Crystal clear

Just over a year ago, the financial services industry in the UK was anxiously awaiting the findings from the Sandler Review into the medium to long-term savings industry. Now a year after the findings from the review were first published, the implications of the Sandler Review are becoming a little clearer. So what does the Sandler Review mean for with-profits? More specifically, what does it means for offshore with-profits?

Sandler's remit was to 'identify the competitive forces and incentives that drive the industries concerned and, where necessary, to suggest policy responses to ensure that consumers are well served.'

In his findings, Sandler concluded that there were a number of factors preventing competitive forces from operating effectively in the marketplace. These include unnecessary jargon, confusing charges and a large number of products and product variations on offer. Sandler believed consumers are vulnerable because they lack understanding of both products and sales processes. Furthermore, as they only purchase financial products infrequently, they have limited opportunities to develop their knowledge. Further complications arise because costs and benefits only become clear over the long term.

He concluded that this lack of understanding on the part of consumers deters some of them from saving and investing and forces others to seek out help from intermediaries. With regards to intermediaries, Sandler outlined further potential problems. While he acknowledged that existing sales regulation protects consumers, he felt that this same regulation increases costs and prices some lower and middle income savers out of the market.

In a bid to counter many of these problems and improve market efficiency, Sandler believes simplification is key.

The recommendations

Sandler endorsed the concept of with-profits saying there was a benefit to be had from 'using pooling between different generations of policyholders to reduce risk'. He accepted that 'with-profits products have allowed investors of even relatively small sums to get access to professional asset allocation and invest in a diversified way across a broad range of asset classes.'

But, while Sandler saw merit in the concept of with-profits, he had concerns about some of the operational aspects of the investment. For example, he felt there is a lack of clarity about how funds are managed and how charges are applied. He was also concerned that the current set up could lead to conflicts of interest between providers and policyholders. Inherited estates, he felt, added to the confusion and distorted competition.

In Sandler's view, the underlying fund structure can either help or hinder transparency. Many proprietary firms operate what is known as a 90/10 fund. In this scenario, policyholders receive 90% of the surplus distributed by the fund and shareholders receive the remaining 10%. An alternative fund structure is the so-called 100/0 fund, where policyholders take 100% of the surplus. Shareholders are remunerated by way of an explicit charge to the fund.

In answer to these concerns, Sandler made a number of recommendations that have since been progressed by the Financial Services Authority (FSA). The recommendations include: separating out the investment account; the smoothing account and supporting capital to improve transparency; not allowing the smoothing account to build up a surplus over the medium to long term; setting a policy pay-out value each year and isolating the fund from profits/losses from other parts of the business.

Arguably the changes suggested for non-stakeholder with-profits will primarily affect with-profit bond providers (rather than intermediaries). Intermediaries may consider these proposals to be operational tweaks and of no consequence to the fundamental concept and benefits of with-profits. The proposed simplified product range however, will be of interest to both parties.

Simplified product range

Sandler thought with-profit bonds should also be made available as part of his range of stakeholder products. The idea behind the stakeholder range is that simplifying products and replacing sales regulation with product regulation would encourage low and medium income consumers to purchase savings and investment products by making the products easier to understand and, by removing the costs incurred by sales regulation - cheaper. Products to be offered as part of the range include a short-term savings product, a medium-term product (which can be unit-linked, with-profits or a collective investment), a pension product and a Child Trust Fund.

Exact product details have yet to be finalised but at this stage it is suggested that in order to be included in the range, a with-profit fund/bond will need the following:

• To be a 100/0 fund.

• To operate within a yet-to-be-specified charging cap. The cap will not be set until later in the year but it is likely to be as near to 1% as the government believes feasible.

• No more than 60% of the fund is to be invested in equities and property combined. The fund is to be diversified to meet the needs of a 'cautious investor investing for a five to 10-year period.'

• To have a separate smoothing account, managed to zero over the long term.

• There are to be no lock in or redemption penalties.

It is believed the tightly specified product features lessens the need for more onerous sales regulation. The FSA has been consulting on a lighter-touch simplified sales regime for the range.

The proposals may hit a stumbling block if the EU's Investment and Savings Directive (ISD) is approved in its current format. As it stands, the directive requires that a suitability test, similar to a fact find, is conducted prior to any sale of a financial service or product.

Impact on with-profits?

So what does it all mean for with-profits? More specifically, what does it means for offshore with-profits? And while the changes might be of interest to providers, what does it mean for intermediaries?

The with-profits market in the UK has come under increasing pressure in the last few years. Three years of stockmarket falls have taken their toll on fund performance, bonus rates and product sales. The market has received more than its fair share of negative press and consumer confidence in equity based products has fallen dramatically. In addition, the financial strength of providers has taken a hit. All in all, it has been a testing time for providers and some, for one reason or another, have decided to withdraw from the market. Scottish Mutual and Axa, for example, have pulled out of both onshore and offshore with-profits markets.

Looking to the future, there might be enhanced scope for international providers to set up their own with-profits funds on the Sandler principles, without the explicit access to the inherited estate of their parent. This could lead to increased competition among the providers who are left in the offshore market. There have already been a number of Sandler-friendly product launches and enhancements, both onshore and offshore, despite a lack of clarity about what the final rules and recommendations will be.

From a regulation point of view, it looks as though there will be one set of rules for stakeholder with-profits and potentially two further sets of rules for non-stakeholder with-profits; one for existing funds and one for new funds. Initial indications were that new non-stakeholder products would differ from existing products in terms of fund structure only (all new funds to be 100/0). However, this point has been widely debated and it is unclear what the final recommendations will be.

From the intermediaries point of view, the stakeholder option might be of interest for two reasons. Firstly, the simplified product and sales process reduces the need for consumers to seek out an intermediaries although many believe with-profits will always be sold, regardless of what is done to the product.

Further threatening the viability of stakeholder with-profits is the issue of supply. There is a question mark over whether there will be providers willing to offer stakeholder products within the price cap. The experience of stakeholder pensions and the effects of prolonged stockmarket falls, heightens the need for providers to choose carefully which markets to compete in.

Assuming there are providers willing to offer stakeholder with-profits and assuming there is demand from consumers, introduction of the stakeholder range could result in downward price pressure across the wider with-profits market in much the same way that stakeholder pensions affected prices across the wider pensions market. Offshore with-profits however, might be somewhat cushioned from any potential falls in prices due to the specialist nature of the market. After all, the tax advantages of offshore with-profits distinguish it from its onshore counterpart.

Potentially, a successful stakeholder market could boost offshore sales if providers and intermediaries, in the face of falling margins on the onshore side, re-direct their efforts on offshore.

Even though Sandler conditions do not apply offshore, providers are likely to experiment offshore and mirror what they are doing onshore to achieve a broad consistency of approach. A more transparent approach is likely to be particularly welcomed in the offshore market.

No-one can predict exactly how Sandler will affect offshore with-profits but it is fair to say that all should become a little clearer when the level of price cap is set, and the accompanying sales regulation is clarified, for the stakeholder product. At that stage, providers and intermediaries will decide whether they want to compete in the market. In the absence of a stakeholder market, it could be argued that the changes proposed to the core with-profit bond market are merely operational tweaks, only of interest to providers, and will have limited impact on the market.

key points

A lack of understanding on the part of consumers deters some of them from saving and investing and forces others to seek out help from intermediaries.

While Sandler saw merit in the concept of with-profits, he had concerns about some of the operational aspects of the investment.

When the level of price cap is set, and the accompanying sales regulation is clarified, the effects of the report will truly be known.

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