Britain’s financial Services Authority has long been on the leading edge of efforts to devise better regulation on behalf of retail investors. Now, the FSA is forging ahead with a plan to overhaul the way retail financial services products are sold, which could sound the death knell for traditional commission structures in that market.

In late November, the FSA published its plans for a new model of retail regulation. The ambitious plan aims to deal with what the FSA terms “the many persistent problems” it has observed in the retail investment market over the past 20 years, many of which stem from the great imbalance in knowledge and market power that exists between the financial services industry and retail clients.

“Insufficient consumer trust and confidence in the products and services supplied by the market lie at the root of what we are seeking to address,” the FSA plan says. “The poor standards of practice that we continue to observe in our supervision of some firms serve only to exacerbate this issue.”

Some of this lack of confidence in the industry’s integrity is the result of bad practices; some of it stems from the industry’s poor image with consumers. The FSA hopes that its new regime addresses both sources of concern by enhancing investor protection and improving customers’ perception of the quality of that protection, thereby encouraging new investors to enter the market.

The FSA project represents an effort to go beyond simply treating the symptoms of fractured investor confidence and aims to tackle the root cause. “We have deliberately taken a different approach,” its plan declares, “to resolving the long-standing issues in this market than we and previous regulators have done.”

The three primary goals of this effort are: reducing the inherent conflicts of interest in industry compensation structures by improving cost transparency; raising professional standards; and drawing clearer distinctions between the types of services on offer and improving clients’ understanding of those differences.

In short, the FSA is planning to draw a clear line between firms that offer independent advice and those that provide sales, such as firms with captive sales forces, or execution-only firms such as discount brokers. Advisors in both categories would have to meet new, higher professional standards.

Firms and advisors in the sales category would have to separate the cost of the product from the cost of their advice and clearly disclose the cost of the advice. Those in the independent advice channel would be required to agree with the client on the cost of advice up front. In addition, product manufacturers will be taken out of the advisor compensation equation as much as possible.

The overriding goal of these measures to reform remuneration practices, the FSA plan says, is “for customers to understand clearly the different services being provided. To recognize the value of advice, separate disclosure is required of the costs of advisory services from product costs.”

Also, the regulator says, firms that purport to provide impartial advice must remove any ability for product manufacturers to influence advisor compensation, if that advice is to be regarded as truly independent. There are two basic ways for advisors to get paid: by the client directly or by a third party such as a product manufacturer. The FSA believes that the latter method is not necessarily a problem. That said, it worries that the process for determining what gets paid can cause conflicts of interest, which can create risks that advisors may not act in their clients’ best interests.

Arrangements in which manufacturers determine what gets paid, and when, create the potential for bias in an advisor’s recommendations, the FSA believes. Its plan suggests that this potential for bias can undermine consumer confidence. And, it notes, it may also encourage advisors to churn their accounts. That’s why the regulator intends to impose new requirements designed to curtail that influence and require distributors to set their own charges for advice.

The FSA plan notes that the FSA would like to go further and completely cut manufacturers out of the compensation chain, but that it may not be able to do this for various legal and tax reasons at this point.

Instead, under the new regime, any compensation provided to an advisor by a product manufacturer must be funded directly by a simultaneous, matching deduction from the client’s product. The FSA is also aiming to eliminate pre-determined payments, such as trailer commissions, as much as possible. The idea is to ensure that clients are bearing the cost of the advice they receive and advisors are setting their own levies, so that manufacturers can’t sway advisors with outsized or unearned commissions.

@page_break@“Our approach to advisor remuneration will be designed to reduce significantly the potential for providers to influence independent advisors’ remuneration, reducing the potential for bias (and the perception of bias) and improving overall industry sustainability and consumer confidence,” the FSA plan maintains. “We also want to improve consumer awareness that independent advice has a cost and has a corresponding value, to empower more consumers and further boost their confidence in the market.”

Introducing a new regulatory paradigm is never easy. In Canada, recent efforts such as the B.C. Securities Commission’s British Columbia model and the Ontario Securities Commission’s fair-dealing model plugged along for a couple of years. But ultimately, they were either abandoned, as in the case of the B.C. model, or revised beyond recognition, as in the case of the FDM. It eventually became the registration reform project, with far less ambitious goals than originally conceived.

However, Britain’s financial services industry is reacting favourably to the FSA’s plans. Following the announcement of the FSA’s proposed approach, the British Bankers’ Association came out in support of the proposals.

“The banks support the FSA’s approach to reforming financial advice: ensuring that everybody knows what they are paying for and that they get what they are paying for,” said the BBA’s CEO Angela Knight in a statement. “Separating the cost of the product from the cost of advice will bring clarity and certainty to consumers, and the drive toward greater professionalism among advisers will ensure their advice is of a reliable quality.”

The Association of Private Client Investment Managers and Stockbrokers said in a release it welcomes “any moves toward increasing professional standards and transparency for clients.” However, it warns, “the devil is in the details.” The FSA must be careful of unintended consequences.

The FSA concedes that there are risks in changing long-standing compensation practices and driving the industry toward charging for advice: “We need to be mindful that the market for investment advice is by no means perfectly competitive,” its plan says. “Consumers may engage an advisor because they lack the skills, information or confidence to understand financial products and services — and they may exhibit price-taking behaviours as a result.”

One of the primary risks the FSA foresees is firms adopting harmful practices such as discriminatory pricing — charging more to consumers that they perceive to be financially unsophisticated. Another risk is product manufacturers trying to undermine the rules by exerting influence over distributors in new ways. The FSA plans to address these sorts of issues in consultations, as it finalizes just how its proposals will work in practice.

The FSA is planning to phase in this new regime over the next few years. It expects it to be fully implemented by the end of 2012. IE