Financial Services Bulletin - The Reform Of Polarisation

This article analyses:

• the existing regime and the timetable for reform;
• the policy considerations underlying the proposed abolition of polarisation;
• the reform proposals in detail.

Polarisation is the regime which applies to the sale of packaged products. Packaged products are, in broad terms, life assurance, stakeholder pensions, collective investment schemes, investment trust savings schemes and ISAs where life assurance and/or collective investment schemes are components. Polarisation requires advisers to be either independent and to advise on products across the market or to represent one company (or group) and to advise on and sell only its products.

Introduction
The FSA’s proposals for the reform of the polarisation regime have gained considerable momentum in the first quarter of 2002. The FSA’s preferred choice is to abolish polarisation and despite adverse reaction from many parts of the independent sector and consumer groups the FSA appears to be proceeding along this route undeterred.

This article summarises the current status of the FSA review of the regime and explains the FSA’s approach to reform based on the SFA’s consultation paper No 121.

It then goes on to consider the FSA’s rationale for reform, as well as the potential benefits and risks of abolishing the polarisation rules.

The Consultation Process
Consultation paper CP80 marked the first stage of the consultation process on the reform of polarisation which ended in March 2001. As a result of CP80, two changes were made to the existing regime:

• liberalising the sale of stakeholder pensions; and
• removing direct offer financial promotions from the scope of the polarisation rules.

As a result of the initial reforms, product providers were allowed to adopt stakeholder pensions provided by other companies and to sell them through their distribution channels. The rationale behind this change was that for stakeholder pensions, as opposed to other personal pensions, consumers do not rely on as much advice because of the nature of the product. Stakeholder pensions have no transfer penalties, are relatively transparent and have capped charges. The FSA also felt that a provider firm might not itself have a stakeholder pension in its product range and as a result tied agents of provider firms would provide less satisfactory recommendations than those of provider firms with a stakeholder within their range.

In relation to direct offer advertisements, the FSA’s view was that firms should be able to use direct offer advertisements to distribute the products of one or more provider. It was felt unfair that independent financial advisers were able to use mail-shots to distribute products of several providers while product providers could not. The condition imposed was that no advice could be given to customers in relation to such products and it should be pointed out to customers that they should obtain independent advice if they were unsure about whether or not the product was suitable.

The second stage of the FSA’s review was to determine whether to abolish, modify or keep the polarisation rules. This second stage has involved consultation paper 121 ("CP121") which was issued in January of this year. This summarises the FSA’s research, explains the FSA’s views on the failings of the existing regime and puts forward the options for change and the reasons for its preferred option of abolition.

The FSA is now considering the responses, and proposes to issue draft rules, together with a policy statement, in the summer. It is envisaged that there will then be a further period of consultation in the autumn but Sir Howard Davies has said he would like to see the review process completed by the beginning of November.

It is worth noting that in relation to the revised rules the FSA is not proposing any transitional period. It does not feel this is necessary provided the FSA is clear about what the changes are and what firms are required to do when they are introduced.

Why Reform Polarisation?
When polarisation was introduced back in 1987, and then again in 1999, the Director General of Fair Trading ("DGFT") decided that the rules were significantly anti-competitive in their effect. The Director General did consider that for life insurance products the rules were probably justifiable on consumer protection grounds but otherwise could not be justified. It was then up to the Government to decide what to do as a result of his findings.

The FSA agrees with the DGFT that the rules are anti-competitive. Following its own research and review of polarisation the FSA has concluded that polarisation delivers insufficient benefits to justify it as an intervention in the market. The original intention of polarisation was that providers through the tied channel would compete on value for money of products but the FSA’s view is that in fact they have concentrated on competition to capture sales distribution.

The FSA’s research indicates that consumers (who do not opt for independent advice) tend to stick with the large tied product providers limiting the range of products available to them and prejudicing their chance of obtaining the most suitable and value-for-money products. The FSA’s view is that the remuneration system of both tied advisers and Independent Financial Advisers ("IFAs"), which gives an incentive to sell a product, may also mean that customers are sold unsuitable products.

In conducting and commissioning its research and surveys the FSA undertook a review of the international market which shows that there is no international equivalent to the polarisation regime.

The FSA has proposed that the polarisation regime of putting advisers in one of two camps should be abolished.

Arguments For and Against Abolition
The FSA recognises that the existing regime does benefit from clarity in that advisers are either tied or independent and the FSA is conscious of the need to ensure clarity in any depolarised regime. It aims to do this through enhanced disclosure of adviser status.

Views on the abolition of polarisation have been mixed. It is the FSA’s preferred option arguing that abolition is supported by the various studies it has undertaken, for example the independent study on polarisation considered by the London School of Economics. The DGFT is also of the view that abolition should improve consumer protection.

Others have been less positive; the head of the Consumers’ Association and the Association of Independent Financial Advisers have been highly critical. Many in the independent sector feel that the proposals of the FSA have raised more questions than answers and the proposals are likely to harm many consumers.

First let us take a look at some of the perceived benefits. The FSA’s view is that there are considerable benefits to be had from abolition, particularly in relation to the tied sector. The research undertaken by the FSA is that the tied sector is the main channel for consumers of packaged products; for example its research shows that the tied sector accounts for more than 70% of life product sales. The FSA research does not, however, highlight the extent to which consumers purchase other investment products such as unit trusts and ISAs through the independent sector.

The argument put forward by the FSA is that in the past consumers in the tied sector have not shopped around for products and this has been to their detriment since they have not necessarily got the most suitable or best value product. The FSA believes abolition will reduce this problem as removing the artificial barriers in the market will enable the market to evolve with increased distribution channels which will mean that shopping around will become less difficult and less time consuming.

One more specific potential benefit identified by the FSA is that consumers in the tied sector are likely to get more choice as providers fill gaps in their product ranges with different types of. product which they do not currently offer, and a consumer is likely to get a more suitable product as a result. The FSA speculates in CP121 that consumers are also likely to benefit where providers introduce a range of the same type of product, including their own and those of other providers, so again a customer is more likely to get a suitable product.

The FSA sees another benefit of increased choice in that there is likely to be a range of prices and as a result consumers are more likely to get better-value products.

From the provider side the FSA believes that there are potential cost-efficiency savings through provider specialisation in particular areas, since they can use the products of other product providers to complete their range. It could also result in providers not having to produce their own product, possibly at a higher cost, in order to be able to offer a complete range. The FSA believes that such savings will be passed on to the consumer.

The FSA believes that by introducing a new type of multi-tied adviser there will be a more diverse distribution channel and this will act as a new competitive pressure in this sector which will ultimately benefit consumers.

The FSA’s view is that consumers understand the concept of independent advice and once it is brought to their attention believe it is better than tied advice and would prefer to use an independent adviser. However the FSA’s view is that consumers are sceptical that truly independent advisers exist because they assume that commission must bias the advice. The FSA believes that its proposals for those wishing to remain independent will maintain and enhance the "independent" brand.

Risk of Depolarisation
Let us look at some of the risks which may result from abolition of the polarisation rules. The FSA acknowledges that abolition of polarisation may result in increased consumer confusion about the status of their adviser. The risk is the detriment the consumer may suffer as a result. As mentioned above, abolition will permit so-called "multi-tied" advisers and a consumer may mistakenly go to a multi-tied believing he is being given independent advice when he is not. For the consumers who were in the tied sector the FSA feels this is less of an issue since they rarely shopped around anyway. However for consumers in the independent sector this is a risk since they would as a result be advised on a narrower product range. The FSA believes that consumers do understand the concept of independence and so believe that this risk is relatively low and will be balanced by the enhanced disclosure requirements it proposes.

The abolition of polarisation is likely to result in a reduced IFA sector. The problem with a reduced IFA sector is that this will potentially reduce consumers’ access to independent advice. The requirement that IFAs be paid on a fee as opposed to a commission basis may prove difficult for many smaller IFAs with limited financial resources. In relation to small IFAs with less than four people, commission payments represent about 90% of their income and particularly, given consumers’ inherent reluctance to pay for advice, they may not be able to transfer across easily to the new regime. As a result, many will end up becoming multi-tied advisers. The FSA’s view is that the IFA market has been contracting anyway, with the number of firms reducing by one half in 10 years. For the upper end of the IFA market, many members of which now run on a fee basis, this is unlikely to be a problem. However the problem is that this means independent advice is likely to be concentrated on the higher end of the market only available to those consumers who can afford to pay fees, leaving the lower income consumer without access to independent advice.

Another possible risk is whether, given the trend of increasing commission rates, a change to the polarisation rules might produce a spiral effect in those retaining commission. Should some control be applied to commission rates? The FSA view is that this will not be necessary since the truly independent advisers will be remunerated on a fee as opposed to commission basis and they will therefore not be applying pressure on providers to increase rates. They also feel that tied agents are unlikely to be in a position to influence fee rates. In relation to multi-tied agents who may be able to exert pressure, the FSA is proposing that they will be required to disclose the commission payable on each comparable policy, so enabling consumers to consider if there is any bias. It is however an area of risk for those consumers who use advisers paid on a commission basis.

Revised Infrastructure
The FSA has identified a number of key areas which will need to be changed if the abolition of polarisation goes ahead.

For firms which still wish to be seen as "independent" then the FSA has said that such independents can only be paid by way of a fee or on the basis of a defined payment agreement. A defined payment agreement does not necessarily mean that the fee is fixed but it must be on a basis agreed in advance, for example an hourly rate. In return, the IFA must rebate any commission payable or offset commission against fees due, or pay any excess commission direct to the customer.

For the market, this will not extinguish commission but it means those persons who wish to advise on the entire market and be remunerated by way of commission cannot be called independent or be called anything synonymous with "independent". The FSA has suggested such firms might wish to call themselves "authorised financial advisers".

Although the FSA has decided that for those wishing to be independent they must be remunerated on a fee as opposed to commission basis, it has not suggested how the commission "bias" is to be addressed for the tied agents, multi-tied advisers or other advisers who will continue to be paid on a commission basis.

The next structural issue is in connection with the equity participation in IFA firms. The current position is that where a product provider and an IFA are financially or influentially connected there is a higher standard of product suitability which has to be satisfied before recommending the product of a connected product provider. The rule, which is known as "the Better than Best" rule is that such a product can only be recommended if it would be more suitable than any other generally available product. The purpose of the rule is to help IFAs deal with potential conflicts of interest. In practice, it means that little if any business is placed with the connected product provider and for those providers who do distribute through the IFA sector it has been unattractive to invest in an IFA because of the likely reduction in business.

The FSA is proposing to remove the Better than Best rule. It sees the introduction of a fee-based system as the best way of managing the possible conflict of interest. Some in the independent sector have been critical of this proposal, arguing that it is difficult to see that an IFA firm will be truly independent where it potentially could be 100% owned by a product provider.

The removal of the Better than Best rule has other potential consequences. The financial implications of migrating to a fee- based remuneration system, given current consumer resistance to the payment of fees, may cause difficulties for IFAs wishing to remain independent but who do not necessarily have sufficient capital resources to support this change. The removal of the Better than Best rule potentially opens the doors for significant investment in IFA firms by product providers and may be a useful source of capital. The Evolution Group, the acquisitive financial services company, has recently taken a strategic stake in Inter-Alliance, one of the UK’s largest firms of independent financial advisers. This may not be quite the rush we saw when banks invested in estate agents but it looks likely that there will be considerable interest in the IFA market from provider firms and vice versa.

To balance the effect of removing the Better than Best rule the FSA has said it will require full disclosure of equity stakes. The FSA is also considering other safeguards to minimise any risk of the IFA firm being required to pass certain volumes of business to the shareholder. This type of arrangement, with full or partial ownership of independent distribution channels combined with full disclosure, is common in other countries such as Australia and New Zealand.

In relation to introducers, there is currently an exemption for introducers where they introduce a person to an authorised firm with a view to the provision of independent advice or the exercise of independent discretion over investments. This situation is unaffected and such introductions to IFAs will continue to be exempt.

Complaints Regime
The FSA is keen to ensure that proposed deregulation and opening up of distribution channels does not reduce protection to consumers where they have a complaint. It is proposed that the complaints rules will continue to apply with some modification for a depolarised environment. The FSA proposes to set out clear lines of responsibility and accountability; for example where there is a multi-tied adviser, then a complaint about the advice will lie with the adviser and the product with the product provider.

Other Options
As part of its consultation process the FSA has considered whether there are any intermediate steps which fall short of full abolition. It has for example considered merely modifying the rules by allowing adoption by providers of externally manufactured packaged products. This partial step has already been seen in relation to stakeholder pensions. It has also considered whether merely introducing the multi-tied distributor firms as a relaxation would be sufficient. The FSA believes both of these options are helpful but sees that the best way forward is to remove the polarisation regime altogether. The FSA argues that, following abolition, the market will develop with a diversity of distribution channels and services available to consumers, resulting in increased choice and competition, particularly in the tied sector.