House of Commons - Retail Distribution Review

Retail Distribution Review - Treasury Contents

3 Commission

Introduction

35. One of the ways in which IFAs are currently paid for the advice they provide is via commission on the products bought by some of their clients. This commission is agreed between the product provider and the IFA, but is fully disclosed to the client. Some IFAs rebate part of that commission to their client.[40] However, the FSA noted potential reasons why such a system of remuneration was inappropriate. It told us that several biases existed in a commission based remuneration environment:

Provider bias—advisers recommending a provider's products on the basis of commission payments;
Product bias—some products carrying higher commission payments than others, biasing advisers' recommendations to those products paying higher commission; and
Sales bias—generation of income is contingent on a sale being made due to the advisory firm's business model being dependent on payments of commission. This can lead to an incentive to "churn" the client's investment in order to generate income.[41]

Consumer Agreed Remuneration

36. Given the potential biases it argues are ingrained by a commission-based system, the FSA has decided, as part of the RDR, to move to a system of Consumer Agreed Remuneration. The essential purpose of the move to Consumer Agreed Remuneration is to ensure that the client and IFA agree the amount of remuneration to be paid to the IFA, rather than the IFA and the product provider agreeing the amount. Commission in its present form will no longer be an option. In his letter to the Committee, Mr Sants provided this description of the new system:

The new rules require advisers to discuss and agree with their customers how they will pay for advice, and there are a number of different charging structures that might be adopted. Payment could be a fixed charge, it could be based on an hourly rate, reflecting the time taken by the adviser to perform the service, it could be based on a % of the amount invested or through some combination of these methods. Some customers with a lump sum to invest may wish to pay for advice upfront. Others may wish to invest a regular amount each month and so be unable or unwilling to pay for advice at the outset. In such cases there are a number of different charging structures that can be adopted, for example, spreading the payment over a period of time. This might be by means of a regular payment to the adviser, or if the product provider agrees, customers would also be able to ask for their adviser's charges to be paid out of their investments. The difference between this and the present system of payment by commission is that it would be for the customer and adviser to agree how much should be paid. The product provider's role is simply to collect and pay the agreed amount.[42]

37. Much of the evidence we received was critical of this move. One of the arguments raised was that it removed a payment choice from the consumer. Mr Maurice Manasseh told us:

There is already a choice available to consumers between fees and commissions. By removing the option of commissions it means that most of middle England will not pay a fee for consultation about insurance, investments or savings for either short or long term needs. The RDR is trying to change a century of habit in one day. Why can't the consumer continue to have a choice?[43]

38. Others argued that a fee-only approach would make advice the preserve of the wealthy, who may already be paying for their advice by fees anyway. SimplyBiz told us that:

It is vitally important to note that independent advice is not at present the preserve of the wealthy with currently around 60% of IFA clients being C1 or below. If consumers are forced to pay a fee for advice it is inevitable that many who would benefit from independent advice will not seek it. Recent surveys have shown that across all groups only between 4% and 10% of clients would prefer to pay for their advice by way of a fee. It is claimed that the radical market intervention of banning commission is necessary because of the extreme bias and consumer detriment caused by the present system. This claim is not supported by the FSA's research.[44]

39. Some however were supportive of the FSA's approach on commission. Alan Smith, of Capital Asset Management Plc told us that:

[...] the removal of payment from a third party (ie commission) significantly improves the integrity of the advice offered—in simple terms if the only way I can be paid is to sell a commission bearing product (rather than, for example, pay off debts or buy NS&I products) then the advice is highly likely to be swayed towards the sale of the product. By asking the client to pay—for true, impartial advice, I am free to give fully considered opinion of the "what would I do if I were him" style—the advice is truly unhindered by conflict of remuneration.[45]

Will consumers pay fees?

40. One of the core concerns expressed to the Committee is over the seeming reluctance of consumers to pay for financial advice via a fee based system.[46] Terry Collins, of Terry Collins Associates, outlined the problem as follows:

The majority of clients within my practice are every day people on ordinary and average incomes. When they have a sum of money which they wish to invest, or when they are looking for advice to take retirement they simply will not be willing to part with hard earned cash for the type of advice which they have in the past received for free. Of course the advice has not really been free and the cost of adviser remuneration is reflected in the charging structure, however clients perceive it to be free. The clients are made fully aware of the product provider charges and are perfectly happy to pay these charges but I assure you they will not be inclined to pay anywhere near the same levels when the fee is to be paid directly.[47]

Many others also emphasised the reluctance of consumers to pay fees. For instance, John Amey, of Cavendish Independent Financial Advice, noted that:

The proposed ban on commission and fee charging will prevent clients from seeking advice because they cannot or will not pay a fee for advice. Why should my clients lose the right to pay via commission if they wish? Commission is disclosed and is no secret. I choose products that are the best for my clients and that is why, along with so many IFAs, we have solid, honourable businesses. Charging fees for advice will have a negative impact—look at what happened when Opticians and Dentists charged for checkups.[48]

When we questioned Mr Sants on the reluctance of consumers to pay fees, and whether this would restrict take-up of advice, especially for those on lower incomes, he told us:

There is reasonably good evidence of the willingness of potential investors to pay fees, but that does correlate with the available amount of money for the investment and clearly at the lower end [...] there is a risk that they would not want to pay, which is why we are encouraging the development of the other advice channels and it takes us back to our simplified advice point earlier. So, we do absolutely acknowledge that moving to more of a fee-based environment in terms of the overall marketplace working requires simplified advice and other services to also be available.[49]

Disclosure

41. Many of those who wrote to us felt that there was already adequate disclosure within the market, and that further reform towards Consumer Agreed Remuneration was not necessary. Terry Collins, Terry Collins Associates, told us that "Advisers and product providers are required to be compliant and existing legislation dictates that every minute detail of the charges and costs are highlighted and brought to the attention of the customer, it really cannot become any more transparent than it already is".[50] This point was reiterated by John Amey, of Cavendish Independent Financial Advice, who described the disclosure process already in force:

Currently, an IFA has to tell clients how he is paid. He has to offer a fee basis, but can choose (as most IFAs do), to offer additionally the option of payment via commission. My clients choose. I explain the commission comes out of the product and in the illustration of the product, the commission is shown. The key facts documents tell the client what commissions are payable for various types of product.[51]

Creative Benefit Solutions felt that given this level of disclosure the problems with the current remuneration system stemmed from the FSA's inability to police their own systems. They told us:

The ban on commission and indemnity terms (factoring) does not act in investors' best interests and removes investor choice. We believe that the FSA already has all the powers it needs in its existing rules and under their Treating Customers Fairly (TCF) initiative to protect investors against commission biased advice and abuse. Any failure in the present regulatory system reflects a failure of the FSA to properly enforce its own rules.[52]

42. The FSA itself acknowledged that there had been a system of disclosure in place. The main point it put to us was that such disclosure was not sufficient, if it was seemingly not acted upon or absorbed by the consumer. Ms Nicoll told us that the FSA "have a disclosure rule now and [...]. The evidence from our consumer research is that consumers don't listen to that disclosure; they don't understand the effect."[53] In their written evidence, the FSA provided further detail on how they thought commission led the public to undervalue financial advice. They noted that:

The role of the intermediary is to provide advice to the consumer. However, advisers' remuneration structures are such that the cost of advice (commission) is often built into the product charges. Our consumer research shows that only around half of respondents understood how the long-term value of their product would be affected by commission. Consumers are left with the impression that advice is free. The adviser's interests are often aligned with the provider, not the customer. Competition between product providers tends to focus on encouraging the adviser to recommend a particular product. As a result, product features, including charges and commission, provide incentives to attract the adviser rather than focusing on product features which are attractive to the consumer (such as delivery of good performance and long term growth or income).[54]

43. There is already full disclosure to customers of the cost of the advice they receive, whether paid for via commission or fees. However, as both advisers and the FSA have told us, many consumers appear to see financial advice as being 'free' under a commission based system, despite adviser disclosure of its actual cost. The introduction of consumer agreed remuneration under the RDR will potentially create a market price for advice. Given that some consumers will have seen advice as 'free' beforehand, it must be assumed that the setting of this price will lead to a reduction in the consumption of advice, just as would be the case in any normal market where the price of a good rises. But this rise in the price of advice may also lead to consumers undertaking greater scrutiny of the advice they are paying for, and who is providing it. Given the past mis-selling episodes of the industry, this must be a welcome development. However, we do not underestimate the scale of the change in culture that this will involve for an industry based so heavily on individual relationships.

Removal of trail commission

44. In its evidence to us, the FSA noted that "The new rules will also prevent advisers from receiving ongoing commission ('trail' commission) where they are not providing the customer with an ongoing service".[55] Consumer Focus were concerned that the need for trail commission appeared confused. They explained that:

Trail commission is paid on the fund value until the policy is either transferred to another provider or used to purchase an annuity/drawn down. The purpose of trail commission is far from clear. Many IFAs see it as compensation for the on-going servicing of their clients. This sentiment is echoed on the trade association's own website. It says: "there may be annual commission payments to cover ongoing advice from your adviser over the lifetime of your products". Others see it solely as deferred initial commission. A number of pension providers require IFAs to continue to act on behalf of their client to receive trail commission and will cease to pay trail commission if they believe the IFA is no longer servicing the client.[56]

45. Trail commission is however an important part of the remuneration system for financial advice, especially to IFAs, as the future stream of income from trail commission allows a current value to be attributed to an IFA firm. As Consumer Focus noted "many IFAs are leaving the industry in the near future and they will often want to develop an on-going stream of income, which adds value to their business before it is sold".[57] Evidence received from Mr Roger Parkes, Ovenden Parkes Ltd, shows how some advisers charged trail commission, and felt it to be a perfectly fair part of their remuneration. He noted that:

As a small company and an individual IFA, I have spent the last 25 years building up my business. I always took 3% plus 0.5% trail on all business. I believed this to be entirely fair.[58]

Consumer Focus provided evidence on the charging structure for pensions, noting that:

The initial commission might be 30% to 50% of the first year's premium for a regular pension plan, or 4% to 6% of a one-off transfer. Trail commission is typically 0.5% of the fund value. (Some pension providers pay IFAs renewal commission based on regular payments into the pension instead of trail commission.)[59]

46. However, Consumer Focus warned that "The existing charging structure for advice is poorly understood. Most (56%) personal pension holders who took their last personal pension with an adviser have heard of trail commission. Of these, only 46% are aware of whether their adviser received trail commission".[60] This corresponded with evidence from the Financial Consumer Services Panel, who stated that:

GfK research found that while most consumers were aware that financial advisers were paid by way of commission from providers, the majority were unaware of the existence of trail commission at all. Often, they did not know specifically how they were paying and sometimes "the absence of a visible payment means that advice feels free".[61]

47. Even fund providers were concerned about the impact of trail commission on the advice provided by advisers. Robert Davies, Fundamental Tracker Investment Management Ltd, told us that:

Traditionally new entrants break into a market by offering lower prices. However, this route is more difficult for collective funds because of the widespread use of trail commission. Typically a fund will have an annual management charge of 1.5% and 0.5% of that will go to the IFA. In effect this is a distribution cost. Offering a low cost fund at 0.5%, as we do, means that there is no, or very little, scope to provide a trail commission to the IFA. He or she therefore has no incentive to sell a low cost product whatever the benefits for the client.[62]

48. We also questioned the FSA on concerns that trail commission in another form would continue after the implementation of the RDR, Ms Nicoll told us that:

we are certainly saying, and our rules very clearly say, that if post the RDR, a firm is taking trail commission, then individuals will still be able to pay for the product through the product, but if trail commission is going to be paid going forward that has to be clearly against the provision of a continuing service and that the individual should be able to say, "I don't want that service any longer and therefore I want you to stop receiving trail commission".[63]

49. Trail commission where advice is not offered is very difficult to justify. However, we note the initial impact its removal may have on the value of IFA firms, and recommend that the FSA analyse the impact of this measure on the market for advice, and especially on the small-firm IFA market. We discuss later in this Report concerns expressed to us about an increase in trail commission being awarded in the run-up to the implementation of the RDR.

Removal of factoring

50. One of the changes brought in by the RDR concerns the use of factoring (indemnity commission). The FSA provided the following explanation of both the change being brought in, and the original remuneration set-up:

Under our new rules product providers will be allowed to offer consumers the choice to have adviser charges paid out of their investments. In particular, consumers who contribute to their investments on a regular basis will be able to spread the cost of initial advice fees, thus helping to maintain access to the market.

However, unlike the current indemnity commission, providers will not be allowed to advance this money to advisers before it has been collected (a practice sometimes referred to as factoring). Effectively this means that providers cannot use their own funds to advance this money to advisers before it has been collected from regular premium insurance products (such as endowments), as they currently can by using indemnity commission—where a future stream of commission payments is rolled up and paid in a (discounted) lump sum when the product is sold. It should be noted this is only a feature of the insurance market and does not feature in other product markets such as mutual funds.[64]

51. AIFA provided the following defence of the need for factoring of regular premium products:

Factoring is the cost-effective way that consumers can receive advice at outset, with the cost spread over a period. It is not practical for an IFA to charge hundreds of pounds up front when the savings plan may be only tens per month, and if the adviser can only recover the cost of his advice over a long period the focus is likely to shift away from serving customers who are seeking regular savings.[65]

Justice for Financial Services were clear as to the impact they considered the ban on factoring would have. They told us that:

The economics of advising on regular pension contributions have already become doubtful for IFAs. The RDR will make giving such advice very unattractive—the ban on factoring will stop IFAs capitalising a future income stream based on a small annual charge. They will have to levy an upfront charge, which will be a high proportion of the first year's payments. IFAs will largely withdraw from this segment of the market.[66]

AIFA warned against under-estimating the impact that the ban on factoring might have. They explained that:

we are extremely concerned by FSA's decision to ban the practice of "provider factoring", which we believe is critical for preserving and encouraging a much-needed regular savings culture. Whilst some would have us believe regular savings are inconsequential, ABI figures suggest otherwise. In Q3 2010, new regular premium investment savings and individual pensions together amounted to 14% of the entire amount invested in investment savings and individual pensions.[67]

52. The FSA were again robust in the defence of their proposals, and provided us with the following arguments for their ban on factoring:

First, there is no evidence that the current indemnity commission, which proposals for factoring by product providers would replace, has led to any substantial increase in new saving. In fact, there is some evidence that it has encouraged churn in the market, adding to its lack of sustainability. Second, the discount rate in factoring offered by product providers would have the potential to bias the recommendations of adviser firms, as different discount rates would generate different "factored" amounts for the adviser. Product providers could compete not on the price of the product to the consumer, but on the discount rate that generates income for the adviser. We have discussed a single factoring rate with OFT and their view is that this would be anti-competitive. During pre-consultation and consultation, we asked the industry for reasons to allow product provider factoring but no compelling arguments were provided.[68]

53. Consumer agreed remuneration will allow advisers to deduct their fees from regular payments made by customers for their products. Advisers would like product providers to be able to use factoring to create a single payment at the start of a product's life from this future stream of income. However, the FSA's concern is that the discount rate used in the factoring process by product providers can be used to influence advisers' decisions in a way consumers may find difficult to understand. We therefore agree with the FSA that allowing factoring by product providers would provide a potential bias in the market at odds with the overall transparency aims of the RDR.

Ensuring a level playing field

54. As we noted earlier, the RDR does not just apply to IFAs, but all advisers in the market. One concern expressed by IFAs was that the ban on commission could not be enforced against vertically integrated institutions (firms that include a product provider and a sales force), such as banks. AIFA explained the problem, and the need for policing, as follows:

we call on FSA to be absolutely clear and public about how it will police its commitment to ensure a level playing field between IFAs and vertically-integrated firms on Adviser Charging. If they are not highly vigilant about attempts to cross-subsidise advice costs from product manufacturing, vertically-integrated firms may disguise the advice costs and so undermine the foundations of the RDR.[69]

Others were more strident in their remarks, concerned that IFAs rather than bank staff would be more closely monitored. Paul Raseta made the following remarks:

The FSA is approaching this issue from entirely the wrong direction. Firstly, if the customer is to receive the correct advice, every adviser in the UK should be independent; be suitably qualified and authorised to provide recommendations across all need areas, having access to whole of market solutions from all product providers. Secondly, the FSA should then be required (by Act of Parliament) to apply identical scrutiny and rigour to monitoring the Banks' IFAs as they currently do with the present IFA individuals. Without being flippant, Hell will freeze over first.[70]

However, the FSA appeared aware of these criticisms, telling us that:

We acknowledge concerns from some IFAs that despite these changes there is still potential for certain reward structures for in-house sales staff in banks and other advisory firms to cause the types of bias we have described. We are scrutinising those reward structures for in-house sales staff across the advisory sector.[71]

55. The RDR concerns not just IFAs, but advisers in banks as well. We would be extremely concerned if banks found ways round the rules that will cover all aspects of remuneration. We recommend that the FSA (or its successor the FCA) report after one year, and then yearly, on the impact of the RDR on vertically integrated firms' remuneration structures, indicating breaches that have been found and what remedies the regulator has asked for. Only with such transparency will the IFA community be persuadable that it has not been unfairly impacted by the implementation of the RDR.

VAT

56. Another concern expressed about the change to a fees based system for investment advice was that it might attract a VAT charge, and that this might lead to price differentials between different types of advice. Mr Stuart Jefferies, of Cerberus Financial Planning Ltd, noted that:

The recent "clarification" of how [VAT] should be charged in respect of financial advice is a potential bombshell. It is clearly being interpreted differently by different product providers and already I am being approached by some with novel ways of avoiding having to charge clients VAT. The current proposals may avoid commission bias but could substitute them with a tax bias in its place. For the majority of advice given today, VAT has not historically been charged because the advice has been hidden around a policy sale. Now with customer agreed remuneration the issue of whether advice is related to a sale or advice is more open and those that are actively seeking unbiased advice where there is no product sale recommended because this is the right thing to do for the client is likely to result in an increased charge. To some extent this appears to undermine the original objectives of better consumer access to advice and ensuring the quality of advice is as good as it can be.[72]

57. Some however were not sympathetic to the concerns expressed about VAT. Jon Lowson, IFA Research and Reports Ltd, argued that:

the Anti RDR brigade continue to peddle the lie that moving to a fee charging structure will mean VAT on adviser remuneration and therefore higher costs for consumers. Whether adviser remuneration is exempt from VAT or not has nothing to do with whether the adviser charges a fee or is paid commission. Commission is exempt, because the IFA gives "free" advice and gets paid for arranging the product (intermediation, which is exempt). If the same adviser took the same commission, but told the client they were taking it as payment for "advice" then that would be VATable. Commission is only exempt if advisers keep up the pretence that they give free advice. If a Fee charging IFA charges only for arranging a product, then it will be exempt too. Personally, it appals me that IFAs give away free advice (their most valuable service) and charge for arranging a product (which requires no special skill whatsoever), even if it does makes the charge VAT exempt. In any case, VAT on fees does not necessarily mean higher overall cost. For example, if an IFA charges £100 per hour plus VAT, that would work out far, far less overall than our friend above who takes £35,000 commission.[73]

58. The evidence we have received suggests that there is some confusion on both when VAT will be payable, and how much it will raise. We recommend that HMRC, in conjunction with the FSA if necessary, report to us as soon as possible with clear guidance on when VAT will be payable for financial advice under the RDR, why it has not been payable in the past, along with any expected additional revenues from the change, and whether further reform of VAT rules in the area will be needed. The FSA should report to us on whether this imposition of VAT will have an impact on the provision of advice, and whether an unfair tax advantage between different advice models will result from the move to the RDR.

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46 It should be noted that Consumer Agreed Commission does allow the fee to be taken by the product provider from the initial investment or early payments. However, the amount must be agreed between the customer and the adviser beforehand. Back

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