This article is part of Morningstar’s special series about the Retail Distribution Review (RDR).
The way you invest your money and receive financial advice is officially changing in 2013. The Financial Services Authority (FSA), which regulates the UK financial industry, has created something called the Retail Distribution Review (RDR), which is a set of rules and regulations that was put in place on December 31, 2012 that fundamentally changes the way the financial advice industry operates within the UK.
The rules were put in place to ensure more transparency and fairness in the investment industry.
Below is an overview of the main changes:
1. Independent vs. Restricted
Financial advisers are being split into two distinct categories: Independent and Restricted. When you speak with any adviser, they will have to tell you which category they are in.
Independent financial advisers (IFAs) will be required to have more qualifications starting in 2013 to ensure they are better able to advise clients on investment decisions. IFAs will need to consider all different kinds of investment products such as funds, ETFs, investment trusts, pensions, annuities and more. They must be knowledgeable about all investment products and investment providers in the market. IFAs do not have to recommend all investment products that are available in the market to their clients, but they do have to consider all products before rejecting them as unsuitable.
Restricted advisers will also have to increase their qualifications but do not have to be knowledgeable about all areas of the market. Instead, they have the freedom to pick and choose which investment products, providers and areas to specialise in. For example, they may focus simply on pensions or focus only on selling products from a specific investment provider. Some restricted advisers will advise clients on nearly all investment opportunities in the market, but if they lack knowledge in just one area, then they will not be able to call themselves “independent financial advisers”. Their ability to advise on all investments will be limited, hence the name “restricted”.
2. Changes to Commissions and Fees
Many investors don't realise that financial advisers used to make money through commissions. But the new RDR rules stipulate that all advisers will no longer be able to receive commissions from fund companies for selling new funds to clients in 2013. Taking commissions out of the equation will be a game-changer for the industry as a whole.
As of 2013, all independent and restricted advisers will have to ensure that they have an upfront, transparent agreement with each of their clients about fees before giving financial advice. The new rules requiring an upfront agreement on client fees instead of commissions will make advisers' charges more transparent for investors and will ensure investors receive unbiased investment advice.
Previously, when an adviser sold a fund to a client, the client would pay an annual management fee each year to the fund company and then some of this money would be sent back from the fund company to the adviser. This commission money was a type of ‘thank you’ to the advisers for selling the product in the first place. For example, if an investor paid a 1.5% annual management fee each year on their fund, their adviser would get a sizeable cut of that fee. That slice of the fee, which is called a trailing commission, allowed advisers to give advice to clients without charging any significant upfront fees. Some investors may have been led to believe that the advice that they were receiving was free, when there were actually indirect costs involved.
This practice of receiving commissions is being phased out in 2013 because it was known to create bias amongst financial advisers: advisers could have potentially been recommending investments products that offered bigger commissions, instead of suggesting more suitable products for their clients.
Meanwhile, investment broking companies (such as online discount brokers) will still be able to receive commissions when they sell investment products, such as funds.
New Charging Structure for IFAs
Different advisers will charge their clients differently starting in 2013. For clients who need one-off advice, advisers may agree to charge a flat fee or an hourly fee. For clients who want more regular contact with their adviser, an annual charge may be arranged where the client pays the adviser a small percentage of their portfolio each year.
If you bought a fund from your adviser before 2013, you may still be paying them indirectly through fund commissions into 2013 and beyond. Your adviser does not have to advise you to switch into a non-commission-paying version of your fund unless they conduct a review of your portfolio and recommend changes. Meanwhile, some fund companies are automatically switching clients into new fund share classes, which strip out the commission charges. These new fund share classes are being dubbed “clean” share classes. Check with your IFA to see if indirect commission payments have continued in your funds.
The Ultimate Goal of RDR
The ultimate goal of RDR is to ensure there is more transparency and clarity in the investment advice industry. The higher qualification standards for all advisers will ensure they offer better quality services. The new rules about commissions and upfront agreements on charges ensure that investors understand the true cost of advice and can trust that they are receiving unbiased information. The ‘restricted’ nomenclature ensures investors are aware that the advice they are receiving may be suitable advice, but it is not based on an assessment of all available options.
For more information on RDR, look at Morningstar’s special series about the Retail Distribution Review and read this document from the FSA about what the changes mean for individual investors.
This article was updated January 2013. It was originally published November 2012.
