Policy & regulatory update - September 2018
Policy & regulatory update: Change ahead!
We are amid a material overhaul of the policy and regulatory frameworks under which the financial services industry operates. Government, in line with global trends, launched an assault of new concepts and acronyms over the past decade: Twin peaks (the PA and the FSCA), COFI, TCF, RDR, retirement reform, SSF, NHI, COBT/PST and RCPD. Enough to make even an anorak’s head spin. Herewith an attempt to make some sense of what is going on.
What is the purpose of acts, policy frameworks and regulation?
The fundamental rationale for regulatory intervention in any industry is to ensure that customers are protected. It would be rather difficult to get anywhere if all motorists were free to drive on the side of the road they felt like on the day. Sound policy creates certainty and aids in the building of a better society. Sound regulation assists in building trust between providers and their customers. This is especially relevant in the financial industry, as providers have access to more information than their customers and because customers may only know decades after an initial purchasing decision whether they received value for money.
Only die-hard ideologues believe that only the government or only the market knows best. Successful countries and industries are those where governments and citizens / providers co-operate in robust, transparent and fact-based processes to find the best balance between freedom and rules. Pragmatic compromises produce better outcomes than forceful apparatchiks ruling by fiat, or tame regulators that are captured by commercial interests. This job is never done, is best attempted in small incremental steps and depend on building knowledge through hard work underpinned by good data. Unfortunately, there are many constraints and biases that can undermine these lofty ideals.
There are common biases that often undermine the efficiency of regulatory interventions in our industry:
- The Streisand effect
The entertainer Barbara Streisand sued an environmental activist for invasion of privacy in 2003. The activist took 12,000 aerial photographs of the Californian coastline to study the impact of erosion and published these on the web. One of these images showed Streisand’s cliffside mansion and she wanted it removed from the record. Before her lawsuit, the image was downloaded only 4 times by members of the public. However, more than 420,000 people eventually viewed it because of the publicity created by her lawsuit (that doesn’t count the google searches that will result from this article). This is the law of unintended consequences in action. No intervention is just virtuous. Every rule change has the potential to create winners and losers. It is very hard to identify these effects before the fact.
Real problems do exist and often require a regulatory response. But when the intervention is too blunt or extreme, much harm can be done in the process. Little regard is in many cases paid to a rational and detailed cost/benefit analysis when new proposals are made. Formal analyses very rarely attempt to cost externalities and second or third order effects.
- Caveat emptor vs. caveat venditor
There is a reason why the common law principle states that the buyer should beware. No amount of regulation will prevent the presence of bad actors or incompetent providers. When new rules are made they add costs to all providers, for the account of the customers. The regulatory approach currently globally in vogue is to attempt to shift to a ‘seller beware’ model. Time will tell whether this will add customer value.
Unpacking the changes
Twin Peaks, the Prudential Authority (PA), the Financial Sector Conduct Authority (FSCA) and the Conduct of Financial Institutions Act
Traditionally, regulation of financial services providers happened in silos. The banks were under the supervision of the Reserve Bank, while everyone else were regulated by separate line departments in the Financial Services Board. As a result, each product (bank deposits, unit trusts, life policies, retirement funds), service (investment management, financial advice and intermediation) and market infrastructure (stock and bond exchanges, depositaries) ended up with their own set of rules. This creates the opportunity for regulatory arbitrage or rule shopping, as activities that would be forbidden by one set of rules may be allowed under another. The purpose of the twin peaks intervention is to regulate by activity rather than license type, to ensure that the same rules are applied consistently to similar activities. The risks of this model include implied equivalence where none exists (e.g. where the legal form of activities is very different, but it ends up being regulated as if the different options use the same contractual principles) and lack of specialisation, leading to a hollowing out of regulatory capacity.
The implementation of the twin peaks model is well advanced, with both the PA and the FSCA now in existence, albeit still in transition from their prior roles. The PA regulates systemic integrity by setting capital adequacy requirements and performing stress tests for banks, insurance companies and in future, retirement funds offering defined benefits. What all these institutions have in common is that they promise certain outcomes for their customers, backed by their balance sheets. These promises are only as good as the quality of the balance sheet making them, hence the focus on capital strength.
The FSCA is responsible for overseeing the market conduct of all players, including banks, insurers, collective investment schemes and advisers, in their customer-focused activities. The next step in the process of fully empowering the FSCA to fulfil its new mandate is the publication of the Conduct of Financial Institutions Bill (COFI) for public comment. COFI will eventually repeal all the conduct standards under sectoral legislation (such as FAIS, the Banks Act, CISCA and the LTIA) and replace these with conduct standards applicable to all entities performing specific activities. The future conduct standards will also be the final phase of implementing the Treating Customers Fairly principles.
The intention is for the new regulators to be more proactive and forward-looking, outcomes-based rather than rules-based as well as more intensive, intrusive and judgmental. Much work remain before this vision will be fully realised.
RDR started formally in 2014. Its objectives are simply to reduce conflicts between advisers and their providers and, where possible, to reduce complexity in the industry to make it easier for customers to know what is going on. The main recommendation - a ban on commission and rebate payments between investment product providers, platforms and advisers - is uncontroversial and has already been implemented by most of the industry without any formal regulation requiring this. It has become a very complex project however, as its scope is much wider than similar initiatives undertaken in other countries, most notably the UK, Australia and the US.
The first phase of the RDR focused on the life insurance industry and resulted in new policyholder protection rules already implemented. The current phase deals with investment matters (currently in consultation) and adviser categorisation. The final phase can only commence once COFI is promulgated.
The consultation on investment matters is still at an early stage. A discussion paper was released during June with a comment deadline in August. Further detailed consultation will follow in the coming months. It is very clear that a necessary, but outstanding step is to agree on the definitions of the various activities in the industry informed by the data. The industry value chain has become complex, with a wide variety of business models. Single managers, multi-managers, funds of funds, model portfolios, white-labelling, sub-advised funds, traditional with-consent advice implementation, platforms and distribution strategies creating no or wide-ranging conflict between providers and advisers all co-exist. This complexity creates ample scope for unintended consequences if changes are not considered carefully. Key risks to avoid are regulatory interventions that end up reducing the availability of unconflicted advice, or inadvertently favour certain business models over others. Regulation should aid fair treatment of customers and fair competition, not tilt the playing field in favour of certain market participants. Blunt responses to isolated problems increase the risk of this occurring.
Adviser categorisation is the other controversial aspect of RDR. The FSCA proposes two types of advisers, regulated financial advisers (RFAs) and product supplier agents (PSAs). The differentiation attempts to answer two questions:
- Who is responsible for a bad advice outcome?
- What are the scope restrictions on the advice that can be given?
The idea is that RFAs will have no scope restrictions and will be solely responsible for the advice they give (as long as no provider influenced the outcome of the advice given). While it is not a necessary condition for RFAs to be independent, the FSCA also seem to want RFAs to be able to prove that their advice is unbiased, despite accepting that RFAs may be influenced by providers with for example a shareholding in the RFA. The intention for PSAs is to have strict scope restrictions, potentially limiting them to only advise on products and services provided by their group, which will always be responsible for advice outcomes. The theory is that PSAs should refer clients with needs better met outside their scope to an RFA. However, it is also stated that PSAs will be allowed to advise on third party funds hosted on a platform in their group. This model seems contradictory and requires clarification. It is the view of this author that regulatory scope restrictions are very problematic for investment activities, given the complexity and variety of industry models referred to above, with one advisory often using multiple models at the same time (an advisory may for example use model portfolios for clients with compulsory assets but prefer bespoke portfolios for discretionary assets).
Vigilance is required to avoid the risks created by an overzealous regulatory response to the increased complexity of the investment value chain. It would be ironic indeed if an intervention designed to simplify and reduce conflicts results in a more conflicted, less efficient and more complex industry.
A private retirement system depends on a contract between a country’s government and its citizens. The essence of the deal is that the state is prepared to give you tax breaks if you save enough to be less of a burden on society when you become too old to work. Because of the tax breaks, they also tell you how you should invest as well as when and how you can get access to your money.
Income smoothing between your working and retired years literally covers a whole lifetime. The retirement system is also heavily intermediated, often not allowing individuals any agency in deciding how to manage their own affairs. All these factors mean this will always be the most intensely regulated component of the savings industry.
The current retirement reform process started in 2004 and is nearly complete. The original objectives were to increase coverage (less than 30% of adults are in the system), increase preservation (interrupting compounding, as most people do when presented with the opportunity, is the biggest pension killer of all) and ensuring fund members receive value for money (queue a big debate about optimising for the lowest system cost or the highest retirement income; this is also a big driver of the dramatic consolidation in the retirement fund industry).
The most relevant retirement reform issues of the day are the approaching deadline for all funds to comply with new default regulations (March 2019), and the ongoing debate about the phasing out of provident funds (or introducing compulsory annuitisation in the jargon).
The big idea behind the default regulations is to make use of a combination of giving fund trustees additional duties and nudging fund members to do the right thing through better system design. It tasks trustees with
- ensuring that default investment options are simple, appropriate and offer value for money;
- offering their resigning members with preservation options, and making it easier for them to move their assets to their next employer’s retirement fund;
- recommending a retirement income plan for members; and
- ensuring members receive good information before they get access to their benefits.
While it is too early to know exactly how the new rules will change behaviour, it is very clear that it will impact the market dynamics in the R500bn living annuity market and the R100bn preservation fund market. The presence of trustee-endorsed alternatives, better information flow and an occupational retirement system designed to preserve retirement capital when changing jobs mean that there will be less demand for individual advice given the presence of alternative supply. However, retirement income is the most complex and individualised area of financial planning, and the early indications are that many fund trustees will adopt a conservative and minimalist approach in setting defaults, leaving significant scope for continued value-add by financial advisers.
The other outstanding decision is whether all retiring fund members with retirement capital above a certain threshold will over time be required to use two-thirds of their fund value at retirement to buy an ongoing pension. This is technically still government policy, but the outcome will be dictated by political rather than technical imperatives. This is an issue that should be on all advisers’ National Budget Day watch-list as this change, if implemented, will have implications for all clients with assets in provident funds.
National Health Insurance (NHI) & Social Security Fund (SSF)
Government is also considering significant changes to our social security system. The current approach is to provide a variety of benefits, operating within separate legal frameworks that have emerged at different points in history, evolved at different rates and are in different states of operational and financial health. Government’s vision is to create a more cohesive system with the ability to provide better healthcare, risk protection and retirement benefits. The ambition of aiming to achieve a quality social safety net akin to the welfare systems in Western Europe is laudable. A society that cares about its weaker members is happier, more stable and fairer than one that does not. These values are enshrined in our Constitution. Unfortunately, good intentions are not enough. Grand plans often suffer from the defect of not being costed, nor having much thought applied to how it will be funded.
The higher priority item now is the attempt to implement NHI in South-Africa. Its vision is to eventually become the single-payer for a range of prescribed healthcare benefits, provided by both public and private hospitals and medical professionals, that should be available to all free at the point of service. This has the potential to displace at least some activities currently funded by private medical schemes if all citizens are required to contribute to the NHI (national health systems are normally funded through payroll taxes paid in addition to income taxes).
It is important to note that there is still significant uncertainty about where this process is headed. While a framework bill that, if passed, will enable NHI was published earlier this year, so much of the detail is still outstanding that is very unclear what, if anything, will eventually be implemented. Tellingly, the NHI have not been formally costed (some private sector estimates put the cost of what is on the wish-list at around R500bn or more than 40% of the total tax take in 2017/8). There is no fiscal headroom to extend either government spend or the tax load any further without doing significant damage to an already fragile economy. And while it may superficially look like you can just redirect current medical aid assets to achieve different objectives, this strategy will not work well. The 8.9 million members of medical aid schemes will revolt against a fundamental policy change that will impair the quality of their care. And it is just not possible to provide similar levels of care for 6x people on the same budget currently being spent for the benefit of medical aid members. Something will have to give. This has the potential to become a significant political issue, like the union revolt that led to the delay in the implementation of compulsory annuitisation mentioned above. Oh, remember that R500bn cost estimate? The total medical aid contribution credit granted in the last four tax years was around R20bn annually, while the public healthcare budget is around R200bn.
Treat anyone telling you with high conviction how the healthcare funding landscape will unfold with some scepticism.
Given the massive funding and implementation challenges in healthcare and the operational challenges impacting the payment of social grants, proposed social security reforms have moved onto the back-burner. It does remain official government policy though.
The plan here is to expand the Unemployment Insurance Fund and the state old-age grant into a more comprehensive set of unemployment, death, disability and retirement income benefits. Well-designed benefits will provide an improved social safety net, but affordability is unsurprisingly a significant challenge. South Africa has a low labour force participation rate, making it very difficult to fund equitable benefits across both the formally employed, informally economically active and the unemployed. If this is implemented, it is likely that the system will be funded through an increased compulsory contribution by all salary and wage earners. Currently the UIF contribution limit is set at 2% of the first roughly R180,000 of earnings. A future social security contribution may be set at up to 12% of this amount. Given that this will displace existing private savings into defined contribution retirement funds, the implementation barriers are high: retirement fund members will require much convincing that it is worthwhile moving their contributions from a proven employer or union fund into an untested government scheme.
All financial service providers are subject to fit and proper requirements. This partly deals with ensuring firms have appropriate business infrastructure such as adequate capital, control and governance systems, but also with ensuring that individuals employed by these firms have the requisite skill and character to be allowed to handle other people’s money. These regulations have recently been updated with additional training and knowledge requirements.
All financial planners have been required to pass regulatory examinations since the early 2000s. These exams deal with the rules of the game. The new requirements include a second set of formal learning requirements, dealing with class-of-business knowledge (e.g. investments or retirement benefits) as well as product-specific knowledge. The implementation approach here is different to the first round of exams. Where all existing advisers were required to pass the original exams, only new industry entrants are required to pass class-of-business and product-specific training. While class-of-business training requires structured tuition and examination, the rules for product-specific training allows for self-guided learning and on-line examination. Many product suppliers are putting in place mechanisms to simplify this new compliance burden. Several investment product providers are working with the ASISA Academy and other partners to find ways to enhance the quality of training available and to provide a variety of centralised training platforms for the benefit of independent advisers.
FPI members will be familiar with continuous professional education requirements. This has now been extended to all licensed individuals, with specific regulated CPD rules set. The most significant implication of this is that there is now more emphasis placed on evidencing attendance at events or completion of online. Think more cumbersome signing in and out requirements at industry events and conferences, and the need to complete a quick test after reading or watching something online. Advisers should also ensure that they keep proper competency registers for compliance purposes.
The world of policy and regulation can seem complicated, cumbersome and sometimes even scary. But the principles are simple. When the focus is firmly on agreeing clearly defined objectives, aiming to find the right balance between rules and freedom through a robust and fact-based discussion where the social partners combine ideas and perspectives, it becomes much more likely that reasonable outcomes will be reached. This also requires an honest recognition that there are rarely easy wins; that you are trading off costs, benefits, winners and losers; that outcomes are always uncertain and often unintended. It is therefore better to proceed cautiously, make sure you have good data and to evaluate outcomes continuously. Above all, it is important to remember that very few things have life-and-death consequences. Many policy intentions do not make it off the drawing board, and the final product in most cases end up looking materially different after consultation. Taking time to understand the facts and evaluate the implications always lead to better decisions than being overwhelmed by an urge to take immediate action.