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Commission possible

There are two essentially separate points in CP121 – the proposed changes to the rules about polarisation and the proposed introduction of the defined-payment system for IFAs.

The first is about distribution and could be introduced without the second (which is about remuneration). The converse may also be true in theory but, in practice, the impact that the defined-payment system will have on IFAs is such that new distribution options are necessary to avoid a reduction in the size of the adviser market.

Most of the analysis we have seen on CP121 has concentrated on the first point. There is a general acceptance that this part of the proposals will go ahead and the discussion is around the detail and how it will operate.

It is less clear that the defined-payment system part of the proposals is an essential part of the package and the justification for its introduction is open to challenge. Nevertheless, I want to look at the implications of the defined payment system if it does come into effect.

Paragraphs 4.30 to 4.40 in CP121 deal with the new definition of independence and the main references to the definedpayment system will be found there.

Most IFAs will be familiar with the detail by now. For those who are not, some may still be working on the assumption that operating a defined-payment system means that you could no longer be remunerated by commission on products sold.

This would be a forgivable misunderstanding since it is what the FSA said in the press release accompanying CP121.

In fact, it is possible to offset commission paid under the contract against the defined-payment system amount if that is acceptable to the adviser and the client. Indeed, if commission exceeds the defined-payment system amount associated with the sale, the adviser can retain the balance on account against future defined-payment system payments for that client.

So is the defined-payment system simply commission by another name and can the IFA, with a little bit extra bookkeeping, can carry on regardless?

Unfortunately, this seems unlikely. For a start, the defined-payment sys-tem amount cannot be dep-endent on a sale going ahead. You have to agree a defined-payment system with your client before you start any discussions and if these do not result in a sale, the defined-payment system amount must be paid by your client.

Curiously, CP121 says you will not be obliged to pursue your clients for unpaid fees but it seems unlikely that you could make a virtue out of this point when agreeing a defined-payment system with your client at the start of the process.

The same customer going in to a non-IFA remunerated by commission is likely to be under no obligation to pay for the advi-ser&#39s time if they choose not to proceed with a sale.

So those approaching an IFA in future will tend to be those who are already in buying mode. This may be good news for the IFA but it does make the point that few IFAs can assume that the defined-payment system will result in business as usual.

If we restrict our analysis to those customers who will buy a product, can the IFA accept commission as usual on that business and apply the commission to the agreed defined-payment system?

This is possible but whether it will happen will depend very much on the preferences of the customer. If the commission is less than the defined-payment system amount, the customer will have to pay the balance.

If the commission exceeds the defined-payment system amount, there are a number of options. First, as mentioned earlier, it can be placed on account for future advice. This means that each time the client contacts his adviser, the defined-payment system account is likely to be debited by an amount representing the adviser&#39s time on that enquiry.

Although this may not be to many clients&#39 tastes, it is potentially to their advantage. If, for example, a client has an investment question for his adviser which he knows he will be billed for, he may not make the contact. As a result, he could fail to take the correct investment advice and may lose money in the long run. On the other hand, knowing he has some “advice on account” is likely to result in the contact being made and the advice being given.

Some fee-based IFAs already operate this system and it works very well. Ultimately, it will depend on the willingness of the customer to deal with advi-sers who operate this way and that, in turn, will dep-end on the other options open to the customer.

One alternative option is to have any excess commission rebated into the investment, thus reducing its price.

The appetite for a bargain among consumers is such that it seems likely that many will prefer this option. It could be a false economy if, as in the previous example, they fail to use their adviser to monitor the continuing appropriateness of the original investment choice.

The third choice open to the customer, where it is permissible, is to have a refund of excess commission. Again, the cashback mentality may make this option more attractive than applying the excess on account.

If the defined-payment system goes ahead, there are thus several ways in which it can operate by integrating it with commission payments.

This should give IFAs some scope to offer a choice to their clients – either pay a fee or take out a pro-duct with commission and use the commission to fund the defined-payment system.

The price of the product will depend on the choice made. If a fee is paid dir-ectly to the client, the product will be priced net of commission. Any client considering this option also needs to consider the implications of VAT on fees versus VAT-free commission – a subject big enough to warrant an article of its own.

The defined-payment system as proposed will result in changes in the way that an IFA does business but it does not necessarily mean a complete switch away from commission to charging clients a fee for the advice.

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