Operating at an adequate level of profitability is already a challenge for many product providers and IFAs. But with the industry going through a significant regulatory transformation, margins will undoubtedly be further threatened.
In this increasingly complex environment, validating the potential for a business to deliver its financial goals requires ever more sophisticated financial analysis.
Building models of businesses and overlaying potential future market scenarios is helpful in providing insight. In this article, I will take you on an illustrative journey and draw some broad conclusions on what may be needed to achieve success. Our comprehensive models project cashflows generated by a product manufacturer and incorporate distribution costs associated with a variety of distribution channels to model future profitability.
Starting the journey
We begin with a well-managed, hypothetical product provider operating IFA, direct salesforce and direct channels. We have a broad range of products and product mix varies by channel and by IFA segment within the IFA channel.
In an environment of no regulatory change, we retain relatively healthy profit margins and our free-asset ratio rises gradually as we experience modest investment growth. But we are not in a no-change environment.
The multi-tied world
We now enter into multi-tie relationships with distributor firms and will assume that Sandler-style stakeholder products have not yet arrived. We have chosen to explore three ways in which we could operate in this new marketplace.
Under the “Jackpot” scenario, we are highly-prized and can secure a 20 per cent share of multi-tie arrangements, each involving no more than four or five other providers. We invest in building each relationship, for example, by creating appropriate technology links. We also raise commission levels but not beyond market norms.
Under the “Middle of the Road” scenario, we are in a more open market where the average multi-tie arrangement involves around seven providers, so our average share drops to 15 per cent. But we still do not have to pay more than others to get our natural share.
But under the “Archer” scenario, we are prepared to pay to secure that 20 per cent share and offer further incentives equivalent to a 10 per cent discount on product terms.
We make three key observations from our modelling. First, while the scenarios do not represent the outer extremes of possible approaches, they show how financial outcome is highly sensitive to the size of share and to the terms of each multi-tie arrangement.
All three scenarios have higher volumes relative to a no-change projection but new business value rises significantly for Jackpot, stays the same for Middle of the-Road and falls in the Archer scenario.
Second, in all scenarios, significantly more capital is needed to finance new business than in a no-change projection. Our model suggests an extra 60 per cent over the next five years for Archer to finance 30 per cent more business but with 20 per cent less value emerging. This could be a significant barrier to entry and suggests that only the bigger, stronger offices will be able to take material levels of market share in this channel.
Third, while there is potential for more volume, there will be lower profit margins in the short term. Part of the reason is the investment being made in the relationship. To the extent that this and higher commission need to lead to longer-term productivity and efficiency improvements, our model projects a gradual improvement in margins in all scenarios. But how will shareholders react to even a temporary reduction in margins?
Stakeholder products and two-tier advice
The next part of our journey is to explore the introduction of the stakeholder product suite. We introduce a lower-tier direct salesforce which operates in a lighter-touch regulatory environment and sells only stakeholder products and non-regulated products such as term insurance. We assume a 1 per cent charge cap.
We focus initially on the direct salesforce channel and look at two scenarios for two-tier advice. First is the Treasury view of a fully-authorised salesforce focused on more affluent customers and a lower-tier salesforce focused on lower-income groups. We describe this as a “No Referral” model.
The second scenario, the “Referral” model, uses the lower-tier salesforce to act as a filter for a fully-authorised salesforce. The lower-tier salesforces conducts all fact-finds and sells the limited product range but refers on customers with more complex needs.
The conclusions of our “No Referral” model will disappoint the Treasury. A 1 per cent charge cap provides little incentive to offer a face-to-face service to lower-income groups. Indeed, the lower-tier salesforce may destroy value. The underlying problem is selling to customers with limited financial means using a transactional sales process and selling a high proportion of low-margin products.
Consequently, while there is scope to cut costs and raise activity and productivity levels, the effects of this are more than outweighed by lower case sizes, higher lapse rates and a higher proportion of low-charge product sales.
Although it may be very hard to create viable business propositions targeted at lower-income groups, it will not be impossible. It may, however, need a business where financial services products are ancillary to the main customer proposition, which suggests potential for the banking and retail sectors.
In contrast, the “Referral” model has the potential to increase margins for the top tier, despite more stakeholder products. This relies on effective prequalification of leads to leverage productivity.
Our illustration has looked at two-tier advice from a direct salesforce perspective but there are similar implications for an IFA firm.
Our provider is currently heavily reliant on with-profits bonds, so there may be a significant margin hit in both the IFA (20 per cent fall) and multi-tied (60 per cent fall) channels when the stakeholder suite is introduced. An obvious response will be to seek to broaden the product range and to alter the mix to protect margins from this potential drop.
The journey need not end
As proposals for regulatory change are firmed up, there is bound to be some retracing of steps. There are many paths to take and our illustration has gone down only a few.
Some paths will lead to money, some to poverty. Choosing the right path is unlikely to be easy.