Inducements and Conflicts of Interest

November 2013 Inducements and Conflicts of Interest In This Issue FCA s Final Guidance on Supervising Retail Investment Advice and Inducements and Conflicts of Interest Cash A forgotten asset class? Do Young People Engage with Pensions? Dates for your Diary Support Hub Update Outsourcing

2 FCA s Final Guidance on Supervising Retail Investment Advice and Inducements and Conflicts of Interest A year after its implementation, we are seeing the proof that the RDR was not an event but a continuing process. One of the key objectives of the RDR was to remove any potential for advisers to distort advice to clients, based on remuneration; hence the abolition of commission payments from product manufacturers. Product manufacturers now have to compete solely on the price and quality of their products, so that advisers cannot be influenced by commission levels. At least that was the intended outcome. The FCA wanted to ascertain whether this objective is being undermined by financial incentives being paid to advisers, distribution groups etc to enter into distribution/service agreements which, again, could influence client advice. If this were the case, then advisers would be breaching Principle 8 (Conflicts of interest) and the COBS inducement rules. In 2013 the FCA undertook a Thematic Review of both product manufacturers and financial advisory firms, which determined that a high percentage of manufacturers and advisory firms were in breach of the inducement rules. The FCA considers that the misuse of inducements has the potential to undermine the overall aims of the RDR. Publication of FG 14/1 follows feedback on its original guidance consultation GC 13/5. Where appropriate, the FCA s finalised guidance takes into account the feedback received from 25 respondents (the feedback is published as a separate document). It is important to note that no new rules have been made. The FCA s concerns are around the fact that rules have not always been properly applied. To whom does FG 14/1 apply? The guidance applies in respect of all retail investment products sold by advisers. It applies in respect of the payment of incentives to any advisory firm providing personal recommendations in relation to retail investment products, this includes incentives offered to unregulated, third party firms, where this ultimately benefits an advisory firm 1. Although the guidance doesn t apply to mortgage and protection businesses, these businesses are subject to the Principles for Business (including 1 Firms within the same group which both manufacture and distribute their own retail investment products (or where the advisory firm is an associate of the provider) are also subject to COBS inducement rules (plus COBS 6.1A.9R) and Principle 8.

3 Conflicts of interest Principle 8), similar considerations as those outlined in the guidance should apply to payments relating to this business. The FCA expects firms to review their existing agreements in the light of the guidance and, if necessary, revise them within three months of publication of FG 14/1 Continuing problems will lead to further FCA action. Responsibility is jointly on providers and advisory firms to make sure payments comply with the COBS inducement rules and that any conflicts are managed fairly. Conflicts of Interest FCA expects all regulated firms to operate in line with its 11 Principles for businesses. Principle 8, along with SYSC 10, covers the need to identify conflicts of interest between firms and clients or one client and another and manage them fairly. Any monetary or non-monetary benefits offered/accepted must be managed so as to remove any possibility that firms interests are put before clients interests. Once an actual, or potential conflict has been identified, firms must take all reasonable steps using effective systems to prevent such a conflict from causing material risk of damage to client interests. The COBS 2.3 inducement rules recognise that some payments or other nonmonetary benefits can be in clients best interests and that conflicts can indeed be managed so as not to harm these client interests. Inclusion of providers on panels (both restricted and independent) should not be influenced by an individual provider s ability and willingness to purchase services from, or provide other benefits to, the adviser firm. This would be in breach of Principle 8, as it would effectively put commercial interests ahead of client interests. Exclusive distribution agreements between a single provider and an advisory firm pose the risk of similar conflicts of interest. Service and distribution agreements in general should be established in a way that ensures personal recommendations by firms to clients are not improperly influenced. The FCA cited examples - such as longer term, multi-year agreements between providers and advisory firms, relying on a significant revenue stream, or clauses allowing providers to provide reduced services for reduced levels of payment (if no longer on an advisor s panel), with resultant loss of income for advisors where sufficient volume of certain product sales is reduced - as having potential for conflicts of interest which are difficult to manage. The FCA frowns upon contracts where payment to adviser firms exceeds straight reimbursement of costs and which are linked to the distribution of products. Staff at adviser firms should not provide guidance and information on provider products to advisers if they are also the ones who negotiate and provide services to those same providers.

4 COBS inducement rules prohibit fees, commission or other benefits being received for any business not specifically designed to improve client services or which breach clients best interests. All benefits must comply with the inducement rules, whether included in COBS 2.3.15G or not. If providers are unsure, they should not make a payment. Reasonable, proportionate, limited benefits with no strings attached would not give rise to conflicts of interest. These must be disclosed to customers under service or distribution agreements. An example might be payment for MI, data and research. Providers may pay cash, or give other help, to a firm (not in the same immediate group) to enable it to use the provider s software, only if it will make equivalent cost savings for itself or for clients. Being paid to assist an adviser firm with the firm s own general IT systems (including maintenance) would fall outside this remit. Training given to adviser firms by providers in the form of written material, software, lectures, etc is allowed only where it leads to an improvement in the quality of service to clients. Hospitality, gifts, prizes, etc of a reasonable value are permitted, again if they enhance client services. Such training should be made available, within reason, equally to all advisory firms that could recommend the provider s products. Providers can take part in seminars organised by adviser firms, and make a reasonable and proportionate contribution to the cost, provided there is a genuine business reason for the provider s involvement in the event. Poor practices in this area include excessive payments by providers to take part in an advisory firm s annual conference, for example, where the payment is disproportionate to the actual involvement of the provider s staff. A genuine active role for the provider would include giving presentations on its products and services, not just having a stand or hosting a small dinner. Providers on Restricted panels would be less likely to add value to clients experiences by taking part in seminars/conferences, as the advisers would, by nature of the panel, be expected to be fully aware and knowledgeable of those providers products and services. The advisory firm would be expected to pay a significant proportion of the overall costs of a seminar/conference and if it were held outside the UK, the totality (although providers would be allowed to attend). Events where hospitality is given/received must be in the UK and must have a business aim. Only essential overnight accommodation is to be paid for and costs of food and drink must not be extravagant. On no account should hospitality be offered on the basis of volume of adviser business placed with the provider. Similarly, gifts and prizes must not be excessive. Records should be kept of hospitality/gifts made to advisers to stop previously agreed limits (how much and how often) being breached. The FCA expects clearly defined policies, agreed by an Approved Person, around hospitality practices.

5 Providers may assist in the promotion of their products by adviser firms, by way of draft articles, news items, financial promotions for inclusion in a firm s magazine, etc, provided the cost is restricted to the market rate (and demonstrated to be as such) and excludes costs of distribution. The payments should not be substantial, nor amount to a key source of revenue for the adviser firm. One way of ensuring this would be to limit payments from providers for placing financial promotions to the reimbursement of actual costs incurred by the adviser firm. In the case of firms which are Restricted around the companies whose products they consider, as with hospitality costs it is less likely that significant payments would be acceptable in the area of promotion/marketing, as individual advisers in these firms will already be familiar with the provider s products. The FCA deems payments by providers to advisory firms for the privilege of holding meetings with the firm s senior management to be outside the remit of the inducement rules, as the commercial interests on both sides could jeopardise best client interests if products were favoured and recommended where those providers were willing to pay for such meetings. MI provides useful feedback to providers but payment for this information should be restricted to reimbursement of the costs incurred by the advisory firm and must result in a genuine business benefit to the provider, as well as an enhanced client service. Systems and Controls Under SYSC 6.1.1R, firms must establish, implement and maintain adequate policies and procedures sufficient to ensure they comply with their regulatory obligations. In order to fulfil these in relation to service/distribution agreements, there should be an overseeing executive committee. Providers should analyse the adviser firm s services and have clear, established, recorded policies on distributor spending. Negotiating these agreements is a completely separate process from securing a place on an adviser panel. Adviser firms must have systems and controls in place to ensure provider benefits do not in any way affect or influence personal recommendations to clients. All this helps firms to mitigate the risk of damaging their reputation and of breaching regulatory rules, with its consequences. Money spent by providers on services offered by advisory firms will not then be linked to, or dependent or conditional upon, introducing new or retaining existing business. Cost Benefit Analysis (CBA) Since the FCA is not making any new rules, Cost Benefit Analysis requirements do not apply, although it is acknowledged that some costs may be incurred by firms in embracing this guidance.

6 Most costs will have already been estimated in the original RDR CBA the only additional (minimal) costs would be in respect of reviewing existing service/distribution agreements to ensure compliance, or implementing better systems and controls to maintain such compliance. Based on the agreements seen by the FCA, it would reasonably expect firms to pay for, say, an internal legal review of its agreement (one day) and a compliance review of its systems and controls, to ensure conflicts of interest management (two days). FCA estimates a cost of around 1,000 per provider/firm agreement (more if external legal advice is sought). Consumers are not expected to incur any additional costs. The results should be a reduction in the risk of provider bias and/or any resultant unsuitable sales. Useful references: Principle 8 (Conflicts of interest) FCA Handbook SYSC FCA Handbook COBS Inducement rules FCA Handbook COBS 2.3.15G Table of non-monetary benefits FCA Guidance Consultation GC 15/5 Supervising Retail Investment Advice FCA Summary of feedback to GC 13/5 Cash A Forgotten Asset Class? When advising clients, priority is given to ensuring that clients have sufficient emergency cash funds an amount of capital set aside for short-term or unexpected needs and a percentage of available investment monies is earmarked for this purpose. However, in many cases, having identified the appropriate percentage to leave in cash deposits, advisers will leave a client to make his/her own arrangements with regard to this cash. They offer no help with selecting the most appropriate deposit taker(s) to maximise return and/or protection under the FSCS. When the amount required for the emergency fund has been determined and set aside, the next job is investing the client s remaining capital according to their needs, ATR, capacity for loss etc. This often involves the creation of some sort of portfolio and, as we all know, the principles of good investment state that investment portfolios need to be well diversified to allow for a spread of risk. The spread of risk is obtained by using as many different asset classes as the adviser (or discretionary investment manager etc.) feels appropriate, with the

2 proportions held in each asset class varying according to a number of factors primarily risk. One asset class which the majority of portfolios will include is, of course, cash. Yet very few portfolios actually contain cash. Instead, they use cash funds. Anyone who has undertaken due diligence on a cash fund will know that it is extremely difficult to find such a fund which genuinely invests only in cash a typical fund description is: Competitive rate of interest whilst maintaining safety and liquidity - investing in a portfolio of cash, deposits and other money market instruments. And, of course, money market is not the same beast as cash. Money markets are wholesale markets where banks, building societies, government etc. lend to and borrow from each other at relatively low interest rates, for short periods ranging from hours to twelve months, using short-term liquid debt instruments, such as Treasury Bills, Certificates of Deposit and Commercial Bills. Typically this sort of mix could be expected to produce a higher return than true cash but obviously with a different risk profile. All of this can reduce the cash part of an individual s portfolio (including the emergency fund) to something of secondary importance; almost that it doesn t really matter where the cash goes, as long as there is some cash (or something like cash) somewhere. Yet cash is a vitally important asset class in its own right, being a favoured method of reducing the risk profile of a portfolio. Cash deposits are also included in the FSCS, under which the first 85,000 per investor, per qualifying institution, is fully protected. There is a very strong case for arguing that the cash part of a portfolio (other than anything being held for purely tactical reasons) should be held outside the main portfolio in true cash accounts. Some advisers leave clients to make their own decisions around cash deposits for their emergency funds and might be tempted to do the same with any strategic cash as well. This could easily result in clients investing in accounts which did not offer the best interest (and other terms) and which failed to take full advantage of the FSCS limits through failing to recognise that various deposit takers operate under one banking licence. It is therefore most important that clients retain their cash in the most appropriate vehicle for their individual circumstances. Historically, researching and comparing all the many deposit accounts available has been too expensive and time-consuming for most advisers but there are systems available to advisers which can provide all the necessary research and build appropriate portfolios of deposit accounts.

3 These do have a cost but with advisers charging fees, this additional work can be built in to the fee structure, enabling advisers to provide a full and comprehensive service to clients, which includes researching the right home for the cash deposits. As with all systems, it is important to undertake appropriate due diligence to ensure that the system selected fits in with your firm s client proposition and that any transfer of control from the client to the cash manager (at least one of the available systems is based around the cash manager having control of the accounts) is adequately protected. Do Young People Engage with Pensions? Research has recently been published (12 th November 2013) around how well young, working people in different countries of the world today are prepared for retirement. This is really important and timely research in light of the introduction of auto-enrolment given the proportion of younger people in most large and medium sized businesses. Although the research is not limited to the UK market, we thought it would be useful information for advisory firms. The research is based on a survey carried out by Aegon, in collaboration with the Transamerica Center for Retirement Studies 2 It shows that young people are ready to save for retirement but lack opportunities. Key findings: 1. Young employees are realists who are ready to save for retirement but they lack opportunities. 2. Aspiring savers can become habitual savers with better education, advice and information. 3. Young employees can reach their retirement goals with access to tax incentives, financial products, and employer benefits. 2 2 Transamerica Center for Retirement Studies The Transamerica Center for Retirement Studies (TCRS) is a division of Transamerica Institute TM, a nonprofit, private foundation. TCRS is dedicated to educating the public on emerging trends surrounding retirement security in the United States, and its research emphasizes employer-sponsored retirement plans, issues faced by small to mid-sized companies and their employees, and the implications of legislative and regulatory changes. Transamerica Institute is funded by contributions from Transamerica Life Insurance Company and its affiliates and may receive funds from unaffiliated third-parties. For more information about TCRS, please refer to: www.transamericacenter.org

Future retirement shortfalls among employed young adults between the ages of 20 and 29 are likely to be due to a lack of opportunity to save, rather than a lack of will. But while young employees are prepared to take responsibility of their financial future, they also require the support of employers, retirement providers and governments to help meet their retirement goals. Initiatives that would make a difference include ensuring financial information is straightforward and user-friendly, financial products that meet modern lifestyles, more generous tax breaks on long-term savings and retirement plans, and employer benefits. On the question of employer support, for instance, contemporary employment patterns demand flexible savings products like portable retirement benefits and other workplace benefit offerings which move between employers throughout life. Meanwhile, easier-to-understand investment products from the private sector would increase young peoples propensity to save. There is also a leading role for government to play through the creation of stable longterm financial and taxation policies. The key findings in summary: Young employees are realists in a challenging environment and changing world. Working adults between the ages of 20 and 29 expect to be worse off financially in retirement than their parents (59%), and take on more financial responsibility, including funding their own retirement. Additionally, 37% believe that they will probably fall short of their retirement needs, including 27% who believe that their shortfall will be a large one - at least half of what they estimate they will need. As a result, 44% are pessimistic that they will not be able to choose when to retire, a luxury enjoyed by many of their parents. Another factor is the financial impact of caring for the older generation, with 28% expecting to provide financial support for retired parents, and 40% agreeing that adult children of retirees should help provide financial support for their parents if needed. Young employees are ready to save for retirement. A surprising and encouraging two-thirds of young employees are committed to or have the ambition to save for their retirement. A core 25% of young employees are habitual savers who always make sure that they are saving for retirement, and a highly encouraging 41% of young employees are aspiring savers who intend to save. Furthermore, the need to save is widely recognized 57% of young employees believe that retirement savings are important, but not a priority for them at the moment. Taken together, these findings suggest that many young employees are prepared to own the retirement problem, having accepted the new reality, perhaps more readily than some older employees.

Aspiring savers can become habitual savers with better education, advice and information. The survey reveals that a significant percentage of younger employees (47%) do not know if they are on course to achieve their desired retirement income a lack of insight into the future which may contribute to savings inertia. Addressing this shortfall, many young employees expressed an interest in financial education and advice. Fully 26% say that better and more frequent information about my retirement savings would encourage them to save more for retirement, 23% cite access to a professional advisor with personal recommendations, and 22% want financial education so I am more aware of what I need to do for myself. Young employees can reach their retirement goals with access to tax incentives, financial products, and employer benefits. Young employees employment patterns are different from those of previous generations. The survey revealed that 39% are planning to look for a new job in the next 12 months, compared to 29% of all employees, and 31% of young employees are thinking about quitting their jobs. Therefore, today s young employees require flexible savings products, such as more portable retirement benefits and other workplace savings offerings, which move with them between employers and across different life stages. At the same time, young employees place a high value on occupational benefits, with 87% believing a workplace retirement plan with employer contributions would be an important factor when choosing their next job. These dual needs of workplace retirement plans and high levels of labor mobility can be resolved with a more flexible range of employer benefits. A third (33%) of young employees would be encouraged to save for retirement by matched retirement contributions from their employer. Again, clarity and insight are themes, with 24% stating that access to simpler investment products would increase their propensity to save. Finally, there is a leading role for government to play through the creation of stable, long-term financial and taxation policy. Among young employees, 34% stated that more generous tax breaks on long-term savings and retirement plans would encourage them to save. The full report can be viewed at www.aegon.com/survey Dates for Your Diary! 1. The National Budget. George Osborne will deliver his Budget Speech on 19 th March. 2. All literature adverts, promotions, websites etc must be updated to refer to FCA instead of FSA from 1 st April. Support Hub Update

Aim Two Three s Support Hub has been providing services to advisory firms for almost 12 months now and those firms have benefitted (and will continue to benefit) from an introductory fee of just 120 pa. Although we reserved the right to increase this in line with CPI, no such increase is being applied for our founder subscribers in 2014. However, for firms subscribing to our services after 31 st January 2014, the annual cost of our services will be 280. Firms subscribing to our services before 31 st January will be treated as founder subscribers and their fees will be fixed through to 2017 s renewal at 120 with only CPI linked increases. There will always be a differential between the amount they pay, as founder subscribers and the fee charged for later entrants. So if the current price is attractive, now would be a good time to subscribe! Outsourcing Aim Two Three s 2013 Big Survey took place in Q4 of 2013. The response rate, while marginally up on the 2012 survey, was slightly disappointing at just 172 (163 answered all questions). However, this is a statistically significant number of responses and came from a satisfyingly wide cross section of firms in terms of size, membership of networks, use of support providers etc. Subscribers to Aim Two Three s Support Hub service can access a detailed summary of the Survey responses through this month s Coffee Break Briefing. Profile of Respondents 69% of responses came from directly authorised firms with just 31% from Network members. Only 15% of the respondents (26) were not members of networks or users of support providers. The vast majority (95.9%) described themselves as Independent. Drilling down to the Network members (53 answered the question) the proportions are about the same as the general response with 96.2% describing themselves as Independent. In line with the findings so far published from the FCA s thematic review, we doubt that all of these firms would qualify as Independent under the detailed definition but on this occasion we elected not to delve too deeply into this aspect as the FCA s analysis from their second thematic review will be published shortly and will provide a more authoritative guide. On average, excluding principals, responding firms had 3.68 advisers. Firms had an average of 1.69 principals each. In house support levels appear high with firms reporting an average of 1.42 paraplanners and 4.9 other support staff. These figures are slightly skewed by a couple of larger firms, but even removing them, the average of support staff is around 4.5 per firm so that it is

clear that firms have been moving towards a more professional structure with support staff numbers becoming roughly equal with advisory staff. Outsourcing Firms do seem to have an appetite for outsourcing some key functions (in so far as they can be outsourced). Already Outsource Consider Outsourcing Fund Research 34.57% 27.43% Product Research 22.36% 28.64% Investment 39.88% 13.12% Management Compliance 53.05% 11.95% Paraplanning 11.80% 30.20% Clearly there is some considerable growth to be anticipated in the outsourcing of investment management services and paraplanning. Fund research support would also seem to be an area where significant support is required. This ties in with the services offered by Aim Two Three. We provide a directory of approved paraplanners and compliance consultants, on whom we have undertaken due diligence, for all subscribers to our Support Hub service.