Product governance. Giving investors what they really really want

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1 Product governance Giving investors what they really really want The investment management industry is changing. The increasing focus on the role of the industry in the economy and wider society has added a completely new dimension to the issues being faced. One of the key challenges is encouraging long term retail investor savings and investments. European households currently hold significant savings in bank accounts; with interest rates at historic lows these could be used more productively. More importantly, many citizens simply do not have enough savings for their future needs. The pensions time-bomb and Europe s ageing population (at least in Western Europe) mean governments and regulators see encouraging retail savings, and investment in funds and related products in particular, as a key priority. Retail investors will only be attracted to invest, however, if they trust the financial system and intermediaries operating within it, if they believe they can safely secure a better return on their savings and know the products they are buying are fully suited to their needs.

2 MiFID II As regulation and supervision can contribute to building investor confidence, a key element of European regulators policy (both domestic and pan-european) is now focused on product governance and product lifecycle management. The updated Directive on Markets in Financial Instruments (MiFID II) and the Regulation on Markets in Financial Instruments (MiFIR) have now been published in the Official Journal. Member States have until January 2017 to transpose the new rules into law. One of the key requirements under the new rules will be the introduction of extensive product governance requirements. These are being brought in as part of a raft of measures designed to further protect investors across the EU. Who does this apply to? The scope of these new rules will be wide. The European Securities and Markets Authority (ESMA) has stated that these rules apply where investment firms create, develop, issue and/or design investment products to be launched on the primary market. Firms will be expected to have explicit product governance arrangements in place and the rules will apply equally to firms that design products as well as those which offer or recommend financial instruments they do not manufacture. They are designed to ensure that firms understand the nature of the products they are manufacturing and/or selling and that they are sold to clients for whom they are likely to be suitable. Firms that manufacture investment products will be required to identify target markets for their products, maintain a product approval process and review periodically the target markets, the performance of the investment products, and their appropriateness for their investors. Equally, distributor firms must also have in place appropriate governance arrangements, including ensuring that they understand the features of the products they distribute. The proposed text is vague regarding who is ultimately held responsible for oversight of product governance procedures. In effect all parties in the distribution chain including independent authorised fund manager service providers, ManCos and platforms will need to ensure they are informed about all products they manage and/or distribute and whether they are suitable for the target investors. Each party in the investment chain will also be co-dependent on the ability of others to comply with the new rules. It is not completely clear whether all these market participants are currently fully aware of their implications of MiFiD II. 2

3 Why is this important? With an ageing population, at least in the West, retirement and healthcare are issues we can no longer avoid. The dependency ratio for the world is forecast to reach 25.4% in 2050, up from 11.7% in In order to deal with this, Member States and Europe, unable to afford adequate pension provision from public funds, are introducing measures encouraging their citizens to focus on the accumulation (and subsequent decumulation) of wealth. European institutional pension fund assets are growing year on year. At the end of 2014 the market was worth 6 trillion. However there is an estimated funding gap across Europe of at least 1.5 trillion and this is only set to get worse in the future. As Daniel Godfrey Chief Executive of the Investment Association points out, Investment management is on the radar as never before. As longevity extends, citizens are increasingly being required both to take responsibility for building the capital that will finance their own financial security as they get older and then draw it down as they need it. Investment managers are necessarily being asked to play the central role in providing for these vital needs asset managers must be the trusted engine room for delivering good investment outcomes to savers. Firms will need to build trust within the broader community and quickly. This should start with ensuring the public understands what asset management is, how it works and how it will benefit them. The financial crisis and subsequent investment scandals have done much to damage the reputation of the financial services industry as a whole, and now asset managers are being called upon repair that damage. It s not stretching the point too far to say that not to do so will potentially abandon a generation to poverty in their old age. 3

4 It is clear to us that meeting our requirements is heavily dependent on a culture of the firm that sees the interest of the customer as paramount. This needs to be much more than what could become vague corporate aspirations. When investors place their trust in your firms to act on their behalf, they have a reasonable expectation that you will act in a fair way and in their interests. Trusted financial partners Regulators want firms to put their customers interests at the heart of what they do, to ensure customers end up with what the Financial Conduct Authority calls fair outcomes, and that customers understand exactly what they are buying. In order to do so, in many cases firms will need to undertake a process of cultural change. Distributors and asset managers are being asked to not let conflicts of interest interfere with making the best possible decisions on behalf of their clients, to ensure they spend their clients money as though it was their own and safeguard that all investment decisions comply with the investor s stated aims and objectives. Managers must be mindful of their inherent position of strength; when one party in a transaction has more or better information than the other part, as is often the case in financial markets, this can negatively affect consumer outcomes. This could lead to mis-selling, reduced trust, and so consequently undermine market integrity. Firms will need to ensure they are assisting their investors to meet their needs, rather than capitalising on their inexperience and lack of knowledge. This is much more than selling financial products that comply with regulations. What regulators across Europe are aspiring to is a culture that centres on the customer. Firms are being asked to demonstrate that they can serve the requirements of their clients and of the broader economy by acting at all times in the best interest of those clients. This cultural change process will only be successful if it comes from the top of the house. Regulators will be looking at how a board engages in conduct issues, including, for example, whether it probes into the reasons behind high return products or business lines, whether it understands strategies for cross-selling products, how growth is obtained, and whether products are being sold to the customer segments they are designed for. It s about taking responsibility at a senior level for what is designed and what is sold, what it does and in whose hands it ends up. In essence they will want to ensure that firms are translating customer focus into practices that drive how all their business decisions are made. Clive Adamson, FCA Director of Supervision, at the FCA Asset Management Conference, London The successful asset managers of tomorrow must focus on building cradle-to-grave relationships with a dramatically different and more diverse client base from today Tom Brown, global head of investment management at KPMG International 4

5 The importance of understanding MiFID is not simply about prescriptive sales standards or new systems it brings changes throughout the business. The mind-set of senior managers, system designers and staff at all levels throughout different organisations will need to reflect the new responsibilities being created when it comes to areas like product governance and staff remuneration. Implementing MiFID s investor protection requirements should be about ensuring that both the standards of conduct and the organisation of firms reflect the interests of consumers and the duties owed to them. Maggie Craig, Acting Head of Savings and Investments, at the FCA MiFID II Conference Understanding client needs One of the things that this sea change throws into sharp relief is a historical lack of retail client engagement in product design in the funds industry. Unlike many other industries that sell to retail consumers, many manufacturers and distributors of financial products are not used to researching what their customers want prior to launching products. Indeed, many fund management firms take an almost industrial approach to asset management, mass-manufacturing investment products. In order to fully understand the complex and changing needs of all their customers, firms will need to become closer to those customers as well as more innovative in the products they offer. Furthermore, the customer base may be radically different from what managers have been used to in the past. Asset managers in the future will have to learn to innovate to respond to their clients changing priorities. Investors will become increasingly focused on outcomes, such as capital growth, liability matching and inflation protection, rather than beating a benchmark. They also want to achieve sustainable returns with limited risk. Solutions will need to be tailored. People are becoming used to customisation in other aspects of life, and will expect it in the management of their assets. One good example of this is ethical investing. Just as many consumers are interested in where their food comes from and how it is produced, so they will want to know where their money is being invested and to what end. Younger people with time on their side may be willing to seek out bigger returns by taking bigger risks. However, as novice investors they may also have an inclination to speculate unwisely if they do not fully understand the investment process. For older investors, demand for solutionsbased products tailored specifically for the retirement market will grow rapidly. Retirees will have increasingly disparate needs, some will favour hobbies over healthcare, others spending over security. It may be particularly challenging for those with lower incomes or smaller pension pots to find products that suit their needs; they may have fewer options and it is important that consumers should not be disadvantaged by this lack of choice. This change in culture and approach may be difficult for some. When ESMA stated that it would not be providing guidance on how target markets should be identified and that would be up to individual firms to make their own assessments, a number of market participants demanded clarification be provided, demonstrating, from some quarters at least, a high level of discomfort with the concept of client segmentation. 5

6 Appropriateness In this new environment many consumers will be coming to the funds market for the first time and will have had minimal, if any experience of investing. As a consequence they may not be in a position to make decisions that are always in their long-term best interests. They may struggle to match their needs and appetite for risk with the products and services on offer. This will be partly due to low levels of understanding of financial products and services, and partly down to the difficulty of knowing what their future financial needs will be, given that their circumstances and the external environment could change significantly. For more vulnerable groups of consumers the challenges can be even more acute, and managers will need to be mindful of the fact that all consumers may, at different times, be vulnerable for different reasons. Client vulnerability, financial literacy and risk appetite are all areas that will need to be researched and documented when matching an investor with a product. Current risk ratings, as defined in the KIIDs are unlikely to be helpful as they measure volatility rather than risk, and firms may need to define an alternative appropriateness scale as a means of alerting investors to the type of product they are investing in. As with client segmentation, there has been a degree of push back from managers concerned about the concept of appropriateness. ESMA s MiFID II consultation contained a question around appropriateness testing, suggesting advisers should assess whether a less complex and lower cost instrument better meets a client s needs; the responses highlighted that many firms see this as a controversial issue. The so-called appropriateness test seems like a measure that should be complementary to sensible product governance, and yet I get the sense that some firms would move heaven and earth to get particular products moved back outside of the scope of the test. It feels like we need to understand why the appropriateness test is seen as such a high hurdle for firms.. Clive Adamson, FCA Director of Supervision, at the FCA Asset Management Conference, London A two way street The discomfort displayed by some industry players surrounding product governance would seem to be short sighted. Altruism aside, the opportunities offered by the potentially exponential growth of the funds industry should be incentive enough to take on board the new way of thinking about how business should be done. Rather than fretting about the difficulties of implementing the new rules, firms should be asking themselves; what are the reputational and consequent business risks of not getting this right? In its latest Annual Asset Management Report, Efama reiterated its belief that the European asset management industry has a key role to play in making capital markets a more important source of finance to Europe s economy, and in channelling savers money into financial instruments more efficiently. The regulator might be at the vanguard of driving change right now but leading asset management firms will also want to foster a culture that centres on the needs of their customers and satisfies the demands of the broader economy by facilitating capital flows and capital allocations. As trust grows between manager and investor as a result of the creation of best practice governance regimes, there will be sustainable and profitable benefits accruing to asset management houses in the future. 6

7 Case study the UK approach The UK has already started work on its own product governance agenda ahead of the implementation of MiFID II. The FCA has placed product development and governance at the heart of its focus and activity. It has introduced a retail consumer segmentation model known as Consumer Spotlight which looks at how people in the UK deal with money and financial services and focuses on the capabilities and potential vulnerabilities of different groups. It includes descriptions of ten consumer segments based on financial characteristics and behaviour. The data has been made public so firms can use it to design products to suit their customers needs should they wish to do so. Furthermore the FCA has stated that it expects firms to make the parameters of a product clear to investors and that they must demonstrate thought and consideration for the needs of investors in order to manage their expectations efficiently. The UK investment manager industry body, the Investment Association, has published a Statement of Principles for Investment Managers. This statement sets out what it believes the responsibility of managing other people s money means in context. It goes further than the regulatory requirement of treating customers fairly and has expressed the view that investment managers always put clients interests first and ahead of our own. The third of the ten principles specifically deals with the product governance agenda: Only develop, offer and maintain funds and services designed to add value for clients and help them achieve their financial goals. The Investment Association is expecting members to sign up to these principles and a list of those members that have done so will be published on their website. 7

8 In conclusion Product governance is a key element of the European investor protection agenda. Changing economic and social trends mean the importance of a well regulated and appropriate funds industry is becoming increasingly important. Simple compliance will not be enough. To make their businesses sustainable, firms will need to take a long-term view. This will mean becoming genuinely customer-centric, refining or, in some cases, completely overhauling operating models, strategy and culture. Products sold must be fit for purpose and investors must be confident they are buying from firms that have their best interests at heart. This may represent a challenge for some firms, but for those that get it right it also offers a great opportunity. And fundamentally, it s the right thing to do. Contact us Peter Hugh Smith Managing Director e: peter.hugh-smith@capita.co.uk Capita Asset Services is a trading name of the following companies. Capita Financial Managers Limited, Capita Financial Investments Limited and Capita Financial Administrators Limited which are authorised and regulated by the Financial Conduct Authority, Capita Financial Administrators (Ireland) Limited and Capita Financial Managers (Ireland) Limited which are authorised by the Central Bank of Ireland, and Capita Sinclair Henderson. FS14724b