House of Commons - Treasury

Select Committee on Treasury Eighth Report

4 Aligning savers' and industry interests

31. The FSA's analysis that some firms have exploited consumers "because they perceive the short-term benefits to outweigh the risks of brand damage"[84] suggests that as well as better information, consideration needs to be given to how to ensure the industry behaves in the long-term best interests of both the consumer and itself. The FSA described one option as being for the regulator "to ratchet up the intrusiveness of our regulation—detailed prescription of standards and behaviour in more areas; more intensive supervision; more enforcement actions."[85] The FSA told us that it "was strongly opposed to this course"[86] due to its likely cost burden on both the industry and savers. One possible less costly approach that better serves the interests of customers may well be to look at means of ensuring that pay and rewards at all levels in the long-term savings industry are tied to those issues that really matter for savers. That some companies are judged by authoritative outside observers to be exploiting consumers for perceived short-term gains while damaging the long-term reputation of the industry suggests that fundamental changes are needed to provide better alignment between the interests of the industry, at all levels, and consumers.

Senior management remuneration

32. Several witnesses[87] told us an essential part of aligning the interests of senior management and staff with those of savers is to ensure that their remuneration, from top to bottom in financial institutions, is related to the sorts of issues that matter to savers. The Consumers' Association observed a need to ensure "that consumer interest is 'institutionalised' from the boardroom to the point of sale"[88] and the National Consumer Council agreed that current corporate governance arrangements did not do enough to align the interests of senior management with those of consumers.[89] The Committee notes that in recent years savers have too often read of top management in financial institutions reaping large rewards and bonuses at the same time as a mixture of a bear market in equities and poor asset allocation has savaged the value of savers' funds.

33. We asked a variety of major insurance companies to provide us with details of senior executive remuneration and how it was determined. Some of the results were striking. For example at Standard Life, most of the Executive Directors for whom we had information and who had not been promoted or retired through the period saw their basic pay and performance related bonuses rise by over 30% between 1999 and 2001, in spite of this being described by the company as a "period of turbulence".[90] The Committee further notes that the same directors also enjoyed substantial additional benefits from the Society's "long-term incentive plan". Other major insurance companies also gave us details of their senior managements' remuneration. In the case of Legal & General, for example, the Chief Executive's salary and cash bonus, excluding deferred bonuses and long-term incentive payments, rose from £795,000 in 2000 to £1,005,000 in 2003, a rise of over 26%.[91] Aviva provided us with information on the range of bonus payments made to executive directors: taking the mid-point of this range each year as a guide, bonus payments rose by 37.5% between 2000 and 2003.[92] Standing out against this general trend was the position at Prudential, where the Chairman of the Remuneration Committee told us the remuneration of the current Chief Executive in 2003, at £1,131,000, was 9% lower than his remuneration in 1999 when he was Finance Director.[93]

34. We also asked for details of how the remuneration of senior management was decided. Most companies replied in similar terms to Standard Life, who told us that basic pay was determined with reference to "the level of salaries paid to senior executives performing similar roles in the financial services industry and more broadly where appropriate."[94] Generally, however, there was relatively little direct linkage between the returns to savers and the total remuneration of senior management. Standard Life, for example, told us that "the relationship between policyholder returns and executive directors' remuneration is a complex one"[95] and Legal & General told us they did "not see a strong linkage with nominal investment returns as the best reward mechanism"[96] given the danger of extreme short-term fluctuations. It was clear that, for most of the companies we asked, it was issues of primary interest to shareholders that dominated the assessment of senior management remuneration. Prudential, for example, told us "we seek in the incentive element of remuneration to align the interests of shareholders and senior executives"[97] but pointed out that as a long-term business it was in the interests of shareholders to provide customers with superior service and investment returns.

35. The Committee recognises that ultimately the level of remuneration of senior management in the financial services industry is a matter for shareholders and, in the case of mutual societies, members. The recent trend in institutional shareholders becoming more active in challenging remuneration reports is welcome, and greater shareholder activism should be encouraged. Shareholders and the membership of mutually owned organisations can nevertheless only benefit from anything which helps restore consumer confidence in the industry; and we suggest that greater transparency in the determination of senior executive remuneration and a more direct linkage between remuneration and the performance of those institutions relative to market conditions and accepted benchmarks would be useful in this respect.

The role of commission

36. Away from the top tier of management, it is clear that unlike most major consumer industries, most of the people actually responsible for the day-to-day marketing of long-term savings products in the UK are paid in terms of commission on sales. Several witnesses indicated that they believed this to be one of the principal reasons why the industry is dogged by accusations of short-term behaviour. The Actuarial Profession, for example, wrote in their submission "salesmen incentivised by commission are motivated to maximise their commission. Such market activity is detrimental to consumers."[98] Similarly Mr Sandler told us that "a commission-based system where the front line is effectively rewarded on the basis of how much product it delivers to the market—and that is true irrespective of whether we are talking about a tied sales force or an independent financial adviser—such a system is always going to be prone to the more enthusiastic or perhaps the less ethical choosing to circumvent the process and deliver a product which may, with the fullness of time, not be suitable for the recipient."[99] In the Committee's view it seems likely that as long as most of the selling activity in the long-term savings industry is rewarded on a commission basis, many savers may remain suspicious that they are being sold a product for the wrong reasons. Shifting away from the current commission-based sales system common in much of the industry is likely to be a key component of any strategy to rebuild consumer confidence in the industry after the long catalogue of mis-selling scandals in recent years.

Regulatory costs & commission

37. The focus on commission within the financial services industry creates obvious dangers that some within the industry will be tempted to make mis-sales to boost short-term gains. Not only does this create loss for those who have been mis-sold, but the need to impose stringent regulations in an attempt to control the conflicts of interest created by the commission system has also added considerably to the cost burdens confronting the industry and, ultimately, the saver. As Mr Myners, author of a major report on institutional investment for HM Treasury,[100] told us, "commission based advice, where the advice is paid for by the product provider, is beset with hazard. It does not mean the hazard cannot be appropriately ameliorated, but it does require a robust regulatory regime."[101] Several witnesses told us that the "robust regulatory regime" needed to guard against the potentially deleterious effect of a commission dominated sales process is producing a sales process that is too expensive to be viable for savers on lower incomes and a sales process that is so lengthy and cumbersome that, in reality, it deters many savers. Aviva, for example, wrote to us in their submission that "the key cost components of advice are the initial and ongoing training and competency costs of the adviser and the necessary supporting compliance and regulatory reporting infrastructure surrounding sales" and that the "typical time to complete a fully advised purchase was seven hours, rising to 12 hours when account is taken of the time spent on unsuccessful leads."[102] Mr Sandler said that in his view "the more that the sales process has become the subject of stringent regulation, the more expensive it has become—the more cost has been added to the process—which has contributed to the effect of pricing out of the market of the small saver."[103] The Financial Secretary agreed, telling us that "people have been put off by the complexity of the process, the time taken and also because it is unprofitable for sales to target [the less affluent saver]."[104]

38. The proposed Sandler suite of stakeholder products is aimed at simplifying the selling process for a limited group of standardised products. More generally, however, the basic conflicts of interests created by the industry's traditional commission-led business model remain, as does the need for a stringent regulatory regime to control those conflicts of interests. It would clearly be desirable to adapt the industry's current business model to create a closer alignment between the interests of all those involved in the sale and purchase of long-term savings products, including senior management, their staff and savers. We would point out that this is an area where the industry can make substantial improvements on its own initiative. During the course of our inquiry the ABI announced that it was commissioning research to look "at the way in which long-term savings are sold, and particularly the role of commission. The aim is an objective and fact-based analysis of how the present system performs, how it might develop in the light of regulatory and commercial changes, and its alternatives."[105] The Committee welcomes the commitment from the ABI to assess the role of commission payments in the long-term savings industry and examine possible alternatives. We would emphasise the negative image created in the eyes of some potential savers by the current commission-driven distribution model. Account should also be taken of the extent to which the heavy cost burden of the current exhaustive regulatory regime reflects a need to offset the conflicts of interest created by payment by commission.

Rewarding superior investment returns

39. A greater emphasis on aligning the interest of those in the industry with savers might also improve the investment performance of the long-term savings industry. We were struck in the course of our inquiry how seldom poor returns to investors were mentioned as a factor hitting consumer confidence in the industry. When it was mentioned, it was usually in the context of the impact of the bear market in equities, a factor that many companies and those advising the industry seemed to view as an unavoidable problem for investors. Thus, Aviva, for example, told us in their written submission that the lack of consumer confidence in the industry had been caused primarily by the poor performance of capital markets since early 2000.[106] This seems to ignore the point that more astute asset allocation policies in many funds might well have significantly mitigated the impact of the fall in share prices and provided investors with greater exposure to the strong rally in bond markets. Leading academics suggest that while UK equities fell by 22.0% between the start of 2000 and the start of 2004, bonds rose by 21.8% over the same period and short-term Treasury Bills rose by 20.1%.[107] The weak returns provided to many investors in recent years in spite of the strong performance in bond markets seems to confirm the evidence we heard from Mr Myners, who told us: "the long-term record of the industry in asset allocation is not terribly good."[108] This is particularly regrettable since, as Mr Sandler told us, "there is no question that the ultimate outcome for consumers in their savings process is governed in the overwhelming majority by the asset allocation decision. Some analysts would attribute 90% of the outcome to asset allocation and the balance to security selection and stock selection thereafter"; he added that, looking at the retail market, "there is almost universally no attention given to asset allocation by advisers in this country. Their focus is on product purchase."[109] Apparently confirming this view, Mr Goford, President of the Institute of Actuaries, told us that he felt that "asset allocation has little to do with restoring confidence in long-term savings"[110] and "the best you can say of the market at any time is that the market can go up and the market can go down."[111] The Committee finds these opinions surprising given the overwhelming evidence that asset allocation is a key driver of investment returns.

40. The weight of the evidence presented to our inquiry suggests strongly that more is required to encourage the industry to focus on asset allocation and investment performance issues. We suggested to various witnesses that it might be useful to provide a stronger linkage between the charges the saver pays and the performance of the underlying investment. Company chief executives pointed out that the trail commission[112] and annual charges that are levied on many savings products are levied on the value of the fund, not the initial investment, and are thus tied to the performance of the savings product, but they agreed with the Committee that there is no arrangement giving any emphasis—or gearing—to this linkage.[113] Many of the outside experts agreed that a more powerful, emphasised linkage between charges and performance might well have a beneficial impact. Mr Sandler told us that "anything that has a performance-related dimension is further to be welcomed because it aligns the adviser more closely to the consumer";[114] likewise Professor Davis argued that a clearer linkage between performance and charges was likely to produce "much more care in terms of sales."[115] The evidence presented to our inquiry suggests that the retail long-term savings industry gives insufficient weight to the issue of asset allocation and the investment returns it delivers to savers. The fee structure that currently dominates the industry primarily rewards the initial sale. A fee structure containing a stronger linkage to subsequent investment performance would help align more closely the long-term interests of the saver and the industry.