The significance of the FSA review into with-profits cannot be overstated.
In the past, disparities associated with the way that with-profits funds are managed have been masked by high rates of return. But in the current lower-return environment, the flaws have become apparent.
The review is considering four specific areas where the existing framework is weak and has invited abuse:
l The amount of discretion managers have on the overall management of the fund and how this is exercised.
l Transparency and how information relating to the operation of the fund is reported.
l How information is provided to policyholders on the performance of their investments.
l The criteria underpinning the policyholders' “reasonable expectations”.
It is hoped to promote regulatory accountability and rebuild confidence. But will it achieve this? Only if it looks into the right things.
It needs to distinguish carefully between explaining how with-profits works and making sure the proposition is presented correctly to customers. A frequent failing in the way complex products are regulated is that regulators believe it is enough just to tell customers how the product works and customers will be able to judge for themselves. But customers cannot reach these judgements unaided and more explanation may just mean more confusion.
The review risks falling into this trap. It is putting emphasis on the deficiencies in the operation of with-profits. The policyholder does not need to know exactly how the market works, only that it works well enough to trust the product.
There are clear limits to what can be explained. For example, customers who lapse early have to be penalised. This is only a source of detriment if customers fail to understand how likely they are to lapse and the consequences. Clarity may require simplification of terms. With-profits could learn from the derivatives-based market – guaranteed equity bonds – where consumers are not allowed to surrender for the product term. Yet there is less consumer detriment on bonds than on with-profits policies which do at least have surrender value. Consumer detriment is worse for with-profits because consumers do not understand what they are buying.
The review will focus on the discretion of scheme managers. This comes in two important forms: who owns the funds, and how far managers can switch funds between different generations of policyholders.
The first type is fundamental to the nature of the product – with-profits has to operate over long-time horizons and discretion to transfer between generations is an integral part of the smoothing activity in the scheme. FSA rule changes could change the nature of the product fundamentally.
The second type of discretion – the degree to which policyholders or shareholders own the scheme – is not essential for with-profits to function but could have a big effect on competition and new entry. If policyholders' funds are ring-fenced, there is no incentive for shareholders to invest capital to grow new funds and entry is unlikely. But there has been little new entry into with-profits more generally and rule changes here are unlikely to lead to more competition problems than the status quo.
Tim Wilsdon is a principal in Charles River Associates' financial services team (Twilsdon@crai.co.uk)