By Hugo Thorman, Managing Director, Ascentric

The last decade, and last few years especially, have seen dramatic change in Retail Financial Services in the UK. The next ten years are likely to see both an extension of some of those changes, but also, as ever, some new, and by definition unexpected, ‘discontinuities’. Both will have an impact on organisations, customers and employees.

The key areas of anticipated change can be categorised as:

• The Environment, Customers and Regulation • Distribution and Group Business • Investment Solutions • Technology • Platforms

I will look to examine these areas in a series of articles over the next few months.

The recently published FSA Papers, PS10/6 on RDR and DP10/2 on Platforms especially, have reconfirmed the direction the industry will have to take. There remain detractors but their arguments are sounding increasingly hollow as it becomes clearer that proposed business models are both workable and beneficial for investors and industry over the long term. As an industry we can continue to wait to see how things turn out or we can take a greater role in influencing and driving how we think the industry should look for the long term benefit of all stakeholders. My view is we should be trying harder to reach some consensus on what this vision might be and lead developments which will turn that vision into reality.

The Environment, Customers and Regulation

What is our industry for?

Before embarking on an analysis of the UK Retail Financial Services industry it is worth first reflecting on exactly what it is there for. Most recognise and agree the important role it plays in allowing individuals to save for both short and long term needs. Further it allows those individuals, either on their own, or together with their financial adviser, to build a Financial, and even ‘Life’, Plan and concurrently optimise the tax opportunities offered by the Government through the Treasury and HMRC.

Less evident in the industry debate is the role played in providing a source of funding for businesses in the UK (and elsewhere) across all instrument types but largely debt and equity. Even more rarely do we hear discussed the importance of a thriving and efficient industry to the fortunes of ‘UK Plc’ i.e. the generation of wealth and GDP growth.

The cost of our industry

The total cost of our industry to the UK economy is a ‘friction cost’ to its efficient working. The cost of cash can be calculated by close analysis of the Report and Accounts of Banks and has been for many years about 2% (I’ve not yet seen the effects of the events of the last two years!). This margin does, of course, reflect margins for provisions of bad debts as well as administration and marketing costs and profit. For equity and managed fund investments this ‘friction cost’ is best reflected by the Reduction in Yield (RIY) which in turn should incorporate the Total Expense Ratio or (TER). These two measures of cost are still too rarely used in a consistent manner and are just not sufficiently understood by both customers and regrettably sometimes even advisers. The recent FSA Platform paper discusses how the industry might best standardise cost and charges to facilitate better customer understanding and comparison of competing propositions.

For our industry to be ‘useful’ and efficient and even to justify its very existence the RIY, over say 10 years, should be less than the expected and realised return above that on cash less an agreed premium for risk. Otherwise it is reasonable to argue that clients should be left in cash (I know I am assuming here that cash is risk free and that may be viewed as naive but let’s assume that – after all, in the end very few people lost money deposited in UK banks!).

I know there are those who will say that through a ‘Financial Plan’ sufficient value is generated for the client that any positive financial return over cash should be seen as a bonus. That may be a view (with which I disagree) but the client must, in any case, understand the potential outcome and what he/she is receiving (and not receiving) in return for the fee charged or commission deducted. That apart, I will argue that the role of the industry is to minimise that friction cost (or RIY) thus delivering both efficient long term savings to individuals and lowest cost funding to (primarily UK) businesses. Ideally it should be possible for advisers to show to their clients a competitive RIY which reflects the value added by each component and provider and the expected return to risk premium over cash equivalents. This argument does, of course, allow for higher RIYs in any part of the value chain where there is evidence of additional value which the client has accepted.

Traditionally, however, the industry has not achieved that objective. For years it believed that financial services were ‘sold and not bought’. This was due to both ignorance and lack of interest on the part of many clients and the ease with which high charges could be hidden inside complex product structures to reward both distributors and manufacturers. The method of the reward to distribution (commission) has further led to a distortion in the market whereby choice to the investor often excludes options such as ETFs and Investment Trusts and is restricted to a narrow range of ‘me too’ funds such that independence of product selection is often being compromised. The regulator is, of course, addressing many of these issues through RDR and emphasised the solution again in the recently published papers.

The impact of RDR and RDIP

The FSA papers PS10/6 on RDR and DP10/2 on Platforms and TCF reflect clearly what the regulator is trying to achieve. For some advisors the qualifications will prove too much, and that therefore there will be fewer advisers and fewer people ‘advised’ face to face. This will, however, be mitigated somewhat by greater opportunities for workplace and remote advice. I’ll provide some predictions later in these articles.

Returning to the likely impact of RDIP and TCF I do believe that they will, in time, be seen positively by the majority (they may be already but views are polarised). Some in the industry have associated regulation with additional cost and a reduced opportunity to make a reasonable profit. This is misplaced. It is helpful for the industry to view the policy of the regulator to encourage, even ensure, that the interests of advisers, product providers and clients are all convergent. This has not been the case traditionally. In fact they have, too often, all tended to be divergent. The result of this to the industry can be seen with the series of scandals which has undermined confidence in the industry and made some customers so cynical that some will never be advised, or sold to, again. Once an environment has been created which brings about a convergence of interests and more importantly a more equal balance of power then all participants should realise value.

There is of course a ‘transition cost’ to moving to a new environment. The costs of training and changing business model that will fully accommodate RDIP and TCF are substantive (for both advisers and providers) and in cash flow terms may be life threatening for some adviser firms. That cost is now an inevitability. Some advisers and providers anticipated them even before RDR, while others will realise belatedly what is happening. It may be that many advisers who have not yet started to change have, in fact, decided not to and intend to leave the industry.

There is one area where the government has really made things dramatically worse for our industry. This is in the area of product tax wrappers. It seems extraordinary that a government who create (sometimes apparently arbitrarily and without sufficient research into consequences) new tax rules (and therefore new product opportunities) or worse new rules and taxes for existing products, then concurrently ask advisers to provide their professional and compliant services more cost effectively. This same government then also expects more individuals to understand the rules and happily to save for their long term financial security. I suppose we all realise that strange decisions will be made due to the pressures and complexities of politics but the current product wrapper and tax rules (including means testing etc) are simply incompatible with a policy to encourage long term savings and independence from the state in old age, at a reasonable cost to both saver and tax payer. This is a fact, about which we can do little in the short term, so I leave it there as a consideration and, perhaps, as yet another potential objective for the industry.

Things we need to be thinking about

The result of RDIP: adviser charging, whole of market investment and product selection and qualifications, on the industry will be to encourage a level playing field across investment vehicles and tax wrappers, more client choice and ultimately lower costs reflected by the RIY of client portfolios. A key part of this is disclosure. There are those who feel that the component parts of the service to an investment client do not need to be disclosed – any more than they do for a ‘can of beans in a supermarket’. I believe there are two important reasons why this is just wrong. Firstly the separation of each component prevents cross subsidies. For example, platforms which ‘bundle’ administration and fund management are able to use fund selection tools to favour in-house funds or funds where margins are maximised for the platform. This argument has been adopted in the recent FSA papers.

Secondly, the Retail Financial Services market is different from Consumer Goods Markets. Cost pressure is not applied effectively to the services being provided because clients, due to relative ignorance, feel that they must accept the package offered by the adviser rather than challenge it and each component. Disclosure of the RIY due to each component i.e. investment management, product wrapper provision, investment administration and advice is important because it will lead to increased pressure and competition in each area.

The portfolio above is not atypical containing commonly held actively managed funds all receiving a platform rebate. At 2.27% the RIY is not low. It is regrettably true that even higher RIYs will be created through higher costs of any or all these components and especially investment where an additional layer of charges are emerging through the use of Discretionary Fund Managers (DFMs). Equally with selective combinations (e.g. passive funds, ETFs) this RIY could also be reduced substantially. As I’ve proposed above, the job of our industry should be to lower this cost through efficient administration and competitive selection processes such that higher levels of consistent real long term value is generated for clients (savers and investors) and ‘UK Plc’.

In the short term there is concern that RIYs are actually increasing due to the move to the ‘New Model’. Some of that may be well founded but some of that cost certainly reflects real added value generated through the selection of new asset classes and combinations of asset classes which offer increased returns at given levels of risk which properly reflect client tolerance. Some may also reflect the additional services now being offered by advisers including, inter alia, the Financial Plan.

This is an area where the industry is coming under more scrutiny from the regulator and where some pre-emptive work, within our industry, will produce benefits.

How it all ties in with TCF

As already mentioned another important part of the future will be the ultimate deliverable of TCF, best reflected by a substantial enhancement of consumer knowledge, understanding and challenge. With the current product wrapper tax environment (given my rant above!) this may be a vain hope. Any improvement in client understanding must however be welcomed. Currently there are clients (who often tend to be ‘self made’) who challenge regularly – after all that is often how they made their money in the first place! There are however those who have significant savings who do not understand the simple equation:

“The expected return from an investment, less costs, less a risk premium should exceed what they can get from cash over the same period.”

Once that is genuinely appreciated then a healthy debate between clients and adviser can take place to mutual advantage. Advantage to clients because they will now understand better the trade-offs being proposed by the adviser, and to the adviser because the better the evidence of client understanding the more secure the advice from subsequent challenge. The current TCF strategy will help to improve this debate and disclosure as described above will also enhance levels of knowledge and debate.

Conclusion

Personal Sector Financial Assets total some £3.5trn. This is largely held in pensions, other life company investments, ‘mutual’ funds, stock market directly held securities and cash at deposit. Much of this is under threat in its current place of ‘custody’. For advisers most easily to analyse and manage client portfolios, the constituent securities and accounts, in whatever tax wrapper, need to come together in one place as far as is possible. During the next decade the level of such securities held on truly ‘adviser charging’ platforms will change from only about £15bn now to over £1trn (in today’s terms). The pace of change might not, however, be constrained by the willingness of clients and advisers alike to aggregate assets but rather more the capacity of potential providers to cope with such volumes.

For further information, please contact: Ascentric Dominic Ventham, Head of Marketing Tel: 01225 787208, Mobile 07590 227039 Email: dominic.ventham@ascentric.co.uk