Paul Resnik writes, from the UK:

I’ve never seen a regulatory breakdown like the one currently gripping Europe & the UK. The FCA is making rules on the run, and the normally reserved investment industry is baying for blood after new disclosure rules came into effect on 3 January 2018. The problem is that a key component of the new rules is proving to be fundamentally flawed.

In January the European Union’s Packaged Retail and Insurance-based Products (PRIIPs) regulation began. The KIDs - Key Information Documents - are the issue. A KID is intended to disclose the potential volatility for that product but, because the rules call for five years of performance data, the information provided in some cases - possibly many cases - is either just misleading, or extremely misleading.

What I don’t understand is how this was allowed to happen. The regulation has been on the table for some time. Several times over the last few years we have talked about the flaws in the calculation and the impact it will have on investors' expectations. We can’t have been the only ones.

I am in the UK now, to better understand the depth of the problem and to look for solutions for our mapping clients and advisers. Currently, no-one knows exactly what to do. The only thing certain is that these new rules damage investment suitability and credibility, instead of making things better.

The grumblings in the media began in early January and quickly grew. The matter became so critical that the FCA took the unprecedented step of saying:

Where a PRIIP manufacturer is concerned that performance scenarios in their KID are too optimistic, such that they may mislead investors, we are comfortable with them providing explanatory materials to put the calculation in context and to set out their concerns for investors to consider.

Where firms selling or advising on PRIIPs have concerns that the performance scenarios in a particular KID may mislead their clients, they should consider how to address this, for example by providing additional explanation as part of their communications with clients.

This is, to say the least, astounding. The regulator is publicly admitting that the regulation it mandates and enforces produces misleading or meaningless results - and sanctioning product manufacturers using their own ‘work-arounds’. It’s had senior industry figures calling for FCA heads to roll, along with a few more heads in Europe for good measure!

There are two core issues:

1. Five years of performance data required in a KID is, in most cases, not enough – while in some limited cases it’s far too much. For products like short-term options a five-year extrapolated figure is just meaningless. Whereas, for long-term investment products five years of performance data simply isn’t enough to properly frame an investors’ expectations.
2. The labels used to described investments do not have agreed and accepted definitions or understandings.

The FCA is saying that if the KID data is insufficient you may provide your own extended performance data and commentary – what the FCA is calling ‘additional explanation’.

But that leaves us as much in the dark as ever! We don’t even know what content is required and/or acceptable in these additional explanations. Nonetheless, for now, the market appears to be stuck with these flawed rules.

What we do know for sure is that improved investment suitability is the intended outcome of the rule change, and that’s the business we have been in for more than 20 years. When we sit down with funds managers and advisers – as I am currently doing in the UK – we try to reinforce the basics for matching investments to the needs of clients.

Broadly, advisers must know the client’s circumstances & goals – and specifically, to really ‘know’ the client they must know their:

• Risk required – the amount of investment risk needed to achieve the goal within the timeframe
• Risk tolerance – the amount of risk they are comfortable to maintain during market volatility
• Risk capacity – the amount of financial loss that can be sustained without compromising goals

There are ways to do this accurately and meaningfully. Indeed, providing tools to do that is exactly what PlanPlus and FinaMetrica do!

For instance, subscribers have access to the FinaMetrica's Risk and Return Guide to frame clients' investment expectations both generally, and against their specific circumstances. In light of the current challenges you might look at how we present almost fifty years of historical investment data in any further explanation of risk you choose to share with clients.

We argue that one of best professional protections comes from having client's properly informed consent to their plan and the risks in their plan. That’s clearly not possible when risk descriptions are so patently flawed.

This is a rapidly evolving area and we will report again soon. In the meantime, here are some of the related articles from January that explain more of the background.

Heads Should Roll

Urgent Review Needed

Dealing with bad KIDs

Regards,
Paul Resnik