The funding of the Financial Services Compensation Scheme has long been an issue of contention for the advice profession.
Among many potential solutions mooted, the idea of a product levy continues to draw interest from the planning community to meet rising compensation bills.
The need for customer protection remains a key priority for the FCA, with FSCS figures on defaulting firms featuring an increasing number of advice businesses.
Eight regulated firms have failed in June so far, five of which were advice firms. In May, 12 of the 21 firms put into default with the lifeboat fund were advisers.
In 2016, the FCA all but ruled out a product levy – where consumers would pay a small additional basis point charge on the top of their fees to contribute to the compensation pot – to fund the FSCS, but said last year that it remained committed to introducing a “package of measures” to reduce the burden on contributors to the funding pool.
On its side, the FSCS has historically argued that reforms for its funding should focus on reducing unpredictability for firms through either pre-funding or risk-rating payments.
The idea of pre-funding hits an obvious snag, in that building an adequate reserve could lead to higher costs for firms trying to pay current and future claims simultaneously – even if later on bills would be reduced. Pre-funding the FSCS would also require a change in legislation, experts say.
Money Marketing takes a look at key considerations for reshaping the FSCS funding model, and whether a form of product levy or risk premium could take centre stage again.
A shifting market
Complaints data from the Financial Ombudsman Service for the tax year 2017/18 continues to suggest that advisers represent a limited number of complaints but feel increased pressure from fees.
Of the FOS’s overall workload, 4 per cent related to pensions and investments, even with a 24 per cent increase in year-on-year complaints in the sector. As a proportion of all complaints, those against advisers accounted for less than 1 per cent, although there was a 14 per cent increase in the number against them.
The Financial Advice Market Review launched in August 2015 initially noted the “unpredictable nature” of the FSCS levy, saying this had a subsequent impact on advisers. It states: “The levy also makes it hard for firms to plan effectively and there are problems which smaller firms experience in obtaining adequate indemnity insurance at an affordable price.”
The hardening of the professional indemnity insurance market has been driven even further in the past year as the compensation payments related to the British Steel Pensions Scheme begin. This burden on the FSCS may also worsen in future after the FOS compensation limit rose to £350,000 on 1 April, potentially leaving fewer firms able to pay redress while solvent, meaning the bill falls on the FSCS.
Personal Finance Society chief executive Keith Richards says: “The FCA’s recent claims that they are prepared to close firms down and are taking a tougher supervisory stance means PI insurers will have the opportunity to limit their liability by further restricting cover, applying exclusions, offering commercially unacceptable terms, or simply retracting from the market.
“Such reactions, while understandable, are already leaving the adviser market exposed.”
I think it’s pretty clear to most observers that the funding to the FSCS does not work, with those who keep clear of anything remotely dodgy and never having complaints paying for those that do.
Providers are now of course paying a larger share of the pot; that clearly helps, but frankly it does not go the whole way and does not solve the fundamental problems.
There are two main options for that, the first being a risk-based levy. If you write more risky business – such as DB transfers, enterprise investment schemes and venture capital trusts, and anything unregulated – then you will pay more than those who do not.
I don’t see why this kind of action needs new legislation and even if it does, it needs to get done. The second option would be to use the fines levied on companies breaking the rules to part-fund the FSCS.
The fines tend to be levied on those who will have dumped liability on the lifeboat fund anyway, so the fine they pay should go directly into funding it. This did used to be the case but was changed a few years ago and should be changed back.
Darren Cooke, Chartered Financial Planner, Red Circle Financial Planning
But finding a way to introduce a consumer-funded compensation levy where, for example, the top-up price paid varies depending on the risk of the product poses a host of practical challenges.
Threesixty managing director Russell Facer says: “Given everything going on with Brexit, there would need to be a really big reason for the introduction of risk-based product levies in the near future. Advisers know the government is the only body that can make this change.
“Risk-based levies are effectively just a form of pre-funding where you build in costs from the outset; it’s not looking at what the costs actually are or how they could change. The most crucial point is that in requiring new legislation – as the FSCS cannot legally be pre-funded – there are a lot of challenges.
“Introducing a product levy isn’t the be-all and end-all for advisers at the moment; many feel the focus should be more on being clear about what is and isn’t regulated first.”
When it comes to whether advisers still care about a product levy, the reason for pursuing it could come down to individual circumstances.
Facer says: “If you do defined benefit transfers for example, which can be risky, there is a clear benefit because you also get an advantage from doing that financially.
“For other advisers that just work with vanilla products that are well regulated and covered, it’s hard to see why they would push for this type of funding change.”
Spotlight on…London Capital & Finance
The 11,500 investors who lost a collective £237m following the collapse of mini-bond provider London Capital & Finance in January are still awaiting news of compensation plans. The FSCS said it was exploring possible grounds for this in May, despite the mini-bonds not being under the protection of the lifeboat fund.
With mini-bonds – unlisted debt securities typically issued by small businesses to raise fund – not regulated by the FCA, the situation has shed an uncomfortable light on the fine line between what is and is not part of the watchdog’s remit and therefore eligible for compensation.
While the issuing of mini-bonds does not require authorisation from the FCA, the promotion of them by authorised firms must be in line with the regulator’s rules. This includes fair promotion and marketing.
The FCA is currently in the middle of an internal investigation into whether its existing regulation of mini-bonds adequately protects retail investors. In the meantime, investors have also faced several false starts on the road to financial recovery. The FSCS apologised to investors at the start of May after communications from the lifeboat fund to investors showed they had been misled to believe their investments were protected.
An FSCS spokeswoman told Money Marketing that the lifeboat fund will examine investors’ individual cases and respond to them directly. The FSCS is now investigating whether regulated activities were carried out. This would then give rise to a claim for investors, but the lifeboat fund has since flagged it as a “highly intricate case” with an accompanying lengthy investigation time frame.
Candid Financial Advice director Justin Modray says the provider’s collapse has served as a reminder of the need for a clearer way of organising compensation for high-risk products.
He says: “A risk-based levy is still a sensible idea given this current environment and with the whole situation around LC&F and the constant news of misselling – particularly on pension transfers – shows that there needs to more structure in the way funding is approached.”
Complete Wealth Solutions director Craig White says the fine line between regulated and unregulated products and providers’ permissions could blur the boundaries between supervisory powers.
He says: “The question then is what is the point of regulation if the FSCS will step in on non-regulated products.
“The public have to take responsibility for their own actions, just as advisers do for their advice.”
When advisers are not talking about the cost of PI insurance driving them out of business, they’re occupied with the problem of shelling out money to cover other advisers’ poor practice.
Sipp operators and DB transfer specialists were specifically blamed by the FSCS in January as catalysts for a £16m increase to its levy for 2019/20.
Former chief executive Mark Neale laid down a “promotion and prevention” strategy for the 2020s before his May departure from the top job, saying that stamping out bad behaviour was a greater priority than a re-think on levies.
New chief executive Caroline Rainbird says: “The promotion and prevention strategy is an opportunity to build on protecting customers when they need it, increasing their understanding of the full range of protection available, and working with partners to prevent failures from occurring in the first place.”
As the former chief financial officer of Royal Bank of Scotland, Rainbird is no stranger to the struggles of poor advice.
The bank admitted it had set aside £206m to cover two separate FCA investigations in its results earlier this year. Both pertain to its provision of advice around potentially risky products.
But defining and tracking how risky a product is could be a complex task. A number of working groups have reared their heads over the years with involvement from the FOS, trade bodies, the government and the FSCS itself.
Facer says: “The FCA is not the best judge to determine what is and isn’t a risky product. There would need to be a working group and it cannot be the responsibility of one entity.”
A key issue for a group of any sort would be how to calculate risk, if it didn’t just base this on how many complaints there had been about various products.
The FOS is still working through thousands of missold payment protection insurance complaints in the leadup to the August complaint deadline. While not on the face of it a risky-sounding product, Facer says running into these situations will leave the watchdog hesitant to risk-rate products for the purposes of compensation.
He says: “It’s all about the way products are sold, and there is also the argument that no product is risky if sold to the right customer.”
Candid Financial Advice director Justin Modray agrees lines could get blurred with the FCA’s current remit and the added pressure on its workforce. He says: “You would assume this is the FCA’s responsibility but I’m not sure it has the resources or capability to carry out fair, sufficient or frequent ratings on products, and it may also not want anything to do with products that are unregulated.”
Regulation in the spotlight
In a 2016 consultation on the proposed development of risk-based product levies, the Bank of England put its spotlight directly on their impact on market competition.
It said risk-based levies could help small firms – a positive given that the majority of the regulatory and supervisory frameworks around advice are designed to facilitate healthy industry competition that relies on keeping a variety of firm sizes in operation.
The Bank says: “Analysis indicated that smaller firms will, on average, pay a lower levy under the proposed risk-based framework than they currently do.
“Smaller firms are, therefore, unlikely to be hindered from a competitive perspective, compared with larger firms that have a much greater market share.”
In a situation of risk-based levies, all firms’ risk metrics vary annually. It will depend on their regulatory data submissions, with patterns that emerge between firms comparable on the FCA’s Gabriel system. This would task the FCA with measuring product risk and reviewing levels each year.
The Bank updated its policy statement with regard to the calculation of risk-based levies in March with a calculation for retail banking customers that could be used as a starting point for advice.
Looking ahead, the regulator’s first review of FAMR is also just around the corner.
FAMR initially recommended the FCA explore options for reforming the FSCS funding classes, including risk-based levies and other alternative approaches to ensure the funds’ sustainability, meaning the issue could be set for revival.
Page Russell Financial Planning director Tim Page says: “If a risk-based levy is followed up, it’s going to be far more interesting than anything actually in the rules that have been published already.”
However the funding of levies is divvied up in the future, there is little doubt the FSCS holds the most vital role in building industry confidence through the protection of consumers. Added to this now is its contribution to the ongoing stability of UK financial markets as they prepare to undergo some of their most difficult challenges since the lifeboat fund’s inception.
Advisers will likely continue to keep a close eye on what role the lifeboat fund will play as the tides continue to turn. Facer says: “Everyone’s concentration at the moment is on Brexit and all its uncertainties, particularly for the government, so advisers are aware this is not a front-of-mind issue for those needed to enact change.
“The rising costs of PI insurance are setting the trend of the market at the moment, so that is likely where advisers’ priorities will continue to lie.”
The current FSCS structure was designed for the old industry
The FCA’s last review of FSCS funding went as far as it could have, since recommending changes to primary legislation was out of scope. The FSCS, as well intentioned as it is, was designed at a different point in time and has built up an unknown level of legacy liability over many years. It is increasingly proving unfit for purpose and the growing concern over DB transfers is likely to compound the level of liability placed upon it, which will result in poor outcomes for consumers and the levy-paying market.
I have personally believed for some time that the funding of the FSCS needs to evolve and incorporate a differently structured funding strategy to incorporate financial education as well investor protection. The time has come to look at a more broad-based solution, combining fair, sustainable, and cost-effective levies covering both consumer investment compensation and funding of a public financial education programme led by the new Money and Pensions Service.
Consumer financial protection and education are essential components for engaging and empowering the public in their financial well-being and the total cost of a combined solution could be covered by a relatively negligible deduction of just over half a basis point (0.00505 per cent) from the estimated £9trn in retail investments. Industry would still pay a contribution providing excess funding to cover unpredictable costs and an accumulated surplus for greater sustainability and confidence. This solution would smooth out the costs of financial compensation, while also obviating the need for professional indemnity insurance, which we have already seen can otherwise be removed at annual renewal leaving firms and their clients exposed.
A more robust and fairer funding solution would be able to provide additional funding to MAPS to enhance financial education and engagement more broadly. It would also encourage investment and sustainable growth in the financial services sector, reducing the advice gap identified in the FAMR because the current system is unsustainable.
Keith Richards is chief executive of the Personal Finance Society