With the release of its PS19/30 policy statement in December 2019, the Financial Conduct Authority (FCA) effectively created a quasi-executive role for Independent Governance Committees (IGCs) & Governance Advisory Arrangements (GAAs), in effect an approval and sign-off process.
We go into more detail around this topic in our recent blog post; Has the FCA created an Executive role for IGCs?
Fast forward six months to June 2020, the FCA published an effectiveness review of IGCs/GAAs Thematic Review (TR20/1), which showed that some IGCs/GAAs did not effectively challenge providers in areas where there was the risk of consumer detriment.
And consumer detriment is a risk which looms large when it comes to non-advised drawdown and is something as a product provider you need to address.
The FCA’s effectiveness review focused on the assessment by IGCs/GAAs of the somewhat unclear concept of Value for Money. Indeed, five years on from the creation of IGCs/GAAs, Value for Money is still not well-defined.
When it comes to investment pathways, however, the FCA has set out its stall up-front. When the FCA comes to review the effectiveness of IGCs/GAAs in respect to your investment pathways solutions, it will be on much firmer ground in terms of the expectations set.
The regulatory duties for IGCs/GAAs are clear and two-fold:
Assess the appropriateness of the pathways solutions proposed by the provider – we use the term Appropriateness Report to describe the document which the provider produces as evidence for the IGC’s/GAA’s consideration.
Ensure customer communications are fit for purpose and properly take into account their characteristics, needs and objectives.
As per the COBS rules, providers are required to:
“Describe to the retail client, using plain language, the level of riskiness of each pathway investment”.
The FCA also states:
“We do not want consumers to select a pathway solution if the risk profile of the solution does not match their attitude to, or capacity for risk” and it is clear that customer communications must be such as “to enable consumers to make this assessment”.
We have developed an Essential Checklist for IGCs/GAAs as they look to assess and scrutinise your proposed investment pathway solutions, to help answer what we consider to be seven fundamental questions.
We outline the questions below and we hope his provides some useful insight to you as a product provider;
Has the provider set out clearly its assumptions about the characteristics of the consumers it expects to be using each pathway solution?
You’ll want to see the evidence. It is these demographic assumptions which will drive the provider’s choice of the proposed pathway solution, in particular its risk profile. As part of this, you’ll want to know under Options 2 & 3 the assumption made as to when customers are likely to start taking income and under Option 4 the assumed pattern for taking out all the money within the 5 years.
Have you considered the Appropriateness Report and the customer communications together in the round?
The two are inextricably linked. The level of riskiness which is described to the customer is a function of the methodology used in the Appropriateness Report and the expectations set for the potential outcome from the pathway. In particular, you’ll want to be sure that the communications adequately reflect both the pathway’s target risk level and customers’ expectations from the pathway.
Having set a target risk level for each of the four Options, does the Appropriateness Report demonstrate for each pathway solution proposed that the risk level is achieved in practice?
You’ll want to see evidence that the pathway meets the target risk level taking into account the way it is to be described to customers. You’ll need to bear in mind the FCA requirement that customers will have to make their own assessment as to whether the risk profile matches their attitude to, and capacity for, risk. For example, Option 3 needs to provide customers with a clear understanding of the risk associated with their long-term income and how it might vary.
Does the Appropriateness Report show the efficiency of each of the proposed pathway solutions, and is it presented in a way which is meaningful to you?
As part of your value for money assessment, you’ll want to assess that the proposed pathway solution delivers on the objective for the pathway efficiently. For example, the pathway solution for Option 1 may offer investment in line with the target risk level but do so very sub-optimally so that the return is low for the level of risk. In effect, this increases charges so that the pathway solution offers poor value for money. Efficiency can be assessed by comparing the pathway solution with an optimised benchmark, and this will be an important component of your value for money assessment. You will likely want it expressed as an equivalent annual reduction in return given this is a measure commonly used by IGCs/GAAs
Is a sustainable income under Option 3 derived in the Appropriateness Report and does it then form part of the communications to the customer?
You should be very concerned if it is not. The customer has declared that they want to take a long-term income. You will want to take into account how this income is being described. For example, the definition of sustainable, whether the income is level or escalating, whether it will increase with inflation. It is important that the communications set customers’ expectations so that they can form a judgement as to whether a particular pathway meets their needs. Setting realistic expectations provides the basis for delivering meaningful communications about the risk so that, in line with the FCA’s requirement, customers are able to make their own assessment as to whether the risk profile matches their attitude to, and capacity for, risk.
Are you comfortable with the robustness of the approach, methodology and associated modelling – and have you challenged these effectively?
You should not be expected to have to interrogate the whole range of assumptions underlying a stochastic model. But you should, for example under Option 3, get comfortable with how the model allows for sequencing risk, i.e. a run of bad returns in the early years of drawdown. Indeed, for income drawdown, it is important that any model used - whether to assess a pathway solution’s appropriateness or for the purpose of supporting customer communication - is fit for purpose.
Putting yourself in the shoes of the customer, does the communication describe to you - in plain language - the level of riskiness of each pathway investment? Does it do so in a way which would enable you to assess whether it is right for you in terms of your risk appetite and your capacity for risk?
While you cannot be expected to wordsmith the provider’s communications, this does provide the acid test – and it is, after all, a requirement in the FCA’s rules.
Read how the role of IGCs has changed, and what impact this has had on product providers regarding the appropriateness of their chosen pathway solutions. Click the link to our previous blog Why Independent Oversight holds the key to Appropriateness.
EV has developed a process which analyses each of the pathway solutions developed by a product provider in detail. This process culminates in the production and publishing of an Appropriateness Report. This report uniquely summarises the results of the analysis and forms a judgement as to the appropriateness of the pathway solutions which the product provider proposes to offer.
The output from Appropriateness Report should also be invaluable to providers as part of their product design processes, and provide their IGC or GAA with evidence that they have undertaken the required due diligence and compliance efforts.
To learn more about the EV Appropriateness Report, or to download a preview, please click here.
Lastly, if you would like to find out more information about our capabilities, please follow the link to our investment pathways hub: https://www.ev.uk/investment-pathways.