Anticipated 10-fold increase in S166s could well be fuelled by failings in Replacement Business processes

11th October 2013

During the summer our sister company Legacy Asset Systems (LAS) decided to probe key trends in legacy asset migration onto platforms. It is clear after all that migration activity is still accelerating and as it does so the risks of getting it wrong rise for businesses that do not have robust systems in place to mitigate those risks.

One of the more worrying findings we gathered was that 12% of the firms we asked admitted that they felt an increase in ‘old for new’ Reduction in Yield (RIY) comparisons of more than 1% would be acceptable and in compliance with regulation in this area. It is not!

The FSA’s Finalised Guidance on Replacement business and centralised investment propositions (FG 12-16)  makes it clear that up to 0.5% RIY increase is good practice. Clarification since this guidance was published back in July 2012 indicates that old for new increases in excess of 1% RIY are less likely to be in the clients’ best interests. Should the FCA undertake an Arrow visit to review the firm’s transfer policies, this could in turn lead to an onerous SI66 report being requested.

So why might IFAs fail to adhere to FG12-16 guidance on replacement business? It may be simply because there is so much to get right. The guidance demands a good deal of firms in replacement business mode. They need to:

  1. Consider objectively their clients’ specific needs and objectives
  2. Collect necessary information of the clients’ existing investments and the recommended new investments, such as product features, tax status, costs and the performance of the underlying investments
  3. Implement a robust risk management system to mitigate the risk of unsuitable advice and poor client outcomes

This requires a robust Fact Finding process which obtains necessary information regarding each client’s financial situation and their knowledge and experience in the investment field relevant to the specific type of designated investment (see COBS 9.2.1). Clients typically want a return on investment generating growth or an income based on their appetite for risk and cashflow forecasts.

To assess investment return the regulator suggests the charges of the recommended investment, performance of the investment and the tax treatment of the investment all need to be properly considered and documented.

When considering cost the regulator needs firms to consider the issue of cost for all recommendations to replace an existing investment. If the new investment recommended “is more expensive…there needs to be a good reason and this reason needs to be justified to the client”. The FSA gave failings in this area as the most common cause of unsuitable advice in the platform review they conducted the results of which were published as far back as March 2010:  

The guidance expands: “Where the advice is to switch or transfer an existing investment to a new investment, we expect to see firms conduct a cost comparison between the two solutions. Firms should consider ALL costs associated with the existing investment and recommended product or portfolio.”

This is no mean feat as the OFT unveiled in last month’s report revealed 18 different variables affecting the cost of DC pension schemes, most of which were not captured within the quoted Annual Management Charges relating to those schemes.

Another concern is tax implications of migrating assets. In the FSA’s example of poor practice in a firm it included in its 17-firm Thematic Review a migration recommendation triggered a capital gains tax liability which could have been avoided by moving funds over two tax years.

Advisers are asked not to come at a fact-finding exercise with a preconceived agenda to switch the client’s investments into a new solution/platform as this may not be suitable option for the client. This implies that a rigorous client segmentation process as well as robust and well documented fact find is needed.

Various other recommendations are given for ‘old for new’ comparisons including considering the value of any guarantees that are available to the client’s existing investment. The FSA, also flags up a warning linked to investment flexibility:

“where a firm recommends a higher cost solution using funds that are available at the existing investment solution, we would deem this to be an unsuitable outcome for the client if there are no other justifications to demonstrate the suitability of the recommendation.”

With all these bear traps highlighted by the FSA just over a year ago, it is perhaps no surprise that IFA firms; most of whom have now completed client segmentation exercises with a view to migrating clients assets’ from legacy plans to a range of wrappers on platforms; are nervous. Let’s just hope that the predicted 10-fold increase of S166 demands (Source: BDO) by the FCA will not be down to botched legacy asset migration activity as it accelerates.

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