Association of British Insurers’ input into the FSA’s review of retail distribution in the savings industry

Foreword

This is the ABI’s input into the FSA’s Retail Distribution Review. This reflects extensive discussion with member companies. Many of our suggestions require further work, including proper cost benefit analysis. Our aim at this stage is simply to provide preliminary thinking on key issues as an input to the FSA’s Discussion Paper. We have taken as our starting point the importance of ensuring that the market works for customers. No other basis for reform would be sustainable. We believe that the reforms needed to benefit customers would also improve the robustness and financial health of the intermediary market, with benefits for the whole industry. Taken together our proposals are designed to strengthen confidence in the market. We strongly believe that increasing long-term saving is in the interest of most people and that reform should give people more confidence to invest. To achieve this we should like the professional standards of advisers to be enhanced. We also believe that intermediaries should be better capitalised and so more sustainable. Confidence also depends on consumers understanding what they are paying for when they go to an adviser and feeling sure that the advice is not being distorted by the interests of the adviser. Our research shows that advice is not biased by commission, yet the perception of this remains and is damaging. Commission cannot however be abandoned. As in many industries, it serves a valuable purpose. In particular, consumers like to spread the cost of services. We therefore expect it to continue to have a place in the market. But at the same time we see a case for alternative models of commission to develop and be adapted if the market (consumers, intermediaries and insurers) see advantage in them. In particular we proposed an alternative based on factory gate pricing that is affordable and provides reassurance that the advice they receive is independent of the commercial interests. To make this work it is essential that the regulatory regime is based on key principles rather than detailed rules about the information the customer needs. The customer needs to understand how advice will be provided but regulation should not replicate a menu approach, with the cost that entails. Stephen Haddrill Director General

Executive summary

Many commentators, including the FSA, have highlighted the shortcomings of the current system for distributing saving and investment products to customers. While the FSA’s review covers a wide range of market participants, addressing the issues it raises is important for the insurance industry’s continuing effort to maintain and enhance its reputation with its customers. Reform will also be crucial for the future commercial health of the distribution market, and will help ensure a sustainable and cost-effective supply of saving products to the customers who need them.

To be effective, reform must build on the existing diverse and dynamic savings market, which already serves millions of customers well. The success of the bancassurance model has demonstrated that in the right environment, the mass market can be served economically. The ABI has made a number of suggestions, reflecting the main themes of the FSA review, which we believe could significantly improve outcomes for consumers.

Our suggestions seek to expand consumer choice, provide better information, and improve trust in a professional advice service. It remains our view that regulation will be required to achieve this. Without regulatory intervention, the real or perceived barriers created by a first mover disadvantage could prevent the adoption of the reforms that we believe are necessary. Such regulation should be principles-based, focussed on outcomes for consumers and supported by a full cost-benefit analysis. Sales regulation in particular should recognise the varied needs of consumers and the different models of intermediary.

First, we need to create an environment in which distribution channels can continue to develop to meet consumers’ needs:

• Generic advice could for some consumers serve as a triage service, directing them to the most appropriate distribution channels.

• Following triage, a new, simplified and portable fact-find might also help lower the cost for some consumers of moving between advisers and channels, although this would not replace a full fact-find for those seeking full regulated advice.

• The current suitability requirement should be significantly reduced for some products, creating a lower-cost sales regime. This might replace the current Basic Advice regime. If Basic Advice is retained, it should be simplified, and the range of products that it covers widened.

Second, customers should understand and agree with their advisers the price they will pay for financial advice and the other services they will receive:

• The regulated disclosure documents should be redesigned, simplified, and focussed on the intermediary’s services and costs.

• The prices consumers pay should be clearly related to the specific advisory services they have agreed to receive.

• The customer should authorise any charge for intermediary services that is to be deducted from their savings.

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• The customer should agree whether an intermediary is to provide post- sale services, and what these will entail. Customers who do not believe they are getting value for money from such services should be able to stop them and have the bulk of the charges reinvested on their behalf.

• If they have chosen to receive post-sale services, consumers should receive an annual service and charges statement from their adviser to ensure they continue to get value for money.

Third, the FSA should use regulation to encourage intermediaries to move away from the current provider-led, commission-based system and towards Customer Agreed Remuneration for Intermediary Services (CARIS), under which:

• Intermediaries would set the price of their services, and charge the consumer for them either through a fee or through charges levied on the product clearly separated from the product’s cost.

• The amount and timing of payment for advice would not depend on the choice of product provider.

• If payment were funded through charges deducted from investment products, the deductions would be clearly and separately disclosed to the customer.

Fourth, the FSA should support robust intermediary companies who should in return expect some form of regulatory dividend. We might improve robustness in a variety of ways, including requiring:

• Additional capital to be built up over time and retained in a separate account for some years after ceasing to trade. Such capital might be provided either by the firm or by individual advisers.

• Enhanced Professional Indemnity insurance, to cover mis-selling liabilities which emerged up to a certain number of years after the company ceased to trade.

• A bond from a bank or another company, secured against the assets of individuals involved in the firm concerned.

• A guarantee from a parent firm. • A risk assessment (similar to Dunn & Bradstreet or Standard & Poors

ratings), with a link to reduced FSA levies.

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Fifth, advisers should hold the qualifications necessary for the specific services they provide, and communicate them clearly to consumers. Insurers and other stakeholders in the financial services industry should work with the industry’s professional bodies to develop enforceable standards of conduct for individual advisers, recognised by FSA regulation.

Sixth, the FSA should make better use of data in supervising intermediaries:

• The FSA and the industry should work together to develop a series of measures of intermediary performance.

• Supervision should target poorly-performing intermediaries. • Well-performing intermediaries should benefit from reduced regulation.

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PROBLEMS WITH THE CURRENT SYSTEM

“…we have a system which serves neither the producer of the services nor the consumer of the services. It is doubtful whether it serves the intermediary either.” Callum McCarthy, Chairman, FSA, Gleneagles Savings & Pensions Industry Leaders' Summit, 16 September 2006

“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.” Clive Briault, Managing Director, Retail Markets, FSA, Cazalet Consulting Conference, 2 November 2006

The current marketplace

1. The ABI welcomes the FSA’s review of distribution as an opportunity to achieve a consensus for sensible reform. The insurance industry wants a distribution system which meets the needs of all our customers. Current market structures are the product of economic, social and regulatory changes over many decades and are not ideal. Low levels of financial capability among consumers, and regulatory interventions of varying degrees of prescription, have rendered the old “industrial branch” direct sales uneconomic for companies serving lower-income customers, because the cost of a regulated sale is too high to maintain such a salesforce. As a result, Independent Financial Advisers (IFAs) now account for a majority of sales in the life and savings market, unlike most other EU markets, where tied advisers dominate. Among IFAs, the business models vary significantly, including one-man businesses, national networks, and emerging national IFA brands.

2. Other distribution channels also exist. These include bancassurance, in which insurance companies sell their products through associated bank branches. The success of the bancassurance model (see Charts 1 and 2) has demonstrated that in the right environment the mass market can be served economically by increasing the efficiency of business systems, while using a high-street presence and well known brands to attract consumers. The challenge is to apply these factors – not currently relevant to most IFAs – more widely in the market.

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Chart 1: Regular premium sales

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2005 TOTAL 2005 Bancassurance 2006 TOTAL 2006 Bancassurance

£m Investment & Savings Protection Pensions

Source: ABI Statistics

Chart 2: Single premium sales

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30,000

40,000

50,000

60,000

70,000

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90,000

100,000

2005 TOTAL 2005Bancassurance

2006 TOTAL 2006Bancassurance

£m Investment & Savings Protection Pensions

Source: ABI Statistics

3. New types of unadvised sale have also emerged. These are limited, because without encouragement and an explanation of benefits, few customer inquiries are converted into actual saving. Because most advice costs are met only when a product is bought, the cost of advice for purchasing customers rises with the number of non-purchasing customers who seek advice. Moreover, a vicious circle can become established. As non-purchasing customers raise the cost of advice, advice becomes less affordable and more potential customers become non-purchasers.

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4. The FSA’s recent depolarisation reforms have encouraged the growth of multi-tie

financial advisers, which are neither linked to a single provider of savings products nor obliged to offer the entire market. Internet, telephone and high street retail sales may in future grow to occupy more of the life and savings market. It is therefore already clear that there can be no single, correct model of distribution. Different sectors of the market will require different approaches, and it will be important to avoid imposing a strait-jacket on future developments.

Current problems: overview

5. It is also important not to overstate the problems posed by the system of distribution which currently covers much of the mass market for savings. While real, they do not affect all sectors. For example, bancassurance and employee benefit schemes already provide access to appropriate products for a large section of the mass market. We must therefore concentrate on solutions for specific, identified problems, and avoid unintended consequences for already healthy market sectors.

Current problems: consumer access

6. The FSA’s distribution review involves a broad set of public policy problems. The

Sandler Report (Sandler Review: Medium and Long Term Savings, HM Treasury, July 2002) recognised that the UK needs to raise its current low level of private saving. The report of the Pensions Commission (A New Pensions Settlement for the Twenty-First Century, Pension Commission, November 2005) came to the same conclusion. Both proposed radical changes to the current savings marketplace, involving the provision of simple savings products in a largely deregulated (and hence low-cost) sales environment.

7. But Sandler’s proposals (which formed the basis of the FSA’s Basic Advice regime)

foundered because deregulation did not reduce sales costs far enough to meet the government’s price target (see box opposite). The government’s proposals for implementing the Pension Commission’s recommendations – which are currently being consulted on – contain similar flaws1.

1 See “Pension Accounts: a new way to save: The ABI’s Response to the Personal Accounts White Paper”, ABI,

March 2007

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Box 1 The Basic Advice regime

The Basic Advice regime failed to open up access to new customers because:

• The process was inflexible. In practice, the scripts filtered out the majority of potential customers. Most of the rest tended to be recommended a cash ISA.

• Market participants feared retrospective action from the Financial Ombudsman Service, which deterred market entry.

• FSA guidance on the approach firms should take when selling stakeholder products to consumers with outstanding debts (e.g. credit card balances) was conservative and ambiguous.

• The flat structure of the charge cap did not cover the up-front costs of advice.

• The responsibility placed on the adviser to make a suitable recommendation on the basis of only limited information led firms to conclude that the risks outweighed the likely returns.

• Demand-side barriers forced providers to spend significant amounts to attract consumers, making Basic Advice uneconomic.

The advice gap

8. Under the current system, many consumers do not receive the advice they need. Up-front payment of commission to advisers encourages them to make sales, but not to provide an ongoing service (see paragraph 18). This may not be consistent with the needs of all customers, some of whom may require a service beyond the initial sale. And for those who simply require a financial check-up with no sale, commission is not the ideal way for an adviser to be paid for his or her work. If the client is unwilling to pay a fee for advice, the adviser will, under the current arrangements, need to recommend a change in their client’s financial portfolio in order to generate the cash flow to pay for the advice.

9. The cost of acquiring new clients via the current intermediary channel is high. Therefore full advice may become realistic only for a diminishing pool of increasingly affluent consumers. But the demand from mass market consumers for advice and support is increasing, as the Government transfers more risk from the state to the individual.

10. Worryingly, recent research by NMG2 found that 46% of with-profit policyholders had received no advice in the past year, despite the high level of surrenders currently seen in the market. The FSA’s review needs to address the barriers – real or perceived - preventing the delivery of appropriate and ongoing help and guidance to customers. Product providers are keen to play their part in this, if a viable range of

2 “Stakes in the Ground Initiative, With Profits” NMG Financial Services Consultancy, September 2006

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different intermediary services can be established. Providers could identify potential customers and point them to the type of service likely to meet their needs. This would reduce the cost of the advice, and tailor it more accurately to the consumer.

Financial capability

11. Equipping consumers with the necessary financial skills before they buy would clearly help. As the FSA has said, current levels of financial capability are low3. But efforts to improve financial capability through education and training are likely to take a generation or more to produce results. Even then, the impact of improved financial capability would be uncertain. More immediate action is needed if we wish to widen consumer access and stimulate demand for saving.

Customer information

12. The information given to customers with the products they buy is therefore of crucial importance. At the moment, the first regulated document they receive is the Menu, which sets out the cost of commission on the products that they may buy. The Menu is too complex. It does not help consumers shop around for advice (one of its purposes) or to consider what services they want. Furthermore, it is given to the customer alongside an array of other documents, so it is often ignored. All this documentation needs to be recast, if consumers are to be supported effectively during the sales process.

Current problems: impact of incentives

13. At present, most customers pay via commission for the services they receive from their intermediary, at rates negotiated between the provider and the adviser. Intermediaries can choose whether to take all of this commission themselves, or refund some to the customer. As Callum McCarthy, Chairman of the FSA, recognised in his speech at the Savings & Pensions Industry Leaders' Summit at Gleneagles on 16 September 2006, commission thus provides an important incentive to IFAs to sell savings products. It is not to be discarded lightly.

14. Indeed, commission is used in almost all markets to provide appropriate incentives to sales forces. These incentives do not always act against the interest of the customer. Commission can bring significant benefits: customers can choose to pay for advice only if they make a purchase; and they can spread the cost over time, increasing affordability and access.

15. And although commission can lead to competition between providers for access to consumers, this is not automatically a bad thing. It is, for example, quite normal for manufacturers to compete for space in shops. Intermediaries have the ability to locate customers and persuade them to invest, so savings product providers use the tools at their disposal to attract intermediaries to their products. Such competition can lead to improvements in customer service. Indeed, despite past problems, there

3 Financial Capability in the UK: Establishing a baseline, FSA, March 2006

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is little current evidence of actual customer harm from commission-based sales (see for example “Study of Intermediary Remuneration”, CRA, February 2005).

16. That said, commission does pose challenges. The perception of bias itself requires attention. More than half of consumers think that financial services firms sell the products that pay the most commission (“Consumer confidence in the financial services industry”, Financial Services Consumer Panel Research Paper, 2/2005).

17. And there are practical problems. Those who sell savings products under the current regulatory regime do so via full regulated advice, or with no advice at all, and are reluctant to take the risk of alternative approaches. This may well bar some consumers from access to the financial support they need.

Potential bias

18. Further, commission typically involves up-front payments from savings product providers to intermediaries to cover the latter’s sales costs. The alternatives - such as trail commission, paid over the lifetime of the policy and linked to the policy’s performance - are less frequently used, and pose their own problems. Customers who opt to pay trail commission are often given little explanation about the purpose of these charges, and no option to cancel them if they do not feel they are receiving value for money. For many consumers with small investments or simple financial needs, such regular advice is unlikely to be worthwhile. And even when customers are given the option to cancel ongoing charges, they rarely benefit financially, because the commission is often not passed back to them.

19. As a result, intermediaries may be incentivised to make inappropriate sales. This may involve sales when it is not in the interest of customers to buy at all (sales bias), or when products or providers are chosen on the basis of the level of commission paid (product and provider bias). Intermediaries may also be encouraged by commission to recycle existing clients between products and providers rather than find new clients (churn).

Persistency

20. Another potential consequence of the current commission system is that product persistency (the length of time that a product is held by a customer) may be reduced. Persistency rates can be measured by comparing the number of policies still active a certain number of years after being started. For example, FSA research shows that, of single premium life insurance-based savings plans sold by IFAs in 1997, 92% were still active in 2001. For similar plans sold by IFAs in 2001, 88% were active in 2005 – a small drop. The comparable 2005 figure for this type of plan when sold direct by insurance companies was 84%. By contrast, regular premium plans show much lower levels of persistency. In 2005 only 46% of the regular premium pension policies sold by IFAs in 2001 were still active. The figure for direct company sales was slightly higher, at 51%.

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21. Another way of measuring persistency is by looking at the annual percentage of consumers moving their money from one savings plan to another (switching). Looked at this way, persistency rates in the life and pensions industry are comparable with those in other sectors of the economy. A recent OXERA study for the ABI reported annual switching rates from a number of different industries: 13% of consumers switched gas provider; 9% switched mobile phone provider; 6% of consumers switched home insurance provider; and 1.4% of consumers switched their current bank account provider. The figures for personal pensions (3.7%) and stakeholder pensions (2.1%) are at the lower end of this range, although they vary significantly between single and regular premium policies. Regular premium switching rates are generally much higher than single premium rates. It is also important to observe that life and pensions products are generally long-term in nature, and may therefore only deliver value for consumers if held rather longer than other services.

22. The available figures also give only a partial picture, masking considerable differences between products, types of sales, and between surrendering (without taking out a new policy) and switching. Clearly, customers may have quite different reasons for switching and surrendering. Distinguishing between these, and between legitimate switching and churn, will be important in drawing conclusions from the available evidence.

23. A recent YouGov survey for the ABI shows that customers on lower incomes are more likely to stop paying into their savings plan, or close it, than consumers with higher incomes. The main reasons are changes in income (47%), the need to pay off debt (36%), and other changes in personal circumstances (36%). Customers who have received advice from IFAs are statistically less likely to stop saving in long-term products. This may be because IFA customers have received good advice, or because they tend to have higher incomes, and so are less likely to stop saving because of changes in personal circumstances.

24. But the YouGov survey also showed that customers receiving IFA advice were more likely to switch between products than those who did not receive advice. Again, this may reflect the fact that IFA customers have higher sums invested, and so can gain more by moving their investments. This is currently under further investigation. There are many perfectly good reasons why customers may switch between products, including changing needs, new or better products and services, media coverage, and one-off events like A-day. Current charging structures often allow IFAs to recommend consumers to switch at little or no cost, either to themselves or the consumer. The adviser may also need to generate commission to pay for fresh advice, or may have moved firm and taken the customer with them.

25. Type of product also makes a difference. The decline in popularity of with-profit policies and the rapid increase in surrenders has contributed substantially to a recent decline in persistency. In-force with-profit premiums have declined from £9.7bn in 2003 to £5.9bn in 2005, alongside a fall of one third (6 million) of all with-profits policies held, in the space of four years. On the other hand, switching between regular contribution personal pensions often follows a change of

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employers. As group personal pension schemes have grown in popularity, and involved more lower income consumers, this trend has increased. Single premium pensions are generally held by wealthier clients and favourable commission rates for new business may therefore quite naturally lead to significant levels of switching. Company data shows that switching between single premium investment plans mostly occurs after the first five years, during which exit penalties apply. Some products are also sold with explicit consumer decision points after five years.

26. More research is needed about customer motives before firm conclusions about persistency can be drawn from these observations. Moreover, the majority of investments by value are made by higher income customers, and the research results so far take no account of value. This is important, because the impact of persistency on the industry depends on the amounts of money involved, as well as the number of customers. More light also needs to be shed on whether the observed levels of surrendering and switching are causing significant detriment to customers. At the moment, there is no such evidence. The absence in most cases of initial or early exit charges is obviously relevant, as is the spread of charges over the entire period of the customer’s investment. Ultimately of course, providers’ reliance on international capital markets, and their need to ensure adequate return on capital, means that consumers must bear the cost of the decline in persistency if it reduces product profitability – either through higher charges or because products are withdrawn from the market.

27. Similarly, the available evidence does not enable us to say whether commission is partly responsible for the observed levels of switching. The ABI is collecting market data from companies about their own experience of persistency, and any visible trends. We also hope to work with the FSA to improve the collection of persistency data for regulatory purposes, including by redefining the categories of this data. We look forward to collaborating with the FSA on their plans for a research project on the quality of advice. All this work should provide a better evidence base.

28. But persistency is already an important issue for providers. Competition from stakeholder-capped products has led many companies to introduce simple flat annual charges (a percentage of funds under management) over the lifetime of the product, often with little or no exit charge. At the same time, insurance companies face higher up-front costs (e.g. for setting up the new policy and paying up-front commission to advisers), and many products make a loss in their early years. The recent decline in persistency rates has therefore increased the number of policies which fail to reach profitability. Even the relatively low switching rates seen in pensions can have a disproportionately large impact on the profitability, because charges are levied at a low level over a long period of time.

29. Providers are responding to this challenge by changing product design and charges. Many companies are reconsidering their charge levels and structures and their approach to exit penalties. An attempt has been made to improve persistency in the pensions market by sharing more of the risk with intermediaries, via extended periods during which producers can claw back commission from IFAs for surrendered policies. Improved product design and better communication should

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help prevent consumers from surrendering their products simply because they do not understand the choices they face. Payment holidays may also be useful. Where products require ongoing advice, insurance companies are encouraging intermediaries to take their commission over the lifetime of the product.

30. It nonetheless seems unlikely that individual company action alone will be enough to reverse current trends in persistency. Customer needs and expectations have changed. We make a series of suggestions in the second part of this paper aimed at increasing persistency in ways that will benefit customers, providers and intermediaries.

Current problems: sustainability

31. The current commission-based system, while responding to immediate economic realities, fails to encourage intermediary businesses to generate and retain significant capital. When products are sold directly by the provider or through bancassurance, there is less of a problem. But independent intermediaries need capital to invest in technology and training to meet client needs, to respond to short-run changes in market conditions, and to meet any future mis-selling liabilities. The current model fails to encourage them to do this. It also allows some intermediaries to exit the industry to avoid mis-selling liabilities and then re-establish new businesses. Despite an annual income of over £4 billion, the IFA sector retains insufficient capital to cover its annual £50 million liabilities to the Financial Services Compensation Scheme (FSCS).

32. This situation in part reflects the dependence of most IFA businesses on individual advisers. As Callum McCarthy highlighted at Gleneagles, most commission income goes straight to such individuals, while the businesses remain relatively unprofitable.

Current problems: professionalism

33. Consumers need to be able to trust the advice they get. While many intermediaries have embraced the new qualifications introduced by bodies such as the Chartered Insurance Institute (CII), others have not. Recent FSA research found that two regulatory documents designed to support consumers in the advice process were only given to customers in 58% of sales4.

34. Consumers find it difficult to assess the quality of advice on offer. They are not helped by the wide variety of qualifications. The new standards introduced by the Financial Services Skills Council (FSSC) have failed to attract new recruits to the industry. And even a qualified adviser may not have kept their knowledge up-to-date. The failure of some large national IFA companies has further fragmented the market, making regulation of the quality of advice more difficult.

35. Any successful solution must ensure appropriate training, continued professional development and effective monitoring. It will never be appropriate or practical for all this monitoring to be carried out by product providers, who are not in a position to

4 “Depolarisation disclosure – mystery shopping results” FSA Consumer Research 48, March 2006

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judge quality of advice on the basis of the information they receive from intermediaries. At present, providers are often in the unfair position of paying a financial penalty for bad advice over which they had little control.

Regulatory compliance

36. Finally, quite apart from the incentives inherent in the current system, FSA research has found problems with regulatory compliance amongst some intermediaries:

“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.” Clive Briault, 2 November 2006.

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PROPOSED SOLUTIONS

Objectives

37. The insurance industry wants to help consumers understand their financial needs and get secure access to appropriate financial products. Our suggestions therefore seek to address the problems described in Section 1 by expanding consumer choice, providing better information, and improving trust in a professional advice service. It remains our view that regulation will be required to achieve this, otherwise the risk of first mover disadvantage will discourage the spread of new approaches (see also paragraph 56 below). Any new regulation should be principles-based, focussed on outcomes for consumers, and supported by a full cost benefit analysis. Sales regulation in particular should recognise the varied needs of consumers and the different models of intermediary.

Solutions: Consumer Access

Generic advice

38. A variety of distribution channels should be allowed to develop to meet consumers’ needs. For some consumers, generic advice could serve as a triage service, directing those who currently do not have saving or investment products to the most appropriate channels. The Thoresen review is currently considering the gaps in the advice available to consumers, and how generic advice can best help consumers address their financial needs. Generic advice should not be seen as an end in itself, but as a first step towards the customer getting the financial products he or she needs. It should be an advisory service which, alongside appropriate help and guidance, makes a basic assessment of a consumer’s circumstances, and then directs them, if appropriate, to where they can meet their needs. This will not necessarily lead to the purchase of a financial product, but might involve guidance on how best to manage debts, or other forms of financial advice. FSA guidance is needed to give firms confidence that they can offer generic/ongoing advice to new and existing customers without incurring the costs and risks associated with the regulated advice regime.

39. A business case for industry funding of a generic advice service has yet to be established. There is a strong case for public funding, given the benefits likely to accrue to the public sector finances. Additionally, the industry already gives significant support to many areas of financial capability work: through the FSA levy; support for organisations such as the Personal Finance Education Group; and other Corporate Social Responsibility activities.

The fact-find

40. To widen access to saving and protection, the current full advice system must be supplemented by other means which will allow easy access to basic products for

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customers in the mass market. For some customers, the cost of shopping around between advisers and distribution channels is currently too high. Customers are forced to complete fact-finds summarising their personal and financial circumstances at each stage of the process. A new, simplified and portable fact-find might therefore lower the cost of moving between advisers and channels for those customers. This could be completed as part of a generic advice service, and then presented by the consumer when they sought further advice. It should nonetheless be recognised that for many distribution channels, a full fact-find is likely to continue to be needed.

Suitability

41. The current suitability requirements should also be significantly lightened for some products, allowing consumers to access financial products through a variety of channels, in line with the principles of the Sandler review. Where the intermediary is offering a sale rather than regulated advice, there should be no regulatory requirement for a suitability test covering all of the customer’s financial circumstances. These changes would make direct distribution more economic for firms, and provide better value for customers who did not want to pay for advice. Products could readily be identified which allowed the consumer to determine suitability for themselves, subject to satisfactory disclosure of risks and clarity about unsuitability for certain well-defined categories of customer. Lessons could be learnt from current models of credit risk assessment, and regulation focused on the method of assessment rather than individual outcomes.

42. Such an approach would be consistent with risk-based regulation, and with the Government’s proposed new Personal (pension) Accounts, the design of which recognises that, for most customers, it will be sensible at least to start saving. It would necessarily involve some reapportionment of risk between provider, distributor and consumer, and some potentially significant changes in the approach of market participants and regulators, including the Financial Ombudsman Service. Allowing the consumer cheaper access to the market in return for a greater share of any risk is commonplace in other markets – e.g. when house purchasers opt for a home-buyer’s report rather than a full structural survey. The net effect is usually a better deal for more customers.

Basic Advice

43. Such a light-touch suitability regime might supersede the current Basic Advice regime. But if Basic Advice is retained, it needs to be simplified and made cheaper to use. Again, a streamlined assessment of suitability is needed, alongside an extended range of regulated products and of investment options within products. It will also be important to address the current presumption among providers that when giving Basic Advice, those customers with even a small amount of debt should not begin to save.

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Disclosure documents

44. The regulated disclosure documents should be redesigned, simplified, and focussed on the intermediary’s services and costs. Consumers who continue to look for, and receive, advice should get much clearer information about their service and its costs. The two regulatory documents currently given to customers at the start of the advice process – the Menu (explaining the costs) and the Initial Disclosure Document (explaining the service) – are both too complex. They should be combined into a single, consumer-friendly document, focussing on the service offered by the intermediary and its cost relative to other options.

Solutions: Impact of Incentives

45. The FSA should take regulatory action to ensure that intermediaries move away from the current commission-based system and towards a new approach, under which intermediaries would set the price of their services. Such an approach is commonly known as Factory Gate Pricing, but would perhaps more accurately be termed Customer Agreed Remuneration for Intermediary Services (CARIS).

46. Customers should agree with their advisers the price they will pay for financial advice (this may be a standard charge, or one negotiated between the consumer and their adviser, depending on the business model adopted by the intermediary), and understand clearly what services they will receive in return. Where advice is called independent, it should be clearly free from bias. The cost of intermediaries’ services should therefore be set by the intermediary, and not by the insurance company. If remuneration is funded through charges deducted from investment products, the deductions should be clearly and separately disclosed to the customer. The amount of the adviser’s remuneration and the related product charges should be authorised by the customer before any payment is made. If products are simply too complex to be sold without further advice, this should be made clear to the customer at the outset.

47. If an adviser recommends that a consumer should receive further advice over a period of time, and pay for it over a similar period (perhaps via trail commission), the consumer should be made aware exactly how much this service will cost, and what they should expect to receive in return. Customers who do not believe they are getting value for money from such services could be able to stop them and have the bulk of the charges reinvested on their behalf (some charges may have to be retained by the provider to cover the increase in the costs they will face). To help them do this, consumers who choose to receive further advice should receive an annual service and charges statement from their adviser. Such a statement would, of course, need to be subject to a full cost-benefit analysis before introduction.

48. When a consumer receives a single, transactional piece of advice, providers may need to agree with the intermediary that the provider will have responsibility for any further needs of the customer. The provider and customer would then have a much clearer understanding about their respective roles in the management of the product and any other services that the consumer might need in future.

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49. Under CARIS, the basic price charged by a provider would vary between intermediaries, reflecting the provider’s assessment of the costs of dealing with each intermediary, and the quality of the resulting business. The intermediary would then set the price of their own services to the consumer so as to cover all of their own costs. The customer would choose how they wanted to pay for the services they would receive, whether directly by fee or via an increase in the product charges.

50. As the intermediary would be expected to set their charges to reflect the work they did, the choice of provider would make little difference to their costs. Provider bias could be eliminated altogether by regulation to ensure that the amount and timing of the intermediary’s remuneration for any given product recommendation did not vary by provider.

51. One advantage of CARIS is that it would retain many of the positive features of the current commission model. The advice charge would continue to vary according to market forces, but would reflect the services and products recommended and the commercial arrangements between advisers and customers, rather than the sales strategies of providers. Payment would still be conditional on purchase.

52. We do not believe that it is possible to ensure that payments made by consumers are matched in their timing to the receipt of payment by the adviser, even if this might be desirable. Providers would continue to be able to offer financing to advisers to allow them to cover the costs of up-front advice to the consumer, while allowing the consumer to spread payments over time. Agreement of a limited number of patterns for payment of advice charges could both help consumers shop around (by making the charges comparable between intermediaries) and simplify the changes needed to providers’ systems to make the payment on behalf of the consumer (by avoiding the need to agree detailed payment structures for each individual customer).

53. Some parts of the market already operate a CARIS-type system. Providers who do so, regularly monitor the level of remuneration set by intermediaries. When these exceed a level the provider considers reasonable, the intermediary is asked for an explanation. Providers retain the freedom to decline business from an intermediary whose proposed charges they consider may give rise to unfair treatment of customers, or may damage their own reputations. This would need to continue to be a feature of CARIS when applied to a wider market.

54. Limits on the range of intermediaries and products covered by CARIS may be sensible. Not all intermediaries will wish to provide a choice of providers, or to give advice. Some will simply promise to sell the most appropriate product from a limited range. Not all customers will therefore need or wish to use CARIS. And where providers sell their own products through their own intermediaries, splitting the cost of intermediation from the product may not be especially meaningful. Given the difficulty of changing existing systems, contractual arrangements, and product charging structures, a move to CARIS would need to be introduced for new sales, only after an adequate period of preparation, and perhaps limited, in the first instance, to investment products.

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55. That said, limiting CARIS to intermediaries offering products from several providers might result in the perception of an unfair advantage for those intermediaries who did not need to disclose the cost of their service. Excluding some products may simply increase product bias in the market. And having two pricing systems might confuse consumers who purchase a combination of investment and protection products. The matter requires further debate.

56. Around a quarter of intermediaries already have some experience of using factory gate pricing (“Intermediaries, today’s business models”, Deloitte, 2006). But so far it has been restricted to specific parts of the market – for example, high net worth consumers who are aware of the value of financial advice and willing to pay for it. There is little evidence of a spontaneous spread of CARIS in the mass market. Many intermediaries are resistant to a change that would require them to make the customer aware of the cost of their services. Given this, providers are in turn reluctant to move all of their products to a CARIS basis, fearing the loss of sales to other providers who continued to offer commission. Under competition law, it would of course be impossible for providers to eliminate this first-mover disadvantage simply by agreeing collectively to change the current remuneration model for intermediaries. Regulatory support is therefore essential if CARIS is to spread to the mass market.

57. CARIS has clear attractions as a way forward for some parts of the market. The ABI proposes to carry out further research to help understand the detailed implications, the necessary transitional arrangements, and a sensible timescale for implementation. It will also be very important to ensure that there is a thorough and comprehensive cost-benefit analysis before specific new regulations are brought forward.

Solutions: Sustainability

58. The FSA should support robust intermediary companies. Intermediaries should be financially sound and have sufficient capital to sustain a thriving business, including the ability to deal with any mis-selling liabilities. This is not currently the case. Current proposals to reapportion the FSCS levy do not address the fundamental problem, and should in any case be seen as short-term measures. Intermediaries operate a variety of different business models, and we believe that the capital adequacy rules should be designed to allow flexibility in the way that they hold capital. The FSA may wish to consider publishing data on the capital adequacy of individual intermediaries to help consumers identify robust intermediary firms.

59. Better capitalisation of IFAs might be achieved in a variety of ways, including requiring additional capital to be built up over time and retained in a separate account for some years after ceasing to trade. Such capital might be provided either by the firm or by individual advisers. Another possible approach would involve enhanced Professional Indemnity insurance to cover mis-selling liabilities which emerge up to a certain number of years after the company ceases to trade. Other alternatives include bonds from a bank or another company, secured against the

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assets of individuals involved in the firm concerned, a guarantee from a parent firm and a risk assessment (similar to Dunn & Bradstreet or Standard & Poors ratings), with a link to reduced FSA levies.

60. Whatever approach is adopted, the FSA should ensure that capital requirements for intermediaries set appropriate barriers to entry and exit from the market.

Solutions: Professionalism

Qualifications

61. Advisers should hold the qualifications necessary for the specific services they provide, and communicate them clearly to consumers. Consumers need clear information about the types of intermediary service available and their relative cost. Regulation should therefore support a clear description of the nature of the services being offered. Consumers should be able to choose between intermediaries selling financial products, those offering independent financial advice, and others offering a full financial planning service. Professional advice should be available to those who want it, alongside a simple sales service for those who know what product they want, and would like it at low cost.

62. Qualifications should reflect the services offered. Consumers should not need to understand the entire qualifications structure. Every customer is entitled to expect staff to be both professional and competent. And there are many roles where high-level qualifications will do little to improve the quality of the service or advice offered, but simply act as a barrier to supply. In other areas, consumers with complex needs should be able easily to identify and access practitioners with the necessary expertise. Advisers need the right level of qualification for the job they are doing.

Supervision

63. Qualifications may provide a good assessment of an adviser’s skills at one point in time. But they may not reflect the standard of advice given to consumers. We need to make sure that advisers maintain the standards of advice implicit in their qualifications. Insurance companies already carry out assessments of their advisers. But this cannot replace effective regulation and supervision.

64. Recent moves towards principles-based regulation with a focus on treating customers fairly should help. The FSA should make better use of data in supervising intermediaries. More effort needs to be made to reflect the significant risks presented by small firms which individually do not pose a risk to the sector as a whole. A simple and automatic analysis of data collected from intermediary firms by the FSA could quickly identify those where the risk of business failure, or poor treatment of customers, was high. The industry would welcome the opportunity to work with the FSA as they develop a series of such measures of intermediary performance. Some possible options are shown in Table 1 below. Supervision could then target poorly-performing intermediaries, while well-performing intermediaries would benefit from reduced regulation. The FSA may even wish to consider

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publishing their risk assessment to help consumers assess the quality of firms they look to employ.

Table 1: Possible measures of intermediary businesses’ performance

Area Possible Measure Data holder

Management: Operational risks: systems and controls FSA

People: Adviser qualifications, staff turnover, Continuous

Professional Development, membership of a

professional body operating a code of conduct.

IFA

Financials: Business plan, reserves, complaint costs,

proportion of income taken as initial commission.

IFA

Customers: Persistency, TCF policy, complaints to sales ratio IFA, insurer

65. While the FSA can monitor intermediary businesses, it would be unrealistic to

expect it to monitor the quality of individual transactions of individual advisers. The industry and its professional bodies in particular must play a role here. Continued professional development and compliance with basic codes of ethics and standards must be enforced by the industry if consumers are to trust a professional intermediary sector. Individuals who break industry standards of conduct should not be able to continue to provide regulated advice. Examples from the medical and legal professions show how professional bodies can help enforce high standards of ethics. Recent moves to create fully independent disciplinary bodies in these sectors could provide a particularly important lesson for the financial services industry.

66. With support from across the financial services sector, we believe that an organisation such as the Personal Finance Society (PFS) could help develop and maintain new standards of professional conduct among intermediaries. A single professional body is required to bring these standards of professional conduct together, rather than the current fragmented approach.

Conclusion

67. The FSA’s review of retail distribution is timely and helpful. We believe that our suggestions would improve outcomes for consumers, by giving them more choice in the way they access financial services. The industry will continue to pursue these ideas. Many will not be possible without significant regulatory support, and there is work to be done to agree the necessary regulatory changes. We also recognise that the restrictions placed on UK regulation by European law will need to be addressed. To overcome these obstacles and demonstrate real consumer benefit from the suggested reforms, a full cost-benefit analysis will be central. We look forward to continuing our partnership with the FSA to bring about the necessary reforms. We would welcome the opportunity to discuss the proposals set out in this paper in more detail.

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