IFA remuneration: structure and level
The basic shape of a possible structure would be initial 3 per cent, renewal 0.5 per cent, varying to initial 0 per cent, renewal 0.3 per cent.
Initial remuneration is based on amounts invested, renewal on funds under management. The arguments that support this structure and the financial and other practical issues which arise, are discussed below. This is only the start of the process of validating, or otherwise, this structure.
Benefits of this approach
How it has worked elsewhere
The structure and levels have been derived from an understanding of the system in place in Australia. This structure seems to have delivered a closer alignment of the interests of the adviser and the client on a long-term relationship basis, elimination of provider and product bias, a stronger capital position for adviser firms – where the market capitalisation of such firms averages around eight to 10 times annual income as opposed to the one to two times typical in the UK.
This is possible because the primary form of income in the Australian model is a stream of recurring and growing renewal income based on funds under management, whereas UK adviser income is predominantly new business commission from new product sales.
This gives the the adviser an income stream which enables a long-term view to be taken. The income stream to the adviser is linked to investment growth and, therefore, over the long term, likely to be at least inflation-linked. It provides a means of attracting good quality new blood into the industry. Good quality graduates now seek jobs in adviser firms because they can see the way towards eventually benefiting from the flow of income which is building up. It also provides a valuable exit route from the business for proprietors
The emphasis on managing the overall value of a client's portfolio has led to the creation of the paraplanner role which provides the ongoing review of the client's needs which both merits and justifies the ongoing renewal remuneration of the adviser gives a job which can add value directly to the fir.
This is without requiring the “hard” task of selling more or less from scratch. It moves the job closer to that of a professional adviser rather than salespeople. But it should be remembered it is dangerous to assume that any aspect of one market can simply be imported to another. The Australian experience is affected by, inter alia, the savings environment created by their compulsory superannuation system.
Other benefits for consumers, providers, freedom of competition
The proposed structure would enable product charges to be shaped better for consumers (no front-end loads, no exit penalties) without providers taking risks on persistency. It would thus improve the probable profitability of the existing providers.
It would also encourage new providers. At present, on a significant number of products, especially regular contribution products, there is a mismatch between front-end-loaded commission and level charges to the consumer. There is thus a barrier to entry to new providers.
Problems with the proposed new approach
Is the current remuneration structure more economically efficient?
There is an economic argument about it being more efficient to have the timing of charges made coincide with the incidence of costs. The argument runs:
Because selling and advice costs are incurred at the outset of a product, the charges for the selling and advice effort ought to be made then rather than spread. Spreading them requires the use of capital and capital costs money.
This argument has a lot of merit. However, in the above model, the adviser's earnings are based primarily on the progressive development of the client's funds, not on new product sales, so the incidence of costs and charges are largely aligned. In the present front-end-loaded system, the commission paid does not just cover the costs incurred in selling to and advising the individual who buys a product but also the abortive costs incurred of sales/advice to people who do not ultimately buy a product.
It does not seem axiomatic that there is economic sense in having those abortive sales costs passed on to the people who just happened to buy products at the same time. It seems just as reasonable for those abortive sales costs to be seen as a general promotional cost to the business and spread like other overhead costs to the business are spread. But there are problems with the transition.
Scaling the transition: the existing strong trend towards single-premium business
The first step in achieving a transition is to scale it. Many discussions about the drop in earnings which an IFA would suffer in the event of a move from front-end commission to trail or fund-based earnings start from a contrast between the historical level of front-end commission on regular-premium business (circa 50-60 per cent of first year's premium) and the 3 per cent or thereabouts initial commission, plus renewal described above. But, in fact, a large proportion of business now written by the IFA market is not regular-premium business. Of the regular business written, a big part is group business, much of which is not written on the historical front-end-loaded rates. Part of the transition has thus already been achieved.
The clear trend from annual-premium business to single-premium business of the second half of the 1990s has slowed or even reverted somewhat in 2001 due to an increase in pension annual-premium business. This is probably the effect of the introduction of stakeholder (both themselves and the knock-on effect on group personal pensions), the move from defined-benefit to defined-contribution schemes and the replacement of Equitable Life business.
An estimate of the size of the transitional gap in IFA earnings
A model has been built to enable projections of the difference in revenue for IFAs as a whole if a transition could be achieved from the present commission structure to 3 per cent initial, 0.5 per cent of fund renewal. The chart (left) shows the shortfall which would occur in the first year and how it would narrow and cross over as years pass.
A number of assumptions have been made in this model, concerning, inter alia, investment returns, the present incidence of fee charging and commission rebating, product mix, volumes of non-investment related business written (mainly protection business), the run-off of existing renewal commission, etc.
The model can be adjusted to take into account any variation from these assumptions. Chart 1 is therefore a starting point for a discussion on what the transitional gap in IFA revenue might be. Once the size of the problem is known, different methods of dealing with it could be constructed. These methods could involve addressing either the capital requirements of IFA firms or their income or a combination of both.
The possible sources of capital are either the usual sources of capital for any business (bank finance, private or stock market equity, venture capital, corporate bonds, etc) or capital from providers. It is necessary to distinguish between capital which providers may make available in their role as investors of client's funds as opposed to capital from shareholders, where the investment decision may be influenced by the fact that the advisers are the distribution channel.
It can also be noted that the transfer of capital from providers to advisers can occur by indirect means such as the maintenance of higher rates of commission than might otherwise be deemed prudent.
Ultimately, the best position to achieve would be one where adviser firms could raise capital at competitive rates in the usual capital markets and do not require any form of preferential treatment from providers. Moving to the kind of system proposed in this note could lead to this result if it caused the market capitalisation of IFA firms to rise as a result of more certain future income streams.
Looking at the scale of the problem will help determine to what extent any pump-priming by providers may be necessary. The scale of any such priming and duration may determine its acceptability to public interests.
Another way of dealing with the transition might be for providers to have transitional scales of remuneration that taper the move towards the ultimate structure.
There is the risk of a free for all, as in 1988 with estate agents. This would almost certainly be counterproductive for all but a few individuals who make their pile and exit the industry. Some form of process could be beneficial.
A first thought is whether use might be made of the capability that has been built up in Pass for assessing IFA firms for the Pass loans scheme. The Pass loans model could also be considered as a means of providing IFAs with capital support with generic industry backing rather than specific provider support which has the accompanying risk of bias.
Problem two: Fund-based commission building up in later years
Even small percentages of fund-related remuneration build up to substantial figures in later years. The real value of these figures, once inflation is allowed for, is not so dramatic but it is quite conceivable that for a regular contribution contract of 20-plus years, the remuneration of the adviser in the latter years could exceed the amount of the regular contribution.
This problem is, of course, the same as that faced for the total charges made in respect of a contract with a flat fund-related charging structure such as stakeholder so the industry faces the dilemma in any event.
The dilemma is that the very small charges made in the early years do not cover the expenses, so the providers – and perhaps advisers – incur losses. When the funds have built up, the client moves the funds elsewhere at a lower negotiated fee level or else bargains down the charge made by the provider/adviser. As a result, the earlier losses are never recovered, leaving an industry with an unsound financial basis.
A solution may be found by explicit disclosure of provider and adviser charges expressed predominantly in relation to the funds under management. This is consistent with a move towards managing a client's assets rather than selling him or her products.
If adviser charges are made – as are provider charges – even in years when there may be no new contribution input at all, then custom will build up for this to be normal practice. The adviser charges (at the proposed 0.3 per cent-0.5 per cent levels) seen – in proportion to the funds under management rather than to the amount of regular contribution – will always appear as a small fraction.
As the nominal amount of a client's funds grows, there will, of course, be pressure on the adviser and the provider to justify the increasing size of the charges or remuneration taken. This is healthy and is what has resulted in Australia, where there is real negotiation between client and adviser over remuneration.
This is what has resulted in the commission levels in the model proposed here. There is bound to be downward pressure on the remuneration where the nominal amount is large and the remuneration basis is completely transparent. But if the adviser's renewal remuneration is in the 0.3 per cent to 0.5 per cent range, there will remain a healthy level of income from which the early expense losses may be recovered. It is part of moving away from a “product sales” market to a “building funds to meet client's needs” market. It also raises the question of whether the distinction between singleand regular-contribution contracts remains a valid one.
Problem 3: Disclosure, a worked example
If all contributions (regular or single) resulted in the adviser receiving the 0-3 per cent initial remuneration, the pattern of an adviser's earnings from a client might be (assuming about 7 per cent investment return):
Year one: Regular contribution paid £1200
Single premium paid £25,000
Total new contributions received £26,200
Funds under management at year end £28,000Adviser remuneration, negotiated initially at 3 per cent for new money invested, 0.5 per cent funds under management:
On new contributions £786
On funds £140
The adviser remuneration would be shown clearly in £s on the statements received by the investor each year or other time period deemed appropriate. The way in which the investor's fund would build over a notional period of 20 years, and adviser remuneration would be calculated and disclosed, is shown below, including the impact of a few simple changes to the investor's pattern of saving
Year two: Regular premium as year one £1,200
No Single premium
Total new contributions received £1,200
Funds under management (say) £31,000Adviser remuneration: 3 per cent New contributions £360.5 per cent funds £155 Total £191
If the client did not do anything other than pay the regular contribution in years three and four, the adviser remuneration paid and disclosed would be £209 in year three and £228 in year four but then if in year five another single premium of £10,000 single premium was paid in, the contributions paid in, accumulated fund value and adviser remuneration would be:
Year five: Regular premium as year one £1,200
Single premium £10,000
Total new contributions received £11,200
Funds under management (say) £53,000Adviser remuneration: 3 per cent New contributions £3360.5% funds £265Total £601
And so on if the client again paid in nothing but the regular contribution until year 10, adviser remuneration would be £327 in year six, £354 year seven, £382 year eight and £412 in year nine. If another single contribution of £10,000 was paid in in year 10 and the same pattern repeated until year 15, the figures in those years would be:
Year 10 Year 15
Regular premium £1,200 £1,200
Single Premium £10,000 £10,000
Total new contributions £11,200 £11,200
Funds under management £92,600 £14,7000
Adviser remuneration: 3 per cent new contributions £336 £336
0.5 per cent funds £463 £740
Total £799 £1,076
But if the client then paid a bigger single premium in, say, year 16 of £100,000, it would be quite possible that the adviser remuneration rates would be negotiated down perhaps to 1.5 per cent of the new single premium and to 0.4 per cent of the total funds under management. If this happened, total funds and total adviser remuneration for years 16-20, assuming no further single premiums, would be:
Year Total funds Total adviser remuneration
16 £26,7000 £2,603
17 £28,7000 £1,182
18 £30,8000 £1,268
19 £33,1000 £1,359
20 £35,6000 £1,461
The adviser remuneration in this example would exceed, in the latter years, the amount of regular contribution input but it would not appear (or indeed, be) inordinate relative to the funds built up.
The worked example above shows how the remuneration could be presented to the consumer each year. It is completely transparent and highly comprehensible. The evidence of a system like this in Australia is that it does engender negotiation.
Problem 4 : Method of payment: Direct or via the product
This can be described as the commission
fees argument. It can be asserted that if the structure and level of adviser remuneration set out in this paper is used, it does not matter whether the adviser remuneration is paid by the client writing a cheque or via the product.
The method is sufficiently clear for either to work. If it is either a matter of fact that consumers would rather pay through the product than by writing a cheque or that payment through the product is more tax-effective, then this could be the determinant of which approach is taken. With equal visibility and negotiability, it is difficult to see why the consumer should not be given a choice.
The important points about adviser remuneration are that it should:
Be simple to understand.
Be clearly disclosed.
Be regularly disclosed.
Facilitate negotiation with the adviser.
Represent good value.
The payment method, whether directly to the intermediary or through the product, is less important than these. If consumer preference is to pay through the product and if they are put off saving by the prospect of paying directly, then the pursuit of the right level of savings on the right terms for consumers and the country would be damaged if payment through the product was eliminated.
It is also worth mentioning that there are a number of different forms of fees and that these are not without vices. For example, hourly fees for service can encourage the unnecessary drawing out of the process before decisions are made.
Problem five: Link into product charges and structures
It would be necessary to develop a form of presentation in which adviser remuneration and product charges are both clearly shown both in their own right and in relation to each other.
We believe that methods of doing this are feasible. The structure of wrap products could facilitate this, in particular in removing the issue of commission-led product bias.
Problem six: How to move to a new method on a consistent basis
The experience since the abolition of the maximum commission agreement has shown how difficult it is to achieve an open market for adviser remuneration. Disclosure of the amounts paid under the historical system has not resulted in consumer bargaining power.
The absence of any controls as to form or level has not been helpful and has contributed to a market where products which are intrinsically similar having different rates of reward, mainly as a result of chance. A means of eliminating the present problems needs to be found. Direct regulation may appear the easy answer but the problems of inflexibility which arise with it can create distortion or could cause, for example, a shift in selling activity towards products which are not the subject of that regulation. This could threaten achievement of the overall savings goals.
Although the industry agreement was discredited in 1988, in retrospect, it may be considered to have worked quite well. It certainly dealt with product bias and adapted quite readily to changed market circumstances. A future system could work better if standards were set by adviser trade bodies rather than by providers.
It has been suggested that in Australia, a simple legal requirement on the adviser to provide an unbiased proposition to his client was sufficient, when accompanied by the threat of strong sanctions, to have achieved the transition from an adviser remuneration even more heavily front-end loaded than in the UK to the model described above. Could this work here?
There is much future work that could be done. In particular, the last two topics are the least well developed of those considered in this paper.