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ABI RESPONSE TO HMT CONSULTATION ON SANDLER PRODUCTS CONTENTS 1. Executive Summary. 2. The Target Market and the Sales Process. 3. Price Caps in Principle and Practice. 4. Alternative Charging Structures. 5. Product Proposals. 6. Summary of Recommendations. ANNEXES

A. Executive Summary of ABI Response to Pensions Green Paper.

B. Executive Summary of ABI Response to FSA Discussion Paper

19 (DP19).

C. Detailed Comments on With-Profits. [M:\LID\FMCG\Sandler\ABI RESPONSE TO HMT Contents V2.doc]

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Section 1: Executive Summary

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1. The ABI is the trade association for Britain’s insurance industry. Its more than 400 member companies provide over 97% of the insurance business in the UK. ABI member companies account for more than a fifth of investments in the London stock market.

2. The insurance industry believes that simplified products that can be sold

through a very simple sales process have the potential to make a major contribution to closing the UK’s £27 billion annual savings gap.

3. We would like to work with the Government to develop the ideas put

forward by the Sandler Review and in our own independent research to bring such products successfully to the market. This paper is our initial contribution to the process, and sets out our reaction to the Government’s thinking on the target market for the products, their design and their pricing. It contains a substantial body of detailed, quantitative analysis in support of some important arguments and recommendations.

4. To move the process forward, the Government should take the following

actions:

As a next step, issue a joint consultation with the Financial Services Authority (FSA) which brings together their separate proposals for product design, sales regulation and price.

Consider alternatives to Sandler’s starting point of a flat 1% price cap. For example:

a contribution charge alongside an annual charge on funds; a single annual charge that is slightly higher in the early years.

Price caps do not have to be part of product regulation, but these structures balance customer and provider interests, allow for more advice and guidance, and increase saving.

Keep product design simple: detailed prescription is not necessary, and it is better for customers that their investments can be managed to match changing economic circumstances.

Keep sales regulation simple. Very substantial cost reductions are essential.

The Target Market 5. The right place to start in designing new products is with the customer

whose needs they are meant to meet. From that can follow decisions on product design, distribution and, finally, price. This is how a commercial

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organisation would tackle the project. Instead, the Government is putting product design and pricing first. The FSA is separately pressing on with designing how distribution will work. Thinking about the customer is taking a back seat.

6. The size of the market matters. It will affect the attractiveness of the products to providers, and the contribution that Sandler products can make to the Government’s savings strategy.

7. In assessing the market, it may be helpful to distinguish the potential size

of the market from its actual size. The potential market is influenced by three things:

• • •

economics and demographics; sales regulation; the price cap.

8. A price cap makes it uneconomic for providers to serve customers with

small amounts to save, limiting market reach. Further analysis on this point follows later.

9. Economics and demographics are the basis of the Government’s definition

of the market in the Consultation Paper. But this analysis is inconclusive: the Government suggests four definitions: there are 29 million adults (64% of the population) who meet at least one of them, but only 1 million (around 2%) meet all four1. This range of estimates is too broad to be useful on its own. The upper end supports the Government’s suggestion that the products are likely to appeal to the majority of the population. On this basis, providers would have substantial economies of scale. At the bottom end, the premium income from such a market is unlikely to offer economies of scale. This has implications for pricing, ability to attract capital, for competition and choice, and for the contribution the products can make to the Government’s overall savings strategy. We are very pleased that the Government’s independent researchers will be looking at this area to better estimate likely demand for the products.

10. On current plans, the FSA will design sales regulation for Sandler products

that screens out people for whom in their view the products are unsuitable. Such a process could cut the target market to the bottom end of the Government’s range (1 million) or below, by setting high levels of cash saving as an ‘entry requirement’ or by screening out anyone who might have State support withdrawn if they save.

11. Sandler products will not succeed if the Government bases pricing

decisions on a potential market derived from economic and population modelling and the FSA determines a different market by a sales regime based on a separate set of consumer protection considerations. The two models won’t match. Instead the Government and FSA must re-

1 Source: ABI Member analysis.

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organise the Sandler Products project to put the customer first: they must come up with a single coherent model on which to consult the market.

12. Once the potential market is agreed, two factors will determine its actual

size. Product take-up depends on:

consumer behaviour; and • •

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how firms and regulators together operate the market to maximise the number of purchases that can be made at acceptable risk.

13. No one knows how people who do not currently save will respond to new

products:

how many will actually buy; how much they will save; whether they will save for a short period or a long period, intermittently or consistently.

14. Getting the largest number of people to buy, save a sensible amount and

save consistently depends on advice and guidance, and often a key element of persuasion. Sandler’s world is a world where persuasive advice and guidance exist without a suitability assessment or know-your-customer requirement on the seller.

15. Creating the largest actual market for Sandler products requires joint

action by Government, FSA, Ombudsman and industry to create the right environment:

the industry must advise, guide and persuade fairly and in its customers’ interests. It must manage its risks so that it takes on customers who are likely to be able and willing to keep saving;

the Government must re-assert Sandler’s core principles to reduce the risk that in future the products are deemed to be unsuitable for important groups of customers.

16. To maximise the take-up of products within the potential market, the

Government must make a clear statement of its policy goals and expected outcomes. These include:

Sandler products aren’t right for everyone – but the Government should be clear which groups they are considered right for;

a goal of policy is to widen the group of people who take equity risk beyond those that currently do;

Sandler products are designed to be sold on the basis of risk disclosure, not of an assessment of attitude to risk.

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17. Against this background, it becomes possible for well-managed firms to

seek out a broad group of customers and actively market the products to them. Without such a background, the cost to firms of managing their risks will rise sharply, and the market will shrink.

Price Caps 18. The industry strongly welcomes the Government’s move to commission

independent research to look at whether the flat 1% price cap proposed by Sandler as a starting point meets the needs of customers, Government and the industry2.

19. There is a strong feeling in the industry that price caps are wrong in

principle, and could distort the market and damage the industry and its customers. Extending Government price controls outside a few very particular situations (eg monopoly suppliers) risks unpredictable and unintended consequences and requires very careful analysis.

20. Price controls are not a necessary part of product regulation. The industry

believes a system of benchmarks would be a preferable way to safeguard consumers while delivering the competitive pressures on costs and value that Sandler was keen to see sharpened.

21. But since the Government is proposing a price cap, the industry has

developed analytical tools to look at the consequences of different choices for firms and consumers.

22. Given Sandler’s “initial starting point” of a 1% cap, our analysis starts with

modelling flat charging structures and looking at the experience of stakeholder pensions. Modelling shows that:

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flat percentage charging structures obstruct the Government’s goal of extending saving. They tie up large amounts of provider capital and provide a payback only over very long periods. They also put capital at increased risk, through exposure to poor persistency, and because revenues are linked to the markets;

higher risk and prolonged payback periods arise primarily from the flat shape of the charges, not their level. The market will ultimately decide, but it is unlikely that the risk/return prospects of Sandler products price capped at 1% will be preferable to other opportunities for the deployment of capital. This has clear implications for competition and choice;

2 The Treasury and FSA both note that to ensure sufficient market entry to deliver adequate levels of competition, any price cap must be set at a level that enables efficient firms to make a reasonable return on capital.

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flat charge caps exclude groups of customers. They make it uneconomic to actively promote products or to provide necessary advice/guidance to those with modest amounts to save. In particular they do not allow the industry to economically market products at levels close to £50 a month.

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23. The stakeholder pensions market bears out these findings. Business is

confined to circumstances where there is real scale, derived from numbers of contributors (eg worksites) or contribution levels. The average contribution into a stakeholder pension has risen to £130 per month. Where there is scale, advice is often available, because employers are more willing to pay a separate fee. But at least some current business is value-destroying for companies. This explains why the industry has by and large stopped promoting stakeholder pensions to individuals, who are not being encouraged to save, or getting advice on their options.

24. Our conclusion is that flat charge caps, and in particular a 1% cap, would:

limit the economic reach of Sandler products to a ‘zone’ consisting of long duration, high persistency products, sold in large case sizes or in large numbers;

not provide a sufficient return on capital or breakeven period to ensure competitive supply;

restrict the provision of advice and persuasion which research shows is crucial to increasing saving.

In short, a 1% market is a market for the better-off, self-motivated individual and the larger or more enlightened employer. While the Government needs to define its target market more clearly, this – we assume – is not it.

25. In looking for an alternative charging structure that better serves the

combined interests of the industry, Government and consumers, we have considered options that:

are based on Sandler’s starting point of a 1% annual charge; offer providers a return on capital and payback period that is not unattractive compared to other options (11% Return on Capital; maximum 10 year breakeven); offer customers transparency and good value for money; encourage the provision of advice and persuasion so that the availability of products turns into increased saving.

26. We have based our work on substantial efficiency improvements, new

business models and radical change to regulation. The last of these is key. Distribution costs are around 70% of the whole cost of delivering products. We assume they fall by two-thirds for individual sales, and

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nearly 90% for group sales. If regulation does not permit such cost reductions, the impact of the products will be reduced.

27. Our recommendation is that charge structures based upon:

the market standard model of an annual fund charge plus a charge based on each contribution paid into the product; and

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• a modest front-loading of the annual management charge offer a better balance between the needs of providers and consumers, while also achieving to various degrees the Government’s aim of improving market penetration to the target market. These structures should be the basis for further work by the Government’s independent researchers.

28. The results of our work are: Smallest

economically viable contribution (£/month)

Potential numbers of customers

Annual charge of 1% plus a contribution charge of:

5%

10%

individuals groups individuals groups

150 80 80 50

800,000 4 million 4 million

6½ million Higher annual charge (average 2½ %) in first 5 years, 1% thereafter

Individuals Groups

150

100

800,000

2½ million

The numbers of customers that are brought into the market are of course subject to all the uncertainties about sales regulation discussed above. These figures show the potential reach, if the price cap and sales costs were the only constraints.

29. This clearly shows:

• the potential for simple products, simply sold, to make a major contribution to closing the UK’s £27 billion annual savings gap by helping up to 6 ½ million more people to save;

• that the products’ success depends on a realistic price cap to stimulate

new distribution (especially in the worksite) and radical change to regulation;

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• the potential to bring substantial numbers of new customers out of the ‘exclusion zone’ where financial advice and savings products are unavailable, provided these very demanding criteria are met.

30. Our models are not predictions. We are not saying any given model will

work. But we believe – as we have argued since 2001 – that entirely new thinking can make a major difference to saving.

31. These figures illustrate the potential of the worksite. The worksite is an

emerging arena, and the industry is still developing new business models. As such, reliance on the theoretical potential of worksite distribution is a policy risk. To improve the chances of success, we recommend demand-side action in parallel to supply-side measures:

• the Government should encourage the provision of advice in the work

site; and

• encourage employers to contribute to pensions, to bring more modest personal contributions into the economic zone.

The ABI has made detailed proposals in each of these areas.

Product Design 32. The Government should “keep it simple” in designing Sandler products:

• it should keep the “brand” simple, combining Stakeholder pensions, Sandler products and CAT-marks into a single set of regulated products;

• it should keep the range simple, focusing on the core medium and long

term investment products. 33. It should keep product regulation simple with high level standards. Sales

regulation should be designed so that any Sandler product can be sold simply, cheaply and safely. But it may be that the FSA will decide that more sales regulation is needed if customers face choices between different types of Sandler products. In that case it may be necessary to specify the products more tightly.

34. For medium term unitised investment, the ABI would support the

Government setting an upper limit to equity, as it proposes. But further regulation, for instance, of:

• minimum equity content • other asset categories

• diversification within categories

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should only be considered if it looks necessary to ensure a simple sales process.

35. For the pension product, a different investment approach is required, with

a higher equity content. 36. But again, the Government should only stipulate:

• the investment mix • risk controls like with-profits or lifestyling

if the alternative is additional costly sales regulation.

37. Our key messages on with-profits are that the Government should

concentrate on the customer and what he or she needs, and not on the technicalities of delivering it. And the Government should take account of the likely sources of capital for new business, and maximise the extent to which existing capital can be applied.

The Sales Process 38. Our proposals for the sales process for Sandler products are set out in our

response to FSA’s Discussion Paper 19 (DP19). In this paper we concentrate on the risk that the process will:

• unduly limit the overall size of the target market if it makes it difficult or

impossible to recommend a product to large categories of people. It needs to give weight to the detriments of not saving, of delay, and of not saving enough;

• take too long, and hence change the economics of distribution; • cost too much. We recommend that advisers selling only Sandler

products should have to have no formal qualifications provided they are supervised by someone who does.

39. The key issue is that the process is simple for customers and for certain

providers and advisers. [M:\LID\FMCG\Sandler\ABI RESPONSE TO HMT Executive Summary V2.doc]

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Section 2: The Target Market and the Sales Process The Target Market 1. In this chapter, we:

• suggest an improved policy-making process to more closely match market methods;

• critique the Government’s analysis of the target market for Sandler products;

• look at additional factors which will determine how big the market is; • discuss why the Government, FSA and Ombudsman need to set out a

joined-up analysis of the target market to provide a sound basis for industry decisions about the potential risks and rewards of entering the market.

The Policy Process 2. In an open market, providers would:

• identify an un-met need in a segment of the population; • develop a solution to the need, and a delivery system; • test whether the solution can be offered at a price the target segment

can afford, and which includes a fair return on capital given likely sales volumes.

3. In establishing Sandler products the Government should follow the

same approach. Instead, however, it is now

• consulting in great detail on product design; and • undertaking research on price caps;

ahead of

• separate FSA consultation on a regulated delivery system which will in

practice determine who the products can be sold to;

and, crucially, while

• asking the industry to take responsibility for defining the un-met need and the relevant population segment.

4. This process is likely to deliver product and sales process outcomes

which do not match the price outcome for some or all of the following reasons:

• the costs of manufacture and sales cannot be recovered through the

allowed charge;

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• the volume of sales underlying the needs analysis or price study is undeliverable because the regulated sales process makes it impossible to sell to certain groups;

• the group for whom the products are intended is in future (with hindsight) determined to be smaller than it is now, because today’s view of economic prospects are reviewed in the light of actual outcomes, and because today’s policy goals are insufficiently clear. This opens the industry to the risk of large volumes of sales being retrospectively found faulty. Managing this risk will materially increase costs of the business, and widen the potential mismatch between price and costs.

5. The Government and FSA can manage this project to minimise the risk

of incompatible outcomes and reduce the likelihood of unintended consequences when the process is complete.

6. To do so, we recommend the following

Recommendation 1: The Government needs to substantially improve its analysis of the target market, taking account of attitudes and behaviour as well as income. Recommendation 2: The Government and FSA should publish an agreed statement of their desired outcomes so that the industry can rely on the regulated sales process to deliver products to a group that it is agreed they are right for.

The Government’s Analysis 7. The Government has not been drawn on the precise detail of the target

market for Sandler products. The consultation paper simply suggests that the products would be “of value to all those who have sufficient savings to consider investing in equity-based products, and who wish to purchase good value, simple investment products” but would be particularly aimed at those on low to medium incomes. It goes on to outline the characteristics of various groups which might fit this definition:

• 15 million “novice” consumers; • the 22% of households with incomes of £15-30,000; • the 30% of households with savings of £1,500-£16,000; and • the 3-13 million people identified by the pensions Green paper as

under-saving for their retirement. 8. But the size and nature of the target market is of vital importance to the

economics of the products; the ability for distributors to make misselling-proof sales; and the structure of the sales process. The detail of the target market will, to a large extent, determine the parameters of the sales process which, in turn, will determine the number of people to whom the products can be sold.

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9. Depending on how the target market is conceptualised, the number of

potential buyers of Sandler products can be cast at varying levels of magnitude. As a starting point we can take those who might be in the target market on the basis of their income. The Consultation Paper suggests this group might be households earning £15-30,000 – about 6 million working age households (although lower-income households may also be able to afford to buy, and higher-income households might choose to buy in preference to more sophisticated products).

10. But if the target market is constructed as people in this group who also

have a particular level of cash savings which may be thought “sufficient” the target market could be reduced, at a stroke, to under 2 million (only a third of households in this group have savings in excess of £1,500).

modest savers

People with incomes >£30,000. Accessible through current advice framework.

People with incomes <£15,000. Current income as a priority?

Target market?

People with savings> £16,000. More sophisticated financial needs?

People with savings <£1,500. Cash savings as a priority?

modest earners

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11. An ABI member company has used data from the ICM Omnibus

Survey to extend this analysis further. Their work shows the importance of clarity in considering whether the target market is those who meet any of the criteria set out in the CP or those who meet all those criteria. 29 million adults meet one or more of the criteria, only 1 million meet them all. In detail, most people meet either one or two of the criteria:

In 1 group → 47% (13.4 million) In 2 groups → 35% (10.2 million) In 3 groups → 14% (4.1 million) In 4 groups → 4% (1.0 million) 12. The magnitude of this difference shows the importance of a clearer

analysis of the target market. Improving the Analysis 13. There are a number of key factors the Government must include in an

improved analysis of the target market:

• the design of the sales process

• clarity on interaction with state benefits

• customers’ attitude to risk

• savings behaviour

(a) the sales process

14. The attached schematic (page 19) shows how a target market based solely on income could be rapidly reduced by a sales process which filters out people on the basis of, for example, inadequate cash savings; high levels of debt; or inadequate income protection (note that there is a large degree of overlap between the potential losses at each stage: people with low savings are likely to be those with heavy debts for example). We are not proposing this schematic as a draft sales process or decision tree to be followed, but rather as a way of illustrating all the areas that may need to be covered during the sales process, and the impact of different choices for market volumes, scale economies and the attractiveness of the market to new capital.

15. The exact scale of this attrition depends on three key factors:

• how wide a range of financial issues should any filtering process cover? Cash savings and debt are obvious candidates, life and other forms of protection could also be included.

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• how will the sales process collect information on each issue? Should potential customers’ levels of savings, debt etc be compared to an objective standard of ‘adequacy’, or should the standard simply be whether or not the customer is satisfied with their own position? (The former comes close to the existing Know your Customer requirement.)

• what happens to customers who do not meet the relevant standard? Will they be given warnings and allowed to continue through the process, or led out of the process altogether?

16. It is the answers to these questions that will determine the potential

size of the target market. On one view, with a sales process which takes into account a wide range of criteria and which removes people who do not meet them, we could be looking at a true target market of less than one million people. On the optimistic assumptions that 50% of these people can be persuaded to buy and that, on average, they save £100 pm this would produce a market of around £600m per year. It is unlikely that a market of this size will offer significant economies of scale, and, at around 2% of the £27 billion savings gap, it is clear that in such a market Sandler products cannot be a major plank of savings policy.

17. The target market could, of course, be made substantially bigger if the

criteria in the sales process were drawn differently and/or people who do not meet them could be allowed to continue to purchase rather than removed from the process. This would clearly entail wider judgement about how generally it is a “good thing” for people to invest in Sandler products compared with the detriment of delaying or not saving.

(b) Interaction with state benefits

18. The state framework is complex and unpredictable. Through the

Pension Credit it complicates the decision to save because many people will face a steep withdrawal of state money as their private savings increase. Equally, it could complicate the operation of a sales process which is intended to be as simple as possible.

19. The FSA view, as expressed in their response to the pensions Green

Paper, is that the Credit means “that private saving for retirement will not be sensible for everyone. Some people may find that they would be better off relying on State provision – for example, people in their fifties […] or those on low incomes who might be able to save only small amounts”3. We have to assume that this view is consistent with the Treasury’s view that Sandler products should reach people with as little as £50 per month to save; that is, that “small amounts” means less than £50. If the two views are not consistent then Government is promoting the sale of savings products to people for whom the Regulator believes they are not suitable. If the views are consistent

3 Response from the Financial Services Authority to Cm 5677, March 2003, para 5.2

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then they should be reflected in a sales process which does not exclude people who can save around £50 per month.

Recommendation 3: The Government and Regulator must agree who, if anyone, should not buy a Sandler product because of the potential interaction with state provision and must reflect this shared understanding in designing the sales process.

(c) Attitude to Risk

20. The Sandler Review makes clear that the proposed products will not be

right for everyone. It notes, for instance, that it would not be right for:

• anyone with an investment horizon of less than 5 years to buy; • anyone with access to an occupational pension to buy a Sandler

pension; • people below a certain income and above a certain age to buy a

Sandler pension.4 21. It is common ground that Sandler products will not be universally

appropriate. But the Review’s indicators are not very helpful in teasing out the spectrum of risk appetites that they might suit.

22. The industry’s view is that:

• in a low-margin market it is more important than ever that customers buy products they are likely to be willing and able to keep paying into;

• customers who are unprepared or unable (due to lack of resources) to take the kind of managed financial markets risk that Sandler products are designed to deliver are well catered-for by existing cash deposit products, including cash ISAs.

23. But we also believe that an important principle underlying the Review

needs to be made explicit: Sandler products are based on the assumption that a wider section of the population should be taking equity risk than currently do so, for their own long term benefit and for the good of the economy.

24. Views however will differ on the groups of people – defined by income

or otherwise – that this removes from the target market. We are pleased that the Government’s independent research will include such analysis, but think the Government must go further. To implement the spirit of Sandler the Government should re-confirm that Sandler products are to be sold without the need for any “suitability” assessment, and simply on the basis of a clear risk warning. Alongside confirmation that it is an aim to widen equity participation, this would

4 Medium and Long Term Savings in the UK: A Review: HM Treasury, July 2002, para 10:25.

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set clear benchmarks for the market, and allow an industry operating on the basis of sound risk management to sell to a wide group.

25. Such a contemporaneous statement would:

• exemplify how the FSA can implement Sandler’s call for them to define “mis-selling” and its counterpart suitability;

• remove an important element of risk, namely that future regulators

may determine with hindsight that the product was unsuitable for particular customers.

(d) Customer Behaviour

26. The success of Sandler products will ultimately be judged by their take-

up, not by their availability. Take up depends on inclination and behaviour:

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ty

tivi

c

s A

ng

vi

t Sa

s

/pa

nt

re

ur

C

Inclination to Save

Can't savedon't save

Could savewon't save

Have saved

enough

Do save - not enoughnot aware

Do save - not enough - aware

Could save want to save

Can't save want to save

Step 1: Develop saving appetite

Saving but may be vulnerable

Step 2: Motivate to

action

Step 3: Guide to

suff iciency

Low

Not

Eno

ugh

Enou

gh

Lifestyle Changes and Government Initiatives

Lifestyle Changes and Gov Initiatives

High

27. Take-up among customers who are not currently saving for the

medium- and long-term depends on:

• marketing the products’ features to make sure they are visible to customers;

• persuading customers that the detriment of delaying saving or inadequate saving is the managed financial market risk in the products;

• encouraging people to maintain saving once they start. 28. We have made clear in our response to the pensions green paper the

need for demand-side measures to create an environment in which saving is more likely to occur.

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29. The range of attitudes and the need for take-up explains why the Sandler Review envisaged most sales taking place in a face-to-face scenario involving an element of prospecting and persuasion. The need for this cannot be avoided. Nor can its cost.

30. The challenge for the industry is to manage business challenges and

risks implicit in a system where persuasive marketing and selling takes place without a suitability assessment by the adviser.

31. Yet delivering this essence of Sandler’s world view – which is to

produce financial products which can be bought and sold like any other – requires the Government and regulator to create an environment in which these risks can be managed within the margins set by the price cap.

32. The industry has good reason to be cautious. Unless there is broad

agreement on the sorts of principles set out above, the risk of business being re-visited later arises.

Recommendation 4: Once the analysis of demand is complete, it should be included in the public statement from Government, regulator and Ombudsman, of goals and expectations for Sandler products.

[M:\FMCG\Sandler\ABI RESPONSE TO HMT The Target Market v3.doc]

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Section 3: Price Caps in Principle and Practice The Principle of Price Caps 1. There is a strong feeling in the industry that Government price controls are

wrong in principle. Any such intervention is prone to unintended consequences, and as such has the potential to distort the market and harm the industry and its customers.

2. The Government should be very cautious about imposing price controls

beyond some very specific circumstances, notably controlling the power of monopoly suppliers who would otherwise make excessive profits at the expense of consumers. Even in these limited conditions (which do not apply here):

• price controls follow rigorous economic analysis of the specific features

of the market, and their coverage is limited to those activities where monopoly poses a clear risk to customers. In particular, price regulators closely analyse the cost-reduction and capital investment plans of firms and the prevailing conditions for drawing new capital into the business;

• there is an open and accountable system of review to ensure the

continued relevance, effectiveness and eventual removal of the controls.

3. Arguably neither of these conditions were met when the price caps for

CAT-marked ISAs and stakeholder pensions were introduced into financial services. Nor does the Sandler Review constitute the kind of detailed economic analysis of the market-place that utility regulators carry out in the operation of RPI-X price controls.

4. There is of course no reason why price caps are a necessary part of

product regulation. The key elements of what the Government is trying to achieve are communication, understandability and limiting investment risk. Prices could be constrained by sharpening competition through disclosure. Indeed the more the product is standardised, the easier it is for consumers to compare prices and the weaker the case for price controls.

Benchmarking: A Market-Based Alternative 5. There is therefore a good case for examining other mechanisms of

ensuring good value for customers in circumstances where:

• Sandler found competition to be working imperfectly, because of information problems, not absent altogether (as in monopolies);

• there is good evidence that the market is highly contested, with direct

competitive forces operating between providers. Sandler after all found the UK industry to be not inefficient by international standards.

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6. After all, the aim of Sandler’s review was to improve competition, not to

increase regulation. He was also concerned to improve the focus of customers on the value of advice and products, rather than further put the spotlight on price.

7. The most obvious alternative is a system of benchmarks for prices. These would have to:

• have a visible icon for customers to latch on to; and • be set at a level which allowed competition to operate. They would probably also require: • mandatory disclosure of whether the benchmark was met or not; • a parallel ‘long stop’ protection for consumers against excessive

charges (such as already exists in FSA’s rules).

8. Benchmarks along these lines might address the key disadvantages of Government-imposed caps

• Market-set prices might lack the overt simplicity of a single figure like

“1%” and in particular might include an element of shaping to manage capital strain and risk, but a clear benchmark could reduce even quite complicated structures to simple icons visible to consumers. For instance, a benchmark could be set with different RIYs at different points in the product term. On its own, this might be hard for many customers to grasp, but the algorithm could be reduced to a simple cipher, such as “AA”.

• Fuller price information could be published (eg on the FSA comparative tables) to allow scrutiny by analysts, journalists and competitors.

• Price caps are one-size-fits-all; benchmarks allow the market to segment to target different groups of customers. In some sectors (eg contribution levels above £150 per month, or group schemes with more than 100 members) competition below the benchmark would bite. This is borne out by the experience of stakeholder pensions: the market for large schemes is very competitive, with prices often below the 1% cap. In these zones, most products might be “AA”, but firms would naturally find ways to signal their particular improvements over the benchmark.

• Other sectors are today not served because of the rigidity of the cap. Again, a visible benchmark would add a competitive ‘hook’; it would be a ‘talking point’ between advisers and customers, forcing firms to justify charges above the benchmark.

• Perhaps most importantly, benchmarks do not have the excluding effects of caps. Some firms would no doubt choose not to market their products to low-moderate income earners; others would, and the ability to price according to costs would encourage capital into currently unprofitable segments.

22

• Benchmarking avoids the need to frequently review the sectors of the market covered by a price cap, which is a resource-intensive feature for utility firms and regulators.

• The Government might, say, allow only “AA” products (or “AA” and “AB” products) which also met risk-control and other criteria to be sold through a light-touch sales process. This could act as a further incentive on firms to meet the benchmarks. But whether or not to do so would be a matter for firms’ individual marketing position. There is the potential for a substantial ‘halo’ effect on the prices of non-Sandler suite products, which will inevitably be compared to the benchmark.

9. The Government has attempted benchmarking before, in CAT-marks. It

is worth looking at the lessons that experience offers:

• CAT-marks acted as a threshold not a benchmark. Products qualified or did not. A true benchmark acts as a reference for customers, encouraging competition either side.

• With CAT-marks, the price element was not market-based. As such, it acted as a de facto cap that firms, by and large, opted out of. A benchmark based on market behaviour is more likely to encourage participation and stimulate competition.

• Stakeholder pensions were also theoretically ‘benchmarked’ in character, but RU64 and the subsequent FSA rules on suitability have made it very hard for advisers to recommend non-stakeholder products. A price benchmark, accompanied by clear disclosure, would pressure firms to give a clear account of each product’s features, including its price by reference to the benchmark. Reasons for each recommendation would be made in the same way. This market-based solution is preferable to regulation.

10. In conclusion, benchmarking is a less radical intervention than capping.

This makes it less prone to unintended consequences. Benchmarking harnesses the natural dynamic of the market in the interests of consumers, and is more likely to produce the right balance between provider and consumer interests.

Recommendation 5: The Government should explore the impact on consumers and providers of a benchmark approach along the lines outlined in paragraph 5 above as part of its research on price caps 11. Even if it is not ultimately adopted, it will provide a sound baseline against

which to judge the costs and benefits to providers and consumers of capping options, especially in terms of market reach.

Options for Price Capping 12. Despite our reservations about charge capping, and the existence of a

plausible alternative safeguard for customers, the industry notes that the Government is attracted to capping the charges of Sandler products, and in view of this, we have modelled various charge structures to illustrate

23

their impact on consumers and firms. We have shared our analysis with the Government’s independent researchers.

13. Before turning to the models in detail, it is worth making a general point

about the level and structure of any charge cap. Charge caps cannot be considered in isolation. They exist in a context that includes the customer, the design of the products and the distribution system. Government should follow business practice in this area, and start with the customer. Once the target customers are identified, it is possible to design a product for their needs and a distribution system to deliver it to them. Pricing follows at that point, once the features of the product and its distribution are selected and designed.

14. It is helpful to consider three broad scenarios:

• the Government’s initial starting point of a flat 1% annual charge; • charging structures which match the industry’s revenues closely to its

costs, especially the up-front cost of promotion, advice and guidance; • some points in between which reduce the capital strain for firms, and

which offer consumers good value. Our Model 15. We have developed a financial model to produce the analysis in this

paper. The basis of the model is to identify the points where customer and provider needs are simultaneously met under given charge structures. Customer needs are defined in terms of the minimum level of monthly saving that providers will actively promote to. Provider needs are defined in terms of threshold minimum capital returns and breakeven periods that are not unattractive compared to other possible uses of capital.

16. This is a key point: providers will have to apply new capital to finance

Sandler business. Capital today is mobile, and will flow to businesses and territories offering the best risk/return prospects. As the FSA have noted, adequately and sustainably capitalised business is also in the customer’s interest.

”…for life insurance firms, the desire for low charges for simplified products, in order to facilitate access to and affordability of these products, must be balanced against the need for charges to be at a level at which products providers will be encouraged to enter, and stay in, this part of the market. Capital providers will withdraw from, or fail to enter, the market if they are not able to generate a reasonable return.”5

17. In our analysis, we have set two threshold conditions for capital entry:

• a risk-adjusted return on capital of 11%; • a payback period on a NPV basis of 10 years or less.

5 FSA: “The Future Regulation of Insurance: a progress report” October 2002 paragraph 1.35

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18. These numbers are based on the experience of ABI member firms, and

appear in line with the minimum project appraisal thresholds for FT-SE 100 companies. But these are thresholds: satisfying these criteria does not alone guarantee that capital will enter this market. Given competing prospects that all meet their thresholds, providers of capital (other than speculators) will still go first to the best prospects, taking account of management strength and political and other uncertainties. Thus our model merely illustrates conditions which if not met guarantee that capital will not enter.

19. Our modelling is based on aggressive cost improvements compared to

today’s business. Since the announcement of stakeholder pensions, the industry has been engaged in radical cost reduction programmes (management targets of 25-40% cuts in costs over 4-5 years from 2000 are typical of ABI’s larger members – the consequences for jobs have been widely publicised). The model is based on cost assumptions that at least assume the completion of these programmes, and in many cases go further towards the medium term aspirations of management. The model therefore pre-supposes that the industry meets in full the Government’s and Sandler’s challenges to improve efficiency and develop new business models.

20. The other key assumption is the reduction in distribution costs that will

emerge from a light touch sales process. Our modelling assumes – based on work by Oliver, Wyman & Company (OWC) last year6. – that distribution costs will fall by two-thirds. OWC modelled a sales process:

• without suitability and know-your-customer requirements; • with a short set of filter questions to filter out prospective customers for

whom medium-long term saving would be manifestly unsuitable; • where there is no risk of retrospective assessment of suitability

provided eligibility has been properly established pre-sale.

This is close to the FSA’s Option 2 (“Guided Self Help”) in DP19. But there is much detail to be developed and these cost assumptions may prove optimistic. Such is the importance of distribution to the overall costs that a slightly more expensive sales process will affect fairly significantly what can be achieved in terms of advice/guidance and market penetration for a given level of price cap.

21. This goes also for group sales, for example via the worksite. The worksite

is an important example of the industry developing new sales and advice models. But experience is still accumulating; the full potential of the channel has yet to be realised. The Government will want to bear this in mind before relying on a set of assumptions about its economics that may

6 Strategies for Tackling the Savings Gap – the Role of the Saver Agent – Oliver, Wyman & Company for the ABI, August 2002

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prove optimistic. Specifically our model assumes that distribution costs in a worksite channel are around one-third of those for light-touch individual sales (or 1/3 x 1/3 = around 11% of the cost of current individual sales). This is a very aggressive assumption in terms of adviser productivity, which will require the introduction and success of new delivery models.

Flat Annual Charges 22. Sandler suggested an initial ‘starting point’ of a flat 1% AMC price cap for

Sandler products. It is worth looking at the experience of the stakeholder pensions market, where such a cap already exists, before exploring the effects of such a cap in future.

(a) Today’s Market 23. We have modelled today’s Stakeholder Pensions market, and compared

the results with firms’ experiences. The results are:

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Figure 1: Model of Today’s Stakeholder Pensions Market

reduction in yield (RIY)

contributions for first 5 years only

contributions paid for full

duration

10 years

20 years

10 years

20 years

1%

1%

1%

1%

Shaded cells below are elements of the business mix that eventually breakeven for a provider, at 11% discount rate.

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24. These tables are based on pensions sold under today’s conduct of

business (COB) rules. This is supported by the recent research conducted for the FSA by KPMG7, which showed that 88% of stakeholder pension sales were made on an advised basis, with 5% by direct offer and 1% by telephone (6% were “unknown”). Firms also reported that sales based on tree walking were low. Decision trees appeared predominantly to be used as an additional information tool during an advised sale, but two thirds of the firms interviewed said that they did not use them at all.

25. The modelling results show that

• stakeholder pensions are economic to sell only where individuals have more than £150 a month to save, and can do so over 35 years or more (which for a pension product with a conventional nominated retirement date means customers under 30);

• this business meets the threshold for return on capital, but not for breakeven periods.

26. These modelling results are borne out by ABI’s empirical research into the

stakeholder pension market. We found that the average monthly contribution into stakeholder pensions is around £130-£140 per month, taking worksite and individual sales together. This is clearly a long way from the market the Government now wants to reach, which includes contributions down to £50 per month. Because it fails the breakeven period threshold, it is also likely to be unsustainable. We therefore predict the average case size will rise further over time.

27. Experience also shows that:

• although there are 40+ designated stakeholder providers on the OPRA register, the great majority do not actively promote stakeholder pensions to any market except larger employers. Almost none actively promote to individuals. The model helps explain why: the capital and breakeven tests are not generally met and resources are being diverted into other business lines;

• some stakeholder pensions are sold in smaller case sizes than this: a

simple model will not replicate the market in all its detail;

• breakeven periods are typically 15 years or more. (b) Sandler Products Sold with Flat Price Caps 28. This section looks at the sensitivity of the results to two important

variables: distribution costs and the level of the charge.

7 Review of the regulatory regime for Stakeholder Pensions: Report on research with product providers and intermediaries carried out on behalf of the FSA by KPMG (Consumer Research 20), FSA, 14 April 2003.

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29. Sandler’s pension product would be sold, if the FSA accept his

recommendations, under a substantially less expensive sales regime. As mentioned above, our model assumes that such a regime reduces distribution costs by two-thirds.

30. The following tables show the results of a 1% flat cap under such a sales

regime, and under alternative, higher, level annual management charges:

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Figure 2: Economics of Flat Charging Structures under Light Touch Sales Regulation

Reductions in yield (RIY)

Contributions paid for first 5

years only

Contributions paid for full

duration

1% 1%

1.5% 1.5%

2% 2%

Shaded cells below are elements of the business mix that breakeven within 10 years or better for a provider, at 11% discount rate and other key assumptions holding.

economic segments at 1% amc

Economic segments at 1 ½% amc

Economic segments at 2% amc

Key:

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31. This shows that:

• moving to a light touch sales regime – even one that saves 2/3 of the costs – without adjusting the price cap does not bring any new customers into the economic reach of the industry.

• raising the 1% cap to 1½% enables the industry to meet its threshold capital tests while marketing products to individuals with 10 years or more till retirement saving £150 a month or more ; and

• raising the cap to enable the industry to economically serve individuals with 10 years or more to go to retirement saving £100 a month or more.

32. Even if distribution costs are reduced even further by serving customers in

groups, there are still no new customers at 1%. At 1½% customers with 10 years or more to retirement and £100 a month to save become economic, and at 2% so do customers with £80 a month to save.

33. This analysis shows that:

• meeting both return on capital and breakeven thresholds for providers requires a substantial reduction in distribution costs and a higher charge cap;

• the lowest distribution cost scenario brings in contributions of £80 a month at 2%. The Government will want to compare this with its aim of including contributions of £50 a month.

How Many New Customers Does This Mean? It is possible to estimate the number of customers that become economically viable under different scenarios of price cap and distribution cost. But to do so, it is necessary to make some assumptions, especially about the impact of the sales process on the size of the market. In total, around 10.2 million adults do not have a pension but may be able – based on their earnings – to make a contribution between £20 and £150 a month. The model shows people who – defined by age and income – the industry would (marginally) be able to serve economically. As discussed in Section 2, the Government and FSA must be clear about the extent to which it is their intention that this group should actually be sold Sandler products. If the sales process filters people out on the basis of, say, inadequate cash savings, then only a small proportion of this group will actually be encouraged to buy. But assuming that this whole population is genuinely in the target market (or put another way, if the price cap and the cost of the sales process were the only constraints) it is possible to say how many new customers the industry could serve.

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Compared to a 1% cap under the same sales process, moving to 1½% would make an economic market of around 800,000 extra people. 2% would bring in a further 1½ million or so.

(c) Conclusions on Flat Charge Caps 34. Two general messages about flat charge caps need to be added to this

analysis. The first is about capital, the second is about customers. 35. The first message is a flat price cap maximises both the amount of capital

required from product providers and the business risk. 36. We estimate that the cumulative requirement for working capital for

Sandler products over this period could well be of the order of £2 billion [say, 5 million new contracts each having a £400 capital strain during the first 5 years]. If a flat charge structure were to permeate the majority of the market, this estimate rises to £50 billion.

37. The modelling results confirm that a flat annual charge is extremely capital

intensive, even in a world of significantly reduced acquisition costs. Income from charges does not match the cost profile well and is at risk from both discontinuance of contributions and funds withdrawal/transfer.

38. A flat annual charge also exposes providers to movements in savers’

funds. ‘Predators’ will undoubtedly entice customers with large funds to switch, leaving the capital strain with the original provider. In this environment, UK companies that have consumed capital setting up products and distribution will be particularly disadvantaged in relation to overseas competitors who have not incurred such costs. Thus not only will a flat charging structure consume capital, but there is a significant risk that expected charges will not be received and capital will never be recovered.

39. Taken in the round, the industry and global market for capital are unlikely

to view this as a marginal ‘business as usual’ requirement given the prospective returns on such capital and the risks to which it is subject. It is not atypical for the shareholders of life companies to be demanding minimum after-tax returns on capital of around 10-12% on their core businesses, and to require investments to demonstrate a breakeven within 3 years or so. A much higher return on capital is common in related parts of the financial services sector such as banking services. Sandler products may well be regarded as riskier, non-core opportunities and shareholders are likely to require higher returns on capital than 10-12%.

40. If there is no or little prospect of capital availability or satisfactory

profitability for industry participants, many (if not most) firms will think long and hard before entering the Sandler market. Whilst, as we noted previously, the industry was more prepared to participate in the Stakeholder Pensions market (at least in the short term), despite uncertain

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prospective profitability, such willingness may not be applied to Sandler products if the price caps are inappropriate. Not only was the industry’s capital position more comfortable in the run-up to stakeholder pensions, the FSA’s regulatory approach, via RU64 and subsequent rules, made it in practice very difficult to market pensions above 1%. This left companies with the choice of entering the market at that level or withdrawing altogether, with significant consequences for their existing customers.

41. The second key message is that a flat price cap is good news for

customers who can still be served by the industry, but such a cap, and a 1% cap in particular, restricts the categories of consumers who can be reached on a commercial basis. These are only marginally relieved at higher levels of flat charge.

42. On historical charges and persistency data, the charge faced by the typical

pension customer is now less than 10% of pre-Stakeholder levels.8 But an unintended consequence has been to increase the proportion of the population that cannot be economically served.

43. In conclusion, the capital strain and business risk imposed by flat charge

cap structures will prevent capital entering the market. Other than at very high levels, this is true regardless of the level of a cap, although the effects become more acute the lower the level is set. Lack of capital will limit competition and choice for consumers, and ultimately the degree to which the Sandler products can close the savings gap in the target market.

Recommendation 6: Because of their impact on customers and providers we strongly recommend that a flat 1% charge cap is the wrong conclusion for Sandler products.

[M:\LID\FMCG\Sandler\ABI RESPONSE TO HMT Principle & Practice V2.doc]

8 based on London Economics (2000) for FSA and PIA/FSA persistency data.

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Section 4: Alternative Charging Structures Introduction 1. In this section we take forward the analysis of flat charging structures and

explore the question of how to strike the right balance between the needs of providers and consumers. There are a number of key parameters:

• the threshold tests for capitalising the business (11% minimum risk-

adjusted rate of return; 10 year maximum payback period); • the prices experienced by different groups of customers, notably those

that persist with contributions and those that do not; • the extent to which the provider and consumer parameters coincide to

extend the market and promote saving.

2. We have modelled two main approaches to the issue:

a scenario where a charge is made on each contribution in addition to an annual fund charge; and

•

• a scenario involving modest front-end loading of the annual charge.

3. For each we illustrate two variants. The model is not primarily a predictive tool. It cannot show what will actually happen in the market, even if the assumptions are met. That depends on the behaviour of a great many buyers and sellers. In particular, it depends on the relative attractiveness of other uses providers and consumers might find for their money. Our aim is therefore not to show conclusively that a particular scenario “works”, but rather to set out for the Government the kind of consequences it faces from different decisions on price capping.

The Role of Advice 4. We have focused on structures which might make it more economic for

providers and distributors to incur the up-front costs of:

• developing product and distribution; • marketing; • active prospecting for new clients; and • persuading and advising clients to save.

As discussed in Section 2, these activities are key to product take-up. Availability will not start to close the savings gap; advice and guidance will.

5. In our view it is essential that Sandler products allow for the cost of advice

or guidance to be recovered through the product. The Government has always recognised that it would be difficult to provide advice or guidance within a 1% price cap. It therefore made provision for separate charging for advice for stakeholder pensions. In practice this has not proved a

34

workable option reflecting the well-researched and deeply held preference that most customers have to pay through the product rather than separately.

6. Since stakeholder pensions were designed both Sandler and the FSA

have examined the opacity of the bundling together of charges for product and advice, and have concluded that regulatory separation – effectively forcing customers to pay separate fees – will not work. Instead, policy is rightly moving towards disclosure, leaving payment method to the market. The Menu, on which the FSA will consult shortly, is potentially a very good way of focusing customers on both the price and the value of advice and guidance.

Recommendation 7: In a world of improved disclosure, the charging structure for Sandler products should allow customers to pay for advice and guidance through product charges.

Model 1: a combination of contribution charge and annual management charge 7. We have chosen to model this type of charging structure because it is the

international norm for investment products, as shown in Figure 3. It is also likely to relieve some of providers’ capital strain and persistency risk.

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Figure 3: International comparisons of charges 9 10 Annual

management charge (%

fund)

Annual additional

fund charge (% fund)

Annual total fund charges (% fund)

Initial charge on

contributions

Belgium 1% 1% 2% 4.5% France 0.8% 1% 1.8% 3.5% Germany 1% 1% 14.3% Italy * 1% 1.2% 2.2% 6.2% Netherlands 1% 1% 15.5% Australia** 1.3%

+$70 0.6% 1.9%+$70 4.5%

UK*** 1% 1% * regular contribution business. Single contribution average has a

4.2% contributions charge. ** Master Trust (benchmark pension) products *** Stakeholder Pensions

This table shows that 1% annual management charges are low by international standards, but not unique. It is notable that no country has fund charges below 1%. However, annual management charges are normally associated with a charge on each contribution. Where AMC’s are as low as 1%, contribution charges tend to be in the 5-15% range.

8. As mentioned in Section 3, the modelling results below are based on the very bullish assumption that the FSA’s eventual sales regime for Sandler products will allow distribution costs to be cut by 2/3. If cost savings are lower, these results would need to be remodelled. Greater savings would allow more customers to be reached.

9. Given the sensitivity of the overall economics to distribution costs, we

recommend that the Government’s independent research include analysis of other – higher and lower – cost assumptions.

Recommendation 8: Our results show specific scenarios, which may not ultimately emerge. As the next step, the Government and FSA ought to consult jointly on specific proposals for product design, sales regulation and price so that their economics can be examined in consultation with the industry.

9 sources: Schroder Salomon Smith Barney – European Life Insurance, October 2001, and ABI research. 10 it is also very important to note that charge caps of any kind do not exist in any major markets, though Ireland has just introduced a Personal Retirement Savings Account that includes a version which has charges capped at 5% on contributions and 1% on annual funds.

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Figure 4. Modelling of Charge Structure Featuring Contribution Charge and AMC

reduction in yield (RIY)


contributions for full duration

10 years

20 years

10 years

20 years

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10. It is clear that a contribution charge in addition to an annual fund charge can increase the reach of products into the target market.

11. A 5% contribution charge makes it economic for the industry to market to:

• individuals with 10 years or more to retirement provided they have over £150 a month to save.

12. Increasing the contribution charge to 10% additionally brings in:

• individuals with 10 years or more to retirement who have over £80 a month to save.

13. Where groups of customers are served together, for instance in the

worksite, penetration increases. The new economic groups with a 5% contribution charge are:

• people with 10 years or more to retirement who save £80 per month or

more. 14. And with a 10% contribution charge, the industry might also reach:

• people with 10 years or more to retirement who have £50 a month or more to save.

15. The following tabulation shows the key results a different way.

Annual management charge of 1%11 plus a contribution charge of:

Smallest economically viable contribution (£/month)

Numbers of customers potentially reached12

5%

10%

Individual worksite Individual worksite

150 80 80 50

800,000 4 million 4 million 6½ million

11 We examined models where the fund charge was higher and lower than 1%. Lower fund charges significantly dent the reach of the products, because the breakeven period is longer. Higher charges obviously improve reach. 12 Based, as before, on the whole population whose income and age suggest they might contribute. Numbers will depend heavily on the filtering process in FSA regulation - see Section 3. The numbers of people reached by worksite and individual distribution are non-overlapping populations based on all sales taking place on each set of assumptions for distribution costs. In practice, sales will be a mixture of group and individual.

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16. In conclusion:

• only under the very specific conditions of group sales, with a 10% contribution charge, and on our aggressive cost assumptions, is it economic for the industry to handle the Government’s target contribution level of £50 a month which is likely to be the kind of benchmark for market penetration the Government has in mind;

• although customers will face prices above 1% they will still be low by international and historical standards. And the position of persisting and non-persisting customers are broadly the same;

• the potential of the worksite for delivering pensions is clear. But to take maximum advantage requires supply side action (major reductions in regulation) and demand side action (via tax incentives and employers). The Government will want to consider these options in view of the need to get people saving in the 90% of stakeholder pension schemes which are current “empty boxes”.

17. A charging structure based on an annual management charge and a

charge on each contribution offers increased market penetration, a larger universe of potentially profitable customers for the industry and a modest increase in the price for consumers.

Recommendation 9: A contribution charge plus AMC structure provides a better balance of consumer and provider interests than a simple flat annual charge and it should be a basis for analysis in the Government’s independent research.

Model 2: A front-end loading of the annual charge 18. We have modelled this type of charging structure because it improves the

match between provider costs and revenues. It will:

reduce the capital required by providers; • • •

•

reduce the capital risk for providers by cutting the persistency risk; allow customers to pay for their guidance via the product charges.

19. Front-end loading of charges has been criticised. The introduction of flat

charges was intended to protect consumers from the lock-in effect of charge structures that took a significant proportion of their early contributions in charges, leaving them with a fund that could be worth less than they had paid in. But in benefiting consumers who put a premium on portability even in the very early years, they have had the unintended consequence of excluding millions of others from the economic reach of the industry, and hence increasing the population who are under-saving.

20. In the following section, we have taken account of:

the Sandler review’s conclusion that these products are unlikely to be suitable for people who are unwilling or unable to save for less than five years (so after year 5 the annual management charge is 1%);

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the level of costs assumed in our model for the light-touch advice/guidance. Once again, it must be stressed that this is an assumption about what those costs will be;

•

the need for charges to be simple and transparent. •

•

•

21. The consumer would have to be made aware at the point of sale of how

the shaping of charges would affect his fund, and of the implications for portability. This is relatively simply done by asking “are you prepared to save for at least 5 years?” at the appropriate point of the sales process.

22. We have therefore modelled two variants of charges for the first five years

of the contract. In each the only charge is an annual management charge. And in each, after year 6, the AMC is 1%. The two variants are:

a tapered charge starting at 5% in year one, 4% in year 2, 3% in year 3, 2% in year 4 and 1% in year 5; a higher flat charge of 2½% in each of the first five years.

23. Again, it is worth emphasising that modelling is a useful tool, but not a way

of assessing all impacts of a particular structure. The structure modelled earlier in this section (Model 1) is already in use in other parts of the market so its practicalities are well understood. Model 2 is new so would need much more analysis of its practicality. For example it may involve major systems changes and could create complexities or perverse incentives. Nonetheless, we think they are a baseline for more detailed work.

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Figure 5. Modelling of a modest front-loading of charges

Reduction in yield (RIY)


contributions for full

duration

10 years

20 years

10 years

20 years

5 / 4 / 3 / 2 / 1% 1.5% 1.2% 1.4% 1.1%

2½ % 1.5%

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24. The modelling shows that these two variants have the same effect on increasing the segments of the market that can be economically served.

25. It will be economic for providers to market to the following groups:

• individuals with 10 years or more until retirement but only if they have £150 or more a month to save;

and where people can be served together in groups: • people with 10 years or more until retirement who have £100 or more a

month to save.

26. Or put another way: Smallest

economically viable contribution (£/month)

Number of customers potentially reached

Modest front-loaded annual charge (either variant)

Individual worksite

150 100

800,000 2½ million

27. So in conclusion:

• substantially greater front-end loading of the annual charge than we have modelled will be required for the industry to economically serve people who contribute the Government’s presumed target amount of around £50 a month;

• conversely, the price impact on consumers, even those who stop making contributions after 10 years of a pension contract, is relatively modest. It is broadly equivalent to an annual charge of 1-1½%.

Recommendation 10: A modest front-loading of charges is another structure that better balances the interests of consumers and providers than flat annual charges, and at the same time improves the market penetration of the products. This structure should be further analysed by the Treasury’s independent researchers. In particular, variants should be studied which assess contributions below £100 a month. However, more work is needed to assess the operational practicality of this model.

Other Possible Price Structures 28. Other charge structures are possible and ABI members will be suggesting

several in their individual responses to the Consultation. This section briefly surveys a few options.

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29. Sandler left open the possibility of an exit charge on his suite of products, though he expressed a preference for none. In our view, based on preliminary analysis:

exit charges are a way to reduce cross-subsidy between customers and address persistency risk for providers;

•

•

•

exit charges are difficult to square with the transparency and simplicity of Sandler products; they would be difficult to operate for products that might be designed to accept intermittent and irregular contributions. Regulating when a customer could be said to have ‘exited’ as opposed to ‘paused his contributions’ would inevitably be arbitrary.

30. Another option might be to tier the charge so that larger contributions,

which have more favourable economics for providers, have lower charges. This approach would offer the Government the opportunity to make more headway into the low-contribution target market, whose economics would improve without increasing the price paid by customers who are being served today. But there are presentational implications to consider of lower contributors, who may be less well off, facing higher charges.

Different caps for different products 31. The consultation asks whether there are specific price cap issues relating

to pensions. 32. Pension contracts have higher administrative costs, and even under the

Green Paper simplification proposals, this will continue to be the case. In addition to extensive post sale disclosure requirements (including the SMPI requirements) and the need to reclaim tax relief, there are costs associated with contracting out and controlling payments out of the scheme to comply with legislation. There are also cost implications in group schemes of dealing with both an employer and employees. Some providers have invested heavily in technology to create cost efficiencies for group business going forward. But these major investments need to be recouped and we should not lose sight of this when analysing administration costs.

33. A further highly significant factor concerns the sales process. All forms of

product which involve voluntary saving need to be sold to consumers. There is a significant degree of persuasion required in this process. The effort required to persuade an individual to save for retirement is undeniably greater than that required to persuade an individual to save in a non-pension contract. In the latter, the individual knows they have access to their investment at any time. With pensions, the money is locked away for many years (to minimum age 55 under pensions reform proposals) and even then, it can be drawn only in installments. This persuasion comes at a considerable cost – both in time per sale and in “conversion rate” – i.e. the proportion of those approached who ultimately invest.

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34. There are a number of important uncertainties around the product design,

sales process and wider legislative environment for pensions. Depending where policy comes out, the higher costs of pensions business could remain or increase further. It is crucial that full account is taken of these costs in deciding on a realistic price cap for pensions.

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Section 5: Product Proposals Introduction 1. This section sets out some general principles for the design, taxation

and branding of Sandler Products. It then deals with the questions in the Consultation Paper on the proposed:

• unitised product; • pension; and • with profits product;

and looks at the other products suggested for inclusion in the Sandler Suite.

2. As a preliminary point, we disagree with the nomenclature used in the

Consultation Paper. Instead we consider:

• unit-linked and with-profits investment options, which can be used within

• a medium-term or pension product wrapper.

General Comments 3. In general, we believe that the Government is right to aim for high-

level product standards rather than prescriptive rules. And, as mentioned in Section 2, we think it is wrong to decide the detail of product design ahead of much clearer thinking on the target market.

4. Our great concern is that decisions on product design and sales

process should be taken together. The Sandler Review recognised the trade-off between product and COB regulation. Where to make that trade-off is a judgement the Government and FSA need to make jointly in consultation with the industry. It will be key to informing a decision on price caps that reflects realistic overall costs. Our clear preference for this trade-off is for the minimum product prescription consistent with a simple sales process.

Branding 5. The Government has introduced CAT marks and stakeholder pensions,

and is now proposing Sandler Products. This is a recipe for customer confusion.

Recommendation 11: CAT marks and stakeholder pensions must be brought within a single “brand” along with Sandler Products.

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Tax 6. There are a number of important implications that follow from Sandler’s

recommendation that all the products in his suite be “ISA-able”. 7. First, the tax differences between mutual funds and life policies

summarised in Annex 3 of the Consultation Paper only apply outside the ISA wrapper. When held in ISA form the two types of product have virtually identical tax treatment. So the question of the very different nature of the non-ISA tax regimes for unit trusts and life policies should be largely irrelevant to the design of the unitised stakeholder product.

8. Within the ISA envelope however, there is one key difference in tax treatment, with life products subject to a maximum of £1,000. This difference needs to be abolished in order to take tax out of the equation. It is also a good illustration of the need to eliminate complexity in the tax system to provide the simplest possible backdrop for simplified products. Recommendation 12: The Government should remove the current discrimination between unit trusts and life insurance built in to the ISA limits, raising the limit for life insurance ISAs to £7,000.

9. Second, an annual limit on saving in an ISA of £7,000 is probably high enough to absorb the non-pensions savings capacity of much of the target market for stakeholder products13. But thinking in this area needs to be put in the context of the overall use of the tax system to encourage saving. There are two aspects to this: - the impact of the £7,000 limit on savings, and specifically on the

overall economics of these products, given it will discourage saving of larger amounts;

- the proposed abolition of the ISA dividend tax credit in 2004.

Unitised Investments

The Government welcomes views on whether to treat collective investment schemes and life insurance products as one “stakeholder product” (Q4).

10. The strongest argument for including unit-linked life policies in this

category alongside mutual funds is that they offer excellent asset diversification.

13 The £7,000 limit was set at the launch of ISAs in April 1999. If uprated in line with inflation the limit would now be around £7,500.

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Recommendation 13: Life and non-life products can and should both be included in the Sandler range, on a level tax playing field.

11. The remaining questions in this part of the Consultation Document

address the choice of appropriate classes of investment, and more detailed requirements for diversification and control of risk.

12. The starting point in choosing the investments must be the needs and

expectations of customers. How willing are they to take investment risks? Do they expect to hold their investment long enough to ride out short-term fluctuations in value for the sake of a likely increase in yield (Sandler suggests his products would be suitable only for those with a 5 year minimum horizon)?

13. There are a number of potential groups of investors, such as:

• long-term investors who wish to keep retirement funds outside an approved pension scheme;

• shorter-term investors who, perhaps without understanding the finer

points of risk/return trade-offs, are willing to take a modest risk with capital for the sake of a possible increase in return.

14. Sandler’s model is for product regulation, including risk controls, to

replace the key elements of regulated advice, especially know-your-customer and suitability, and for the absence of these requirements to remove the risk to providers of retrospective re-assessment of the appropriateness of sales.

15. To deliver Sandler’s model most faithfully, the Government could:

• restrict product regulation to high level standards, admitting a variety of asset mixes and risk controls into the market;

• state very clearly that any such variants can be sold without

suitability and know-your-customer, provided there is adequate disclosure, and set out clear expectations and aims for the kinds of customer they want the products to reach.

This is our preferred approach.

16. The attraction for the Government of non-prescriptive standards is that

it does not become responsible for defining investment strategies which would look more or less sensible as economic conditions change over time. Equally, fund managers would have most freedom to respond to changing conditions in the interests of their customers.

17. However decisions in this area may have important implications for the

sales process. The absence of a know-your-customer requirement means salesmen will not gather evidence on customers’ attitude to risk.

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18. Extending the sales process to help customers choose, from the

selection available, a product which matches their risk preference would make selling costlier and riskier for providers, especially if the Ombudsman judges that Sandler salesmen owe a duty of care to their clients, which widens with the range of investment risks they are choosing between. It is also likely that attitude to risk judgements and investment choices will lead to demands for the salesmen to have more qualifications.

19. The best way to handle this is for the Government to make a clear

statement of its approach along the lines of paragraph 15 above, and for Government and FSA to state very clearly that people with a variety of risk appetites will be eligible to buy them. The Ombudsman will have to take account of such a statement and alongside a description of policy aims and expectations this will go part of the way to reducing the risks for well run firms to affordable levels, and keep the point of sale process simple. But ultimately, any extra costs and extra risks in the sales process would have to be reflected in the price cap if the products are to be economic for providers. In practice, the sales process is likely to closely resemble current COB regulation, and advice will be priced, as now, beyond the means of moderate earners. Sandler products will fail to achieve our ambitions for them.

20. The trade-off between product and sales regulation can be made in

many different ways. Given the relative costs of product and distribution (distribution is around 70% of the total cost of product delivery), our conclusions are

Recommendation 14: The Government and FSA need to consult jointly with the industry on specific combinations of product design and sales process to determine the most cost-effective trade-off. Recommendation 15: The correct presumption is to make the trade-off with the lowest level of product prescription consistent with a genuinely simple sales process.

Does a 60% maximum equity exposure provide an appropriate level of risk-control for unitised products? (Q5) Should there be a minimum level of equity exposure as well as the maximum? (Q6)

21. Setting only a maximum equity component represents a fairly minimal

level of product prescription, with which many ABI members have no difficulty. Stipulating a minimum level as well represents the next possible degree of prescription. Any range will always be a bit arbitrary, but it might help:

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• define the customers for whom the products are meant as those with a clear appetite for equity risk; and so

• keep the sales process simple and its risks contained.

Recommendation 16: If it is necessary in order to keep the sales process simple, the Government might consider defining an equity range of 30-60% for Sandler products.

Diversification and control of risk

Should there be additional constraints in terms of the permissible portfolio of fixed-income securities? (Q7) Are additional diversification requirements necessary, and if so what should be their form and content? (Q8) What is the potential for alternative means of controlling risk, other than through diversification requirements? (Q9)

22. The same considerations about product and sales regulation apply at

this level. The Consultation Document explores issues including the possibility that the equity component of the fund might be placed in a small number of high-risk shares (eg technology stocks), or that an apparently “safe” bond fund might concentrate its holdings on highly-correlated junk bonds.

23. It further outlines two possible approaches to the diversification issue,

while leaving open the choice between them:

• The use of a “principles-based approach”, which states that the fund must be diversified across sectors, geographical markets and investment types, without setting quantitative limits; there would be a duty of care on the fund manager to make appropriate decisions, supported by the desire of firms to protect their reputation.

• A “regulations-based approach” which explicitly spells out additional

requirements, such as 90% minimum developed country exposure, 20% maximum exposure per sector, 5% maximum exposure to each company, 50% maximum exposure to non-UK markets.

24. Our preference, as before, is for minimum regulation consistent with a

simple sales process. There are obvious objections to the specific criteria suggested by the Government under the regulations-based approach, eg different sector sizes might make a fixed percentage limit for anyone inappropriate; individual companies can account for a high percentage even of a large market such as that of the UK; the possibly limited correlation between the country where a security is quoted and that in which its activities are based; and the lack of clear boundaries between sectors.

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25. On the other hand, while the principles-based approach avoids mechanical limits which may be or become inappropriate, it may, expose firms to a greater risk of being held to account for post hoc misjudgements or misapplications of the specified high-level criteria. In the context of potentially-large “Government-approved” funds, this may well prove a significantly higher risk than for other funds for which the objectives are often set in more general terms and which are less politically sensitive.

26. For this reason, if a principles-based approach turns out to add to the

cost, complexity and risk of the sales process, the Government should investigate whether it is possible to develop simple diversification criteria which are more robust and relevant than those it has initially suggested, and which could form the basis for a proportionate regulations-based set of criteria. Such criteria might be along the following lines:

• each fund must specify and operate within minimum and maximum

percentages in equities, fixed interest securities and property, within the overall limits set for stakeholder products;

• within each of the equity and fixed interest categories:

- maximum holdings in securities quoted on each recognised exchange should not exceed (say) twice the weighting of that exchange in relation to all recognised worldwide exchanges (with a higher multiple probably being allowed for UK quoted securities);

- maximum holdings in securities within each market sector

should not exceed (say) twice the weighting of that sector;

- maximum holdings of any security should not exceed

(say) four times the weighting of that security in relation to all recognised worldwide exchanges (with a higher multiple probably being allowed for UK quoted securities);

- compliance with these criteria should be reviewed (say)

monthly and action taken to correct any breaches of the limit by the time of the next regular review (it being recognised that such breaches will inevitably happen from time to time);

• within the property category, broadly equivalent criteria should be

set to limit the size of investment in development properties, in office/retail properties etc, in UK/overseas properties, and in individual properties.

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27. The Consultation Paper also discusses whether any attempt should be made to control the level of risk more directly by specifying an upper limit to beta values, the absolute value of the standard deviation of returns, or tracking errors against specified indices. These controls could be applied only by reference to historical data on the relevant measures and would not necessarily be effective prospectively in limiting risk. For this and other reasons, the Government does not propose to adopt such measures. We agree with this conclusion.

Pension 28. Key areas to consider include:

- Existing stakeholder pensions;

- Investment related issues. Existing Stakeholder Pensions

29. In line with Recommendation 16 above, we support the intention to

subsume existing stakeholder pensions into the Sandler suite. To have two ‘Government-endorsed’ pensions is a recipe for customer confusion. Providers are also less likely to offer another form of stakeholder pension alongside an existing offering. Those relying on building scale to cover overheads would soon stop writing new contracts under the “old” regime. Future premiums might also gradually redirect towards the “new” suite. From the Government’s point of view, this approach will also make the Sandler suite appear more widely available, building brand and confidence.

30. But all the implications of bringing Stakeholder and Sandler pensions

together need to be identified and handled.

The Government welcomes views on options for bringing stakeholder pensions into the Sandler regime. (Q21)

31. There are two connected issues here:

• the range of funds available; • the transition of stakeholder pensions into Sandler pensions.

32. Our initial view is that the decision about funds does not greatly alter

the complexity of the transition. On either approach the transition presents major challenges for:

• providers, for whom pensions administration is already complicated,

and for whom any alteration to the product offering is a big task;

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• employers, who will want to examine the choices that are put before their employees and their decisions on scheme designation. We know many are cautious about the cost and potential liability of administering pensions and of appearing to make investment decisions for their employees;

• customers, new and existing, for whom the transition could be

confusing and off-putting;

• Government, who have to legislate in a way that does not cause a major dislocation in the market;

• regulators, who will need to work out how a new light-touch sales

process is applied under different scenarios. 33. All of this points to a significant further piece of work, which can only be

done when some of the detail in this consultation and FSA’s Discussion Paper 19 is filled in. We will work with the Government to tease out the issues and develop a sensible basis for a further consultation, with a different and wider audience, including employers and unions.

Recommendation 17: The Government should consult separately with employers, unions and the pensions industry on how to manage the transition from stakeholder to Sandler pensions. This is essential to understand fully whether fund choices materially affect the complexity of the change.

34. On the two options for fund selection, our initial steer to the

Government is towards Option b. This is consistent with our general approach to product regulation and in particular it would allow providers who wish to offer with-profits and unit-linked variants within their Sandler pension.

The Government welcomes views on appropriate lead-in time for product development. (Q1)

35. The potential for a disorderly transition and the resulting consumer confusion / loss of confidence should not be underestimated. This suggests a significant lead-in time of perhaps 12 months from the finalisation of both the product specifications and of the accompanying lighter touch sales regime. Additionally,

Recommendation 18: Government needs to co-ordinate these developments with the many other regulatory changes – implementing the Pensions Green Paper, European developments, polarisation reform, the regulation of mortgages and general insurance and point of sale disclosure. The particular need to co-ordinate pension changes points to April 2005 as the earliest feasible date for introduction.

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The Government welcomes views on these 3 options for investment restrictions, and on how a general duty might best be framed, if respondents support it (Q22).

36. In line with our view of unitised investments, we believe that unitised pension investments should be prescribed only in so far as is necessary for a simple sales process. Taking a consistent approach, we believe a maximum equity content of 60% is likely to be too low. A figure closer to 100% is likely to be better for customers. Long term investment, especially for retirement, requires maximising growth potential early on and minimising loss potential later. This raises the question of lifestyling. Firms are likely to offer lifestyling whether required to or not. So mandating lifestyling and how it should work should not be necessary and should only be considered in the unlikely event it is needed to simplify the sales process. Leaving lifestyling to the market will allow it to evolve, while any approach regulated now is likely to become obsolete. Recommendation 19: A different investment mix with higher equity content should be adopted for unitised pension products. Further regulation, including mandatory or prescribed lifestyling, should only be considered if it is essential to remove complexity from the sales process.

With-Profits 37. Ron Sandler’s review proposed:

• a number of changes that should apply to all new with-profits business. They are the subject of the FSA Discussion Paper 20 to which we are responding separately;

• specific requirements for the ‘stakeholder’ version of with-profits – the subject of this Treasury/DWP consultation.

38. In this response we address the latter issue – the specification for the

with-profits product within the stakeholder suite. We accept the Government’s view that a measure of product prescription is appropriate for the stakeholder version of with-profits. We deal in Annex C with each of the areas raised in the HMT/DWP consultation document and indicate some areas where we think a prescriptive approach is right for the stakeholder product and others where we think the permissive approach for with-profits is more appropriate. This response reflects the mainstream view within the industry and commands the support of a range of companies with different with- profits set-ups. Individual companies may of course have slightly

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different positions on some issues reflecting their company position and outlook.

39. Overall we share Sandler’s and the Government’s view that including

with-profits investment options within the Sandler suite is a beneficial move which will make the product range more attractive to those who want to invest in real assets but are concerned about full exposure to volatility. To achieve widespread availability of this option requires a design that customers will want to buy and providers will want to provide.

40. We believe the key elements of such a design are:

• explicit charging which protects customers from expense over-runs or similar risks;

• ring fencing of stakeholder business so that customers are not exposed to profits or losses from the provider’s business (such as protection business or direct investment related to the provider’s business);

• a separate smoothing account within the policyholder fund which

aims for a neutral balance;

• a facility to apply an MVR in adverse market conditions so as to protect continuing policyholders coupled with a facility to offer specified MVR-free dates (eg specified retirement dates) when customers can be sure of the full benefit of accrued smoothing regardless of market performance;

• a pricing structure and level which reflects the economics of the

product, including the cost of capital for smoothing;

• an overall approach which seeks to maximise the availability of capital from existing sources whilst ensuring that there is no conflict of interest between shareholders and policyholders.

Other Products

41. The Government is consulting on whether additional products should be included in the Sandler suite of products (in addition to a unitised product, a with-profits product and a pension product).

42. Our overall approach is based on the principles that:

• The products in the suite should have a common factor so as to

help establish a meaningful brand and consumer understanding. We believe the common factor should be that they are all medium to long term savings vehicles which are equity-based but with some

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design safeguards designed to balance the risks and rewards of investing in the markets;

• There is no benefit in a product being included in the Sandler suite

unless this would involve some corresponding reduction in the sales process. Where products can already be sold with minimal regulatory requirements (such as deposit accounts or term assurance) we believe that Sandler advisers should be able to sell them too, but without their needing to be included in the suite;

• The more products are included in the suite, the more complex the

advice process could become, and the higher the risk of subsequent mis-selling claims;

Recommendation 20: The Government should for the time being restrict the Sandler product range to medium and long term investments to help build brand and consumer understanding.

Specific Products 43. Guaranteed Investment Product Government line Welcomes views. ABI response The ABI does not believe that Guaranteed

Investment Products should be included in the Sandler suite. The product design features would be complicated for a Sandler adviser to describe and to compare with the mainstream alternatives. Such products would also require a separate, realistic price cap.

44. Term Assurance Government line Welcomes views. ABI response The ABI does not believe that there is any merit

in bringing a term assurance product into the Sandler suite. The branding of term assurance as a Sandler product may be confusing to customers. Moreover – unlike the investment market – there is no problem with the protection market that is amenable to a “Sandler product” solution.

45. Deposits Government line Welcomes views on advantages and

disadvantages of rebranding the CAT-standard cash ISA to make it consistent with the wider “stakeholder” suite and on how this might be done.

ABI response The ABI supports consistent branding, but not application of the sales process and product

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regulation associated with the Sandler “suite”. Appropriate cash products exist, and can be sold without conduct of business regulation. There is nothing to stop advisers selling such products if they wish to do so, for example if it became clear during the sales process that the customer was unhappy with any level of market risk.

46. Annuities Government line: Proposes that an annuity should not form part of

the suite. ABI response: The ABI agrees. Advised sales of annuities are

currently subject to the full COBs regime. There would be cost reductions if some sales could be brought into a lighter touch regime, but creating a standard product specification would not be in the interests of customers since many would benefit from alternative forms of annuity. Personalised advice is also important since, as the Government recognises, purchasing an annuity is a once and for all decision, typically involving a large proportion of an individual’s lifetime savings. Mistakes cannot be rectified at a later date.

47. A financial health-check Government line: Welcomes views on whether an advice service

could have a place in the suite, and the form that it might take.

ABI response: A fairly extensive body of research evidence raises doubts about whether customers would be prepared to pay explicitly for such a service. However, we would like to work further with Government and FSA to explore whether a carefully designed and benchmarked service, which offered customers a useful report but without any obligation to buy a product, might find a market.

48. The Child Trust Fund Government line: Interested in views on whether explicitly linking the

CTF to the other “stakeholder” products would be helpful.

ABI response: The Government is planning to consult on the details of the CTF regime in the Summer, and the ABI will respond to that consultation. Our initial view is that the success of the CTF will

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depend on: • Encouraging additional contributions from

parents and relatives, through some form of incentive;

• Keeping the product and the sales process as simple as possible;

• Having a substantial equity component, to maximise the potential value of the fund;

• Setting any price cap to reflect the economics of offering the product; and

• Accompanying it with a sustained programme of financial education in schools.

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SUMMARY OF RECOMMENDATIONS The Target Market and The Sales Process 1. The Government needs to substantially improve its analysis of the

target market, taking account of attitudes and behaviour as well as income.

2. The Government and FSA should publish an agreed statement of their

desired outcomes so that the industry can rely on the regulated sales process to deliver products to a group that is agreed they are right for.

3. The Government and Regulator must agree who, if anyone, should not

buy a Sandler product because of the potential interaction with state provision and must reflect this shared understanding in designing the sales process.

4. Once the analysis of demand is complete, it should be included in the

public statement from Government, regulator and Ombudsman, of goals and expectations for Sandler products.

Price Caps in Principle and Practice 5. The Government explore should the impact on consumers and

providers of a benchmark approach along the lines of paragraph 5 above as part of its research on price caps

6. Because of their impact on customers and providers we strongly

recommend that a flat 1% charge cap is the wrong conclusion for Sandler products.

Alternative Charging Structures 7. In a world of improved disclosure, the charging structure for Sandler

products should allow customers to pay for advice and guidance through product charges.

8. Our results show specific scenarios, which may not ultimately emerge.

As the next step, the Government and FSA ought to consult jointly on specific proposals for product design, sales regulation and price so that their economics can be examined in consultation with the industry.

9. A contribution charge plus AMC structure provides a better balance of

consumer and provider interests than a simple flat annual charge and that it should be a basis for analysis in the Government’s independent research.

10. A modest front-loading of charges is another structure that better

balances the interests of consumers and providers than flat annual charges, and at the same time improves the market penetration of the

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products. This structure should be further analysed by the Treasury’s independent researchers. In particular, variants should be studied which access contributions below £100 a month. However, more work is needed to assess the operational practicality of this model.

Product Proposals 11. CAT marks and Stakeholder Pensions must be brought within a single

“brand” along with Sandler Products. 12. The Government should remove the current discrimination between

unit trusts and life insurance built in to the ISA limits, raising the limit for life insurance ISAs to £7,000.

13. Life and non-life products can and should both be included in the

Sandler range, on a level tax playing field. 14. The Government and FSA need to consult jointly with the industry on

specific combinations of product design and sales process to determine the most cost-effective trade-off.

15. The correct presumption is to make the trade-off with the lowest level

of product prescription consistent with a genuinely simple sales process.

16. If it is necessary in order to keep the sales process simple, the

Government might consider defining an equity range of 30-60% for Sandler products.

17. The Government should consult separately with employers, unions and

the pensions industry on how to manage the transition from stakeholder to Sandler pensions. This is essential to understand fully whether fund choices materially affect the complexity of the change.

18. Government needs to co-ordinate these developments with the many

other regulatory changes – implementing the Green Paper, European developments, polarisation reform, the regulation of mortgages and general insurance and point of sale disclosure. The particular need to co-ordinate pension changes points to April 2005 as the earliest feasible date for introduction.

19. A different investment mix with higher equity content should be

adopted for unitised pension products. Further regulation, including mandatory or prescribed lifestyling, should only be considered if it is essential to remove complexity from the sales process.

20. The Government should for the time being restrict the Sandler product range to medium and long term investments to help build brand and consumer understanding.

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ANNEX A

EXECUTIVE SUMMARY: ABI RESPONSE TO PENSIONS GREEN PAPER • The Green Paper is a missed opportunity: The Green Paper does not

go far enough fast enough and lacks clear direction. While many of the proposals are helpful, they will not, taken together, generate a step change in the level of private pensions savings and make significant inroads into the savings gap. This is a missed opportunity. We recommend a radical package of reforms designed to get Britain saving for retirement.

• The Government must set clear targets: There must be a clear direction

for government pension policy articulated through explicit government targets for the level of private saving it expects. We recommend the target is set to cut the number of people seriously under-saving from 3 million to zero and the number potentially under-saving from 5-10 million by half; and which ensures that 75% of employees receive an employer contribution of 5% or more. The New Kind of Regulator (NKR) should check that progress towards meeting the targets is being made.

• A robust and durable state pension system must be established: A

successful private pension system can only be built on the foundations of a robust and durable state pension framework that provides benefits at adequate levels, removes reliance on means-testing and gives people clear incentives to save beyond the state minimum. The current state pension system fails these tests and until these issues are addressed, the effects of any reform of private pensions will, at best, be muted. We recommend reforming the state pension system by enhancing the State Second Pension (S2P) to ensure that everyone with a reasonable working record is kept off means-tested benefits whilst also providing incentives to save so that it genuinely pays to save.

• We support the voluntarist approach to private pension saving: But

this can only work if there are genuine – financial – incentives to save. The Green Paper fails to provide any genuine new incentives to save beyond some measures designed to inform people about their entitlements. This low key approach simply will not work. This is the last chance for voluntarism. We recommend that the Government introduces a package of employer-focused fiscal incentives to raise levels of pension saving. If it does not, compulsion must follow in short order.

• A genuine and fair partnership is essential: Ensuring that more people

are able to save more for retirement requires a genuine and fair partnership between the Government, the savings industry, employers and individuals, which recognises the need for pension providers (including occupational scheme providers) to be able to conduct business in a cost-effective way. We recommend that all the key stakeholders are actively involved in designing the solutions to our current pensions

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crisis. • Fiscal incentives are the way to encourage higher savings levels: The

Green Paper sets out ways to encourage people to save. But this is not enough. In our voluntary pension system, in which the need to raise retirement savings levels is urgent, people need clear financial incentives to save. We recommend the introduction of a Pension Contribution Tax Credit (PCTC) and a Workplace Advice Credit (WAC) both focused on employers, and which could help over 4 million working people, taking more than £5bn off the savings gap.

• Informed consumer choice requires government action: The Green

Paper rightly places considerable emphasis on increasing consumer awareness of their pension entitlements. Consumer awareness campaigns must also focus on the need to save for retirement and the risks of not saving. The Government must take the lead in promoting retirement saving. We recommend a national strategy to increase consumer awareness. Employers have a pivotal role to play. But the Government must also take a leading role with a hard-hitting advertising campaign.

• Employers have a central role to play in promoting pensions: The role

of employers in encouraging pensions take-up is indisputable – the presence of an employer contribution alone can see scheme take-up levels increase from 13% to over 70%14. We recommend that employers should be permitted to actively promote the schemes as well as being actively encouraged by government and regulators to contribute to schemes.

• Tax reforms: Collapsing eight pensions tax regimes into one is a welcome

and long-overdue step. But action must be taken to smooth out the remaining rough edges around the lifetime limit. We recommend that the level is increased in line with earnings and also to take account of longevity and investment conditions. The entitlements of those whose pensions exceed £1.4m on ‘A Day’ must be fully protected and a neutral recovery charge applied to large funds.

• We support the New Kind of Regulator (NKR): A risk-based regulator to

replace Opra is a welcome development. The regulator must focus its efforts on those schemes where members’ rights are most at risk. We recommend that the NKR should have a small number of statutory objectives which it interprets flexibly.

• A Central Discontinuance Fund will not work: We support measures to

protect scheme members, particularly where the scheme and the employer are insolvent. But a Central Discontinuance Fund (CDF) is no way to remedy this situation. It will not work and there is no market for this product. We recommend that if the Government wishes to proceed

14 What makes people save? ABI, November 2002.

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with a CDF, it must be underwritten by the State. • Simpler pensions will encourage more saving: Green Paper proposals

to simplify pensions administration are welcome and will encourage employers to run schemes and employees to join them. But the proposed reforms will still mean legislative arbitrage between pension types. We recommend a more radical pensions simplification combined with measures to protect scheme members.

• Self-employed: As a group, the self-employed under-save for retirement.

The proposals to allow the self-employed into the state second pension on a voluntary basis will help, but do not go far enough. We recommend that the self-employed are required to save in a second pension on the same basis as employees.

• Timing: ABI members are keen to work with the Government to

implement the changes in the Green Paper efficiently and effectively. But it will be counter productive if the changes are introduced too soon and providers do not have time to make the necessary systems and administrative changes. We recommend that ‘A Day’ for both the Inland Revenue and DWP changes is no earlier than 12 months after all legislation and regulations have been finalised. This will mean April 2005 at the earliest.

• Stability: Continued uncertainty has the dual disadvantage of deterring

consumers from starting to save for retirement whilst at the same time discouraging employers from continuing to offer pensions. It also increases costs to commercial pension providers. We recommend that following these Green Paper reforms there is a period of stability which allows consumers, employers and providers to plan and raise retirement savings levels.

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ANNEX B EXECUTIVE SUMMARY: ABI RESPONSE TO FSA DP19 1. This paper sets out the response of the Association of British Insurers

(ABI) to the FSA’s Discussion Paper 19 (Options for regulating the sale of “simplified investment products”).

2. DP 19 sets out how fresh thinking on the sales process can produce a

streamlined system that provides the key elements of customer protection at an affordable cost. Depending on the final details of the process and the qualifications that advisers need, this could be under half the current cost per sale.

3. We set out last August how a simplified sales process could reduce the

costs of sales and thereby help bring financial advice to a wider market. (on the basis of work by Oliver, Wyman & Co).

4. The FSA’s research on Stakeholder Pension decision trees (published on

14 April) shows that they have not achieved the objective of enabling customers to buy pensions without advice. Three out of five consumers feel they need more help and assistance than the trees alone to make their decision.

5. The ABI believes that Option 2 (“Guided Self-Help”) has the potential to

offer this at a realistic price and would repay more detailed work. This sort of sales process would allow sales people to encourage many more consumers to save for the future, whilst using a few key questions to ensure that those who would be better off not doing so are clearly warned away from buying these products.

6. Consumer groups who compare a simplified sales process with the

current full Conduct of Business process are missing the point. As Oliver, Wyman & Co research has shown, and as the FSA has previously recognised, the real alternative for most customers is no protection and no encouragement to save for the future.

7. Option 3 would also be a “no change” option. It is based on advisers

being able to cut some corners in the current full advice process, but remains unclear about which these should be. Against this uncertainty, firms would not wish to venture into the market and would necessarily take too cautious an approach to enable them to make real cost savings or offer a service that was attractive to consumers. This would continue to leave millions of consumers excluded from advice altogether.

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8. For the industry to be confident of selling these products to a mass market, and helping to close the savings gap, the Government and the Regulator need to be clearer about the extent of the risks involved – in particular:

• That equity-based products can be appropriate savings vehicles for

many consumers, if they already have some cash set aside for emergencies;

• That saving for retirement is almost always a good idea. The Government and the regulator need to be clear that this is so even for people who might find themselves receiving the Pension Credit when they retire.

9. There are many points of detail that still need to be clarified in the months

ahead, but we believe that light-touch regulation for simple products can work.

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ANNEX C DETAILED COMMENTS ON WITH-PROFITS 100/0 Structure

The Government proposes to require a 100/0 fund structure for the “stakeholder” with-profits product and welcomes views. (Q11)

1. We think it is important to approach the question of product design

from the viewpoint of the customer rather than the technical mechanics of the product. For the stakeholder version of with-profits we think the key thing from the customer’s viewpoint is that there should be a clear and risk-free charge for management expenses and that no other deductions for the same expenses should be made from the policyholder’s fund. (Certain costs for other purposes – eg dealing charges – would continue to come out of the policyholder’s fund on the same basis as they do for unit linked/mutual fund business). Nor should there be exposure to ‘business risk’.

2. This could certainly be achieved using 100/0 as the mechanics. In

doing so, it would be important to recognise that whilst the specific charge would often be paid to shareholders (as envisaged by the consultation paper) it may equally be paid to other entities. For example a mutual has no shareholders. So in this case the explicit charge paid by stakeholder customers would go to the funds of non-stakeholder members of the mutual (ie policyholder funds in the main with-profits fund). Similarly, those funds would be used to pay the management expenses. None of this matters to the stakeholder customer – he is simply paying an explicit charge to another entity in exchange for both the management of his policy and to meet other costs.

3. Similarly in a proprietary company it would be feasible for the

management charges to be collected by, and expenses met by either

- shareholder funds or - an existing 90/10 with-profits fund.

Again, it doesn’t matter to the stakeholder customer as the deal for him is the same either way.

4. Assuming this approach is adopted, then the supply side of stakeholder

with-profits is likely to be much better served. If the Government were to insist that only shareholder funds could be used for this purpose then the supply would be very constricted – mutuals would be unable to offer the product and the capital held in 90/10 funds would also be

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unavailable. We cannot imagine this is the Government’s intention – since it would not benefit stakeholder customers – but we highlight this issue so as to avert unintended problems when the policy detail is being worked out.

5. There is an important read-across here to the FSA’s consultation on

non-stakeholder with-profits products (DP20), which asks whether the investments of mainstream with-profits funds should be confined to conventional asset classes thus banning investment in the provider’s business activities. If this policy were to be adopted for all with-profits business (not just stakeholder) then those businesses would be unable to provide the capital support for writing new stakeholder business. We say in our response to DP20 that disclosure of investments in the provider’s business activities is to be preferred to banning such investment.

6. We believe it would also be possible to deliver the customer outcome

described at paragraph 4 above by using a 90/10 approach for the stakeholder fund. Whilst (up to) 10% of the returns would go to shareholders under this model the total amount they receive could still be capped at whatever level is set by the price cap. This model has a number of attractions:

- it caps the price just as effectively as the 100/0 version; - it means that if the returns are poor the provider receives less,

thus creating a shared interest in achieving good results; - it would be likely to improve the supply of capital for with profits

business. We think this approach deserves further consideration.

7. So, in summary,

- we favour explicit charging for the stakeholder version of with-profits;

- we see no advantage to stakeholder customers in insisting that

only shareholder capital may be used to write this business; the key point is that it should not be a risk to the stakeholder with-profits fund;

- imposing restrictions on where the capital comes from is likely to

constrict supply in a market where capital is now at a premium;

- whilst a 100/0 model as described above could deliver the requirement we believe that it could also be delivered under a 90/10 approach suitably adapted. This could help with the supply of capital.

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Explicit Management Charging

The Government welcomes views on these options for establishing an explicit management charge. (Q12)

8. This section of the consultation paper addresses two main issues:

- the question of whether separate management companies should be set up to provide management of the fund, guarantees and the protection elements of the new stakeholder product;

- whether the existing stakeholder with-profits model provides a

practical clear and transparent way of delivering the new stakeholder with-profits product.

9. On the first point we see no need to set up separate management

companies. These would be costly, bureaucratic and may confuse customers rather than aid transparency (see also our response to DP20). Instead the Government should simply lay down the requirements that must be met from a customer viewpoint leaving providers to arrange the most effective corporate structure.

10. The consultation paper asks about the existing stakeholder pensions with-profits model. As noted, only a small number of providers have chosen to offer this investment option within their stakeholder pension but it has proved very popular with their customers (one member reports 70% opting for with-profits). The main constraint on supply has been the overall 1% price cap and the fact that it does not allow for the cost of externally provided smoothing capital or guarantees.

11. From a customer viewpoint the current stakeholder pensions model is very similar to that proposed by Sandler. Given the similarity of these models there could be advantage in adopting the existing stakeholder pensions model as the basis for new stakeholder products but with a new charging structure. This approach could minimise transitional problems and may help the product get off to a smoother start.

Separate Smoothing Account

The Government welcomes views on requiring the maintenance of a separate smoothing account. (Q13)

12. We support the proposition of a smoothing account which should aim

for a neutral balance over the long run. The smoothing account should be part of the policyholder fund thus ensuring that, over time, the smoothing is shared between policyholders. This would avoid very apparent conflicts of interest between shareholders and policyholders when a negative smoothing account was being brought back towards

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zero or a smoothing account was steadily growing over many years because the stock market was rising. Any mechanical formula which sought to ensure that the balance of the account must be a particular amount on a particular day could operate to the detriment of policyholders in unexpected market conditions. Instead we propose in our response to DP20 an approach based on transparency and scrutiny. We think the same approach will work for the stakeholder variant too.

Parameters for smoothing

The Government welcomes views of whether it is desirable to specify parameters within which smoothing can take place, and whether this should be done by specifying a single smoothing model or through higher level guiding principles. (Q14)

13. Whilst it may be possible to prescribe a smoothing model or some

guiding principles we doubt that such a high level of prescription by Government will benefit consumers for the following reasons:

- it is unlikely that a single approach chosen by Government

(particularly without detailed consumer research and extensive testing using stochastic modelling) will prove to be the best formula for most or all customers;

- very detailed prescription of this type inhibits product innovation

and removes flexibility to adapt product design in the light of a changing social/economic environment. A set design may render the product redundant after a few years as more popular alternatives develop freely outside the stakeholder umbrella;

- over-specifying the design is always likely to restrict supply as

those providers whose existing products are a long way from the specified design are less likely to then play in the stakeholder market;

- in any case, there is no incentive for firms to operate smoothing

policies which disadvantage policyholders since the smoothing account rests within the policyholder fund.

14. The Sandler philosophy is that people should have easy access to

products that will be good for them – not necessarily the very best match for them. We know of no smoothing model which isn’t sensible. The fact that the product has a sensible smoothing model (rather than meeting a specific design) seems to us to be good enough. For those customers who want to understand more detail, or to shop around, the PPFMs of each with-profits fund will give full details of their smoothing approach. And the governance arrangements proposed in CP167 will ensure the approach is followed.

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Guarantees

The Government welcomes views on the relationship between smoothing and guarantees, and in particular whether smoothing is viable in the absence of guarantees and whether guarantees are likely to be viable within a stakeholder with-profits product. (Q15)

15. The consultation paper raises some key questions here which can

perhaps best be summarised as:

- is smoothing worth having if it is always potentially subject to an MVR?

- but if you offer a guarantee that full smoothing will apply on a

particular date with no MVR (eg on planned retirement date) then those who exit the policy early may not benefit;

- yet guarantees which also benefit early leavers are likely to be

too costly. 16. In considering these issues it is important to bear in mind that the ‘with-

profits’ stakeholder product – just like its unitised counterpart – is intended for people who are able to leave their investment for a substantial period of time – at least 5 years and often much longer (indeed at least until age 50/55 in the case of a pension). Those who are likely to want early access to their funds should be steered away from market-based investments.

17. Against this background we believe that the best balance between

security and cost is likely to be achieved by the provision of a smoothing mechanism which allows the possibility of a no-MVR promise which would apply to particular dates or events (eg retirement, death, specific dates). The cost of honouring this smoothing promise would be met from the smoothing account thus protecting the asset shares of other policyholders.

18. We have also given some initial thought to the idea of providing

additional guarantees from outside the stakeholder with-profits fund (eg provided by shareholders). Whilst this would be technically possible we have some reservations about such an approach. In particular, it could create at least the appearance of a conflict of interest since the cost of honouring such guarantees could be reduced (benefiting shareholders) by altering the asset mix of the with-profits funds (affecting policyholders). We don’t think Sandler’s idea of setting up a separate company to provide guarantees would really deal with this appearance of conflict since the separate company would still be owned by the provider. The new governance arrangements proposed in CP167 should serve to counter any such abuse in practice but it may

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be better – for the stakeholder product – not to create any apparent conflict in the first place.

Market Value Adjusters

The Government is interested in views on the implications for funds of disclosing unsmoothed asset share, particularly on the scope of arbitrage. (Q16) The Government would welcome views on how effective MVAs could be in protecting both funds and remaining policyholders from the effect of selection against the fund. (Q17)

19. We believe the same approach should apply for stakeholder products

as for mainstream with-profits products – as set out in our response to DP20.

Charging

The Government welcomes views on the level and structure of a charge cap for smoothing and guarantees. (Q18)

20. We agree that the key additional pricing issue regarding the with-profits

version is the question of charging for smoothing and/or guarantees. Assuming that the smoothing account is part of the policyholder fund (see earlier) then smoothing (including on no-MVR dates) will be mostly self-financing. However, when the account is in deficit it will need to borrow from other provider funds and should be charged interest to be paid from the policyholder fund.

21. We can see two possible ways in which the borrowing cost could be

accounted for:

- Model A takes as its starting point that providers would need to set capital aside (earning lower returns than if it could be freely invested) in case it was needed to be loaned to the smoothing account. The cost of keeping the capital earmarked and available could be calculated and expressed as an explicit charge in addition to the annual management charge;

- Model B would operate on a pay-as-you-go basis so the with

profits fund would only pay interest when it actually borrowed money. We would need to do more work to explore whether this could be a viable proposition – to make it commercially viable it would be likely to involve higher interest rates (for shorter periods) than Model A. This model would not involve an explicit charge, instead the cost of borrowing would be reflected in the annual return on the fund.

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22. We would be happy to develop these further in discussion with Government.

Risk Control

The Government welcomes views on whether the underlying investment fund of the “stakeholder” with-profits product should have the same risk-controls as the “stakeholder” unitised product. (Q19)

23. As the graph in the consultation document demonstrates, with-profits investments held to maturity have proved a good deal less volatile than direct equity investments. It should be acknowledged that smoothing, guarantees and asset allocation have all played a role in this outcome and that those surrendering early will face greater volatility.

24. If the Government decides to impose quantified restrictions for the unitised stakeholder product then it would probably make sense for the high level areas (eg 60% equities limit for the non-pension product) to be read across to the with-profits version. But a less detailed approach may be right for with-profits both because of its reduced volatility and the need to meet prudential regulation requirements.

Terminology

The Government welcomes views on alternative names for investment products with smoothed returns. (Q20)

25. We think it is best that products should be described in a way that best

captures their essence for the customer. Until the product design is settled it is hard to know whether one single name/description set by Government would help or hinder customer understanding.

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