Prepare for illustration chaos

New mandatory investment return illustration requirements are generating some astonishing anomalies says Chambers Townsend Consultancy managing director Nigel Masters

The FCA is trying to simplify Key Feature Illustrations (KFIs) issued when people are taking out personal pensions or other contract based plans regulated by the FCA.  Meanwhile, there is also a further set of Financial Reporting Council rules governing the production of Standard Money Purchase Illustrations (SMPIs), which are provided annually to every member of any defined contribution pension scheme.
For years these two organisations have been trying to bring the two sets of rules into line. As a result, major changes are being introduced in April 2014 – but these are raising a number of concerns.   
Current KFI projection rules say that illustrations can be provided on three bases – a lower 5 per cent, a middle 7 per cent and a high rate 9 per cent.  Years ago the FSA started to point out that it did not believe that these rates were realistic especially for investment in bonds or deposits, so they said their rules stated that the 5:7:9 per cent rates had always been maximum rates and lower rates should be used if these could not realistically be attained.   
As a result, the larger providers – insurance companies and platforms – have for several years been differentiating the growth rates they use for different classes of investments and, in some cases, even quoting differing rates for each fund. This has been leading to increased confusion as different providers may be using different rates for the same underlying fund.
The landscape has become even more complex as since last April Sipp providers have also been required to provide KFIs for all new business, with their more complicated set of investment opportunities.  Worryingly, there is some evidence of arbitrage entering the market whereby advisers or consumers are choosing the provider using the higher projected growth rates.  Hardly a transparent level playing field, and clearly contradicting the RDR’s aims.
Next April’s changes will make the situation even more confusing.  There are several layers to these changes.  Firstly, the FCA are reducing the maximum growth rates from 5:7:9 per cent to 2:5:8 per cent.  These are gross rates of return before charges, so if charges are 1 per cent per annum the projections will then use growth rates of 1:4:7 per cent, low rates but still positive.  
But now for the other big change. The FCA has wanted to bring the KFI regime into line with that for SMPIs so from next April pension projections must be shown in real terms after further reducing the growth rates by an allowance for inflation.  This RPI rate is set at 2.5 per cent a year and means that the growth rate used in projections will further reduce to -1.5:1.5:4.5 per cent.  This means that in all cases new customers will see projections which show that after years of investing they get back less than they paid in.  Now whilst this is the reality of inflation, it is likely to deter people from saving.   
The first concern is that all those being auto enrolled into contract-based schemes will receive these projections during their opt-out window.  Up to now commentators have been surprised at the relatively low opt-out rates, but the introduction of this new regime must raise the possibility that these opt-out rates will increase and possibly increase substantially, hardly the outcome the government wishes.
A second concern is that KFIs only need to be provided to those joining contract-based schemes.  It is not a requirement for the trust-based arrangements where the first projection only needs to be provided as a SMPI one year after starting.  
A third concern for the pensions industry is that these requirements only relate to pensions – they do not apply to ISAs, nor of course to regular bank or building society savings.  Therefore cash deposits may show higher future returns than comparable pension funds. This problem is only exacerbated when it is remembered that the rates quoted above are maximum rates.  If a 5 per cent central growth projection is suitable for equities it can hardly be right for those taking a more cautious approach to investment, such as the core Nest investment funds.
One step to help create a more level playing field would be some standardisation of the core growth rates used for the same investments.  However, setting such a standard could come from the regulator but needs to be a market practise set by the industry itself.