Retail distribution: breathing life into a stalled market Debate on the Retail Distribution Review over the coming months will determine the shape and tone of the regulatory framework for the foreseeable future. John Gaskell, the Faculty's financial planning manager, identifies the main themes. July 2007 In broad terms the Retail Distribution Review represents one further attempt by the FSA to address the market failures that have plagued the UK retail financial services sector. At the highest level, the history of retail financial services in the UK can be perceived as a prime example of the problematic nature of markets, which by their very nature are characterised by the phenomena that economists and academics refer to in terms of 'asymmetric information' and 'credence goods'. Some of the most obvious manifestations of market failure include: ● The fact that only a relatively small percentage of the UK population actively engages in the market for personal financial advice, products and services; ● Barriers to entry are perceived as disproportionately high, and existing players continue to have difficultly generating adequate returns on capital relative to the perceived risks of participating within this particular market; ● The UK retail financial services sector has, at best, had a patchy track-record in delivering products and services that are consistent with the long-term interests of retail consumers (endowment and pension review, low persistency rates, etc). The general level of public trust and confidence in the ability of providers to meet the long-term interests of consumers is below that required to support a functional marketplace for sustainable retail financial solutions. High-level consequences The above outlined summary of market failure in this sector, arguably, has a number of broader socio-economic consequences, to include: ● The retail financial services sector has failed to deliver an efficient market mechanism capable of facilitating the transition from the welfare state, to a post welfare state socio-economic model capable of accommodating the demands posed by the demographics of an ageing UK population; ● Personal savings rates remain persistently low and the related pensions shortfall continues to build; ● Inefficient allocation of resources across the retail financial services sector characterised by: a significant proportion of capital which has evaporated in the form of disproportional administration costs; high levels of lapsed policies that have delivered little or no value to consumers; and, substantial regulatory fines which imply that providers have had considerable difficulty in aligning their business models to the longterm needs of consumers; ● The failure of the state and the private sector to harmonise their respective regimes has impeded customers in constructing affordable, practicable, and privately funded, long-term financial provision that is complimentary with the state system of tax, pensions and health and social benefits.

Proposed solutions The Retail Distribution Review proposes a number of regulatory changes that are perceived as capable of addressing the market failures in the retail financial services sector. These proposals include: Market segmentation Dividing the retail financial services sector into four segmented and connecting layers, with a fifth segment, which is referred to in terms of, 'non-advised purchases and sales: ● Generic, non-regulated advice: intended to deliver information, guidance, and steerage to consumers; ● Primary advice: low-cost, mass-market distribution channel, described in terms of delivering regulated advice on a substantial range of savings (and, possibly, protection), but which require limited analysis of needs when determining product recommendations; ● Full advice, covering the full range of in-depth needs and analysis, which will be delivered by advisers who possess higher levels of competence and experience and which is, presumably, intended to serve the needs of the more affluent; ● Focused advice: deep-level analysis, restricted to a narrowly-defined range of needs; ● Non-advised purchase and sales: consumers choose a particular product without being specifically advised to do so. The rationale behind these particular proposals is, presumably, rooted in the notion that a more highly segmented retail distribution model will enable consumers and producers to more readily engage and, by so doing, generate substantially higher levels of mutually beneficial outcomes. To date, the prevailing retail distribution model has, arguably, proven itself relatively unable to accommodate the diversity and complexity of needs that characterises the UK retail financial services sector. However, attempts at resolving the challenges and opportunities posed by market diversity does not necessarily equate to the need to add further layers of perceived regulatory complexity, particularly within a market environment which consumers tend to perceive as opaque, confusing and, often, simply of limited relevance to their perceived needs and priorities. The professional model The Retail Distribution Review states that the FSA now perceives the development of a professional environment for the delivery of retail financial services as a fundamental cornerstone in addressing market failure in the retail financial services sector. To that end, the FSA appear to be highly supportive of exploring ways to create an environment that is conducive to the development of a body of competent, ethical and respected professional personal financial planners. Indeed, within the Review, the FSA confirms that: "The group concluded that the main way of achieving higher standards of competence and behaviour, and better labelling of services, would be to enhance the role of professional bodies. We (FSA) support this idea." The above statement gives every indication that the FSA recognises the relevance and importance that the professional model and notion of the professional ideal in respect of addressing market failures, and it would appear that these concepts are beginning to occupy more central ground in the consciousness of the FSA. The move towards principles-based regulation is also highly supportive of that perception.

The application of professional discretion, in accordance with broad principles, requires high levels of professional competence if suitable advice is delivered on the basis of professionally conceived judgments, rather than in the form of mechanistically conceived recommendations that, on occasion, arguably represent little more than the prescriptive adherence to regulatory rules. ● Qualifications, Competence and the Professional Ideal Presumably, a profession of financial planners would broadly be developed on a similar basis to other established professions. Securing profession status for this emergent profession would, thus, be contingent upon the acquisition of appropriate knowledge and expertise, operating within a business model conducive to the application of that knowledge and expertise in accordance with the best interests of clients. The importance of the notion of professional independence, and the relevance of a code of professionally framed ethics and conduct as a controlling mechanism within such a market environment, would increasingly occupy central stage. In this regard, the FSA proposals outlined within the Retail Distribution Review highlights the desirability of consolidating examinations, but also alludes to the view that that there may be room for professional guidance from more than one professional body. The Review welcomes specific input from one or more professional bodies during the six-month consultation period. ● Independence and Customer-Agreed Remuneration Professional status dictates that professional advisers must act in the best interests of clients, which, in turn raises issues as regards how and by whom professional advisers are remunerated. The FSA proposes that professional independence and the avoidance of potential conflicts of interest should be facilitated through the introduction of the notion of 'customer agreed remuneration' or so-called 'factory-gate pricing'. The idea here is hardly either new or revolutionary, and in broad terms, revolves around the principle that advisor and advisee must, in advance, agree the terms of their relationship and that , with the consent of their client, an advisors is free to engage with a product provider to negotiate individual terms from that product provider, subject, of course, to the overarching caveat that the advisor's role is to protect the best interests of their client and their client alone. Capital inflows and outflows The Retail Distribution Review provides specific reference to the need to reduce barriers to entry, and to create an environment that is relatively attractive for new entrants and that is supportive of business models that are consistent with generating long-term transferable capital value. With the above in mind, the Review proposes that a 15-year long-stop is put in place in respect of the ability to refer complaints to FOS. In other words, the proposed long-stop would result in consumers losing the right to compensation if they had not become aware of the cause for complaint until 15 years after the event to which the compliant refers. The argument in favour of this ostensible reduction in the power of consumers principally revolves around the notion that, to attract and retain capital into the retail financial services sector, monetary risks must be quantifiable and manageable. If no such finite and manageable quantification of risk is possible, the free market dictates that capital will exit the sector and potential capital inflows will be constrained to the extent that, on balance, consumers will be substantially disadvantaged. Sustainable business models

The Review places some considerable emphasis on supporting business models that are capable of building long-term relationships with retail customers, and that remuneration models are consistent with this objective. In this regard, the relevance of WRAP platforms, and the need to balance advisers and providers shorter-term cash flows needs with the with longer-term interests of customers, requires detailed consideration within the scope of the consultation process. Financial capability A number of high-level linkages are made within the Review for the continued importance of driving and building on the Financial Capability Programme as a means of reducing consumer apathy, encouraging healthy financial habits, and reducing the negative market consequences of information asymmetry. Role of wraps and fund supermarkets Alongside its work on retail distribution, the FSA issued a discussion paper on wraps and fund supermarkets. Here, the FSA identifies the potential benefits and risks involved in firms using wraps and examines the extent to which platforms might fit into retail distribution in the future. Many platforms offer advisers facilities designed to support them in making changes to the services they offer, such as moving away from being paid by commission, or building ongoing client relationships instead of offering purely transactional advice. The consultation period for DP/07/2 "Platforms: the role of wraps and fund supermarkets" closes on 26 October 2007. CII urges advisers to focus on professionalism An independent report commissioned from Deloitte and Touche by the Chartered Institute of Insurance Group, which incorporates the Personal Finance Society, shows its members strongly advocate a framework to raise standards for the public benefit and encourage professionalism and trust across the intermediary sector. Around 90% of the CII Group membership believe the future prosperity of the financial services industry depends on achieving parity with other professions such as accountants and lawyers. The CII/Deloitte and Touche report suggests adopting a 'tiered professionalism' approach to create the opportunity to raise existing standards: ● Clearly-defined tiers of service from professional through to primary/generic advice; ● Significant consumer input and research to refine ideas developed by the industry; ● A regulatory dividend for any changes that are proposed; ● Any distinction between the role of professional bodies, the FSA and the EU needs to be clearly defined; ● The adoption of a model for professional self-regulation in the future. Initial Reactions to the Review The publication of the RDR generated huge response. On the opposite page, FS presents a selection of comments. The consultation period runs until 31 December 2007. FSCP: Can industry move away from commission? The Financial Services Consumer Panel congratulated the FSA, saying the RDR Paper is important and timely: "If the right changes are made, it could be the

most important thing that the FSA has done for consumers. The Panel is pleased that the Review has looked at how to improve the standards of training and competence for advisers and the impartiality of the advice they give." However, the Panel had reservations: "We are concerned that the options proposed by the FSA would create new categories of adviser when there are already so many different types of adviser in the marketplace. This does not make it easy for consumers." On the future of commission, John Howard, FSCP chairman, said: "The FSA has acknowledged that ending commission payments to advisers is a possibility, and the Review suggests the remuneration model we have been advocating of 'Customer Agreed Remuneration' or 'Factory-Gate Pricing' as an alternative. However, the industry may need the FSA to take more of a lead on ending commission. We doubt whether the industry can move to a new system of its own volition, as there is little advantage to the first movers in the market." ABI: celebrate focus on professionalism Stephen Haddrill, director general of the Association of British Insurers, said: "We are looking for proposals that will strengthen consumer confidence in saving. We recommended that the role of commission be reduced and that the training and qualifications of advisers should be strengthened. "The FSA's focus on improving professionalism and on making it clearer to customers what they can expect from their advisers is the right one. And we are encouraged by the FSA's willingness to review whether regulation is producing unintended consequences, and therefore discouraging people from saving." IMA: tackle commission bias The Investment Management Association has urged the FSA not to miss the opportunity to tackle commission-bias in the retail market. Richard Saunders, IMA chief executive, commented: "We should not shy away from accepting that commissiondriven mis-selling is a reality in the retail market. I do not see how it can be consistent with treating customers fairly for clients to be put into high commission paying products without first ensuring the first £7,000 of savings is placed in a tax-free ISA." On the subject of an overhaul of the advice regime, he said: "The ideas for the creation of a new tier of professional financial planners are welcome, as they go with the grain of developments in the market and will help promote transparency. The growth of platforms will also play a significant part in fostering greater transparency in the market. But the concept of offering a range of simple products backed by simple advice has been tried before without success. It risks creating an uneven playing field which will work against more transparent products such as funds. Even a simple product can be mis-sold and we are concerned that certain types of distributors, and therefore products, may be favoured in a mistaken belief that the product being sold is 'simple'. "Experience in continental Europe has been that bank distributors have favoured opaque but profitable structured products over transparent, regulated products like funds. It would be a great pity and bad for consumers were the FSA to allow such a situation to develop here." Sesame : caution over open liability IFA network Sesame urged the FSA to use its analysis of prudential requirements to limit IFA liabilities. Advisers are concerned about the impact

of open-ended liabilities on capital requirements and the market value of a business, since any buyer would effectively be taking on, say, liability for pensions advice perhaps given decades earlier by a previous owner of the firm. Sesame supports the move to raise capital requirements and the introduction of risk-adjusted capital for adviser firms. It says this will help to ensure that successful adviser firms no longer have to pay excessive levies for the past mistakes of failed firms: "However, to be successful, this must form part of a robust package of measures. The FSA must provide concrete incentives to those firms that demonstrate the highest professional standards, in the form of reduced regulatory burden and costs. While it is right that certain firms should be expected to hold more capital, the continuing open-ended liability from past business is an unacceptable burden on all professional firms, and acts as a disincentive to quality firms investing further capital. " Sesame has called upon the FSA to provide a six-year statute of limitations for complaints. IFA Promotion: caution over "independence" IFA Promotion, working under the brand unbiased.co.uk, is concerned some advisers may qualify as "independent" even if they only advise on one company's products by virtue of the fact they are remunerated by the consumer rather than by the product provider. David Elms, chief executive, said: "Many pieces of research over the last 10 years have pointed to the fact that only a small percentage of consumers believe independence should be based on payment method. The majority of consumers believe the term independent should only apply to advisers that can offer advice on products available across the whole of the market. "The RDR proposals directly contradict this. We have grave concerns that the proposals if implemented would lead to more unnecessary consumer confusion." Ernst & Young: winners and losers Ernst & Young insurance lead partner, Shaun Crawford, said: "There are two clear winners from this paper: the truly independent, whole of market fee-based IFAs who are actively seeking chartered qualifications. They should be able to demonstrate that their liabilities are adequately managed and thus avoid larger capital outlay. And secondly, the banks for whom this paper almost appears to have been scripted. "The likely significantly increased capital requirements of the general financial advisers (GFAs), including the multi-tied existing IFAs and their lack of 'independent' status, will drive an enormous amount of consolidation. This will be particularly pertinent as new branded distribution businesses, including provider-owned distribution, take ownership and the banks take advantage of the license to expand their market. “The big question is; will the banks finally seize the initiative handed to them on this silver platter?" Deloitte: more work needed Deloitte says the RDR is only an initial step to retail distribution restructuring. Caroline Gardner, insurance director at Deloitte, said: "To truly change the distribution market significant progress will need to be made on consumers' willingness and ability to become informed buyers of complex savings products." Deloitte also argues that work needs to be done to enhance providers' ability to offer alternative remuneration models, with product charges designed to reflect costs, and that a wider range of products should be considered within the scope of the review, including protection products and mortgages. The firm says the review will lead to

greater institutionalisation of advice, providing opportunities for large financial institutions, such as banks, to grow their market share.