RDR rules remain ‘far from clear’

A key message was: “If a structured investment product would best meet the client’s needs and risk profile, then an independent adviser should have sufficient knowledge of these products to be able to recognise this and make a recommendation to buy this product.” (FSA consultation paper CP09/18 –Distribution of Retail Investments: Delivering the RDR, June 2009).

Now that the regulations have kicked in, the advice landscape is far from clear. Advisers who thought structured products were complicated enough – let alone difficult to advise on – have been none the clearer since 1 January. One challenge in particular relates to independent or restricted advice.

The Retail Distribution Review requires all advisers to take into account all investment options when making recommendations to clients.

That being so, an independent adviser will have to include structured products in his research process and make a judgement on the appropriateness of its use for a client. The FSA has produced some helpful guidance on this with a “Suitability of Advice” assessment template, which contains some 10 pages of detailed fact-finding and risk assessment. This is a clear marker as to the seriousness with which the regulator views this area of advice.

The problem is compounded by the regulator’s reshaping so that certain structured products are governed by RDR rules whereas others are not. As I understand it, those structured products that are “deposit- based” are not governed by RDR regulation, whereas plans that are “investment-oriented” are covered by the new rules.

In a 2012 study, Inside Structured Products, Defaqto produced some powerful business intelligence on the FSA view on such plans in the post-Lehman Brothers world: “The key outcome from this document was that any companies wishing to promote structured products must be clear on where the client’s money is invested, clearly explain counterparty risk, prominently state that capital is at risk when relevant, use language the advisers and investors are likely to understand and avoid using the terms ‘guaranteed’ or ‘protected’ if thought to be misleading.”

Another consequence of this differentiation between structured products is that advisers who have adopted a “restricted advice” business model may take the view that they are effectively excluded from having to advise on structured products.

This may help to reduce advice risk to their business but could also be seen as negative and may mean clients miss out on the opportunity.

The proof of the pudding will be when true clarity emerges on what a “restricted advice” model looks like

The proof of the pudding will be when true clarity emerges on what a “restricted advice” model looks like. This is at odds with one of the aims of RDR, which I believe was to make investment advice and products clear and fair, and not misleading.

While advisory firms are getting to grips with RDR-friendly business models, many are also taking a more pro-active view on the integration of wraps and platforms into their client relationships. With the increased regulatory attention on capital-at-risk products, it would be sensible to make use of technology and online capabilities to meet RDR’s more stringent requirements, while increasing turnover and attracting investment capital from clients.

This was flagged clearly in a recent comment from Mark James, head of distribution at SPwrap.com: “Extending the ability to hold, purchase and monitor structured products on a platform will help level the playing field between mutual funds and structured products and, with empirical evidence indicating growing interest in structured products among financial advisers, this can only see the structured products market grow sizeably in the next few years, benefiting advisers and investors.

So will the increased interest in the use of structured products benefit clients and investors? We should remember that historically many structured products were arranged with clients on a “commission” basis and the charges and costs for the plan were implicit – that is, buried in the overall cost of the plan. I am not clear on how this will pan out – for advisers with a fee proposition, product providers will need to market their offerings on a clear charging basis. This approach fits nicely with the RDR requirements, but I suspect in the short term, some structured product offerings will remain on a commission basis and will therefore prevent a move to a level playing field for clients.

With all the regulatory noise and changes, is anything really different in terms of value to clients from the use of structured products in an investment strategy? Consider some of the information contained in the marketing for a current structured product and consider the potential benefits to clients. The plan is described as:

“A structured investment pro­position that provides investors with pre-defined equity-linked returns, transparency, daily liquidity and protection from counterparty risk.”

So this is selling a return in the future, based on market forces but set at a level agreed at the outset of the term. Taking it at face value, the risk the client is taking appears to be managed and known from the outset. This may appeal to investors who take a cautious view.

“Share class A is aimed at institutional investors and requires a minimum investment of £100,000. Share class B is aimed at the retail market and requires a minimum investment of £3,000.”

Share class A is clearly relevant for advisers working in the discretionary space but not, I would suggest, appropriate for advisory businesses that should not be committing £100,000 of a client’s money to one product.

“The fund has a maximum term of six years but has the potential to mature early or ‘kick out’ if at the end of years one, two, three, four or five the FTSE 100 is above its initial level.”

I struggle to understand how these sorts of plans can be helpful when advising a client. Just when you think you know what the plan may deliver, things change in the market and you are back to square one with the capital, plus a bit of growth, and new advice is needed.

“If the fund runs for the full six-year term and the FTSE 100 has remained equal to or above 50 per cent of its initial level during this period, the fund will pay investors 100p per share plus 1p for each 1 per cent rise in the FTSE 100 over the investment term, or if the FTSE 100 finishes below its initial level, the fund will return 100p per share.”

That sets out pretty clearly the likely returns for an investor. The good thing here is that the final result is not clouded by the averaging of an index over certain periods, and the index being used (the FTSE 100) is a household name that is relevant to a UK taxpayer.

“If the FTSE 100 falls by more than 50 per cent from the initial level at any time during the investment term and finishes below its initial level, investors will receive 100p per share less 1p for each 1 per cent fall in the FTSE 100.”

The bottom line is if the market does not perform as anticipated at the outset, the investor could suffer serious capital loss if the FTSE 100 breaches 50 per cent of its initial level at any time and fails to recover before the end of the six-year term. That is a high level of risk and would take some explaining to a client considering whether to proceed with the investment.

In a nutshell, while much has changed with the implementation of RDR, a number of key considerations for advisers remain problematic.

Nick McBreen is an independent financial adviser at Worldwide Financial Planning

Key points

■ Structured products were complicated enough but have become no clearer since 1 January.

■ Advisers need to get to grips with how structured products create and deliver returns to investor (and the provider).

■ The key concern with structured products in an investment strategy has to be inherent risks, such as lack of clarity and transparency; counterparty risk ; taxation and inflation; inflexibility; market risk and the loss of dividend returns.