OUR PROFESSION

CONSULTATION RESPONSES

 

 

Our Profession

Consultation Responses

Response from the Association of Independent Financial Advisers to FSA Consultation Paper 07/05 – Financial Services Compensation Scheme – Funding Review

Introduction

The Association of Independent Financial Advisers (AIFA) is the trade association that represents independent financial advisers (IFAs).  Under the AIFA umbrella we also represent mortgage intermediaries and secured load intermediaries through our subsidiary associations the Association of Mortgage Intermediaries (AMI) and the Association of Finance Brokers (AFB).  AIFA currently represents over 75% of IFA firms in the UK. 

The FSCS came into operation in December 2001.  Since then, there have been changes to the FSA’s regulatory scope bringing Lloyd’s policies and mortgage and general insurance mediation within the scope of the FSCS.  The current model of 12 contributing groups each with a contribution cap, no longer affords the compensation scheme sufficient financial capacity and in the event of extremely adverse circumstances, the scheme could even be left unable to pay claimants.  The fact that the scheme to date has coped with the demands placed upon it is does not mean that it could do so in the future.  AIFA shares the concern of the FSA that the default of a medium-sized company could put a significant strain on funding and we agree that the recommendations set out in the review are only prudent.

The discussion paper DP06/1: FSCS funding review was published in March 2006 to address these issues.  Of the record 450 replies received, 300 were from the IFA sector, reflecting the importance of this review to the intermediary market. 

The IFA sector is the dominant distribution channel for retail financial products generating over 63% in monetary value in 2005.  The sector is particularly strong in the private pensions market, generating 77% (in monetary value), of all pension and annuity business in 2005.  As such, IFAs are extremely important in helping to meet government objectives by encouraging self-provision and increasing personal wealth.  Any regulatory impositions that threaten the survival of the sector would, therefore, impact negatively not only on consumers but on government policy.  Currently, the burden of FSCS levies on the IFA sector is reaching the tipping point of threatening sustainability.

Executive Summary

Design Principles

AIFA supports the FSA’s approach to the funding review.  The design principles, underpinned by the FSA’s statutory objectives, provide a robust and solid framework which can deliver a compensation scheme which is funded in a fair manner, and most importantly, is sustainable for the future. 

The discussion paper process was utilised well, encouraging firms and other key stakeholders to assess future funding at a high level and in the context of the design principles, rather than an assessment driven purely by the costs to each individual firm without reference to the future needs of participants or consumers.  The proposals set out in this consultation paper are evidence that the design principles selected by the FSA were entirely correct and will underpin a future compensation scheme that is durable, resilient and fair, acknowledging mutual financial interest where it exists. 

A real and significant issue for the IFA profession

AIFA is a member of the FSA industry funding group and has worked closely with FSA, FSCS and representatives of Oxera at the discussion paper stage.  Participation in this process has provided us with the opportunity to discuss with member firms across the country the issues around the future of the Compensation Scheme, its role, funding and modus operandi.  The excellent response of the intermediary sector to the review reflects the very real concerns of our membership and their appreciation of the regulator opening up such a wide ranging and open discussion. 

Our response is based on significant member involvement and is supported by the evidence of Deloitte’s The cost of regulation study 1 which found that costs associated with regulated activities were significantly higher in the IFA sector than other sectors.  We would wish FSA to recognise that the perception of unfairness that FSCS funding now provokes is not just anecdotal but is supported by independent evidence.  We have estimated that this year’s FSCS levy will be £1,284 per AP.  At this rate, it is yet again the largest single regulatory cost per capita as evidenced by Oxera’s findings.  IFAs pay a disproportionate share of the FSCS funding requirement and we have significant worries that it is becoming both a barrier to entry and a matter of competitive market distortion.  It cannot be right or fair that the FSCS levy has been the largest cost for firms every year for the last five years.  The impact of this is that firms are paying for departed competitors; an anomaly which a robust and sustainable Compensation Scheme should not tolerate.

Not an ‘IFA’ issue

This CP recognises that the industry and consumers need a scheme which is fair, recognises the mutual financial interest and responsibility of all parties, and is sustainable and robust.  We believe the scheme, as proposed, has the ability to deliver this.  However, while Oxera’s findings confirm that FSCS funding issues are not a uniquely IFA problem, certain myths still need to be de-bunked.  For example, paragraph 2.8 of the consultation paper refers to the argument for a strengthening of the minimum capital requirements for personal investment firms in order to lessen the possibility of defaults.  IFA firms are mortal whilst the sector is not.  Practitioners retire, change careers, etc, and the time lag between business being written and claims falling on the scheme is often lengthy.  In a fast-moving market, the firms paying the compensation often bear little resemblance to those who have been declared in default.  Indeed, the majority of firms currently meeting these costs are not the ones who have profited from what is primarily legacy business. It remains exceptional, not systemic, that an IFA firm is put out of business due to being unable to meet current liabilities.

What is more, fluidity of finance and labour has always been fundamental to the success of the UK economy and it would be untenable to have large sums of capital locked away in order to meet increased capital adequacy requirements beyond the trading life of firms.  The FSA already has the ability to require firms to hold a certain level of capital in the event of regulatory issues when they exit the industry.  More use could be made of this power rather than introducing new requirements which are limited and untested and may lead to other market distortions.  

The mortality of IFA firms does not indicate market failure but is rather the nature of intermediary business – a sector which is structurally sound2.  Evidence from the FSCS supports this assertion.  The current high levy falling on fee block A13 is not because of some firms’ willingness to ‘dump’ liabilities and reconstitute themselves as new entities.  It is mainly the result of the legitimate retirement of practitioners and the unexpectedly high compensation claims for mortgage endowments that have fallen on the IFA profession.  It is interesting to note that had the principle of ‘mutual financial interest’ been applied from day one, a completely different FSCS economic model would exist; providers who designed and marketed mortgage endowment policies and are still earning fees from them, would be contributing toward the resulting liabilities.

In our view, if an IFA were to ‘dump’ liabilities on to the FSCS, this would constitute regulatory, not compensation scheme, failure.   This has occurred previously, for example when firms were allowed to continue to trade despite still having not completed their pensions review but eventually defaulting, creating an unanticipated surge in compensation payable by the A16 block. This underlines the importance of accountability and transparency in the regulatory process.

Statute of limitations

In order to meet the aims of section 213(1) of FSMA which is concerned with ensuring that valid claims are paid, we strongly urge the implementation of a statute of limitations with a fifteen year long-stop.  This would allow firms to build intrinsic value and be better able to estimate - and therefore have sufficient resources to meet - potential compensation scheme payouts in the future.  The current open-ended approach is a barrier to entry and can no longer be considered fair either to the intermediary sector or consumers who cannot be expected to recall the precise details of meetings with advisers after such a long period of time. 

Competitive issues

The proposed scheme addresses the issues that, in our view, were damaging the sector’s ability to attract new sources of capital.  The future long term viability of the FSCS is better served by the new proposals and should go a long way to ensuring that the FSA’s prediction of a downward spiral does not come to pass.  The risk of good firms being put out of business through paying the FSCS bills of those who have left should be mitigated under the new proposals. 

The spreading of costs across the industry amongst those who benefit from a mutual financial interest, appropriate prudential regulation, and the encouragement of on-going professional development and leadership will nurture an accessible and competitive market.  This will be to the benefit of consumers, the industry and the UK economy as a whole.

 

Specific questions

Q1:  Do you have any comments on our analysis of the impact of our proposals in light of our principles of good regulation and our statutory objectives as described in the compatibility statement in Annex 2?

AIFA supports the proposed new structure. The proposals meet the design principles and are compatible with good regulation and the FSA’s statutory objectives.  We agree that the FSCS funding review should be run independently of the Retail Distribution Review (RDR) and that there is no justification for delay in implementing the new model. In our view, the continued and unsubstantiated emphasis on lack of capital being the cause of the current problems with the scheme, are mis-guided.  Whatever the outcome of the RDR, the scheme needs to be restructured to deliver fairness and ensure its sustainability. We do not think the impact of the proposed changes is likely to be significant enough in any sector to create financial hardship, market distortion or any adverse effect on consumers.

Q2:  Do our proposals strike the right balance between the various conflicting interests when applying the principle in section 213(5) of FSMA and having regard to the statutory objectives to which we have referred?

Yes, we agree with FSA’s interpretation of the requirements under FSMA.  We would agree in particular with paragraph 2.20 which is concerned with the affordability of levies for particular classes and sub-classes and refer to the above paragraph headed Statute of Limitations.

Q3:  Are these proposals for the intermediation sub-classes appropriate?

We supported Option B presented in the FSA’s  DP but recognise the potential risks associated with a model restricted to broad classes comprised of provider and intermediary firms. The impact on intermediary firms in the event of a major provider failure, could decimate the sector. This risk would be compounded for IFA firms, as most would be threatened by provider failures in three of the broad classes. We therefore support the introduction of intermediation sub-classes. 

We certainly would not wish to see any further segmentation between different types of intermediary as this would create both complexity and inefficiency. Many firms have different business models within one authorisation and the intermediary market is subject to constant change through acquisition and consolidation.

We have re-considered the benefits of having one broad class for life, pensions and investment business and conclude that there are advantages and disadvantages to the having separate classes. A merger of the two would be administratively simpler. The increasing use of wrap platforms for investment, whether directly into mutual funds, bonds or SIPPs means that money is being held on the same platform, albeit in different tax wrappers. FSA has clarified that identification of business should be at ‘product’ (i.e. tax wrapper) level.  This proposal could create difficulties for firms in identifying income generated from business being undertaken in separate sub-classes of life and pensions and investment.

However, the separation does address the concerns that we expressed about firms changing their business model over time thus allowing the possibility of removing themselves altogether from any liability for compensation in respect of traditional life and pensions business, which they may well have conducted in the past.  We therefore support the separation but will wish to work with FSA to help overcome any practical issues and ensure there is clarity over the identification and reporting of business.

Q4:  Do you agree with the special case, and the treatment, we propose for credit unions?

No comment.

Q5:  Do you agree that the home finance provision sub-class should be excluded from the general retail pool?

We do not agree with the exclusion.  As FSA rightly points out, there is mutual financial interest between home finance providers and those who recommend their products. Home finance companies design and market their products to intermediaries and benefit from the business written over the life-time of their products. We therefore believe they should contribute to the general retail pool, should the (unlikely) need arise.

Q6:  Do you have any comments about the proposed model?

In our view, a general retail pool meeting liabilities once the threshold of a broad class is exceeded is correct.  We support the proposal for a threshold as open-ended exposure for contributors would not be desirable or fair.

Q7:  Do you agree with our proposed mapping of the existing contribution groups to the new structure?

Yes.

Q8:  Do you agree with the constitution of the proposed life and pensions intermediation sub-class?

Yes.  We are pleased that FSA recognises the distinct risks presented in the life and pensions market. The inclusion in the intermediation sub-class of all firms who distribute life and pensions products, irrespective of the type of firm, is a very welcome move. Following depolarisation new distribution models are evolving and the clear division between independent intermediaries and tied is becoming increasingly blurred by composite firms, wrap services and provider ownership of and investment in IFA firms. We therefore firmly support the apportionment of the costs attributed to the intermediation sub-class being applied to all L&P business.

Q9:  Do you agree with the constitution of the proposed investment fund management sub-class?

Yes. 

Q10.  Do you agree with the constitution of the proposed investment intermediation sub-class?

The proposed constitution is fine but the point raised previously about the practicality of identifying investment business separately from life and pensions will need to be considered.

Q11:  Do you have any comments on our proposal to continue the existing arrangement in respect of claims relating to the intermediation of pure protection policies?

There is a case for firms undertaking non-investment life business to be included in the life and pensions class. Although there are some ‘pure protection’ firms, most protection business is written alongside other life and investment products or in conjunction with mortgage advice. The business models of general insurance brokers and firms advising on protection business are distinctly different, both in operation and risk.  The fact that providers of protection products are in the L&P class makes it more logical to include those that distribute their products to be in the same broad class. This aligns the interests of both provider and distributor and groups those with mutual financial interest together – which is a design principle of the Scheme.

However, we have considered the wider impact of any move to include protection business within the L&P class. If this were to proceed, the sub-class would include mortgage advisers that conduct protection business and also direct sellers of protection. This would expose firms to levies relating to pension and investment life business which would not be fair or appropriate. We therefore conclude that protection business should continue to be classed as general insurance business.

Q12:  Do you have any comments about our proposal to discontinue the A16 contribution group and for any future compensation costs to be paid for by the life and pensions intermediation sub-class?

The historic reason for ring-fencing pension review liabilities should not be forgotten. The 85% provider subsidy was agreed and accepted by all parties, including FSA, due to the wide range of extenuating and specific circumstances relating to the pensions review. However, we accept that the explicit cross-subsidy is at odds with the principles of the proposed Scheme and that the lifespan of A16 is near its end. We are also conscious of the financial strain that the current basis puts on those IFA firms that are subject to A16 levies. Absorbing the costs into the L&P sub-class, which will include providers, represents a fairer distribution of the remaining costs arising from pension review claims and retains an element of cross-subsidy.

Q13:  Do you think that the proposed levy raising structure is appropriate?

We are broadly in agreement with the proposal.

Q14:  Do you agree with the proposal to give the FSCS discretion to levy up to a 24 months period, provided that this would not lead to a threshold being reached?

Yes.  Member firms would welcome any move that helps to smooth costs. This helps toward improved financial management and increases the ability to attract investment and, on a day to day basis, manage cash flow and financial budgeting. The rule restricting the FSCS to levying for 12 months only to prevent the cross-subsidy being triggered is an essential safeguard.

Q15:  Do you agree that the last level of contributor should receive the first benefits of any recoveries made?

Yes.

Q16:  The costs of implementing the proposed model are discussed in the cost benefit analysis in Annex 1.  Do you broadly agree with the conclusion we have reached in Annex 1?

Yes, we broadly agree with the conclusions.  The proposed changes will lead to a vastly improved Scheme delivering resilience, robustness and fairness. The increased costs at Level 1, primarily affecting L&P providers, are still relatively modest unless there are significant defaults. The implementation costs for FSA and the FSCS are proportionate to the benefit that the revised Scheme will bring to consumers and market stability.

Q17:  Do you have any practical suggestions for an appropriate tariff measure for a potential wholesale pool?

AIFA have no view on appropriate tariff measures for the wholesale pool but strongly agree with FSA’s view that the wholesale and retail markets are not insulated from each other and that any major default in the retail market would have a knock-on effect on the stability and profitability of the wholesale market. 

Q18:  In addition to the issues set out in this chapter of the consultation paper, are there any other issues we should consider in formulating our proposals?

No.

Q19:  Do you agree that thresholds should be based on consideration of affordability?

The methodology used to set the thresholds appears sound. Affordability must remain the prime consideration and as most IFAs will fall into four of the five sub-classes, which have a combined threshold of £355m, account should be taken of the accumulative effect, particularly as thresholds are reviewed in the future. Currently, IFA firms are paying a percentage of turnover in FSCS levies far in excess of any other sector.  This is neither fair nor sustainable.

Q20:  Do you agree that basing financial size on estimations of the total income generated by a sub-class is a reasonable approach?

In our view this is a reasonable approach.

Q21: Do you have any suggestions on a more appropriate method of judging affordability and setting thresholds?

No.

Q22:  Do you agree that it is reasonable to set different thresholds based on different percentages of threshold size depending on whether a firm is a provider or a firm carrying on intermediation activities?

We strongly support this proposal.  Thresholds should reflect probability and impact as part of the ‘affordability’ test. The Oxera analysis is well researched and sound. It also clearly states that based on historical data, breach of the proposed thresholds to trigger the cross-subsidy should be the exception not the norm.

Q23:  Do you agree that the approach taken for the home finance provision sub-class is proportionate?

Yes. The 4%, in addition to their contribution to the intermediation sub-class is a proportionate and fair proposal. 

Q24:  Do you agree that the approach taken and threshold proposed, for the credit union sub-class is appropriate?

No comment.

Q25:  Do you agree that the thresholds should be reviewed every three years?

Regular reviews are important.   They should be carried out as frequently as is necessary to protect the integrity of the scheme.  We are happy with three years as an initial proposal but would like to see a provision for an ‘exceptional’ review in the event of industry trauma. 

Q26:  Do you agree that eligible income is a fair measure of determining each firm’s share of the FSCS levy in the intermediary sub-classes?

We agree that this is a fair measure as it avoids double counting. But regulatory fees should be looked at ‘in the round’, taking FSA and FOS fees into account.  There could be unintended consequences if contributions to the other regulatory tripartite bodies are not considered alongside a change of tariff base in one area. If FSA and FOS were also to adopt an income-based tariff we would need to assess carefully the combined impact. 

Q27:  Do you agree that insurers’ contributions to the funding of the FSCS should be based on a firm’s eligible portion of its mathematical reserves or gross technical liabilities, as well as premium income, to take account of possible claims against insurers with little or no new business?

Yes.  It is only fair that insurers which have any liability for past business, including those with closed books, should contribute.   

Q28:  Do you agree that the same tariff measure should be applied to firms on the basis of the activities they undertake in any sub-class?

We agree that the same tariff measure should be applied to firms on the basis of the activities they undertake in any sub-class.  We do not support risk-based discounts as both a firm’s risk profile and the products or activities the deal in, can change over time.

Q29:  Do you agree that there is not a case for any further special cases?

Yes.

Q30:  Do you agree that pre-funding is not an appropriate method of funding the FSCS?

We agree.  Capital would be tied up unnecessarily.

Q31:  Do you agree that a product levy is not a viable option?

A number of AIFA members have been encouraging support for a product levy, which does have its attractions. However, for the reasons stated in the CP we agree that this is not a viable option.  Also, as with any pre-funding, the assumption (at the point of sale) of requiring prepayment to meet future compensation sends out the wrong message to consumers.  ‘Pay as you go’ is far more appropriate.

Q32:  Do you agree with our approach to insurance for the FSCS? 

Yes.  We agree that this is an operational matter for FSCS.

Q33:  Do you agree with our approach to borrowing for the FSCS?

Yes.  We agree subject to financial scrutiny and safeguards such as NAO audits.

Q34:  Do you agree with our approach to the treatment of CTFs and ISAs?

Yes. There is a slight anomaly where a fee-based adviser may well charge for advice on cash CTFs and ISAs. We assume that this income would be excluded from any income attributed to the investment intermediation sub-class.

Q35:  Do you agree with advising and arranging in relation to all personal pension schemes should fall within the remit of the life and pensions intermediation sub-class?

Yes.  It is logical that all pensions should fall into the same sub-class.

Q36:  Do you agree that the proposals for the financial clean break are proportionate?

Yes.

Q37:  Do you agree with the proposal not to allow changes to firms’ tariff data if submitted more than 12 months previously?

On the whole, we would agree but we also believe that the scheme should have operational flexibility in special circumstances. The FSCS must also notify firms well in advance. AIFA will also advise members of the deadline to ensure that due consideration is given to the timing of any significant changes being made.

Q38:  Do you agree with the proposed 75%/25% split of the FSCS levy according to premium income and mathematical reserves/gross technical liabilities?

Yes, we agree.

Q39:  Do you agree that it is reasonable to levy advisory firms on the existing approved persons tariff measure and allow firms to notify the percentage of business they undertake in each sub-class for the financial year 2008/09?

We agree that providing a ratio of L&P and investment business is a fair way of avoiding double counting, which would affect virtually all of AIFA members. However, to arrive at this assessment, firms will have to identify relevant income from each activity so is there any reason why income data should not be collected from the onset?

Q40:  Do you agree that gross income is a reasonable tariff measure for the fund management sub-class for the financial year 2008/09?

No comment.

Q41:  Do you agree that the approach taken for proprietary traders where they are also registered as an approved person is proportionate?

Yes.

Q42:  Do you agree that this approach is appropriate given the need to maintain costs at a reasonable level?

Yes.  To do otherwise would be complicated and not cost effective.   

1 Deloitte,  The Cost of Regulation Study, p63

2 ABI Research Department Understanding Intermediaries, 2007  Intermediary sector employs 128,000 people, turnover was £6.5bn in 2005 with IFAs accounting for £5.3bn (82% of total).

AIFA

June 2007

 

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