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Financial Services Consumer Panel

Foeke Noppert
We would strongly challenge the assumption underpinning the discussion paper, as outlined on page 25, that risks are purely stock market-related, such as the potential for loss of capital or liquidity issues.

Research undertaken on behalf of the Consumer Panel has shown that asset manager conduct and practice, the weak principle-agent relationship, and the arbitrage between different fund structures are also very relevant when it comes to the risks associated with an investment product.

However, our research primarily shows that the level of costs and charges applied against underlying assets has the largest effect on return. (See response to Question 4) Therefore, when considering market risk, costs and charges applied must be taken into account.
In our view, the data that have been proposed for inclusion in the risk calculation suffers from significant shortcomings. In section 3.6.1 of the discussion paper, the ESAs have taken performance scenarios as the reference point for calculating risk. However, we believe that this approach is inherently flawed because of the inadequacies of performance data on investment funds.

As outlined in the Panel’s research, such performance data is based on annual or 5-year periods, but the impact of alterations such as fund name changes, closures or mergers make performance and cost tracking virtually impossible for the long-term retail investor. A risk indicator based on such data would not provide consumers with meaningful information.

With reference to statements such as ‘probability distribution of expected returns of the product fed by historical data’ (paragraph 3.6.1 of the discussion paper), the Panel would note that from a behavioural perspective, most retail investors do not distinguish between ‘risk’ and mathematical probability.

The Panel is of the view that some measure of the 'effect of charges', i.e. a Reduction in Yield such as is currently used in the UK, should be included in the measurement for market risk. The level of disclosed and undisclosed charges will have a direct effect on the return of the investment and should therefore be included. At the very least portfolio turnover rate should somehow be evaluated as a high level of transactions is traditionally associated with higher risk, and is therefore very relevant.
The Panel believes that any performance scenarios should be based on the most likely or realistic outcome for a given investment. Any performance scenario must show the negative as well as the positive effects, and positive return should be shown after costs, charges and an assumption for inflation are taken into account.

Most importantly, a consistent approach must be taken by all providers of KIDs particularly on assumptions for growth and inflation. However, providers could be made to make an assumption for the effect of their own costs and charges based on, for example, costs applied against the underlying assets over the past 3 years.
If historic data is to be used then a longer time frame such as 10 years plus should be used. As per the response to Question 4, the Panel’s recent research shows that performance data based on annual or 5-year periods does not provide meaningful information and can produce results that are misleading.
The final format of performance scenarios should be based on extensive consumer testing to ensure that whatever format is decided upon, consumers can relate to it. However, too many scenarios will prove to be confusing.

The key information consumers need to know is the potential loss they might make, meaning that a simple table indicating how much might be lost in monetary terms should the underlying asset decrease in value would be helpful.

Many consumers find it difficult to relate to percentages and may not understand the true nature of the risk if it is relayed in percentage terms. However, if the potential for loss can be illustrated in monetary terms, i.e. the potential amount of the capital invested that could be lost if the underlying asset decreased in value, that would be a more meaningful message.
The Panel takes a close interest in the transparency and fairness of fees charged to retail investors, as fees can have a significant impact on investment returns. For example, illustrative calculations by the UK’s Department for Work and Pensions in November 2013 show that an individual who saves throughout their working life into a retirement scheme with a 1% annual charge could lose around 24% of their pension pot at retirement as a result of charges.
Therefore, in order for the performance scenarios in the KID to give retail investors an accurate picture of potential returns, the costs used in the calculation of different performance scenarios must be as comprehensive as possible. Although the PRIIPs Regulation applies only to manufacturers of retail investment products, many of the costs (excluding distribution costs) that will be charged to the investor can in principle be stated or estimated with some degree of accuracy at the point of manufacture.
Accordingly, any cost the manufacturer is aware of should be included in the KID in a way that enables the investor to compare the costs of one PRIIPs product with another.
However, in the Panel’s view, a key hurdle to be overcome in this regard is that in many instances, the true and total costs – including those that must be included in the KID - simply are not known because of opaque cost structures in the retail investment market.

After a review of a wide range of studies and methods of calculation, researchers commissioned by the Panel in 2014 concluded that the full costs borne by savers are simply not known, and many costs are deducted from the fund directly.

The main reasons are simply that many costs are not properly measured or declared. Even fund managers frequently do not appear to know: in its survey of fees, consultancy Lane Clark & Peacock found that around two-thirds of investment managers could not provide information on transaction costs.

Moreover, explicit costs charged to the customer – included within the annual management charge (AMC), the total expense ratio (TER) and the ongoing charge figure (OCF) – are a poor guide to the full costs. This was the conclusion of a 2000 study commissioned by the UK’s Financial Services Authority and holds true in more recent studies.

In one study, “total” charges, excluding transaction charges, were calculated (with difficulty) from published, but not necessarily comprehensive, mutual fund price lists. They were typically more than twice the annual management charge in a number of countries, including the EU member states such as the UK.

The problem is so entrenched that even institutional investors of multi-billion pound pension funds may not know the full costs of investing. It took a major study by Hymans Robertson, a pensions consultancy, to find potential for significant savings in the UK’s Local Government Pension Scheme by switching to passive investments away from generally underperforming actively managed funds.

Similarly, it is reported that Railpen Investments, a £20 billion pension scheme, took many months and encountered great difficulty to estimate that the headline fees it paid to asset managers were around a fifth of total costs.

In November 2014, the Panel published a discussion paper which outlined a number of recommendations to address these issues. In particular, the Panel considers that disclosure of costs (and risks) is only effective if those to whom the details are provided can understand and act on the information; overly complex disclosure to consumers would be counterproductive in many cases.

In addition, disclosure by itself would not immediately change the incentives for fund managers to control those costs that can be charged against the value of funds and are consequently hidden from the investor.

The Panel has therefore recommended that competent authorities consider the introduction of a single investment management charge; all other intermediation costs, charges and expenses incurred by the investment manager, including transaction costs, would be borne directly by the firm and reflected in the single charge. Such a change would require firms to price their services in a way that they remain profitable yet competitive.
The Panel is not aware of any concrete evidence showing whether the different examples of visual representation of the summary risk indicator (as shown in section 3.7.1) are effective in informing potential retail investors about the risk they may be taking on. However, the Panel supports the display of a visual indicator as it may help those consumers who struggle with more abstract representations of risk.

In this regard, it will be important that the consumer testing exercised organised by the European Commission as part of the PRIIPs Regulation implementation process will include testing of any proposed visual summary risk indicators.
The Panel has welcomed the inclusion in the PRIIPs Regulation of a requirement for the KID to include disclosure of costs of all types, whether direct, indirect, one-off or recurring in nature. However, it acknowledges that the difficulty will be in achieving a truly representative figure of the costs associated with a particular product. As noted, it would be useful to align cost calculation methodologies with the approach to be adopted under MiFID 2 as much as possible.

In order for the KID to provide consumers with a meaningful tool for comparison between different products, the information on costs must be as comprehensive as possible. Although the PRIIPs Regulation applies only to manufacturers of retail investment products, many of the costs (excluding distribution costs) that will be charged to the investor can be stated or estimated with some degree of accuracy at the point of manufacture.
In the Panel’s view, a key hurdle to be overcome in this regard is that in many instances, the true and total costs – including those that must be included in the KID - simply are not known because of opaque cost structures in the retail investment market. This prevents meaningful comparison between different investment products covered by the PRIIPs Regulation, undermining the usefulness of the Key Information Document.

After a review of a wide range of studies and methods of calculation, researchers commissioned by the Panel in 2014 concluded that the full costs borne by savers are simply not known, and many costs are deducted from the fund directly.

The main reasons are simply that many costs are not properly measured or declared. Even fund managers frequently do not appear to know: in its survey of fees, consultancy Lane Clark & Peacock, found that around two-thirds of investment managers could not provide information on transaction costs.

Moreover, explicit costs charged to the customer – included within the annual management charge (AMC), the total expense ratio (TER) and the ongoing charge figure (OCF) – are a poor guide to the full costs. This was the conclusion of a 2000 study commissioned by the UK’s Financial Services Authority and holds true in more recent studies.

In one study, “total” charges, excluding transaction charges, were calculated (with difficulty) from published, but not necessarily comprehensive, mutual fund price lists. They were typically more than twice the annual management charge in a number of countries, including the EU member states such as the UK.

The problem is so entrenched that even institutional investors of multi-billion pound pension funds may not know the full costs of investing. It took a major study by Hymans Robertson, a pensions consultancy, to find potential for significant savings in the UK’s Local Government Pension Scheme by switching to passive investments away from generally underperforming actively managed funds.

Similarly, it is reported that Railpen Investments, a £20 billion pension scheme, took many months and encountered great difficulty to estimate that the headline fees it paid to asset managers were around a fifth of total costs.

In November 2014, the Panel published a discussion paper which outlined a number of recommendations to address these issues. In particular, the Panel considers that disclosure of costs (and risks) is only effective if those to whom the details are provided can understand and act on the information; overly complex disclosure to consumers would be counterproductive in many cases.

In addition, disclosure by itself would not immediately change the incentives for fund managers to control those costs that can be charged against the value of funds and are consequently hidden from the investor.

The Panel has therefore recommended that competent authorities consider the introduction of a single investment management charge; all other intermediation costs, charges and expenses incurred by the investment manager, including transaction costs, would be borne directly by the firm and reflected in the single charge. Such a change would require firms to price their services in a way that they remain profitable yet competitive.
As regards the method of calculation, the Panel would not want the implementing measures to be overly prescriptive or granular, taking into account the fact that the Regulation will cover a wide range of products with differing features. PRIIPs manufacturers should use costs that have been actually incurred as a proxy for the expected costs and charges, and make reasonable assumptions only where such a proxy is not available. However, where actual costs are used then a Reduction in Yield calculation would be acceptable, although the Panel does have concerns that some consumers may struggle to understand the results.
It is imperative that whatever method of displaying risk is decided upon, that this is easy for consumers to understand. Preferably some sort of risk rating should be adopted that amalgamates all three main risk elements. If one single rating cannot be realistically shown, then a system similar to the ‘traffic lights’ food nutrition rating system could be adopted with levels of market, credit and liquidity risk shown in one diagram but with green, amber and red levels shown beside each risk label.
The Panel would strongly urge you to consider whether the costs should be presented as a single annual charge, which will aid comparability and prevent firms from charging retail investors ‘hidden’ costs such as transaction costs, which are usually defrayed against the value of the funds invested rather than charged directly to the consumer.
In Chapter 4 of the discussion paper, the ESA’s focus is on providing consumer-friendly cost disclosure. While we welcome this focus on simple numbers and comparability, we would reiterate that it should not distract from the overall disclosure model.

In this regard, the Panel has concerns that the ESAs have not adequately addressed the issue of undisclosed costs, which can be very significant and should therefore be known to the investor or, at the very least, their intermediary.

The discussion paper appears to assume that such costs, including transaction costs, are not easily identifiable or that they are embedded in a way that makes analysis impossible (section 4.2.1, page 49 of the discussion paper).

The Panel’s research into investment costs also challenges the idea that transaction costs are wholly unknown in advance and that the risks of the fund manager securing efficient costs should be borne by the fund and therefore the investor. It indicated that this is a key area where conflicts of interest between asset managers and their service providers come into play: deals are arranged that might benefit the asset manager or other share classes in the fund, rather than the retail investor.

The Panel looks forward to engaging in more detail on the substance of these issues with the ESAs when the technical consultation paper is published later this year.
The Panel considers that implementation of the PRIIPs Regulation in this regard should be based on the approach adopted by ESMA for MiFID 2: in the case of ex-ante in-formation, where the disclosure provided to the client is based on reasonable assumptions, the disclosure should be accompanied by an explanation stating that projection is based on assumptions and could deviate from costs and charges that will actually be incurred. However, wherever possible firms should use, as a proxy, costs that were previously incurred. We could not support an interpretation of the Regulation that would allow manufacturers to apply a blanket policy of (under-)estimating ‘problematic’ costs where they could rely on more accurate previous experience of the costs associated with a specific product. The Panel strongly believes that, without inclusion of accurate predictions of transaction and performance fees in the estimated cost, an aggregate cost figure will not provide consumers with the information needed to make an informed decision about making an investment.
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