The RDR Game

The Retail Distribution Review (RDR) could produce the most substantial change to the structure of the industry since the demise of the direct sales force. I had a look at some simple game theory – modelling the incentives and penalties for each party to a transaction - in an attempt to understand what is driving it, and what a sustainable outcome might look like.

If you look back at the pensions industry, say, 15 years ago, you would have found a market that was characterised by two market forces relevant to this particular analysis.

Firstly, the commission paid by providers to advisers was (and often still is) determined primarily by the providers, on a basis that bears no relationship to the amount or value of work done by the adviser. Providers used commission levels, along-side product features and benefits, to compete for new business. This creates the risk of “provider bias” – where some advisers may be motivated by factors (commission levels) beyond suitability to the customers’ needs.

Secondly, providers protected themselves against “churn” by charging policyholders with exit penalties. So policyholders paid for the bulk of the costs of switching, while the advisers and providers were able to protect themselves, to a considerable extent. Because policyholders often had a poor understanding and were not particularly financially aware, there was little they could do about this.

By the end of the 1990s, politicians and regulators had identified the imbalance this second market force created. One of the results of this was the decision by the new Labour government to intervene to protect policyholders by introducing stakeholder pensions, which, amongst other things, disallowed exit penalties.

However, this stakeholder regime has still not produced equilibrium in the industry. Advisers can still benefit in the form of commissions from switching between providers, only now it is the providers (or rather their shareholders), rather than the policyholders, who bear the costs. As a result, switching has continued to escalate. The most recent persistency report produced by the FSA shows that more than 50% of policyholders have stopped paying premiums after 4 years. The FSA has recognised this. In 2006, Sir Callum McCarthy (Chairman of the FSA) described “this in-built encouragement to churn” as a “fundamental flaw in the business model” 1.

Stakeholder had simply shifted the costs of switching from the policyholder to the provider, and had failed to address the issue of provider bias.

The RDR provides the regulator with another opportunity to correct both provider bias and the costs of churn – and if it is to produce long-term stability, it must do both.

Customer Agreed Remuneration (“CAR”) is gaining increasing popularity as a possible solution. Its appeal lies in its ability to resolve both issues (along with several other advantages).

Firstly, the amount of CAR is agreed between the client and the adviser independently of the selection of a provider, who then charges a standard “factorygate” price. Although the CAR can be paid by the provider to the adviser out of a deduction from the product rather than as an additional fee paid by the policyholder, the provider has no influence over the amount of CAR to be paid. Consequently, assuming that the CAR is the only remuneration paid to the adviser, the risk of provider bias is eliminated.

Secondly, the costs of switching are now more evenly distributed between the customer and the provider. The provider continues to bear the administrative burden for switches and lost business but the policyholder bears the cost of the CAR on the advice received. The interests of all three parties are therefore more closely aligned, as the adviser will only persuade the policyholder to switch if the benefits of doing so outweigh the CAR to be deducted.

In conclusion, CAR provides an opportunity for a level of stability this industry has long lacked. 1 Speech by Callum McCarthy, Chairman, FSA Gleneagles Savings & Pensions Industry Leaders’ Summit, 16 September 2006, “Is the present business model bust?”. © Financial Services Authority


Chris Fox,
Head of Corporate Business
Email: CFox@scottishlife.co.uk
Website: www.scottishlife.co.uk