Investment Bonds - UK -
Internal Market Environment
Key points
●
The global
financial crisis has provoked a flight-to-safety (and flight-to-quality)
approach, and a focus on wealth preservation, with greater interest in cash and
fixed interest securities.
●
Negative publicity
associated with poor bond performance and mis-selling continues to cast a
shadow over the industry’s reputation.
●
The changes in the
CGT regime work against the investment bond industry, but all is not lost, as
some investors will still find the product to be a suitable investment.
●
The RDR will lead
to a restructuring of intermediary remuneration practices and is likely to
drive product design going forward.
●
Commissions paid to
advisers have been cut by a number of providers in order to improve margins and
be more ‘RDR-friendly’.
●
The FSA’s TCF
initiative is forcing a revision of legacy business in order to make sure that
they meet today’s standards.
Investors influenced by global events
As market
conditions have taken a dramatic turn for the worse in recent weeks and months
the nerves of even the most stoic of investors have been put to the limits. As
a result of the extreme levels of volatility there has been a marked shift
towards wealth preservation and preference for cash. Simultaneously there has
also been an increase in demand for professional financial advice as investors,
especially those of high net worth, require assistance in persevering through
the current uncertainty, and also comfort that their wealth is being managed by
capable individuals.
Wealthy clients,
the primary holders of investment bonds, are demanding not only guarantees but
also justification for the fees they pay for having their wealth professionally
managed. As a result, private banks and other intermediaries are increasingly
having to demonstrate to clients how they create ‘added value.’ To a certain
extent, new regulatory developments such as Treating Customers Fairly and the
Market in Financial Instruments Directive (MiFID) have been able to help
achieve these goals.
Industry continually haunted by past mistakes
Adverse publicity
linked to the previous troubles of with-profits funds, the mis-selling accusations
surrounding precipice bonds and, more recently, the significant losses incurred
by investors in AIG Life’s enhanced fund have damaged the reputation of the
entire industry.
The with-profits’ fall from grace
Earlier in the
decade, investor confidence in with-profits funds was so badly damaged by the
bursting of the dotcom stock market bubble, and ensuing regulatory
requirements, that it was believed the with-profits concept of investing would
be completely eradicated from the investment landscape.
The smoothing
effect concept unique to investment bonds relies on sufficient funds being
built up in years when returns are strong in order to provide payouts in years
of poor performance. Although this model can be very effective in reducing
volatility, the severe nature of the bear market that followed the dotcom crash
exposed a fatal flaw, as the reserves of many with-profits funds were unable to
handle the considerable decline in stock markets. Subsequently, many providers
were forced to close funds or significantly cut bonus rates.
Making matters
even worse for many was the implementation of so called MVRs (exit charges
intended to protect investors who plan on remaining invested in a particular
fund). These put policyholders in the difficult position of having to decide
whether to risk future losses by staying invested in an under-performing fund,
or losing up to a quarter of their investment by cashing in early. The
considerable bonus cuts and MVRs exposed a fundamental weakness in the
with-profits model, specifically its opaque nature and the problems associated
with withdrawing funds when markets are performing poorly
Current market conditions see the return of bonus cuts
and MVRs
Although positive
fund performance has made with-profits investment bonds look more attractive
again, the current economic downturn and sharp decline in stock market
performance has indicated the return of bonus cuts and MVRs.
Indeed as of
January 2009, Friends Provident, has become the latest major provider to cut
bonus rates and reduced payouts on its with-profits policies by up to 20%,
saying the reduction reflected weak investment performance in its with-profits
fund. Other providers that have cut bonus rates in recent months include,
Norwich Union and Prudential, two of the biggest providers of with-profits bond
policies.
The mis-selling of precipice bonds
In the late
1990s, as the base rate fell, just as it has done recently, the returns on
precipice bonds (or high-income bonds) became particularly attractive to capital-rich,
income-poor retirees. These bonds promised to pay substantial rates of income
(up to 10%), over the term of the investment. The catch, however, was that this
promise came at the cost of a certain amount of risk to the original capital.
Unlike most guaranteed income bonds the amount of the original investment
returned at the end of the precipice bond’s term was dependent on the
performance of the underlying assets.
As a result of
the prolonged bear market following the dotcom crash it became necessary for
providers to take deep cuts into the fund’s capital in order to maintain the
previously promised payouts. This in turn meant that many investors lost almost
all of their original investment. As expected, the FSA as well as the Financial
Ombudsman Service received thousands of complaints, as many policyholders
argued that they were not made aware by their advisers of the risks posed to
their original investment.
Despite their
moderate success in arguing that they had simply offered ‘information’ rather
than advice to precipice bondholders IFAs were ultimately responsible for
having to justify the mis-selling claims. As a result of the precipice bonds
mis-selling scandal and the burden of meeting the costs of claims, the leading
firm of David Aaron & Partners was pushed into administration in 2004,
while RJ Temple, another perpetrator, was liquidated shortly afterwards.
Other IFA firms,
such as Chase De Vere were fined for handing out misleading literature while
several insurers including Scottish Mutual and Canada Life were also fined. The
highest profile case involved Lloyds TSB, the only bank to have sold such
policies, which was ordered to pay almost £100 million in compensation to
investors and was fined more than £1.9 million for mis-selling Scottish Widows
precipice bonds.
AIG debacle puts another blemish on the investment bond
market
In September
2008, AIG Life announced it was closing the enhanced fund held within its
Premier Access Bond and Premier Bond products (valued at the time at £5.7
billion), which had been popular among wealthy UK investors thanks to its
covenant and competitive tax-free yield. By taking advantage of its unique XSE
tax position, where tax on the interest payment could be avoided, AIG was able
to offer a rate via the investment bond tax wrapper that was 50 to 70 basis
points above deposit accounts offered by competing providers.
Although
positioned as being similar to cash, the enhanced fund was only 45% cash with
the remainder invested in short term deposits and bank securities (this
included £210 million with Lehman Brothers, about half of which is expected to
become a total loss).
As is now well
documented, when things took a turn for the worse and the US insurance firm got
into major financial problems, ultimately leading to its rescue by the US
government, many investors lost confidence in the fund. Rising redemptions
forced AIG to close the fund, which had been sold by a number of UK private
banks. Before the fund’s closure, the approximate value of an average
investment in the fund was £750,000.
AIG has given
investors the option to switch half of their cash into its ‘Standard Fund,’
which allowed them to make immediate redemptions from 15 December 2008 (the
closure date). Investors were warned, however, that they would only be able to
recover between 50% and 85% of the full value. The rest of the money from the
fund is being moved into a ‘Protected Recovery Fund,’ where they are guaranteed
to receive at least the full value of their enhanced fund holding if they hold
until maturity (July 2012). For investors opting to take the early ‘exit’
route, it is estimated that they could expect to lose up to 25% of their
investment. AIG has stated that 95% of investors have moved to the recovery
fund.
A lobby group of
investors, led by criminal attorney Joseph Hill, has been formed and is
currently contemplating launching a class action suit against AIG Life as well
as four private banks, Barclays Wealth, Coutts & co, Lloyds TSB and UBS,
for recommending the products to their clients. It is rumored that clients are
angry because they had been led to believe that they were placing their money
in a fund that functioned like a deposit account.
Expensive and complicated charging structures
problematic
A significant
downside to investment bonds is that they are often very expensive to invest in
because of overly complicated charging structures, which can significantly
shrink the original value of capital from the outset. In some cases, for
example, an investor can incur an initial charge of 5%, plus an annual
management charge (AMC) of 1 to 1.5%. Other bonds may have no initial charges,
but come with a higher annual fee in the first three to five years.
Moreover, nearly
all investment bonds have expensive early withdrawal penalties if they are
cashed in within the first five years. When it comes to with-profits bonds, one
must also keep in mind the possibility of a Market Value Reduction (MVR) being
applied, which would further diminish the value of the investment.
High commissions paid to advisers could lead to
mis-selling…
Commission bias
has been a common issue for regulators and this is especially true when it
comes to investment bonds, as advisers selling them have been known to collect
up to 6-7% or even possibly 8% initial commission.
It has frequently
been stated that such high initial commissions have led to some of the more
unscrupulous advisers recommending investment bonds to their clients when
another investment would have been more appropriate.
Even if this is
not totally true, the allegations undermine confidence not only in investment
bonds but also in the advisers recommending them. In fact there is even the
possibility that a fear of being accused of chasing commissions could actually
make advisers hesitant to ever consider recommending the product even if it
might be appropriate for the client.
…and also squeeze margins for providers
Paying high
commissions to advisers has also
proved to be detrimental to many investment bond provider’s bottom lines. As
competition for sales and market share progressively rose over the years, the
increasing levels of commission paid to advisers
have only had a limited impact on profitability and in some cases have actually
had a negative impact.
In response to
this, as well as a movement to more RDR-friendly commission structures, several
providers have recently started to cut bond commission. Led by Norwich Union,
which made its cut in October 2008, Scottish Equitable, AXA, Scottish Widows,
L&G and Skandia have all reduced bond commission.
REGULATORY DEVELOPMENTS
Changes in CGT undermine investment bond
competitiveness
The rate of CGT
is an important factor to take into consideration when determining the best
possible place for an investor’s money. On 6 April 2008, together with an
increase in the exemption for capital gains, a new 18% flat-rate CGT regime was
put in place. Previously the rate was 40% but it was possible to reduce this
via indexation (which reduces gain by the annual rate of inflation for the
years between 1982 and 1998) or via taper relief depending on how long the
investment had been held.
As data on new
sales will confirm, these changes have thus far had a significant and negative
impact on the investment bond market, where gains are taxed as income at a rate
of up to 40%. As long as the rate charged on investments which produce capital
gains is lower than on income producing ones (like investment bonds), the best
advice from IFAs will be that most investors, especially higher rate tax
payers, should be holding collective investments directly.
…but all is not lost
On the other
hand, although the simplification of the CGT regime will benefit the collective
investment market, there will still be a small but growing niche of investors
who may continue to find investment bonds attractive. The decision to choose an
investment bond or invest directly in a collective is complex and is influenced
by a number of factors depending on the individual involved.
Investment bonds
will still remain attractive to certain investors because of the following
factors:
●
Investment
bonds are much easier to hold in trust than collectives and are useful for IHT
planning.
●
The
5% tax deferred income annual withdrawal facility is particularly useful for
those of high net worth.
●
Unlike
collectives, switching between funds does not expose the investor to any tax
liability.
●
There
are guarantees available in certain investment bonds which are not available in
collectives.
●
Offshore
bonds can prove attractive for high rate tax payers and those retiring abroad.
Furthermore, it
should also be noted that the prospects for the investment bond market could
change significantly should the government decide to increase the rate of CGT
or make other changes in the UK tax regime. As one trade interviewee has
highlighted in the Trade Perspective section of the report the government’s
current level of borrowing indicates that the tax regime is likely to be
altered in order to pay for it.
“Given
the need to significantly raise tax revenues to pay for the credit crunch bail out
in the next five to ten years any product that provides shelter from tax could
see its attractiveness change dramatically. Equally other products are more
vulnerable to tax raising measures in future, the relative balance between
bonds and alternatives is what will decide that future.”
-Gavin Fielding,
Product Manger Norwich Union/Aviva
The Retail Distribution Review
The Retail
Distribution Review (RDR) was first launched in June 2006 in reaction to
problems frequently reported in the distribution of retail investment products.
With the co-operation of the FSA as well as industry and consumer
representatives, the Review seeks to find solutions to the current market
inefficiencies that can work to the benefit of both firms and consumers. The
key goal of the RDR is to infuse greater confidence and engagement among
consumers in the products and services offered in the retail investment market.
In November 2008
the FSA published its RDR feedback statement. The key proposals in the feedback
statement include distinguishing between independent advice and sales to create
better clarity for consumers about the investment services available. The key
points of this distinction are:
●
Independent advice is where adviser
firms provide recommendations that are unrestricted and unbiased and consider
all investments and providers from across the market to ensure they meet a
customer’s needs. Consumers will agree the cost of advice up front – removing
the potential for bias – and independent advisers will adhere to high
professional standards.
●
Sales advice is where firms
recommend the products of one or a limited range of providers and make this
clear to customers. Sales advisers will also have to meet the same
professional standards as independent advisers and show clearly the cost of
their advice.
It is believed
that the RDR will have a significant impact on not only the distribution of
investment bonds but also on future product design. While it is probable that
the review will produce long term benefits it is likely to make selling
investment bonds more difficult in the short term as the industry adjusts to a
move away from more traditional remuneration structures.
TCF initiative forces a revision of legacy business
The FSA’s TCF
(‘Treating Customers Fairly’) initiative has had a positive impact on the
production of literature and customer communications (for example unit
statements are much easier to understand and more comprehensive than ever
before). But it has also forced providers and intermediaries to look back at
legacy business and make sure that it is adhering to TCF principles.
Although TCF
generally has less effect on most bonds sold today, the array of legacy
products and associated guarantees and rules means extensive effort has to go
into old products to make sure they meet TCF requirements. This makes things
hard on older products, which are now judged by today’s standards.
Efforts to make with-profits more transparent
With the dotcom
crash exposing the vulnerabilities of the with-profits concept of investing
this segment of the investment bond market has been heavily scrutinised for its
complexity and especially opaque nature. The ‘behind closed doors’ features of
with-profits funds, (the mechanics of smoothing, the charging structure, and
the way that bonuses are calculated), remain a mystery to most small investors
not to mention many intermediaries and industry professionals. This is plainly
against the current trend for demanding more transparency and clear charging
structures, and makes many in the industry sceptical of the hidden structure
behind with-profits.
In reaction to
these issues, in June 2005, the FSA put into practice a set of rules and
guidance on the treatment of payouts, surrender values, MVRs and closed funds,
to help make certain that policyholders are treated fairly and that the amount
of discretion by providers is not abused.
With-profits fund
providers must now set and closely monitor target ranges for payouts and also
have in place ‘a properly articulated formal smoothing policy.’ While the
measures still allow for a certain degree of discretion, the key goal is to
ensure consistent treatment across policyholders and different timescales. In
April 2006, more new rules were implemented that gave investors the ability to
accurately compare returns available from all with-profits bonds. Life
companies are not obliged to publicly reveal information, as participation in
the industry survey is now mandatory thus removing the ability of certain
providers to conceal poor performing with-profits funds.
With greater
transparency it was anticipated that consumer understanding and confidence in
the products would increase. What has actually happened, however, is that most
of the big players who had previously been active in the with-profits sector
have actually left altogether. This has worked in favour of a few providers who
have remained active in the sector, in particular Norwich Union and Prudential,
who have benefited from the small renaissance with-profits funds have
experienced over the past couple years. Nonetheless it is unlikely the segment
will ever regain the form of its glory days earlier in the decade, especially
in light of the fact that fund performance is likely to suffer as a result of
the current market turmoil.
MiFID’s positive impact
Having come into
effect on 1 November 2007, MiFID, endeavours to provide a single jurisdiction
for all securities products. It has an impact on all stock market participants,
from buy- and sell-side firms to vendors and exchanges. The principal
implications of this new EU legislation for intermediaries catering to the high
net worth end of the investment market include:
●
Client recruitment – the directive
enhances the prospects of attracting new clients by providing services across
borders and establishing offices in other EU countries.
●
Client
categorization –
MiFID requires firms to evaluate and classify every client. The level of
protection applied depends on whether a client is deemed ‘eligible
counterparty’, ‘professional’ or ‘retail’ investor, with the latter
guaranteeing the highest level of protection. Categorisation is established
according to information obtained from the client, expressly the ‘client’s
knowledge and experience in the investment field relevant to the specific type
of product or service, his financial situation and his investment objectives.’
●
Due diligence – discretionary
portfolio managers and financial advisers are required to ensure that what they
do and advise on is suitable for each specific client. Execution-only brokers,
for example, when asked by a client to trade a complex instrument, must
evaluate if the request is appropriate. If it is not, they must warn the
client, or even (one would assume) refuse to carry out the request.
In general
intermediaries providing services to high net worth individuals have found the
obligations to categorise their clients bothersome as many individuals at the
upper end of the wealth spectrum reject the idea of being pigeonholed.
Moreover, categorization has proved to be an expensive administrative burden.
On the other
hand, firms have also come to the realization that there are also some
advantages to pulling together all this new customer information. It has given
them the opportunity to renew dated customer agreements and update internal
business procedures. Another positive residual effect of all the extra administrative
requirements has been that it gives advisory firms the chance to market new
products and services, on top of improving their advice.
If you want Dissertations on Investment Bonds, Contact Mahasagar Publications.
