Just over a year ago, the FCA published its thematic review on clarity of fund charges (TR14/7). It received less publicity at the time compared to other reviews since the implementation of RDR. This lack of publicity may have been because the usual warning of follow-up reviews was absent.
Instead, the FCA indicated that, with Priips and Mifid, it expected European legislation to change communications to investors in the near future. However, changes to the pension rules may make this review one of the most important for both advisers and their clients.
TR14/7 reiterates the FCA requirement that firms must put the consumer at the heart of their business model.
It says: “As part of the overall relationship between firms and consumers, firms need to manage the costs with as much tenacity as they produce returns, and make the costs they charge clear”. With the new rules on pensions, more consumers will be looking at drawdown as an option for providing their retirement income.
The costs associated with this strategy can have a seismic impact on its success, so it is clear consumers need to be aware of this from the regulator’s point of view.
Cost is not the only issue with a drawdown strategy: the underlying investment growth clearly needs to achieve the target return as well. Not only does the target return need to be achieved, it needs to be achieved in a way that avoids “pound cost ravaging”. If the early years’ returns are poor or, worse still, heavily negative, capital can be eroded, jeopardising the entire strategy.
In 2008, the FTSE 100 fell by more than 22 per cent in the calendar year. For a basic drawdown strategy seeking to achieve a 4 per cent return after charges, this would equate to a 26 per cent loss of capital. For a fund of £500,000, that would represent over £125,000 of capital including the drawdown payment. The following year the fund would have needed to achieve growth of over 40 per cent to recover the position.
While the market did recover in 2009 it was by 30 per cent. From this growth, another drawdown payment of 4 per cent would have been taken. By now the £500,000 fund would be worth less than £468,000. The original 4 per cent withdrawal of £20,000 would reduce this to £448,000, requiring the fund to grow by 16 per cent in the following year to recoup the £500,000 capital and provide a 4 per cent drawdown payment.
It is not a new problem. Investment bonds have suffered over the years from exactly the same issue: fixed payments of “income” that were not always supported by underlying growth of the investments, leading to capital erosion.
When a client is investing their life savings in a drawdown arrangement it is not unreasonable for them to expect a clear understanding of the risks they face when selecting their “income” level. Those risks include not only the level of return required but the manner in which that return is achieved, as well as the impact of charges.
While the FCA is to be commended for its review on charges, it favours the ongoing charges figure as its measure. The OCF is, sadly, not always an accurate reflection of the charges. For example, OCF does not include, among other things, bid and offer spreads on underlying assets, custodial charges or performance fees. This latter element might have a dramatic impact on the chances of a client recovering their capital in the above example.
A 16 per cent return on investment would be even harder to achieve if the manager was being rewarded with a 50 per cent performance related fee for returns over a hurdle of, say, 4 per cent, as with some funds. In this example, the return before this fee would need to be 30 per cent.
Our industry is compelled to provide communications that are “clear, fair and not misleading” and rightly so. Delivering that clarity of communication requires the providers to deliver information to advisers that matches that standard. At present, OCF may be the best measure that can be delivered easily but it is flawed when looking at specific situations.
While the FCA may be waiting for Priips and Mifid to solve the problem, consumers are making irreversible decisions on their future financial security. It then falls to the adviser to rectify this situation by lobbying providers for better clarity on charges and ensuring clients are aware of the real and often hidden risks they face.
Richard Leeson is chief executive officer of Adviser Advocate