Trust pays, but it all costs
Earlier this month FSCS published important research in partnership with the Warwick University Business School on trust in financial services.
Among other things, it showed that there was a big trust deficit when it came to seeking financial advice. Consumers were not confident they would be protected if the advice turned out to be bad.
That is, of course, a misapprehension. Consumers can take complaints against trading firms to the Financial Ombudsman Service. FSCS will step in to protect consumers where they have legitimate claims against a failed regulated firm for mis-selling or negligent advice.
And, by the way, let me repeat again, for FSCS to rule that a claim is legitimate we must be satisfied that a Court would have concluded that the firm owed the consumer a civil liability because the advice received was negligent. We do not compensate for ordinary investment losses. We do not second guess advisers.
The evidence is, in other words, that FSCS protection is part of the solution to promoting higher take-up of advice, not the problem. In fact, the industry should do more to raise awareness of that protection with FSCS and so overcome the barriers of distrust.
But FSCS protection also comes at a cost because the compensation we pay to consumers is recovered from other advisory firms through our levies. We pool the compensation costs.
These costs are high. Over the last six years, since 2009/10, FSCS has raised levies of over £1.25bn on advisers: £280m on insurance brokers; £260m on life and pensions advisers; and £720m on investment advisers. The total would be closer to £1.5bn if you add in the contribution of £234m paid by investment providers to the costs of the Keydata failure.
Because we operate a pay-as-you-go funding system – raising levies as failures arise – these costs have been unpredictable and hard for firms to absorb. They generate understandable frustration among well-run advisory firms which rarely, if ever, mis-sell or give bad advice.
So is there a better way?
As a contribution to the debate about our funding, FSCS is publishing today an analysis of compensation costs and levies in the advice sector since 2009/10. I hope it will explode a few myths, but also provide a sound evidence base for testing new ideas.
Others will no doubt quarry the information to identify new insights, but I would highlight a few key findings that seem important to me.
The first is that a substantial proportion of the compensation paid by FSCS over the last six years flows from a small number of idiosyncratic firm failures. In fact well over half the total compensation costs arising in the investment advice sector flow just three failures: Keydata, Arch Cru and Catalyst.
This is far from a sector wide failure.
It is also striking that, at least over this period, FSCS has paid out a great deal of compensation because of bad advice to retail investors to buy unregulated or unusual products.
The Keydata and Catalyst failures both involved investments in so-called “death bonds” - bonds secured on second-hand life policies. The compensation FSCS is now paying as a result of SIPP claims resulted in a £100m levy this year on life and pensions advisers. That reflects negligent advice to move retirement savings out of occupational schemes into SIPPs and to hold in those SIPPs illiquid and highly risky investments such as shares in overseas property developments.
So a small number of failures involving very risky business models have generated big compensation costs for the great majority of advisory firms. These are partially offset, it should be said, by FSCS’ excellent work to maximise recoveries from the estates of the failed firms from third parties who shared responsibility for investors’ losses.
So what are the answers? Is there a fairer way of funding FSCS to provide the protection which underpins that essential trust?
Well, that is the question for the FCA’s funding review which will get under way in the New Year.
I hope that the review will be comprehensive in the range of options it considers. I hope it will consider whether firms can be better insured or capitalised to absorb their own liabilities without recourse to FSCS. I hope the review will look at the case for reducing the risk of negligent advice by restricting further what unregulated or exotic products can be recommended to ordinary retail investors (while maintaining protection for investors who nevertheless are still advised to buy them).
I hope we shall not rule out some form of pre-funding as way of giving firms greater certainty about FSCS’ levies. I hope we shall look again at how FSCS levies are distributed to see if we can reflect the riskiness of business models so that the firms running the highest risks make proportionally higher contributions to our costs.
Finally, I hope that the industry itself will join in the debate. It’s easy to say what’s wrong or unfair; less easy to find fairer solutions. We need to know what the industry would regard as fairer.