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The Sandler Review

Pete McGurk, a partner in our life team, discusses the Sandler report on medium and long-term savings in the UK.

The Sandler Review
The bombardment of the life insurance and pensions industries with reviews, discussion documents and consultation continued apace in July 2002 with the publication of the Sandler Review. This review, commissioned by HM Treasury, covered medium and long-term savings in the UK. Its brief was to focus on aspects of competition and efficiency and to suggest policy responses to ensure that consumers are well served. Sandler recognises that it is not a realistic goal for the market to operate like most consumer goods markets but believes that major improvements can be made using simplification as his main theme.

Analysis of the current industry
Its main conclusion is that consumers are in a weak position (no surprise there), although many within the life insurance industry struggling to live within the "1% world" introduced by the stakeholder regime, and handing out compensation payments like confetti, may feel that this particular tide has turned quite markedly in recent years.

Other key observations by Sandler on the current retail scene are:

  • The complexity of the issues involved results in the real customer of the product provider being the adviser and not the consumer.
  • The current lengthy, heavily-documented sales process arising from fear of mis-selling introduces significant fixed costs, to the probable detriment of lower income groups, and has led to sharp increases in life industry unit-costs since 1986. The burden of proof falling on the adviser rather than the customer is a key factor.
  • Commission is bad. It leads to adviser bias, complexity and confusion, a poorly functioning advice market, incentives to focus on higher income consumers and higher administrative costs.
  • Sandler broadly welcomes the FSA's proposals in its consultation paper CP121 for reforming the polarisation regime for financial advice but feels that some modifications would be desirable.
  • With-profits, as a concept for pooling investment risks between generations and allowing lower income groups access to the benefits of "professional" asset allocation, receives support.
  • As a means of delivering competition between providers, the current structure of with-profits business is attacked with vigour. The opacity of current with-profits products focuses competition on maturity payouts and the insurer's financial strength, both of which are poor measures of value for money.
  • The conflicts of interest between shareholders and policyholders in with-profits are weighted in favour of the former with the "unambiguous duty" of the directors to the shareholders being set against the "vague contractual rights" of the policyholders. The Appointed Actuary system is felt to be an insufficient counterbalance.
  • The charging of expenses entirely to the with-profits fund and the distribution of the fund's profits on the "90/10" basis ( i.e. 90% to policyholders, 10% to shareholders) is considered a weak incentive to cost efficiency. The 10% share to shareholders is seen as an arbitrary measure of the cost of capital provided by the shareholders.
  • Issues surrounding the use of the "inherited estate" for with-profits business are also raised as causes for concern.
  • On broader investment matters, Sandler is concerned by consumer attitudes. He believes there is excessive focus on past performance and insufficient on charges, leading to premium prices for a good past record. To make matters worse, the focus is on performance over inappropriate (i.e. too short) timescales.
  • He finds consumers' apparent preference for active management hard to justify and points to evidence that "tracking errors" on active funds have reduced considerably in recent years, which suggests that consumers are paying for active management and getting "quasi-passive". The greater prevalence of active management in retail funds compared to institutional funds is counter-intuitive. He believes that active management of a with-profits portfolio is completely unjustified over the longer term of the underlying policies.
  • The complexity of the taxation system underlying various forms of longer-term saving is a key target for criticism, pensions being the main (and obvious) example. The favourable tax treatment given to savings under a life assurance wrapper compared to other, essentially very similar, schemes without the wrapper is perceived as unnecessary and distorting competition. ISAs though, are given the "thumbs up", though some tinkering may be necessary.
  • The tax framework in particular has led to the advice process being product-focused rather than focused on price and performance. There is little incentive for advisers to seek out the best price, brand being more important.

Sandler's proposals

Product regulation

An extension of the charge-capped "stakeholder" concept used in the pensions field to a suite of simple comprehensible products is proposed. The range would include three products:

a mutual fund/unit-linked product;

a with-profits product; and

a pension product.

A protection product is also suggested as a possibility. The charge-capping would involve no initial charges and limited annual charges (1% p.a is suggested as a starting point subject to periodic review). Surrender penalties would be strictly regulated and ideally zero.

The degree of investment risk of the product would also be regulated.

The sales process would also be simplified by giving a number of clear warnings to a customer who would then certify that he had received and understood them. The bulk of the current Conduct of Business requirements would not then be applied to the stakeholder products including "suitable advice", "know the customer" and the requirement for the adviser to be FCP3 qualified.

Distribution

Sandler supports the proposals of CP121 and believes that independent advisers' remuneration should be purely for negotiation between the customer and adviser but further advocates that a sales-contingent fee should be permitted in the independent sector. Furthermore, the term "adviser" should be restricted to this sector.

With-profits

The numerous concerns on with-profits are addressed by a proposed re-design of the product. In particular:

  • Shareholders should not share in the returns of the fund i.e. funds must be 100/0 and not 90/10.
  • A separate management company (which could be owned by the insurer) should run the fund for which explicit charges are made.
  • A separate smoothing account should be set up underpinned by supporting capital but aiming to be neutral (an average balance of zero) in the long term.
  • Annual statements should be given to policyholders giving key information and including the unsmoothed value of the underlying assets.
  • The application of Market Value Adjusters (MVAs) should only be used in specific pre-defined circumstances.
  • With-profits funds should not be used to finance other business.
  • Policyholders funds can be charged for the capital support provided.

The proposed requirement would apply to all of the proposed stakeholder products. It should apply to all other with-profits contracts issued after a future date with the exception of the 100/0 requirement. Existing with-profits contracts would require consistent disclosures.

Tax

The Review recommends considerable simplification of the existing regimes and that future tax-based incentives should be avoided as a means of increasing overall savings levels. It is generally content to leave recommendations on the vastly complex pensions system to the Inland Revenue's own review. Sandler does recommend, however, that the barriers to non-life companies as pension providers should be removed.

Life companies are again the target as Sandler proposes that the qualifying regime be abolished for new business together with the "5%" rule on withdrawals, although the latter should be replaced with another partial disposal rule.

The ISA regime should remain, but the maxi-mini distinction might be removed on depolarisation.

Investment

One of the key themes of the Review is the lack of prominence given to investment issues as opposed to product issues. It recommends that the qualification regime for financial advisers should focus on investment issues, particularly asset allocation. Sandler was also asked to consider the relevance of the Myners Review of institutional investment to retail products. He concludes that retail customers should be informed of the overall investment objective, approach to asset allocation strategy, strategy for stock selection, process for minimising transaction costs and the provider's position on shareholder activism.

Commentary
The views below are entirely the author's and not necessarily those of Barnett Waddingham.

The underlying theme of simplification is a laudable one and certainly few could sensibly oppose any proposal to simplify the tax regime surrounding long term savings, particularly pensions.

The extension of the "stakeholder" concept of charge-capped products with a reduced intitial regulatory requirement appears at first sight attractive. However, it relies on the customer signing that he has been given and understood a number of initial warnings. Given consumers' propensity to let such warnings pass over their heads, would this not open the industry up to claims of mis-selling? The consumer may end up with a cheap product but not necessarily the right one in the absence of a client fact-find. This must surely be a concern.

A 1% annual charge does not fit well with the pattern of expenses borne by the provider, including marketing, which are very much geared towards the start of the contract. The pay-back time to recoup these initial expenses is generally many years (and for some contracts may be never), during which time the provider must provide the capital. Clearly, the lower the amounts invested, the lower will be the charges and the less attractive will be the product to the provider. This will discourage selling to the very group the products are presumably most aimed at i.e. the less sophisticated lower-income investors. This has clearly been a factor in the disappointing sales of stakeholder pensions. The charge-cap should not be set so low as to discourage providers from offering the product to a wide range of consumers, nor should it preclude an element of initial charge which, after all, reflects the reality of the situation. Providers would of course be free to compete on price beneath these maximum levels.

The with-profits proposals are a step in the right direction, though clearly require some further development. It has been clear for some time that the opacity of the product and the inherent conflicts within it, particularly for proprietary companies, were inconsistent with the modern investment scene. Indeed the opacity has probably led to a negative perception of a concept that has served the great majority of its consumers very well over the years. It is perhaps asking too much that any disclosure of methodology will mean too much to most consumers. The race is on to come up with methodology, and the required systems, to ensure that with-profits is presented as a "clean" product before it is killed off by public scepticism.

Pete McGurk, September 2002.