FOOL'S EYE VIEW
Foolish Ron's New Deal

By James Carlisle
July 10, 2002

Ron Sandler is a Fool. He's got up and said that the competitive forces within the retail savings industry drive towards greater complexity, not simplicity, of products. The Wise financial services industry won't like it, but that's more evidence, if it was required, that big Ron has taken a major step forward.

The extreme complexity, and opacity, of financial products, means that the bamboozled consumer is generally unable and unwilling to purchase products without advice. Unfortunately, there is a certain level of fixed cost for that advice and, for those on middle and lower incomes, that cost is seriously detrimental to product quality.

The heart of Sandler's solution is to tweak the emphasis of regulation away from the expensive advice and towards the financial products themselves. So the Review recommends that there be a suite of simple and comprehensible 'Stakeholder' products. These can then be tightly regulated so that, with some additional safeguards (which I'll come to), they can be sold without the need for expert and highly-regulated advice.

The Review has highlighted three types of product that are required:

• A mutual fund or unit-linked life fund (rather like a unit trust);
• A pension; and
• A with-profits product.

It also suggested that serious thought be given to providing a fourth type, which would be a 'protection type' product, like life assurance.

Product Features

Charges

Charges are the easy bit. Not surprisingly, the Review concludes that they should be explicit and low. The 1% limit on annual charges already being used for CAT-standard ISAs and Stakeholder pensions is recommended as a starting point. There should be no initial charges and "there should be strictly regulated surrender charges – ideally none at all".

Controlling risk

This is where things get tricky. Sandler starts off by saying that it would be wrong to rule out particular asset classes for being too risky, since it takes no account of the basic principles of diversification (in other words, depending on the other things in a portfolio of assets, adding a risky asset may, in some circumstances, actually reduce overall risk). He says that blanket prohibitions like this would risk creating "exactly the sort of distortion to investment decision-making that this Review and the Myners Review were established to remove".

The review then looks at the possibility of controlling the "volatility" of a product (that is, how much its returns bounce around). But it concludes that any limit would be arbitrary and, besides, volatility measures are backward looking, while the dynamics of financial markets change.

So, Sandler reckons that the regulatory approach should be to "require a high level of diversification of risk". Maximum diversification means, in a given market, investing in the market portfolio: which is basically an index tracker. But, just in case you were worried that too much Foolishness was creeping in, he backs away from that conclusion at the last moment and goes the other way.

Entire markets, he says, can have very high risks. An 'emerging markets' index tracker, for example, will have the broadest diversification possible within those markets, but will still be very risky. There's another point he makes which I'm afraid I didn't quite follow, but he doesn't even mention the fact that some markets can have high concentrations in particular stocks and sectors. If you bought an index tracker for the Finnish stock market, for example, you'd have most of your money invested in Nokia.

So he ends up making two general recommendations. Firstly that every 'Stakeholder' product should have a certain amount of fixed interest securities (that is, gilts or corporate bonds) and, secondly, that the shares component of the fund should not be invested entirely in one market or sector.

Clearly a lot more thought is required on this and Sandler says that the industry should be consulted on detailed rules. The basic point, though, about wide diversification, is a good one.

With-profits

For the with-profits products, Sandler recommends a "smoothing account". This would basically mean giving full details of reserves and investment performance, so that it's made clear how much money is being "held back" from investors in the good times and how much is being given to them, out of the reserves, in bad times.

Quite how all the investors would react to this it's hard to say, but I'm not sure I'd be keen to see 'my' investment returns being kept back for investors that come after me. I'd far rather have my cake and eat it and I expect most others would too – it's only human nature. Certainly there are problems that will need to be addressed.

Point of Sale Warning

Sandler recognises that, even with tight regulation, there is scope for consumers to get themselves the wrong products. In particular, they might not recognise the risks of stock market based investments.

There are several specific problems in the case of pensions. Firstly, there is the risk that consumers invest in a personal pension, where they'd be better off investing through a company pension. Secondly, consumers need to realise that receiving a pension later on may reduce their entitlement to certain State benefits. Finally, people need to know that once money goes into a pension, you can't get it out again (until you start receiving the pension).

These issues will always be a problem, but the report has reached the conclusion that it's often counter-productive for those on low and middle incomes to receive expensive advice about them. So where does it go? The answer is in the "Point-Of–Sale Warning". This warning should (like everything) be in plain English and make certain points to the consumer, which they will then certify that they have understood. At a minimum, Sandler says they should include:

• An explanation that the consumer is being offered a limited range of simple products and that no expert advice can be given about their suitability.
• That, of the range of products, the pension would most likely not be suitable for (a) people on low incomes who are above a certain age and (b) people who had access to an occupational pension. If people are in either of these categories, they should restrict themselves to the other products and seek advice about their pension arrangements.
• That the product being sold has an element of financial markets risk, and that consumers should consider carefully before putting too much of their savings in them (there might be a specific percentage of savings mentioned here as being an appropriate limit).
• That these products are not suitable for meeting a specific future liability as their future value can not be guaranteed.
• That the products should not be considered if the intended savings horizon was less than, say, five years.

The concept of a point-of-sale warning is far from perfect. But then life isn't and "the perfect is the enemy of the good". The concept of giving perfect financial advice has rightly been discredited and a system of warnings is the natural alternative. Some "middle of the road" solutions have been suggested before, involving a certain amount of very basic advice, but these may involve the worst of both worlds: expenses and consumers placing too much reliance on the advice.

Sandler's recommendations are a major step towards creating a fairer and more effective environment for financial products, but a lot of work remains to be done. What do you, Fool, think of it all? Is the Point-Of-Sale warning enough to protect consumers? And how should the product risks be regulated? Have your say on the Fool's Eye View discussion board.

More: Savers To Get A Fairer Deal ¦ The Sandler Review