This article is part of Morningstar’s special series about the Retail Distribution Review (RDR). It was updated January 2013, after originally being published November 2012.
New industry rules mean the fees and charges you pay on your investments are probably going to be changing in 2013, and that could have a knock-on effect on your overall portfolio returns. The new rules are called the Retail Distribution Review (RDR) and they were put in place by the Financial Services Authority (FSA) on December 31, 2012. The rules were designed to ensure that there is more transparency in the industry, especially when it comes to investment fees.
One of the main things RDR is changing is adviser commissions. For the most part, adviser commissions are being scrapped. On the surface, it looks like this change could mean more money for investors over the long run, however, new charging structures that are being put in place do not guarantee more money for individual investors.
An Explanation of Ye Olde Commissions
To understand the new rules and fees, you will first have to understand how the industry operated ahead of RDR implementation:
Pre-RDR, an adviser would construct a portfolio of investment products according to their client’s needs. Those products, such as some actively-managed funds, would charge annual management fees, and a portion of those fees would be paid by the fund provider back to the adviser in the form of commissions. In this scenario, many advisers did not charge explicit fees to clients, which made the advice seem free. But, in fact, the investor was paying indirect, on-going fees to their adviser through annual charges. As with all fees and charges, this commission and management charge would eat into investors’ overall returns.
Here is a simple breakdown of typical pre-RDR fund fees:
Typical Annual Management Fee Paid by Client: 1.5%
The fee was split into three parts and shared between the fund management company, the platform and the adviser:
|
Fund Management Company |
|
0.75% |
|
Platform |
0.25% |
|
|
Financial Adviser |
0.50% |
Note: Platforms are accounts where clients can put their money and view their investments. A client can use a platform to buy, sell and hold investments and tax wrappers, such as pensions and ISAs.
Note: The above charges/fees were widely used by actively managed funds.
The Future of Investing with an Adviser
The new RDR rules are formally splitting investment fees apart and removing adviser commissions.
Starting in 2013, advisers will have to make an upfront agreement with each of their clients about their financial advice fees and will not be able to take commissions. This should result in lower overall annual management charges on investment products.
Meanwhile, it’s expected that platform fees will also be split out into a separate fee category, though the FSA have not yet confirmed new regulations for platforms. The FSA is expected to release its platform fee regulations in early 2013 and the new rules should go into effect in early 2014.
To cope with these changing platform and fee rules, many investment product providers have been proactive in creating new fund share classes that cut out the platform fees and adviser commissions. These are being dubbed “clean share classes” because they “clean” out other fees.
Investment providers will likely be charging an average annual management fee of 0.75% on their products (i.e. funds). They will keep this entire 0.75% fee for themselves and the platform is expected to seek fees from investors via financial advisers. (In some cases, product providers will keep the platform fees embedded within their annual investment product charges for 2013, which means that some annual management charges will likely be 1.0%, instead of 0.75%.)
This £1,000+ difference is no small change!
This change in fees from 1.5% to 0.75% may look small, but over the long-run it could make a big difference to your investments, said Andy Pettit, director of data and research strategy at Morningstar. For example, if you invested £10,000 over a 10 year period where the market rose by 5% each year, by the end of the 10 years you’d have roughly £15,100 if you were paying a 1.5% management fee. Alternatively, if you were paying the 0.75% fee, you’d have closer to £16,200. This £1,000+ difference is no small change!
Note: If a client stays invested in a fund or investment product that they purchased through their adviser before the RDR rules kicked in in 2013, the adviser will continue to receive commissions on this investment. These legacy trailing commissions will only stop if the adviser and client agree to review their investments together and agree on a new form of payment. Advisers are under no obligation to take their clients out of old, commission-paying funds unless they are asked by the client or they perform a portfolio review and agree with the client that this is the best choice. Of course, many advisers will be informing their clients of the RDR changes but individuals should check that they understand the charging structure on all their investments pre- and post-RDR.
Brave New World for Investors and Advisers
Going forward, when a client seeks financial advice, they will make an explicit agreement with their adviser on some type of adviser-only fee (i.e. hourly/flat rate/percentage of assets), they may also agree on separate platform fees, and then they will continue to pay annual management charges on their investment products. Sometimes that annual management charge will be bundled to pay the investment provider and platform (i.e. a 1.0% fee), but most times it will just pay the investment provider (i.e. a fee of 0.75%).
By mid-2013, the FSA’s rules for platform charges should also be clearer and will be put into effect in early 2014.
Ultimately, these RDR rules were designed to introduce more transparency for clients around investment fees, and it also ensures advisers will focus more on their client needs when recommending investment products, instead of considering commission payments. This will help raise the reputation of the advice industry as a whole and help build trust with clients.
Changing Charges?: Investing Directly with a Fund Provider
For those people who invest directly with a fund management company or investment provider, they unfortunately may not find that investment product fees will get any cheaper in 2013. Investment product providers will still be able to charge that typical 1.5% fee, and they will simply pocket the extra money as they have done in the past. Unlike people who invest through a financial adviser, these investors will probably not have access to share classes with smaller fees.
While this industry practice may not seem fair, Pettit says it’s more difficult to sell products and work directly with individuals as opposed to working with financial advisers. Therefore, the provider can partially justify these higher fees by saying that they should be compensated for dealing directly with individual investors.
Changing Charges?: Investing Through an Online Broker
For those people investing through an online, execution-only broker, overall fees on investment products are also expected to remain the same, at least for the time being. The 1.5% annual management charge will still have to be paid, with the fee being split to pay the investment product provider, the platform and the brokerage house. Brokerage houses in 2013 will still be able to receive commissions, just like advisers did in the pre-RDR days. However, the FSA is in the process of reviewing this area and may issue new rules about commissions and fees in this particular market.
Overall Impact on Investment Costs
The FSA created these news rules and is continuing to review industry practices to ensure there is more transparency and professionalism in the investment industry. The goal was to create transparency for investors, not alter the overall fees that investors paid. Therefore, as an investor, whether you’re investing through an online broker or adviser, you should not notice any extreme fluctuations on overall costs. Simply put, there will just be a shifting of costs to bring them more clearly into focus.
