and that it is right for us to be one of the catalysts for achieving this.

I should also say here that we recognise that there is no shortage of alternative business models out there, many of which look more attractive than what exists at the moment. But, that said, the puzzle is why those proposing many of these alternatives have not turned their analysis into action and delivered their ideas to market. Is this because the alternatives depend upon a level of consumer awareness and understanding that we remain well short of? Or because of a “first mover” disadvantage? Or because of a preference to analyse rather to act?

The FSA's retail strategy

One question that has been asked of us since we launched the review in June, is how does this fit with our other key initiatives such as Treating Customers Fairly and financial capability?

Our aim for the retail market is to have:

• Capable and confident consumers;
• Clear, simple and understandable information provided for, and used by, consumers;
• Soundly managed and well capitalised firms who treat their customers fairly; and
• Risk-based and more principles-based regulation, through firm-specific and thematic supervision and policy.

So on the demand-side, our financial capability and disclosure initiatives aim to move consumers to a stronger position to influence the way that products and services are demanded by them and delivered to them, so that they make better informed decisions when buying financial products and services. On the supply-side, we aim to improve the quality of retail financial products and services through our focus on firms' fair treatment of their customers.

But these demand and supply side initiatives will not make a difference overnight. We have always been careful to present our financial capability work in particular as a very long term strategy. It is in this context that we look for additional measures that could enable the market to operate more efficiently. Can market forces be harnessed to work towards better outcomes for producers, distributors and consumers?

Retail Distribution Review

Since launching our review of retail distribution in June we have met with representatives of the market, principally the trade, professional and consumer bodies. We have also sought the views of our three Panels (Consumer, Practitioner and Smaller Businesses), and shared our plans with the Treasury. And we have asked ourselves some searching questions. All this has given us valuable insight into the areas on which the review should focus.

We have identified five themes that we will take forward in the main phase of the Retail Distribution Review. These five themes are:

• the sustainability of the distribution sector;
• the impact of incentives;
• professionalism and reputation;
• consumer access to financial products and services; and
• regulatory barriers and enablers.

We aim to publish a Discussion Paper in the middle of next year, setting out our analysis, our initial conclusions, and any recommendations we draw from this. I want to emphasise at the outset that we have a very strong preference for market solutions here, so our role is to a large extent limited to responding to the solutions that you might design. We know that, in some cases, we may also need to make referrals or propose joint work with other bodies. This is particularly important in the context of our relationship with the Office of Fair Trading, with whom we are working more closely than ever. Some of our work here, for example on incentives, links into areas the OFT is also exploring. Our findings may also uncover issues around competition, in which case we will need to engage the OFT in our work.

The Discussion Paper will of course include a more thorough analysis of the problems, the potential solutions, and the costs and benefits of change than I can give this morning: today is about setting the train in motion.

Sustainability of the distribution sector

First, sustainability. We, like you, want a distribution sector that is here today, here tomorrow and here into the future. For that, we need businesses that are sustainable over the long term.

As Callum noted at Gleneagles, the financial advice sector is not hugely profitable. And concerns about the level of persistency of life and pensions business raise questions about the profitability of provider firms. Moreover, we continue to see too many examples of firms – particularly advisory firms - with unrealistic long term strategies for their business. This is often with a view to growing the business at a speed that neither the management nor the infrastructure of the firm can cope with. This year, we have cancelled the permission of firms in two major financial advice groups because they could not meet their capital requirements.

Taken together, these indicators cause us to ask whether the current business model is sustainable and whether the current regulatory requirements achieve their aim of securing adequate resources for firms. We do not aim to operate a zero-failure regime. So we are not concerned about the failure of one or two firms. But we are concerned about the constant failure of firms in a sector simply because the business model is not sustainable. This is unlikely to be consistent with the fair treatment of customers, or with efforts to reduce calls on the compensation scheme.

We want to have a better understanding of the drivers for profitability in this sector. Our initial work on the value chain in the manufacture and distribution of investment products indicated that the cost of manufacturing the product was less than half the total cost of delivering the product to the customer. The costs of finding and securing business from new customers are a significant proportion of a distributor’s total costs, and the conversion rate of leads into sales appears low. Given that, and the need to recover costs, there is inevitably a temptation to exploit the existing customer base rather than search for new clients. We want to expand this work to enable us to create a fuller assessment of where the value is added, and indeed where it is destroyed.

We also want to understand more about the persistency of pensions business. In particular, do the new business volumes reported as Annual Premium Equivalent by the major product providers demonstrate real growth in the market, or, as some commentators suggest, do they reflect the churn of existing business? How large is any consumer detriment arising from churning? How worried should we be about surrenders of business by consumers who do not make any alternative provisions at all?

We want to look further here at the scope for the industry to begin to introduce its own solutions to churning in those cases where churning is detrimental to the consumer. Some major providers are beginning to acknowledge publicly the importance of business going out of the back door as well as that entering through the front door. And some household names are beginning to take steps to identify those advisors in their distribution chains who appear to be advising their customers to churn unnecessarily, and to take action to stop this happening. So market forces are at work in some places. And I was pleased to see recently that the ABI is starting to grapple with the true picture of the in-force business rather than focussing on new business figures. All this is to be welcomed. However, I am surprised that more analysts and shareholders do not ask more probing questions when considering the results of life companies. This might be another element of a market-led solution.

We will also consider what impact current remuneration models have on the way that firms manage their businesses and whether any changes to these models might result in a more sustainable business.

Finally, we intend to review our own capital requirements for financial advisory firms. Informed by the Retail Distribution Review, we will think about whether a more risk-based approach to capital, consistent with other sectors, would deliver better incentives for firms and deliver a more sustainable sector.

Professionalism and reputation

Our second theme is professionalism and what I am sure is our shared aim to raise consumer confidence in the way that investment products and services are delivered. This in turn should translate into increased business volumes and ultimately a more sustainable business model.

It is clear from the past instances of mis-selling, from pensions to endowments, and from splits to payment protection insurance, that the reputation of the investment market has been severely damaged. Our recent work to assess the quality of advice shows that large parts of the investment market lack the basic competence to deliver advice in a way that builds – rather than undermines – the sector's reputation. For example:

• over half the firms we visited did not, overall, obtain know your customer information before making a recommendation;
• suitability letters issued were insufficient and lacked clear and concise information about the key risks and reasons for the recommendation;
• almost all firms held themselves out as offering a full-advice service but only a third undertook a full review of customers' needs and objectives;
• around a third of firms had inadequate training and competence procedures in place, with a quarter of firms either not identifying training needs or not providing appropriate training; and
• less than a fifth of advisers gave consideration to recommended products that did not attract commission, for example the repayment of debt.

These findings are of particular interest to me and they raise one of the key questions to be addressed by the Retail Distribution Review: is the real root cause of the problem with the current distribution model the impact that commission arrangements have on the sales process, or is it the lack of professionalism – and basic competence – of some of those operating in this market? Or is it a mixture of both? Looking at this question another way, if standards of advice were very high because of the professionalism of those providing it, would commission have any impact on their recommendations or would suitability prevail?

We therefore want to understand more about why financial advisers are not generally considered in the same light as professions such as lawyers, accountants and surveyors. Why, for example, are consumers willing and able to pay significant fees to most professions, for example for basic conveyancing on the purchase of a property, but not to pay for financial advice? Is this because consumers do not view financial advisers in the same light as conveyancers, or because they do not realise the value of financial advice? Either way, what are the solutions? We believe that there is a close link between the professionalism and reputation of financial advisers – whether in banks, building societies, direct sales or financial advisory firms - and the sustainability of the distribution sector.

We have been told that this sector has difficulty attracting and retaining young talented individuals. If so, is this related to the level of training that is necessary to enter the profession, or to how competitive and stable remuneration levels are, when compared with other areas of the financial services landscape?

I should acknowledge here the contribution of the Financial Services Skills Council and welcome the work that is already in hand by the trade and professional bodies. Notable contributions include the Personal Finance Society’s introduction of chartered status; the ABI’s Consumer Impact Scheme; and the Institute of Financial Planning’s work on certification, including their recent tie-up with Manchester Metropolitan University. We also recognise the contribution that many authorised firms make in this area, particularly around events such as A-Day. We believe that raising standards is one area in particular where the solution lies firmly in the hands of the market.

On our part, we will seek to ensure that our longstanding training and competence regime, which we are presently reviewing, is proportionate, consistent with the overall aim to improve professionalism in the market, and for everyone is more than a 'tick in the box' to securing employment. As we move to a more principles-based approach to regulation, we will also be asking whether parts of the regulatory regime should be differentiated to take account of the level of service being offered.

Impact of incentives

I turn next to the impact of incentives. Our third theme will consider the wider impact of incentives on both the efficiency of the market as a whole and on the cultures within individual firms in the way that staff are paid. Most of our work on incentive structures within firms will fall within our Treating Customers Fairly work on remuneration and incentives, which we set out in July. So I do not propose to cover that in detail today.

On the wider question of incentives operating between firms, we are keen to understand how far commission structures between provider and distributor influence the decision of the distributor: to what extent does commission lead to detriment?

When commission-based selling occurs, it creates three potential sources of detriment: product bias, provider bias and churn. As our quality of advice work identified, product bias arguably leads to greater detriment than provider bias; consumers may not be advised to take actions such as surrendering with-profits policies that do not result in remuneration for the adviser; and consumers may not be advised to buy products such as National Savings or investment trusts with no commission attached. Similarly, it has been suggested that higher commission levels on investment bonds has led some advisers to have an undue preference for these over mutual funds, particularly when the latter could be held within an ISA wrapper.

Provider bias also clearly exists – otherwise product providers would not increase or decrease their commission rates payable to distributors to influence business flow. The impact of commission on the sales process may not result in a happy state of affairs for either the provider or the producer, let alone the customer. And the result of such bias is quite possibly churn: where business is switched without any clear benefit to the consumer - the only benefit appearing to be that it generates commission earnings to the adviser.

Various analyses of the impact of commission have been undertaken to date – none of which appear to have produced any clear-cut conclusions. The very fact that major product providers increase their commission levels to gain business share suggests that commission influences business flow. But do all commission arrangements result in detriment to the end customer? And if so, what are the alternatives?

To answer these questions, our work will cover at least five aspects. First, what is the economic impact of changing commission levels on business volumes? Second, how do distributors respond in reality to different commission levels? Third, how often are product switches in a customer's interest, for example a switch to a product with a lower annual charge? Fourth, what alternatives to commission, or more efficient ways of structuring commission, exist? And fifth, how can we be sure that any change will be to the benefit of consumers?

Our analysis will enable us to consider what impact commission really has on the efficiency of the market, whether the conflicts that are inherent in commission structures can be managed, and how strong the forces are for change in the industry. We recognise that some firms are already adapting their business models to increase the amount of income generated from pure fee-based advice and others are steadily increasing their income stream generated through trail commission, thereby reducing reliance on up front commissions. And the ABI has already signalled its intentions to review the structure of commissions, following the research it commissioned on commission bias.

Let me stress that we have not already concluded that commission is bad, or that we should ban commission altogether. But we are open to suggestions about alternative structures. In light of our own work, and your solutions, it might be that we need to create regulatory incentives here rather than regulatory restrictions. But we must wait and see.

Customer access to products and services

Our fourth theme is the extent to which customers have access to investment products and services. Feedback from our stakeholder meetings suggests firms have by and large responded to the current regulatory regime by offering full advice, or no advice, because they are reluctant to take the regulatory risk of offering something inbetween. This, we are told, creates barriers to innovation and distribution. The lack of advice available to, say, holders of with-profits policies and the limited response by firms to provide stakeholder products suggests that there is currently a huge gap between the type and volume of advice available, and that which is needed. And we believe it is vital that consumers have access to financial advice, products and services that both meet their needs and are suitable and affordable.

We also recognise that some of the potential responses to sustainability, the quality of advice, and incentives might have the effect of driving up the price of full advice, and thus restrict its availability and affordability.

Equally, however, some consumers who do not want, need, or cannot afford, full advice, might benefit from a more basic advice service that improved their financial position, especially if this was linked to a range of simpler products. And some firms have told us that they are keen to explore the possibility of introducing a more straightforward advice regime. This could be linked to simple products that might be rolled out through a variety of channels, be it direct sales forces, branches, or on the internet. We want to facilitate innovation, and I would encourage firms thinking in this way to come and discuss their plans with us.

We also recognise that the market for Basic Advice has not developed as some would have hoped, and we want to examine why take up of that regime has been limited. Our Consultation Paper "Reforming Conduct of Business", published two days ago, includes consultation on the scope of a full review of Basic Advice. We have deliberately not yet set the remit because we want to encourage all interested parties to contribute to its formulation and development. We are seeking responses by the end of January and our Retail Distribution Review will be informed by these.

Our work on customer access is not limited to the Basic Advice review, although this will be a major factor in it. We will consider whether there are other ways in which customer access to financial products and services can be improved. And we will take account of market developments such as the "personal accounts" associated with the proposed National Pension Savings Scheme.

We are also keen to encourage, in particular through our work on financial capability, a greater supply – and take up by consumers - of generic money advice. We see great potential for this, including through the development of existing channels such as Consumer Direct, Citizens Advice, and a wide range of channels already provided through both voluntary organisations and indeed the financial services industry itself. The Economic Secretary to the Treasury announced two weeks ago that the Government's long term strategy for financial capability, to be published later this year, will also explore options for how access to affordable, high quality generic advice might be increased.

We therefore want to look at the full range of advice that is available, or that could be made available, to meet people's needs at a price they can afford, and to provide access to a wide range of good value products through channels that treat customers fairly. We recognise that regulation will be a factor in the viability of any alternative advice processes that may be identified.

That leads me neatly on to our fifth and final theme: regulatory barriers and enablers.

Regulatory barriers and enablers

In explaining our first four themes, I have touched upon areas where regulation may have a key role to play as a catalyst for that change. Indeed, we had considered initially that regulation should only form part of our other four themes rather than be a theme in itself.

On further consideration, and with an explicit recognition that some aspects of regulation could be a barrier to greater market efficiency, we concluded that regulation should be a theme in itself. We recognise that, particularly in the market for advised sales of investment products, regulation plays a major role in constituting the very nature of the market – not least because of the succession of regulatory interventions in response to poor behaviour by some firms in this market.

We are clear that we need to take a hard look at where regulation has reached, where it is going, and what that means in terms of the distribution of investment products.

We will examine whether our regulation of the retail market creates barriers to greater market efficiency. If it does, we will consider whether removing or changing regulatory requirements will enable the market to help retail consumers get a fairer deal.

Invitation to the industry

So these are our early thoughts on how we will take forward our five themes for the retail distribution review. They will need much more consideration before we commit pen to paper.

We want the industry and other stakeholders to be fully engaged in this review and we want you to start that engagement now. We have a preference for you to take the lead with market-generated solutions, building on some of the initiatives already under way in the market.

To this end, we want the industry to play a key role in taking forward each of the five themes. We will identify leaders and members of working groups for each of the themes. We anticipate that the groups will be cross-industry, with representatives from all parts of the supply chain, ranging from life insurers to banks and financial advisers. Where appropriate, they will include consumers. The groups will also include senior FSA staff. We will work very closely with the groups, but we will not – indeed we cannot - give you the answers. The answers to the problems lie very much in your hands. On our part, where the answers are regulatory, we will be open to making changes that will enable you to deliver the solutions you devise.

Conclusions

I have set out some of the characteristics of retail distribution that we currently find most troubling, and in some areas even the most baffling.

I have set out the five themes on which our Review of Retail Distribution will focus, and offered an outline of how we want to take them forward.

I hope you agree that these five themes present a strong framework to identify and to address the root causes of the problems in the distribution of retail investment products.

And I am clear that the solutions lie principally in the hands of the market. The industry is on the cusp of change, and I am pleased that reaction to the review has been positive. Indeed, the areas we have identified are already firmly on the industry's agenda and our desire to act as a catalyst to industry-led solutions should come as neither a surprise nor a threat, but rather as an opportunity.

We look forward to working with you to achieve a more efficient market for the distribution of investment products.