European Commission’s proposed retail investment strategy targets better value and a safer market for retail investors

At a Glance

• The European Commission has published its much-awaited Retail Investment Strategy, covering retail and insurance-based investment products. The proposals have some controversial aspects – particularly in relation to inducements and value for money – so negotiations between the European Parliament and the Council could be lengthy and result in significant changes to the text. Nevertheless, the proposals give an important indication of the Commission’s intention, the direction of travel and what some of the key impact areas are likely to be.
• While the strategy does not include a full ban on inducements, some of the proposals could have a significant impact on the business models and revenues of EU retail investment firms. Taken together, the following proposed requirements could result in downward pricing pressure on both product charges and distribution costs, including inducements:
  • the requirement for product manufacturers and distributors to assess whether total costs and charges are justified and proportionate (including comparing against benchmarks to be produced by ESMA and EIOPA);
  • the requirement for advisors to recommend cost-efficient products; and
  • the ban on inducements for execution-only business.
• 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 would also have some significant operational impacts, including the need for strong governance and operational processes to assess whether costs and charges are justified and proportionate, to assess whether product features are necessary to achieve particular investment objectives, and to redesign suitability and appropriateness tests. Firms may also need to update their IT systems to comply with the new investor disclosure rules.

Overview

The European Commission published its much-awaited 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 in relation to inducements and value for money – so negotiations could be lengthy and the text could change significantly. Nevertheless, the Commission’s proposal gives an important indication of the direction of travel and what some of the key impact areas are likely to be.

While the Commission is not proposing a full ban on inducements (at least for now), some of the proposals could have a potentially significant impact on retail investment firms’ business models and revenues. This blog sets out what we think would be the most significant impacts if the proposals became law as they currently stand, and the attached slide pack summarises the strategic, revenue, operational and IT impacts as well as the scope of the proposals.

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 a comparison against benchmarks on costs and performance which are to be published by ESMA and EIOPA. 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 this assessment. 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.

ESMA and EIOPA would develop benchmarks for all products in scope of the PRIIPs Regulation. Common benchmarks would be developed for products (or individual share classes where they have different costs) that present similar levels of performance, risk, strategy, objectives or other characteristics. The benchmarks would display a range of costs and performance, especially cases where these depart significantly from the average. Firms would be required to report to supervisors on the costs and performance of their products to help ESMA and EIOPA develop the benchmarks.

Experience from the UK (where authorised fund managers are already required to 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 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-standardised, 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, but this may be spelt out in the delegated acts.

Value for money – distributors

Distributors assessing distribution costs

Distributors of PRIIPs must 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 a comparison against ESMA and EIOPA’s benchmarks, which would be broken down by cost components including distribution costs. If a product, together with the distribution costs, deviates from the benchmark, the firm would only be allowed to distribute it if additional testing and further assessments establish that the costs and charges are nevertheless justified and proportionate. Distributors in scope of the Markets in Financial Instruments Directive (MiFID) would need to report to supervisors on distribution costs.

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

Where firms provide advice, the proposals require that, in order to act in the client’s best interests, they must recommend the most cost-efficient product among those identified as suitable for the client 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 give rise to extra costs. The criteria to assess compliance with these requirements, including for firms receiving inducements, would be set out via subsequent delegated acts. This replaces the “quality enhancement” test under MiFID II and the “no detriment” test under the Insurance Distribution Directive (IDD).

At this stage, there is no definition of such “additional features”, although examples given in the proposal include funds with an investment strategy which implies higher costs, a capital guarantee and structured products with hedging elements. The broader the definition set out in the delegated acts, the greater the impact would be. Advisors would need to go through 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 choose to remove certain complex products if they are less cost-efficient.

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 embedded into the price are likely to be less cost-efficient for the investor.

Inducements

The Commission’s impact assessment concludes that a full ban on inducements would be the most effective measure to address conflicts of interest, but the Commission does not propose one now because an immediate and full ban could disrupt existing distribution systems with consequences that are hard to predict. Therefore, the Commission proposes a “staged approach” to allow firms to adjust their distribution systems and minimise the costs of such a change. This includes:

• a proposed ban on inducements for execution-only transactions on behalf of retail clients under MiFID, and a similar a ban on inducements for non-advised sales of insurance-based investment products under IDD, with some exclusions (e.g. minor non-monetary benefits; where an investment firm provides advice on the same transaction; investment research on smaller companies). Member States would be allowed to impose stricter requirements for insurance e.g. banning inducements for insurance advice;
• requirements for advisors to provide cost-efficient product options (see above);
• standardising the presentation of investor disclosures on inducements, including explaining their purpose and quantifying their impact on expected returns in a standardised and comprehensible way; and
• introducing a harmonised 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 ultimately include a full ban.

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

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

Suitability and appropriateness

The Commission proposes that, when conducting suitability tests for advice or portfolio management, firms must obtain information about the composition of any existing portfolios, and the need for portfolio diversification. Currently, the advice market includes both advice which considers only one transaction and advice on the client’s whole portfolio, and this would mean that advisors would always have to consider the whole portfolio. Some firms would need to change their suitability model, which would increase their costs when providing advice.

The Commission also proposes 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 looking to do this would need strict controls around the types of products they recommend to avoid unsuitable advice.

On the appropriateness test, which is required where firms offer complex products without advice or where the service is not provided at the client’s initiative, there is a proposal to require firms to ask clients about their capacity to bear full or partial losses and their risk tolerance, in addition to the existing requirement to ask about knowledge and experience. This reduces the gap between a suitability test and an appropriateness test. As some firms use the appropriateness test for all their non-advised sales to simplify their operations, they would need to decide whether to restrict it to where it is required. Firms selling products through automated channels would need to integrate the new test into their online tools.

Disclosures and marketing communications

The proposals aim to standardise investor disclosures and make them more suitable for digital communication. This includes more standardised disclosures on costs, charges and inducements. The proposals also streamline insurance disclosures under IDD, PRIIPs and Solvency II and create a new insurance product information document for life products that are not insurance-based investments.

Firms would be required to display risk warnings for particularly risky investments, with ESMA and EIOPA to develop guidelines on what counts as “particularly risky”, and with the format and content of the warnings to be specified via regulatory technical standards. This could discourage investors from investing in riskier products, depending on the content of the risk warnings and the definition of “particularly risky”. As UK experience has shown, there can be a trade-off between making the warnings simple for consumers to understand and providing more nuanced information about the risks.

The proposals also require marketing communications to be balanced when presenting benefits and risks, and the content and distribution channel to be appropriate to the target market. Boards would have to receive annual reports on their firm’s marketing practices.

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 they can display information in a clear and informative way, 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:

• Standards for advisors: The proposal sets out minimum knowledge and competency requirements for advisors, including in relation to continuous professional development. One area where advisors may need to upskill is on sustainability. While requirements to collect clients’ sustainability preferences are already in force (see our blog), if advisors are required to recommend cost-efficient products they would need a detailed understanding of product sustainability features and how they match to client sustainability preferences.
• Client categorisation: The proposal allows a wider range of investors to be treated as professionals on request under MiFID, which would reduce the burden on firms in some cases and allow certain clients to access a wider range of transactions.
• Financial literacy: Member States would be required to promote measures that support financial education in relation to investment and insurance. This could increase client engagement, but it remains to be seen how much resource would be allocated and how it would be funded.
• Supervisory cooperation and enforcement: The proposal aims to strengthen supervisory enforcement through harmonising supervisory powers and increased collaboration between supervisors.

Next steps

Negotiations in the Council and the European Parliament will begin in the coming weeks. Given next year’s European 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.