06 Sep 2011 | Capital Hill

Capital Hill on... the changing face of advice 

The face of financial advice is set for widespread change, under new rules being brought in by the Financial Services Authority (FSA).  

The Retail Distribution Review (RDR) bans the payment of commission from product providers to intermediaries, raises the qualifications bar and redefines how advisers do business. But what will it mean for consumers? Capital Hill takes a look...
 

What are the present rules?  

Most financial advisers are paid by commission from product providers, either in full or part. Initial commission on individual savings accounts and open-ended collective investments is typically 3% of the sum invested, while investment bonds and some other investment contracts pay up to 7.5%.  

Clearly, commission creates a bias: the products offering the highest rates of commission might not be in an individual’s best interests.  

The FSA has long recognised this and has tried to increase transparency. Since ‘depolarisation’ of the market in 2005, advisers who want to call themselves ‘independent’ have had to give clients the choice of paying fees for advice or for their adviser to be remunerated by commission.  

However, who pays for what remains incredibly opaque, with commission often built into annual investment charges.
 

How will the rules change?  

The RDR will ban the payment of commission from the sale of investment products, replacing it with client-agreed remuneration.  

Advisers must also satisfy a higher minimum qualification requirement, known as the diploma in financial planning, raising the bar from the financial planning certificate.
Many independent financial advisers (IFAs) already hold the new qualifications and have adapted their business models ahead of the changes, and others are in the process of doing so.  

However, many small firms are expected to go under or be taken over by larger rivals due to the cost of implementing the new legislation and reluctance to comply with higher qualification requirements. Early estimates of the number of advisers forced to quit the industry or merge with larger rivals was originally mooted at 10% of the market, but this has since grown to 50% as more advisers admit that doing business will no longer make sense for them.
 

What are the pros?  

It is hoped the changes will mean that consumers will receive better quality advice, not paid for or influenced by commission generated from product sales.  

Patrick Connolly, head of communications at AWD Chase de Vere, the independent financial adviser, said: “The RDR should, in theory, be excellent news for investors. They will clearly be able to see how much they’re paying for financial advice, how they’re paying it and what advice or service they can expect in return.

“With higher levels of professional qualifications, investors should also have more confidence in the advice they receive.”  

The RDR should also be positive for investment trusts. Financial advisers don’t always consider recommending them just now because, unlike open-ended funds, they don’t pay commission and are not available on all of the main investment platforms.  

James Budden, director for retail marketing and distribution at Baillie Gifford, said: “Those in the investment trust world welcome RDR as a good thing because it appears to level the playing field between the two collective fund structures. [It] could offer an opportunity to the investment trust sector to go mainstream at last.”

The biggest winners are likely to be the most popular trusts, according to the Association of Investment Companies. These include Scottish Mortgage (with £2.48 billion invested) and Monks (£1.18 billion), both managed by Baillie Gifford; Templeton Emerging Markets (£2.29 billion); Murray International (£1.14 billion), managed by Aberdeen Asset Management; Mercantile (£1.37 billion), managed by JP Morgan; and Edinburgh Investment Trust (£1.13 billion), managed by Invesco Perpetual.*

That said, one unintended consequence of RDR is that investment trusts could be disadvantaged by the continued ‘bundling’ of charges by fund platforms.  

“The current bundling of platform charges, like commission, doesn’t do consumers any favours; they have to pay it anyway, but it’s hidden in the good old-fashioned way within the annual management fee.

“The continuance of wrapped charges acts as a barrier, as trusts cannot load their shares to accommodate platforms’ fees. As a result, the sector will have to convince these platforms that potential demand justifies inclusion.” says James Budden. 
 

... and the cons?

Banks are increasingly expected to withdraw from branch-based financial advice, with the cost of face-to-face advice to retail clients making it no longer financially viable.  

Some banks, particularly private banks, will continue to offer these services, but mainly to high-net-worth individuals. High street banks are likely to offer an execution-only model to the mass market, so they don’t need to give advice when they sell products. All in all, there is expected to be a big upturn in the number of people forced to make their own investment decisions.  

“Currently, many wealthier clients receive a similar service to less well off clients but pay more for it; in effect, wealthier clients often subsidise other clients,” said Connolly.

“In contrast, less wealthy clients won’t be able to afford the level of service that many of them currently get, and will have to accept a more basic service or take the execution-only route and make their own investment decisions.

“Execution-only services don’t need to adhere to RDR rules and can offer products where charges will be less transparent. This could create a problem for investors, as they might not be able to compare costs.”

Moreover, buying a financial product online with no advice could cost consumers more in the long run.
 

When will the changes happen?  

The industry is expected to be RDR-compliant by 31 December 2012. The Treasury Select Committee recently proposed to postpone its introduction for 12 months to give advisers an extra year to reach the new qualifications benchmark.  

However, a string of industry players have urged the FSA to press ahead with its original deadline. Peter Vicary-Smith, chief executive of consumer group Which? said: “The industry has had plenty of time to prepare for the RDR. The majority of IFAs have worked hard to meet the deadline and have bought into the need to raise industry standards, but a vocal minority seem determined to derail the process.

“Delaying the RDR would prolong consumers’ exposure to the potentially disastrous effects of poor financial advice, so it’s vital that the FSA sticks to its guns.”

How much will advice cost?

Consumers have hitherto been reluctant to pay fees for something they believe they can get for ‘free’ – without realising that the cost of commission is taken from their investment in some way or another.  

However, the big difference will be that, unlike under the old regime of commission, consumers will have to pay upfront for advice. So how much will it cost?  

An initial meeting with an IFA is often free-of charge, but after that you’ll pay for the advice you receive at an hourly rate or with a pre-agreed sum. Advisers typically charge between £75 to £250 per hour, depending on the level of expertise involved, according to unbiased.co.uk, the website that promotes the benefits of independent financial advice.  

So how does this compare to commission? Fees remain static regardless of how much you have to invest, whereas commission is paid as a percentage of the size of the investment involved, making fee-based advice more cost effective at higher levels of investment and commission-based at lower levels.  

Let’s take a closer look. If you use a fee-based wealth management firm you can often access investments at creation price or net asset value. In most cases, this means that the initial charge is waived.  

On a £10,000 investment, a 3% initial fee would equate to £300. If you went to an adviser at the more expensive end of the scale, the advice you receive is likely to cost more than this, as the adviser will probably spend more than an hour on your account.  

However, on a £100,000 investment, the saving is £3,000. No adviser is likely to spend 12 hours preparing paperwork for a single investment, so the charge saved outstrips the cost of paying a fee.  

Think about annual costs too. Post-RDR annual management charges (AMC) should come down, as advisers will no longer receive ongoing commission – another way in which investment managers try to ensure they keep advisers’ business. This commission, known as ‘trail’, is typically 0.5% per year of the sum invested, but can range from 0.1% to 0.9%. A reduction in the typical AMC from 1.5% to 1% might not sound like much, but a saving of 0.5% a year will add up to a tidy sum over a lifetime of investing.

*Source: AIC MIS (All figures are total assets as at 31 July 2011)

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Author: Jennifer Hill
Jennifer is an award-winning British financial journalist. She recently left The Sunday Times, where she was deputy Money editor, to set up her own company, mediahill Ltd. She is a previous personal finance correspondent of Reuters, the global news service, and personal finance editor of The Scotsman newspaper.

She has won or been shortlisted for six Headlinemoney awards, the ‘Oscars’ of personal finance journalism in the UK. She has also scooped or been nominated for accolades from the Association of Investment Companies, Ignis Asset Management, the Association of British Insurers and the British Insurance Brokers’ Association.