How capital adequacy will change the Sipps industry

In 21st century Britain, the Sipps industry is fast approaching its own year zero. Fortunately, Madame Guillotine has long since retired and while there is no prospect of public beheadings this time, many in the industry quietly fear a period of immense upheaval.

We know neither the full details nor the date they will come into force, but it is already clear that the FCA’s long-delayed new rules on capital adequacy for Sipp providers will be a game changer for the industry – both in the short and the long term. They may impact most in areas where one would least expect it, shifting the balance of power and forcing some providers to change the services they offer and the fees they charge.

For both large and small Sipp providers, the most immediate and noticeable impact will be in the introduction of higher capital adequacy requirements. This means many providers of all sizes will have to hold more capital in reserve.

This additional capital will have to come from somewhere, and if a provider cannot get hold of the required funds easily they will be forced to generate it by other means. For many, the easiest options will be to increase client fees, or to withhold some of the bank interest paid by clients’ Sipp current accounts.

But those providers who are trading on very thin margins may struggle to raise enough extra cash quickly enough – and could be driven out of business.

It is tempting to think that smaller firms would feel the burden of the new requirements most keenly. Certainly some of the larger providers have been smugly warning that the capital adequacy rules will squeeze smaller firms more than them.

But such a smugly sweeping generalisation is nonsense. In fact, some large providers have a lot to fear. Size alone is no guarantee they have an abundance of spare capital to use for these purposes, or of higher profit margins.

In fact, larger companies often spend proportionately more on infrastructure and staff – and could find it very expensive to change systems and update their fee schedules.

By contrast the best run small firms are more nimble and should be able to make changes without such upheaval. But then again, with a smaller pool of clients, their ability to raise extra capital by raising fees is more limited.

The current capital adequacy regime is based on a firm’s expenditure and running costs. Generally speaking, larger providers have larger running costs and hence a higher amount of capital in reserve.

Under the proposed new regime the size of the company will still have an impact. But what will matter will be size in terms of the assets under administration - and the higher that is, the more capital the firm will need.

However a new variable is also being introduced – the percentage of a firm’s client base that holds ‘non-standard’ assets. This category includes clients who hold commercial property in their Sipps, as well as investments, such as unregulated collective investment schemes, unlisted shares, unconnected loans, non-stock exchange-listed bonds and so on.

It is this second restriction that is likely to have most impact on the market. The move to AUM as the measure by which size is calculated will not change radically the capital adequacy requirements of most firms, but limits on the number of “non-standard” clients will.

So when trying to plot which firms will be hit hardest by the new regime, do not think in terms of big versus small – the decisive factor will be the firm’s exposure to non-standard (and usually illiquid) investments.

A small firm with clients who do not hold non-standard investments is no more likely to be affected than a large platform-based Sipp with lots of clients with standard investments.

This new requirement is likely to lead to some seismic shifts in the industry in the long term.

More providers are likely to stop doing non-standard business – limiting the type of investments they allow clients to hold and becoming a ‘restricted Sipp provider’.

As a result the bespoke providers who continue to offer non-standard investments will not just have to hold higher levels of capital, but may face less competition for business too. The combination of these two factors is almost certain to lead them to crank up client fees.

But it is in the short and medium term that we will see the most dramatic changes. The harsh truth is not every Sipp provider will be able to meet the new requirements, and will be forced to make some tough choices.

Those that do not go into administration will either attempt to sell their client book to another provider or team up with another firm that finds itself in the same situation.

But bear in mind that finding a willing buyer for a book of clients with lots of non-standard investments is unlikely to be easy. Realistically, the only firms that could buy such a book without falling foul of the restrictions themselves would be those that currently have a tiny proportion of non-standard clients.

The merger option is not without its complications either. All things being equal, if two providers – both with 60 per cent non-standard clients – were to tie up, the combined book would still be 60 per cent non-standard. However the combined firm will also have more capital, sufficient perhaps to meet the capital adequacy requirements.

The proposed new capital adequacy requirements are part of a broader thematic review into the Sipp market called by the City regulator.

As well as shining a light on where the industry needs to improve, I hope the thematic review will also result in some more straightforward guidance being issued – both for providers and customers – on what a Sipp is and what an investor can and cannot do with one.

The whole of the Sipp industry is crying out for clearer communication from the regulator and precise guidelines on good practice.

Without fail, at every pension conference I attend there is at least one person demanding the return of an approved investment list. Handled right, a simple and clear document would be a great help to the whole industry, and a positive step forward for Sipp clients.

Much of the current confusion stems from the replacement of the old permitted investment list by the Registered Pension Scheme Manual. The compendious manual is open to interpretation, and as a result has led to the current muddled position on non-standard investments. It often confuses as much as it clarifies.

In its initial capital adequacy paper, the FCA outlined its thoughts on what it considered to be “standard investments”. I would now urge it to build on this good start, and use the review as an opportunity to set out some more concrete investment principles for the industry.

This will be a huge help for both Sipp providers and the growing number of clients who are keen to use a Sipp to take more active charge of their pension planning.

John Fox is managing director of Liberty Sipp