Problems and Solutions
in the
Financial Services Industry
by Stephen Wynn
1. The need to ensure that savers get a good deal should be the first duty of the Financial Services Authority
The government wants people to save. They should only do so if they obtain reasonable benefits in return for their contributions. It should be the first duty of the FSA to ensure that savers get such benefits from any product that they buy from any of the institutions which it regulates. It should be concerned with monitoring these benefits and investment performance.
Past investment performance is not included in its Comparative Tables. The benefits which are in practice provided by products which have been bought in the past, are not discussed in its publications, beyond the occasional fleeting reference to past performance. For example its Feedback Statement on the With-profits review refers to the performance of mortgage endowment products as inflation and interest rates have fallen (2.2). The Consumers' Association states:
The poor performance of endowment policies seems to result largely from high charges, rather than falling interest rates. Savers are paying all sorts of charges on different products. There is inadequate analysis of what they receive in return in benefits. The publications of the CA are very much concerned with the benefits actually provided, unlike those of the FSA. For example:
A policyholder with a 25 year endowment who cashed in their policy last year after investing for 7 years would have earned a return of minus 2 per cent a year, while a similar unit trust grew by 10% a year.
The FSA's Policy Statement on Split-Capital Investment Trusts (Splits) states:
Just because the sector has grown, it does not follow that it is efficient, any more for example than personal pensions are efficient because there are many of them.
How has the investment trust sector performed as an investment between 1980 and 2002, in comparison to the stock market? The report on Splits and other reports of the FSA discuss issues such as disclosure, transparency, awareness, governance, but are vague about investment performance. For example, the Feedback Statement starts by saying that there are:
This is reminiscent of the 1993 report of Sir Andrew Large, chairman of the Securities and Investments Board which preceded the FSA, Financial Services Regulation: Making the Two Tier System Work:
"There is deep public concern that too much mis-selling is taking place... opaque products, delivered through intensive selling methods..."
(paragraph 3.2, page 100)
A lack of understanding of risk is understandable when consumers are told, as in the case of some Splits that they are "low risk", "have more safety features than a volvo" (3.5) - only to see their capital disappear a few months later.
Complexity, opacity and lack of understanding, is surely unimportant if savers are receiving an excellent return on their contributions. It is the job of the FSA to understand products, rather than consumers.
People are saying "we need simpler products". For example the charges on a stakeholder pension are a delightfully simple maximum 1 per cent of capital per annum - until you look at the charges outside the 1 per cent cap: stamp duty, stockbrokers' commission, and perhaps further charges such as custody fees. A computer may seem simple to a user, but not to an electronics engineer.
If you are seeking to reform something it is necessary to firstly state, what are the problems. In the case of the financial services industry this is: a) sometimes poor rates of return on savings, b) time spent by consumers on their investments, especially those which cause worry. Improving consumer understanding is one suggested solution. It needs to be explained how this will reduce a) and b). Perhaps by helping consumers avoid poor products?
Account numbers and other reference numbers for ISAs and other products sometimes change. This causes confusion for savers. Such changes should not be allowed. The policy numbers of insurance policies do not change. It becomes difficult to trace investments when the amounts invested change and account numbers change. The names of providers also change, usually because of take-overs.
Benefits are not monitored by the FSA. Its Comparative Tables show only "charges and deductions" not investment performance. If the benefits provided are particularly disastrous, as in the case of some Splits, there is then an enquiry. But what about less disastrous investment performance?
For example one of my relations took out a whole life policy in 1929. which has been cashed in this year and returned 5.7% which seems unreasonably low. But Sir Howard Davies states:
It is not clear that they have delivered superior returns in the past. The Consumers' Association says they are:
With the FSA saying the performance of with-profits policies has been good, and the CA saying they have been bad, it becomes difficult to have a rational discussion. There needs to be preliminary discussion of past investment performance.
What do with-profits policies dating from 1929 return on average? The Feedback Statement refers to with-profits policies giving a return "better than the deposit rate" (1.12). But for a long time period surely the return should be compared with the stock market rather than deposits in bank or building society accounts.
A sum invested on the stock market in the 1920's with dividends reinvested to the present day is shown in sales literature such as that of unit trusts or stakeholder pensions, to give a remarkably high return. But this is not comparing like with like. because an investment in the unit trust or pension is not directly on the stock market. There are various charges and fees to be paid.
2. The need for a computer system, especially to monitor benefitsTo understand the products we need to determine the value of the benefits provided by the industry. This needs to be determined for all the products of the industry, which will require a computer system. The FSA's Comparative Tables are a step in the right direction.
There is much information about rates of return and charges already in the press and on websites. The rates of return need to be related to the charges, including dealing charges information about which is missing. There should be comparisons of the charges and investment performance of the industry with the investment performance of the funds of occupational pension schemes and their cost.
Such a computer system would help for example with information for anyone studying the industry such as the CA, which says that:
it is severely restricted by difficulties in getting information from the companies and regulator about past and current behaviour.
The FSA's Feedback Statement on the With-profits review recommends "give consumers a better understanding" "provide clearer and more transparent information" (1.15). (It mentions the word "transparency" 31 times). The table "Enhanced disclosure and key recipients" lists 17 items of information to be provided to policyholders and their advisers.
This is information required to make investment decisions which is not the same as the kind of information required by the CA, studying the industry in general.
Annual policy statements should give a) the value of the policy if it is cashed in and b) the value of the policy if the insured life dies, if this is different. In some cases only a) seems to be given. When the insured life dies the value of the policy then comes as a surprise, which is an unsatisfactory situation.
One of the 17 items of information is "principles applied to the fund" which is subdivided into: investment strategy, business risk, bonuses / smoothing, MVRs. It is suggested in the table that this information should be supplied in particular at the point of sale.
There can be no objection to understanding and information, but for example:
transparent disclosure of the effects of financial engineering, reinsurance and other factors on the solvency of a with-profits fund.
(1.23)
This seems to be offloading excessive responsibility onto consumers. This information could cause confusion if given to savers at the point of sale! Will it result in better rates of return? The FSA will not know because it is not monitoring such rates of return, which is a reason for the proposed new system.
There is an analogy in the area of public health. You can choose what you eat. But all food which is sold has to be up to a certain standard. This is the reason for setting up the Food Standards Agency. It has the duty to:
There is not the consumers should take responsibility for their decisions in the Financial Services and Markets Act 2000 (FSMA) (5 (2) (d)). All food must be up to a certain standard, irrespective of what people choose to eat. Professors of Medicine N. J. Wald and A. V. Hoffbrand, state in a letter in The Times (May 27th 2002):
"The contemporary view is that public health is essentially an issue of personal choice. In fact, the essence of public health is that it is a collective strategy that does not require personal choice (it is there for all to benefit from)."
This letter advocated the fortification of flour with folic acid. But it might be argued that there is a large literature, and articles in the press, on the merits of folic acid. Anyone who is not having enough has only themselves to blame for not reading the literature.
One of the objectives of the Food Standards Agency is to help consumers make informed choices by honest and informative labelling. Labels are a safeguard even if few people have time to read them. But they must be accurate. To say "charges are capped at 1 per cent" in the case of stakeholder pensions, when there are charges outside the cap is inaccurate.
Food is too complicated for everyone to understand what they are eating, at the level of micronutrients such as folic acid. Life is too short to spend much time looking at labels. There is a similar situation in the financial services industry.
3. Pointing at the customer rather than the provider
There is a Caveat Emptor clause in the Financial Services and Markets Act 2000 (FSMA). "The appropriate degree of protection for consumers" includes "the general principle that consumers should take responsibility for their decisions." (5. (2) (d)) This is condescending. Of course everyone is responsible for their own decisions.
The Sale of Goods Act provides a statutory guarantee that goods are reasonably fit for the purpose for which they are needed. This is preferable to an emphasis on "suitability" to individual requirements. The sale of products of the financial services industry does not come under this Act. It is regulated by the FSA rather than trading standards officers. Similarly advertisements for these products is regulated by the FSA rather than the Advertising Standards Authority. The industry is in effect regulating its own sales.
Financial advisers should only recommend products which are fit for the purpose for which they are intended, such as repaying a mortgage. This puts the emphasis more on the product than the individual. It is pointing in the direction of the product rather than the individual.
"The protection of consumers" in the FSMA is slightly confusing. It is pointing in the wrong direction. It is savings that need protecting rather than consumers. In the case of the whole life policy referred to above, the person who bought it has not been alive for many years, so how could he have been protected?
The government wants to encourage saving and investing rather than consumption. People should not be consumers, they should be savers and investors. What needs to be protected by the regulators are investments, not from stock market fluctuations, but from inefficiency, incompetence, fraud and so on. The first duty of the FSA should be to protect the savings of the public which is held in the institutions which it regulates. This is quite a long why from "securing the appropriate degree of protection for consumers" (FSMA 5 (1)).
4. Continuing self-regulation
The FSA has a wrong constitution from the point of view of investors. The government seems to regard its role as similar to a referee in a football match. From time-to-time it cries "foul". There is an investigation. Some players may be sent off. The game continues very much as before.
The Financial Services and Markets Act 2000 is said to have ended the self-regulation of the industry and brought regulation under statutory control. But was not the previous Act, the Financial Services Act 1986 also a statute? Why is the regulatory system more under statutory control than previously? The staff of the regulators are largely the same as the previous system.
They are still acting on behalf of the industry - within various constraints. The FSA has issued 145 "consultation papers" - at the time of writing. It also publishes "feedback statements" and "policy statements" discussing the responses to these consultations. These frequently refer to "most respondents" or "the majority of respondents". But the respondents are listed, and it can be seen that they are mostly the financial services industry. Therefore in following the wishes of the majority the FSA is acting on behalf of the industry. The reason given by the FSA for not including the dealing costs in its Comparative Tables, is that "most respondents" thought this would not be a good idea.
The FSA has the duty to promote market confidence, which is damaged by scandals. To this extend it is concerned with preventing scandals. Otherwise it is acting as a cheer-leader for the financial services industry.
From time to time there will be committees such as the Sandler Review which introduce reforms. But this cannot compensate for regulators who are constantly acting on behalf of the industry. The July 2001 Consultation Document of the Sandler Review states that "It is not, as such, a review of the adequacy or effectiveness of current regulation" (paragraph 7).
The Consumers' Association is becoming increasingly critical of the FSA saying that it is "not proactively acting in the best interests of consumers", referring to the "mortgage endowment mis-selling, pensions mis-selling, the Equitable Life and Axa scandals". It has made a number of proposals for the reform of with-profits business, which have not been adopted by the FSA. It is hoping they will be adopted by the Sandler Review.
5. Conclusion
The government sometimes introduces legislation without adequate follow-up. It is then taken by surprise when disaster follows some years later, as in the case of the 1968 personal pension legislation. The same should not be allowed to happen with the FSMA. We are unlikely to have an entirely new Act in the near future. But there could be modifications.
The Act is weighted towards inputs - the market in products, rather than outputs - the benefits provided by these products. There needs to be a legal requirement to monitor and disclose the cost and benefits the products of the financial services industry provide in practice for consumers. This is measuring the success of products in terms of the benefits they provide for savers. There are no benefits if policies are unclaimed, which is a reason for the large size of orphan funds.
There is considerable information about charges and returns for different products in the press, and on websites, but there are gaps. For example dealing charges are missing. There does not seem to be readily available information about the returns provided by with-profits policies over long periods.
All available information needs to be gathered together into one system, or at least links provided to websites where the information can be found.
6th June 2002
E-mail: centre@cwcom.net