On 5 April 2018 the FCA published a policy statement, summarised in our recent blog, on its first round measures as part of its asset management market study. Particular interest has been generated by the new rules and prescribed responsibility this contains on assessing value for money. In this blog, we focus on these new rules and consider their implications for firms and senior managers.
What are the new rules?
Regulators at both EU and UK level are seeking to clamp down on poor value offerings through scrutinising governance and investor disclosures.1 To this end, the FCA will require authorised fund managers (AFMs) to assess the value for money of each fund, take corrective action if it does not offer good value for money, and explain the assessment annually in a public report.2 Moreover, under a new Senior Managers and Certification Regime (SM&CR) prescribed responsibility, a senior individual will be required to take "reasonable steps" to ensure that the AFM carries out the assessment of value and acts in the best interests of fund investors.
Given the inherent complexities and subjectivity of assessing value for money, only experience will tell whether the assessments required by these new rules will be sufficiently comparable to show investors which products offer the best value. However, firms offering products with particularly poor value may well struggle to justify their offering, and, as is the underlying policy intention, will be put under pressure to reduce fees, improve the quality of service, or move investors into better value share classes.
How should value for money be assessed?
In our view, for value for money assessments to be effective they need to be integrated into a firm's overall product governance process, including in pre-launch reviews and regular post-launch assessments. Value for money is integral to many of the product governance elements required under MiFID II and PRIIPs, including identifying a target market which would derive value from the product, setting a distribution strategy to reach that target market, scenario analysis to identify the risks of poor outcomes for clients, assessment of the impact of costs and charges on the product's expected return, and the transparency of the charging structure.
A firm's product governance process needs to be underpinned by effective board governance. To provide external perspective and challenge, the FCA has set out a new requirement for AFMs to appoint a minimum of two independent directors and for them to comprise at least 25% of the total board membership. Notably, however, the FCA has not insisted on a majority of independents.
What constitutes good value for money?
The FCA sets out seven factors that firms must consider when assessing the value for money of each fund:
- Quality of service: the range and quality of services provided to investors;
- Fund performance: this should be considered over an appropriate timescale given the fund's objectives, and should be measured net of fees;
- AFM costs: the cost to the AFM of providing the service to which each charge relates;
- Economies of scale: whether the AFM is able to achieve savings and benefits from economies of scale for larger funds;
- Comparable market rates: the market rate for any comparable service provided by the AFM or to the AFM (including by delegated investment managers);
- Comparable services: the AFM's charges for comparable services, including institutional mandates of a comparable size or funds with similar investment objectives; and
- Classes of units: whether it is appropriate for investors to be in share classes with higher charges than those applying to other similar share classes of the same fund.
The FCA does not prescribe a level of charges that it considers to be acceptable. However, the cap of 0.75% per year that it has imposed on default funds in auto-enrolled workplace pension schemes gives an indication of the level of charges it considers reasonable for a type of fund that is likely to be relatively non-complex. The FCA also gives examples of where firms are likely to be offering poor value for money: these include expensive "partly active" funds and legacy pre-Retail Distribution Review (RDR) share classes where cheaper but otherwise identical classes exist. In practice, what the FCA judges to be an appropriate charge will depend on factors such as the complexity of the investment strategy, the potential out-performance of the fund, the size of the fund, and the availability of cheaper alternatives.
The FCA will expect firms to ensure good value for money not only in the annual management charge, but also in execution costs, research fees (if charged separately), and charges for other third party services. In 2017 the FCA found shortcomings in firms' oversight of best execution and research and it is expected to pursue these issues following the implementation of MiFID II.
The FCA emphasises that fund charges should be assessed in relation to the overall value delivered. Firms can assess fund performance in a variety of ways including the potential, as well as actual, out-performance of the fund against a benchmark; the actual risk-adjusted net return; customer satisfaction levels; and complaints volumes.
Recent research by Fitz Partners showed that a third of UK retail fund assets remain in share classes that pay rebates to financial advisers. The FCA is keen to see investors moved out of such legacy pre-RDR products. The new rules therefore remove the need for an AFM to get consent from each investor before converting them to a cheaper but otherwise identical class of the same fund. This will make it easier for firms to transfer investors out of legacy share classes and will allow firms to close expensive share classes in which only a small number of investors remain. Firms will, however, need to address any barriers to switching to better value products, such as exit fees or unnecessarily burdensome administration.
How should value for money be communicated to investors?
The FCA's recent behavioural testing on the effectiveness of costs and charges disclosures found that the prominence of such disclosures, and the type of information displayed, had a significant effect on decision-making. Firms should take this into account when considering how to communicate to investors the costs, performance and risks of their products.
Implications for Firms
The new requirements on value for money assessments will, as intended, be a key focus for boards and senior management, especially given the new prescribed responsibility and the requirement to make public the results of the fund assessments. Assessing value for money is by nature subjective, but the FCA has set out clear guidance on the factors that should be considered, as well as examples of where investors are likely to be receiving poor value for money. Firms may, however, face challenges in distilling a potentially complex value for money assessment into an easily digestible annual disclosure.
In our view, for value for money assessments to be effective, and to meet FCA requirements generally, they need to be integrated into a firm's overall product governance process, overseen by board governance with a substantial independent element, and communicated to investors in a clear and user-friendly way. These new rules are an important further instalment in a series of concerted regulatory initiatives on product governance and disclosure of fees and charges. We expect the FCA's supervision teams to scrutinise performance and outcomes in these areas firm by firm, and in depth.
1 Both the revised Market in Financial Instruments Directive (MiFID II) and the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation have introduced new requirements on product governance and investor disclosures. The European Securities and Markets Authority (ESMA) has also been scrutinising "closet-tracking" and disclosures on costs and past performance for retail investment products.
2 This can either be included in the fund's annual report or in a separate document published within 4 months of the fund's annual accounting period end date, effective for periods ending on or after 30 September 2019.
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