From 31 December 2012 commissions will be banned on all new product sales, including funds, via financial advisers. While this change, part of the FSA's wider Retail Distribution Review (RDR), won't initially extend to sales where advice isn't given, it likely will further down the line. The FSA also has imminent plans to prevent fund managers from paying fees to fund platforms/supermarkets.
How might all this affect the fund charges we pay moving forwards?
First, a quick recap
A typical fund (unit trust) has the following charges:
Between 3% - 5%, of which 3% is paid as a sales commission.
1.5%, of which 0.5% is paid as sales commission, 0.25% to a fund platform and 0.75% kept by fund manager (there's a bit extra on top of the 1.5% for things like custody charges that we'll ignore for simplicity).
For more details take a look at my earlier article
Funds sold with financial advice
From 31 December 2012 sales commission will be banned where financial advice is given. This means we can expect fund charges to typically fall by 3% initially and 0.5% annually.
Advisers will instead charge fees, agreed with their client. These may be paid directly to the adviser or, with the client's permission, via the fund (or, more practically, a fund platform), which will increase its charges accordingly. So we could end up with pretty much the same position as now (i.e. the adviser taking 3% initially and 0.5% annually from the fund) provided their client has signed a piece of paper giving the ok.
In practice I hope we see a prevalence of lower overall fund charges and lower cost fixed fee financial advice, which should give the majority of customers a better deal. I'm confident about the former, but less so about the latter.
Funds sold without financial advice
Funds sold on an execution-only basis (e.g. via discount brokers) will be allowed to continue paying sales commissions, so in theory no change to current charges. However, the FSA seems minded to ban commissions via this route too (which makes sense) - my guess is this'll happen by 2014. Although such change will probably only apply to new sales rather than existing (so called 'legacy') business.
Fund platform/supermarket fees
At present most fund platforms make their money by charging fund managers rather than investors. The typical charge seems to be around 0.25% a year, but as most platforms don't disclose these they're somewhat shrouded in secrecy...I've heard rumours of one large platform/discount broker demanding a total of 0.85% a year - effectively 0.5% commission and 0.35% platform fee.
The FSA has said it wants to ban fund manager payments to platforms, with investors paying an explicit fee instead. Again, greater transparency makes sense and should give most investors a better deal (provided they shop around). The tentative date for this change is 31 December 2013. If the rule change goes ahead we can expect to see fund charges fall by around 0.25% a year.
The overall impact
Put all these changes together and you come up with a simple conclusion. Fund charges for consumers should fall to 'institutional' levels - i.e. the same lower level enjoyed by professionals - where no sales commissions or platform fees are incorporated into charges. For most funds this should mean no initial charge and an annual charge of around 0.75%. Consumers will then pay an explicit fee to use a fund platform and for any discount broking or financial advice services taken. Let's hope the necessary rules are all introduced by 2014 at the latest.
However, competition in the marketplace might drive through (voluntary) change more quickly, as a couple of platform/discount brokers have already introduced this type of arrangement. Both Interactive Investor and Alliance Trust Savings rebate sales commissions and platform fees, instead charging annual platform and dealing fees. While I'd prefer them to use institutional versions of funds (as it's simpler and probably a bit cheaper), this broadly gives the same end result and provides very good value for the majority of investors.
Note: As I write Club Finance has also announced a new charging deal with full rebates, I'll update the ISA discount broker comparison shortly.
A problem for traditional discount brokers
Such new charging structures tend to make traditional discount brokers (who keep most/all trail commission) look expensive by comparison. And if/when commission on execution-only sales is banned these brokers could find themselves struggling to stay in business. Instead of receiving 0.5% annual trail commission from fund managers, they'll have to charge their clients a fee instead. Unless the broker is providing great value-added service (which is rare) then why would their customers want to stump up cash for something they probably thought was 'free' in any case?
If the ban only applies to new fund sales (likely) these brokers could continue to take trail commission on existing business, but I still think they'll struggle. Running two different charging structures would confuse customers. And more and more of those customers will probably wake up and realise they can get a much better deal elsewhere in any case.
And a squeeze on discount brokers with their own platform
Discount brokers who've invested heavily in their own fund platforms, such as Hargreaves Lansdown (HL) and Bestinvest, could suffer a double whammy if fund manager platform payments are also banned. These brokers are currently quids in, as they pocket both trail commission and platform fees, giving a potential gross margin of about 0.75% or more. After they've rebated some trail commission, usually around 0.15%, this leaves them with c0.6% of the 1.5% annual fund charge - a very healthy margin - in fact Citigroup estimates HL's average margin for Vantage clients even higher at 0.68% (partly because it doesn't rebate trail commission on its SIPP). And that's excluding the margin these companies make from paying paltry cash interest rates on their platforms. Of course, it costs money to run a platform, but margins like these are the envy of the industry.
A ban on fund manager platform payments and execution-only sales commission could see HL's and Bestinvest's juicy margins shrink overnight. They'll almost certainly have to hit their customers with explicit fees for holding funds, which will likely be met with major resistance given these services are largely perceived as 'free' at present. And, even if such fees were widely accepted, I think they'll struggle to squeeze the equivalent of 0.6% or more a year out of their customers.
Throw in the FSA requiring platforms to allow 're-registration' by the end of this year (removing barriers to move your investments 'as is' from one platform to another) and you can see why these brokers/platforms might be nervous...
So potentially bad news for some discount brokers but good news for customers?
Yes. There's a danger some fund managers will try and get away with not passing on the full extent of commission and platform fee savings to customers, but I expect this to be the exception rather than the norm. And, rest assured, we'll kick up a fuss against such offenders!
Many financial advisers will probably try and charge commission equivalents as fees taken from funds, meaning no real change for their customers (if they agree to such fees). I think there's a gap in the market for good, low cost fixed fee advice - but given the FSA seems bent on pushing up IFA operating costs whether such a service is viable on a large scale remains to be seen.
And expect more discount brokers to either follow the Interactive Investor/Alliance Trust Savings type model or attempt to add value with fund research tools and features (e.g. Dennehy Weller's fundexpert website). Neither will be a guarantee of success, but failure to do anything could see them sink not swim if the FSA does ban commissions on execution only sales.
For once the customer stands a fighting chance of coming out on top. Something that doesn't happen very often in financial services...