Using RIY calculations to make product cost comparisons easier
Making relevant cost comparisons on products is far from easy, particularly when you can’t rely on the numbers given by product providers, but using Reduction in Yield (RIY) calculations can help make the process easier, suggests compliance consultant Stan Kirk
Reduction in Yield (RIY) has been with us as one of the disclosure requirements on illustrations for investment products for 20 years. The equivalent for loans is APR. These calculations come from the same family of compound interest calculations as discounted cash flow (DCF), internal rate of return (IRR) and return on equity (ROI). In the latter cases they are valuable and well respected tools, frequently used in the accountancy profession to evaluate business plans. Yet financial services firms do not seem to have taken RIY (or APR) to heart and it remains largely unappreciated and often even ignored. Neither has it been adopted for European investment disclosure regulations that require a simpler OCF (ongoing charges figure) disclosure. The message seems to be that professionals can and do find these compound interest tools useful, but that the client finds the concepts involved tricky to understand. So what role can RIY play in the post RDR world of more complex products and charging structures?
One of the most obvious side effects of the RDR driven ‘unbundling’ of financial services fees is that, instead of quoting the investor a single Annual Management Charge (AMC) covering all the participating parties’ fees (adviser, fund manager, platform provider, etc) these must now be disclosed separately. So headline AMC is much less informative; it may even be misleading if there are other applicable fees (such as trading or switch charges) that can’t be avoided. You could argue that it is ‘fair’ to have a fee menu so that investors only pay for those services that they actually use, but this leads to considerable complexity. The resulting potential for confusion makes comparison between competing services that much harder.
A lot of column inches have been devoted to publicising the results of various cost comparison studies (mostly not useful in any particular client situation unless identical to the client profile assumptions used in the survey) and at the same time bemoaning the increased complexity. So the job of making comparisons has become harder, but advisers can rejoice in the fact that it provides yet another reason why clients need impartial professional advice.
Cost sensitivity has also increased at the press and regulatory levels; perhaps not quite so much at the investor level.
Evaluation and ‘replacement’ business
Normally advisers are faced with two reasons for making cost comparison.
The first is to evaluate all the relevant propositions in the marketplace to reach a decision about what to recommend to the client. Most press comment is solely about this subject. The Regulator has stated that they don’t regulate cost, but that cost is a key part of suitability assessment as a result of COBS 6.1A.16G: “a firm should consider whether the personal recommendation or any other related service is likely to be of value to the retail client when the total charges the retail client is likely to be required to pay are taken into account.” In a low interest, lower return world (even with cheaper passive fund choices) total charges can often erode a third or even more of the available growth. Therefore, the FCA warns of ‘self-defeating’ recommendations, i.e. where the overall costs can outweigh the benefit of the advice and/or investing. In other words, ‘value for money’ matters when assessing suitability.
The second requirement for cost comparison has attracted even more regulatory interest with a series of five thematic reviews into transfer or ‘replacement’ business. This process requires the adviser to compare the carefully chosen, new proposition with the existing plan or plans that the client already has and is being advised to switch or replace. In my experience, the great majority of advised business is replacement business and the regulator has set out a challenging cost comparison hurdle. The most recent ‘Finalised Guidance’ from the regulator (FSA FG 12/16) gives an example of ‘good practice’ as follows; “One firm placed a limit on the additional acceptable cost of replacement business at 0.5% per annum. Recommendations could only exceed this limit in exceptional circumstances….”
In the context of other comments in the same guidance document, it is clear that the 0.5% refers to RIY and not AMC (comparison based only on AMC is labelled as ‘poor practice’ in another example). Working within 0.5% is not easy, although it is a practice standard that has grown more widespread following the work done by early platform adopters more than 10 years ago.
Cost of using platforms
There are a number of ‘soft’ benefits from moving a client from a series of ‘silo’ products, held across a number of providers, onto a platform proposition that enables ‘holistic’ asset allocation and changes, across the whole portfolio, in various ‘tax wrappers’. You can’t put a precise value on these soft benefits, but holistic asset management, wider investment choice (including new investment opportunities as they become available), 24/7 valuations, income statements for self-assessment tax filing, etc, may be worth something to the client. Where some or all of these benefits are relevant to the client these may add up to increased ‘value for money’, even if the new proposition ends up costing a bit more than the old one (which it normally does).
The question of how much additional cost is ‘too much’ needs to be addressed by the adviser firm and a policy decided and supervised. This supposes that the investment performance will be the same (i.e. that the existing plan has available a portfolio choice at the same risk level as the new), even though we all know that it won’t be. Extra cost has a known and certain effect, whereas a ‘better’ investment performance is hard to deliver and who can promise that with equal certainty?
One easily comparable number
The aim is to reduce all this complexity to one easily comparable number. The FCA’s ‘Final Guidance’ paper endorses both Projected Value and RIY as being such numbers, provided their calculation takes into account all the relevant charges, in other words, illustrates the total cost of ownership.
This does present challenges. Projected values must be done to the same growth rate or they are completely meaningless. Yet providers can vary the growth rates they use depending on their opinion of growth potential. Opinions vary so two providers frequently use different projected growth rates for much the same fund. RIY also varies according to growth rate, but not by much, so it can still be very useful even if providers use different growth rates. An even more serious issue is the charges that providers leave out of their projections and RIY illustrations. These include fund switching charges that can be highly relevant to the proposition being put to the client (highlighted as an issue in the Final Guidance document) and others, sometimes including adviser charges.
The FCA has used a very good example, covering many of these issues, in their recent “Cost and Suitability” presentation, that they have been making around the country.
1. The allocation rate and initial charge for the existing plan are now irrelevant, only charges still to be paid matter for cost comparison.
2. The AMC alone does not tell the whole story.
3. The existing plan current exit charge will reduce the amount invested in the new plan compared with staying in the existing plan. This means that effectively it is an initial charge on the new plan and should be calculated as such for cost comparison. Projected values would automatically do that, whereas the new provider’s RIY illustration would require amendment.
4. Adviser fees make no difference if they are the same (say a review fee for the analysis) but if they are contingent (or different) this will affect cost comparison.
5. The effect of the existing plan policy fee will depend on the fund size and could range from high impact (say, on a £5,000 fund) to increasingly irrelevant (on a fund above £100,000).
Assuming a larger fund, the AMC is the dominant existing plan charge and difference between the new and existing plans is already 0.5%. The effect of the exit charge will increase that in RIY to above 0.9% (assuming a 10 year RIY illustration period). That’s starting to look like being well into the ‘too much’ additional charge territory. And what about the adviser charge? Another 3% initial charge, contingent on accepting the advice, will increase that RIY difference to nearer 1.2% making things worse – or does it?
Charge for continuing advice
Say the new AMC includes a provider facilitated adviser fee of 0.5%. There may even be some trail commission in the existing plan, but that will disappear in the event of a ‘disturbance event’ (i.e. continuing advice) without reducing the provider’s charges. Shouldn’t the adviser charge a fee for continuing advice whether the client changes plans from existing to new? Indeed, many would argue that to deliver the adviser’s service proposition (say quarterly reporting, strategic asset allocation, tactical tilting or rebalancing, etc) will be more expensive with off platform plans (that may offer limited fund choice) and this should also be reflected in the adviser’s fees.
Factoring all this information into an RIY calculator now gives a difference nearer to 0.3% between the existing and the new. Is that still too much? Your professional judgement and the client will decide that.
The result effectively gives the client three choices:
1. Do nothing, keep existing plans and seek further advice as and when necessary.
2. Keep existing plans, but join the adviser’s ongoing advice service.
3. Join the adviser’s ongoing advice service and move assets to the recommended platform.
Why advisers need their own RIY calculation tool
The RIY examples given here all share a common factor, they require additional inputs over and beyond those that providers are required to take into account in their illustrations. Some of these inputs increase cost (not included in the RIY given by the provider) while keeping projected values the same. In other words, advisers now need their own RIY calculator. Some advisers may have the compound interest and spreadsheet knowledge to construct their own RIY tool. However, all advisers can access the ‘institutional strength’ calculation tools now becoming available (usually as online services) from suppliers whose normal customers are the providers. These calculators can provide suitability report ready output and the flexibility to create a level playing field by taking into account all the cost comparison factors relevant to a particular client situation.
Independent advice will increasingly mean advisers running these mission critical ‘professional judgement’ calculations themselves, rather than relying on the numbers given by product providers.