Skip to main content

European Commission targets better value and a safer market for retail investors

How the proposals could affect EU business models, revenues and operations

To the point

 

  • The European Commission published its much-awaited Retail Investment Strategy in May. The proposals include some controversial aspects, particularly regarding inducements and value for money, which are expected to generate extensive debate before their finalization. Nevertheless, they give an important indication of what the key impact areas are likely to be.
  • While the strategy does not include a full ban on inducements, some of the proposals – especially those on value for money and inducements - could have a significant impact on EU retail investment firms’ business models and revenues. Manufacturers may need to consider amending pricing or product features to make them more cost-efficient, while distributors may need to review their product ranges and consider their own revenue models.
  • In their current form, the proposals could also impose significant operational impacts, as firms would need to:

- have strong governance and operational processes to assess whether costs and charges are justified and proportionate;

- evaluate whether product features are necessary to achieve particular investment objectives; and

- redesign suitability and appropriateness tests.

Firms may also need to update their IT systems to comply with the new investor disclosure rules.

The European Commission published its Retail Investment Strategy on 25 May, covering retail and insurance-based investment products. The package consists of legislative proposals for an Omnibus Directive and a Regulation amending the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation. These will now be debated by the European Parliament and the Council before becoming law, after which further detail will be fleshed out via delegated acts. The proposals have some controversial aspects – particularly on inducements and value for money – so negotiations could be lengthy, and the text could change significantly. Nevertheless, the proposals indicate the key impact areas, and if enacted, could significantly affect retail investment firms’ business models, revenues, and operations. This article outlines the most significant impacts we would anticipate if the proposals became law as they currently stand.

Value for money – product manufacturers

 

Product manufacturers would be required to assess whether all costs and charges related to the product are justified and proportionate. This includes comparing against benchmarks on costs and performance which would be developed by ESMA and EIOPA for products with similar levels of performance, risk, strategy, objectives or other characteristics. Where a product deviates from the relevant benchmark, the manufacturer should only approve it if additional testing and further assessments establish that the costs and charges are nevertheless justified and proportionate. Delegated acts would specify the criteria for carrying out these assessments. UCITS and AIF managers would also be required to prevent undue costs being charged to investors and to reimburse investors if undue costs are charged.

Experience from the UK (where authorized fund managers must already assess value) suggests that the elements needed to assess effectively whether costs and charges are justified include: an assessment framework that is consistent across products but flexible enough to reflect each product’s purpose; a sufficiently granular assessment (e.g. at share class level); due consideration given to different value indicators; and robust governance and challenge. Given the importance of pricing, firms would want to engage senior management early when developing their frameworks. Where a fund is manufactured by a third-party management company, the management company would need to cooperate closely with the investment manager.

In our view, to create meaningful comparisons, ESMA and EIOPA’s benchmarks would need to use narrowly defined peer groups so that the products are genuinely comparable in terms of investment objectives and charging structure. Since investment products are often non-standardized, there would still be cases where products would provide value despite deviating from the benchmark, but firms would need robust justifications. At this stage it is not clear how factors such as service quality or sustainability would be considered.

Value for money – distributors

 

Distributors assessing distribution costs

Distributors would have to identify and quantify distribution costs and any further costs and charges not already considered by the manufacturer, and assess whether the total costs and charges are justified and proportionate. This would include comparing against ESMA and EIOPA’s benchmarks, which would include distribution costs. If a product, together with the distribution costs, deviates from the benchmark, the firm should only distribute it if additional testing and further assessments establish that the costs and charges are nevertheless justified and proportionate.

Since distributors would have to quantify any costs and charges not considered by the manufacturer, end distributors would presumably need to consider not only their own costs and charges but also those of any other firms in the distribution chain, such as platform charges. If they cannot justify these, they may need to consider using alternative providers.

Distributors assessing product costs

To act in the client’s best interests, firms providing advice would be required to recommend the most cost-efficient product among those identified as suitable and offering similar features. They must also recommend, among the range of products identified as suitable, a product or products without additional features that are not necessary to achieve the client’s investment objectives and that incur extra costs. Further details would be set out in delegated acts.

At this stage, there is no definition of “additional features,” although examples given include funds with an investment strategy which implies higher costs, a capital guarantee, and structured products with hedging elements. The broader the definition, the greater the impact would be. Advisors would need to examine their product range to determine which product features are necessary to achieve particular investment objectives. In some cases, they may need to add new products so that they have cost-efficient products for all investment objectives, or they may remove less cost-efficient products.

These requirements are likely to result in downward pricing pressure on investment products, and could lead to more investment in simpler products, which may include index-trackers. It may also put a downward pressure on inducements, since products that have higher levels of inducements are likely to be less cost-efficient for the investor.

Inducements

 

The Commission supports a full ban on inducements, but notes that an immediate and full ban could disrupt distribution systems and cause unintended consequences. Therefore, it proposes a “staged approach” to allow firms time to adjust. This includes:

  • a ban on inducements for execution-only transactions for retail clients under MiFID, and a similar a ban on inducements for non-advised sales of insurance-based investment products under IDD (with some limited exclusions);
  • requirements for advisors to provide cost-efficient product options (see above);
  • standardizing the presentation of investor disclosures on inducements; and
  • introducing a harmonized regime for independent advice under IDD and banning inducements for it (to align with MiFID).

Three years after the package is adopted, the Commission would assess the effects of inducements and, if necessary, propose legislative measures which could include a full ban.

Many distributors in the EU receive inducements for execution-only business, so this would affect their revenues. For most distributors, inducements for execution-only business are much lower than from advice. However, some firms – including some investment platforms – rely more on inducements for execution-only business. Firms losing this revenue may want to consider the implications for their pricing and product offering strategies.

Firms would still be able to receive inducements from advice, but the requirement to provide cost-efficient product options may put a downward pressure on these revenues and affect decisions around revenue models.

Suitability and appropriateness

 

When conducting suitability tests, firms would have to obtain information about the composition of any existing portfolios, and the need for diversification. Currently, some firms offer advice that considers only one transaction, and this means that advisors would always have to consider the client’s whole portfolio. These firms would need to change their suitability model, which would increase their costs.

The proposals introduce a form of simplified advice, where advisors do not have to obtain information on the client’s knowledge and experience or on their existing portfolio composition if the advice is independent and restricted to well-diversified, non-complex and cost-efficient products. In our view, firms doing this would need strict controls around the types of products they recommend to avoid unsuitable advice.

For the appropriateness test, firms would have to ask clients about their capacity to bear full or partial losses and their risk tolerance, in addition to asking about knowledge and experience. Given these changes, firms that use the appropriateness test for all their non-advised sales to simplify their operations may decide to restrict it to where it is required.

Disclosures and marketing communications

 

The proposals aim to standardize investor disclosures and make them more suitable for digital communication. This includes more standardized disclosures on costs, charges and inducements. They also require marketing communications to be balanced when presenting benefits and risks, and Boards to receive annual reports on their firm’s marketing practices.

Firms would be required to display risk warnings for particularly risky investments. This could discourage investors from investing in riskier products, depending on the content of the warnings and what counts as “particularly risky”, which are still to be specified. As UK experience shows, there can be a trade-off between making the warnings simple to understand and providing more nuanced information about the risks.

Proposed amendments to the PRIIPs KID include moving to a digital-by-default format, introducing an “ESG dashboard”, and removing the comprehension alert for complex products. In our view, PRIIPs manufacturers may want to start considering how to display information clearly and informatively, particularly given the increased flexibility to use layering and interactive tools under an electronic format, with notable care given to explaining technical terms, including those related to sustainability.

Other proposals

 

Other proposals include:

  • minimum knowledge and competency requirements for advisors (one area where advisors may need to upskill is on sustainability)
  • widening the range of investors that can be treated as professionals on request under MiFID;
  • requiring Member States to promote measures that support financial education; and
  • strengthening supervisory cooperation and enforcement.

Next steps

 

Negotiations in the Council and European Parliament will begin soon. Given next year’s Parliament elections, a final agreement may not be reached until 2025. Once the final text enters into force, under the proposals Member States would have 12 months to transpose the Omnibus Directive. Firms would have to comply 18 months after the text’s entry into force.

Conclusion

 

Although the proposals are likely to be much debated before being finalized, many firms are already starting to assess the potential impacts on their business model, strategy and operations. 

The proposals on value for money and inducements could have a significant impact on firms’ business model and revenues. The proposals on suitability and appropriateness, and on disclosures and marketing, could have a significant impact on firms’ operations and IT systems. The proposals on knowledge and competency may require some advisors to upskill, especially on sustainability.

This article is adapted from a previous article published by Deloitte’s EMEA Centre for Regulatory Strategy.