Financial regulators are rarely the most popular guests at the dinner table, particularly when they are in the business of changing rules. The UK’s own Financial Services Authority (FSA) is no exception to that trend. The Retail Distribution Review (RDR) is one example of regulatory reform that has made the FSA the unpopular subject of a popular debate.
Yet when Hector Sants, Chief Executive Officer of the FSA, stood in front of the Treasury Select Committee two weeks ago, he said that as work on RDR is being finalised, he is seeing “no widespread opposition” to the reform. Indeed, we at Morningstar agree that improving cost transparency in the business of financial advice and building a better qualification framework for advisers are respectable objectives.
That said, there are multiple questions regarding how successfully the regulatory changes will achieve their intended goals and what the impending impact will be on individual investors. Two years and 713 pages of written evidence after the RDR inquiry first began, several contentious issues remain, not least the question of whether RDR-induced industry consolidation is in the interest of the end consumer, or the question of how the switch from various business models, including one based on commission, to a fee-based business model will impact the affordability of financial advice.
Who Is Getting Kicked Out of the Market?
The FSA expects that between 8% and 13% of currently operating IFAs will leave the market after RDR is implemented. This translates into 3,800 to 6,100 individual job losses.
The main impetus for this change is that RDR requires advisers to achieve a standardised level of qualification and to bare the cost of this education in order to continue practising. “We can probably safely say that many of these advisers have chosen to leave the market because of the need to take exams,” commented Dennis Hall, founder of Yellowtail Financial Planning. “There is therefore an argument to suggest that individual clients will be better protected because the person they deal with in the future will be better qualified.”
Arguably, the FSA aims to improve the marketplace by ridding it of the type of practitioners that No Monkey Business founder Stuart Fowler calls “cowboys”, or “people who have not been particularly concerned about anything other than maximising the profit of their business.” However, Fowler is doubtful of whether introducing tougher qualification requirements was necessary to achieve this goal. Fowler, who was a member of the Financial Services Skills Council's working group on exam standards, believes knowledge gaps in the investment management industry remain unaddressed by the RDR exam requirements. One such gap, in his view, is advisers’ understanding of financial mathematics and the use of probability calculations in portfolio planning. This is one of the main reasons why Fowler does not believe that qualification changes will “make any difference for consumer outcomes.”
In fact, Fowler points to a study by the Centre for the Study of Financial Innovation which concluded that the most likely way to improve the outcome for customers via the raising of skills and standards across the IFA industry is to popularise technology-based advisory tools and give IFAs the skills to take advantage of them.
From where we stand at Morningstar, we see a perpetually evolving financial services industry, which in turn creates a need for continuous education. Therefore we look favourably on the concept of increasing qualification requirements for IFAs and actively support this objective by providing training support for advisers through dedicated Gap Fill sessions.
An (Oliver) Twist for Investors?
The prospect of thousands of advisers leaving the market has naturally raised the question of ‘orphaned clients’ and the new costs they will have to face in seeking advice. “Individual investors who can afford to pay for the advice will be adequately served, but clients who have had advice that has been effectively subsidised by wealthier clients will find they either need to pay more, or receive a lower [quality] service,” said Hall.
Indeed, the IFA community is engaged in various discussions of how to adapt its business model in order to retain both its profitability and client base and the range of competing views on the impact of RDR is broad.
“The fact that RDR will price people out of access to financial advice is overstated,” said Jim Murphy of Morningstar’s Adviser Workstation team. Murphy explains that in certain situations individual investors who may find the cost of independent advice too high are not precluded from seeking guidance from less sophisticated and therefore less expensive outlets. “The key,” says Murphy, “is to know that you get what you pay for.”
The Independent, the Restricted and the Simple
So what is it that you can get? The RDR reform envisions that financial advice will be categorised into three separate tiers. The highest tier is independent advice. According to FSA publications, this is advice based on a comprehensive and fair analysis of all products and providers in the relevant market. In contrast, restricted advice, the second category the FSA has created, is advice based on a limited range of products or providers.
The third type of advice is the so-called simplified advice. In his recent hearing in front of Parliament, Sants dubbed this service a “key component” of making advisory services widely accessible. Although definition issues around what simplified advice actually entails still remain, a simplified advice provider would normally offer standardised, cost-effective solutions that provide consumers with investment recommendations based on a simplified—one could read ‘limited’—assessment of their financial needs. They usually rely on sets of pre-determined questions and are heavily based on software models.
State Your Value Proposition
The potential emergence of new players on the simplified advice market, and the emergence of a tiered wealth management environment in general, will force advisers to clearly define their value propositions. That is, by pursuing the objective of making the cost of advice transparent, RDR is simultaneously mandating the industry to make clearer the value added by their services.
A cost differentiation will likely be introduced between advice that focuses on planning and advice that focuses on product selection. In addition, “where that advice covers higher risk areas, the fee may increase,” Hall believes.
What Do IFAs and Travel Agents Have in Common?
As often happens with consumer choice, too little can impair the consumer experience but too much can confuse the consumer unnecessarily. By expanding the range of available advisory services, RDR could leave investors debating between the cost of sophisticated independent advice and settling for an off-the-shelf product whose servicing fees are likely to be lower. Choosing one over the other is a question of needs as well as financial resources.
In addressing this scenario, Fowler highlights the difference between investment planning advice and investment advice. In his view, there are four or five key life stages and financial planning milestones which should be planned for with the help of an adviser. Allocating your resources during your wealth accumulation years and saving for retirement are examples of important long-term goals where paying for professional advice can yield significant benefits. “If you have done good work in defining the objectives and the time horizon,” Fowler says, “then managing the money is a piece of cake.” Planning is less well addressed by software products and instead relies much more heavily on conversation between the client and adviser. While the planning aspect is very much reliant on building a relationship and understanding, the investment process, on the other hand, can be largely reduced to mechanistic processes. In this scenario, the reliance on technology can massively reduce the cost of providing investment implementation, Fowler said.
Ana Georgiou, product manager of Morningstar’s Adviser Workstation software, offers a helpful metaphor: think of investing as taking a trip and deciding whether you will book your flights online or through a travel agency. If you know where you are going and approximately how much you want to spend on getting there, the do-it-yourself option is preferable. If you are embarking on a long multi-city trip, then paying for the help of a professional might be worthwhile.
A Travel Tip
Seeking financial advice and travel advice have one more key thing in common – you have to have a general idea of what you expect from your journey and how many stops you will be making on the way. In the context of financial planning, this means that a saver should be able to identify the crucial stages in their wealth management process and the complexity of the advice they require. By pushing advisers to clearly define their value proposition and motivating individuals to understand what level of service they need to pay a fee for, RDR is likely to increase financial planning awareness among the retail segment of the market. However, the bottom line is that individual investors need to actively seek value for their money in the post-RDR environment in order to avoid situations of overpaying for a level of advice that they don’t require or receiving advice of sub-optimal quality. In our view, this is a consumer responsibility no qualification exam can remove.
