The Commission Conundrum: How Are UK Consumers Doing?

Commentary

One of the lynch pins of the Department of Labor fiduciary rule is the Impartial Conduct Standards for fixed annuities and the Best Interest Contract for variable annuities (and mutual funds).

The Department and most proponents of the rule believe that receiving a commission in exchange for making a product recommendation is a material conflict of interest. Initially, when the DOL first introduced their fiduciary rule in 2010, the commission-based compensation system was completely gutted and tossed over the side.

The claim is that this is “fixed” in the latest version by allowing compensation other than fee for service – IF:

1. It is reasonable;
2. It is paid by the product provider or a legal affiliate (i.e., the insurance company or a wholly owned subsidiary); and,
3. It is disclosed (along with other “material” conflicts of interest).

In addition, the new “kinder and gentler” (insert smiley face here) rule prohibits almost any other form of compensation other than reasonable commission. Of course we are provided with no definition - leaving any determination of what is reasonable to the courts and inviting the legal sharks to circle.

Another possible outcome is that carriers will take it upon themselves to define “reasonable” commissions in the form of levelized payments, trails and sales restrictions.One of the least understood and most onerous impositions of the rule is that if any one of the above three requirements is not met, the entire transaction becomes prohibited.

A prohibited transaction then becomes the target of the Internal Revenue Service. Section 4976 of the Internal Revenue Code allows the IRS to require that the advisor pay a tax of up to 100 percent of value of the prohibited transaction. Americans for Annuity Protection, as well as many other, interpret that to mean the value of the annuity.

In essence, barring the removal of annuities from their unreasonable inclusion in the rule’s new requirements, up front commission-based annuity sales will all but disappear. With that likely outcome, let’s take a look across the big pond to see what happened when the United Kingdom banned commissions in favor of fee-for-service compensation.The UK’s Association of Professional Financial Advisors, recently completed their third edition of The Financial Advisor Market: In Numbers.

The purpose of the study is to show the size and nature of the UK’s advice sector two years after the Retail Distribution Review (RDR) was implemented and commission-based sales were banned.The RDR had several aims – to improve the investment management service to clients, to increase the standards of professionalism for advisers, and to clarify the way advisers are paid for their services.

So, we thought it would be instructive to see if consumers were better served without a commission-based advisory service and which, if any, of these lofty goals were met. Key findings of the study revealed the following changes when commissions were no longer allowed beginning in late 2012.

Access to Advisors goes DOWN!

After a steady decline in the number of advisory firms between 2010 and 2012, during which time the details of the final Retail Distribution Review were just starting to emerge, 2013 and 2014 showed that the decline had more or less stabilized. While there is a sharp drop of almost 8 percent of the firms leaving the marketplace during the period of uncertainty, the study shows that by 2014, the number had almost returned to its 2009 number of 14,648.

Unfortunately, the number of staff in each firm who are advising has not recovered - dropping almost thirteen percent from their high of 27,080 staff advisors in 2009. In addition, the average number at each firm dropped 11 percent to 4.53.

Diving deeper into the data you find that the number of advisors who are considered in the UK to be financial advisors or wealth managers saw even more serious drops of 16 and 53 percent, respectively. These drops in the number of advisors, the average number per firm and the advisors remaining who actually help clients plan for retirement, ultimately leaves consumers with less access to advice.

Another troubling trend in the post-RDR marketplace is the number of advised versus non-advised sales. In the UK the term 'advised sales' relates to how a customer is given advice about the service or product they're receiving. Characteristics of an advised sale include explaining why the particular product or provider would meet the customer's demands and needs or giving a recommendation tailored to the customer's needs.

In non-advised sales, the advisor does not make any personal recommendation and lets the customer decide how they wish to proceed. In an example provided by the FCA, a non-advised sale would be providing generic information “recommending your client should buy household contents insurance (without mentioning a specific insurer or policy) that is unconnected with the sale of a contract.”

Before the RDR was implemented advised sales made up 60 percent of the total proportion of product sales and the remaining 40 percent were non-advised sales. Importantly, these proportions had been holding steady since 2006. However, since the implementation of the RDR, the proportion of advised sales to non-advised sales has completely flipped and 67 percent of the product sales were non-advised in 2013-14.   That means consumers are left to figure it out on their own.

It is clear where the DOL looked to formulate the definition of investment advice back in the states. In the latest version of the rule any recommendation to move money from an employer-sponsored plan to an IRA product or from an existing IRA to a new IRA product is deemed investment advice and triggers the requirements of the rule.

Advice Cost Goes UP

As predicted by Mindful Money, the social news and knowledge network for investors and savers published in the UK, the RDR was likely going to increase the use of discretionary managers.  Discretionary managers in the UK are advisors to whom you hand over complete control of your investment portfolio including key asset allocation decisions versus a financial advisor who must consult with you about significant changes and fund switches.

In 2011 before RDR, there were zero discretionary fund managers, according to the study, and by late fall 2014 they grew to represent about 5 percent of the total number of advisors. While the actual number of discretionary managers may seem small, the reality is that the USE of discretionary managers has risen considerably.

An April 2015 survey by Defaqto showed that 43 percent of UK financial advisers are currently outsourcing their investment proposition and of those 72 percent are using discretionary management services.

Using discretionary managers may allow a financial advisor to make changes to portfolios quickly and easily because they don't have to ask permission of investors. Unfortunately, it could also prove pricey, with many discretionary managers charging, 2 percent a year of the portfolio value – on top of fund charges and other transaction costs[1].

…AND, Savings Suffer

The most troubling finding from the report is the overall UK savings ratio. In the United Kingdom they define their savings ratio as the percentage of disposable income that is saved.  The study shows a steady decline since 1997 when it was at 13 percent and, predictably, it dropped to its lowest point of 6 percent in 2008 at the beginning of the financial crisis. Encouragingly, the households in the UK bounced back and moved their savings ratio back to 11 percent in 2010 only to see it crash to a new low of 4.7 percent[2] in the second quarter of 2015. A startling drop of close to 65 percent.

The timing of the steady decline after the significant improvement in the years following the economic crisis cannot be ignored and it would be difficult to label it as mere coincidence. Did the RDR improve the investment management service to clients, increase the standards of professionalism for advisers, or clarify the way advisers are paid for their services. It is really too early to tell, but we do know that consumers are already paying the price of this decision.

As the association’s director, Chris Hannant, points out with the cost of advice rising and the access to advise falling many of the folks heading for retirement are finding it difficult to save. Lesson learned? As difficult as it is to assume a direct cause and effect, it is certain is that the savings outlook today is worse than it was pre-RDR in the UK. Can we afford this exercise in good intent with bad outcome here in the United States?

Sadly, unless Congress heeds our advice to remove annuities from the devastating effects of this rule, Americans will find themselves adrift without a retirement plan and advisors to help them stay on course. Visit www.aapnow.com and ask your representatives to take action and stop this rule.

[1] What is discretionary fund management and is it better than an ‘advised’ portfolio from your IFA?

[2] Source: National income accounts Q4 ONS

Kim O’Brien is the vice chairman and CEO of Americans for Annuity Protection. She has 35 years of experience in the insurance industry. O’Brien served The National Association for Fixed Annuities (NAFA) for almost 12 years and led the organization to defeat the SEC’s Rule 151A.

Contact Kim at [email protected].