Several of the issues raised in the FCA’s Thematic Review of Retirement Income Advice are inherently behavioural and therefore can be tackled only with behavioural solutions
The introduction of pension freedom reforms in 2015 fundamentally altered how investors and their advisers should approach drawing an income in retirement. However, despite the reforms being introduced nearly a decade ago, many firms’ suitability processes are still playing catch-up.
With the greater freedoms, naturally, came greater responsibility. The significant shift towards drawing an income from a fund that remains invested (potentially for many decades) has meant retirement-income decisions have become more complex, long-term pension incomes have become riskier, and giving suitable advice has required greater expertise. Understanding who clients are, and how they evolve in relationship to their retirement needs over time – and especially as they psychologically adjust to the move from accumulation to decumulation – is paramount. Alongside the greater freedom and responsibility, therefore, has come a greater need to understand and work with individual behavioural traits and tendencies throughout an extended investment journey.
The FCA’s Thematic Review of Retirement Income Advice doesn’t mention the word ‘behavioural’, or even ‘psychology’. But it’s a deeply behavioural document. Investor psychology is embedded in the spirit of every page.
It’s crucial to understand how. Because the problems the Review highlights that need to be addressed are behavioural, and therefore the solutions to those problems must be behavioural too. The first shoots of a regulatory trend towards making suitability processes more behaviourally conscious are already starting to show. The growth of those shoots appears inevitable.
The importance of understanding the direction of regulatory travel
While the Review doesn’t explicitly mention behavioural aspects of advice, it does make multiple references to the Consumer Duty rules, which are the FCA’s clearest statement of intent yet for making more explicit requirements to account for investor behaviours in advising, and communicating with, clients.
(See here for our in-depth look at Consumer Duty through a behavioural lens).
Regulation is cumulative. Each new piece of legislation or guidance is best understood in the context of what’s come before. Looking at the journey of evolving regulation indicates a clear, and consistent, direction of travel. Understanding this direction helps you to see where the regulations are heading next, and shows you how to future-proof your suitability processes now. The Thematic Review is an interesting case, because it was researched prior to Consumer Duty coming into effect, but published afterwards.
That there is a ‘behaviour gap’ between the theoretical return investors would have achieved in a behavioural vacuum, and the one they do achieve in real life has been long understood. We estimate that this gap costs the average investor 3% per year in lost returns. It’s likely that for many, if not most, investors, the worst enemy of their investing outcomes really is their own behaviours, so it’s no wonder that the FCA, as the body responsible for protecting those outcomes, is taking an ever-keener interest in ensuring advisers are adequately accounting for investor behaviours in the advice process.
(See our white paper, Behavioural Engagement Technology: Using technology to understand, map, and improve engagement in personal finance for more on this cost of lost returns, and how to recapture them.)
From disclosures to engaged choices
The most obvious example of the direction of regulatory travel is the disclosure requirements.
Not telling prospective investors important information about the features and risks of their investments-to-be in adequate detail is clearly bad. So a legal requirement to do so was inevitable. However, if a disclosure falls into a lap and nobody can understand it, or if they’ll likely forget it before they need to act on it, does it still sound suitable?
The act of disclosing information is necessary, but given that it frequently has the exact same effect on investors as if nothing had been disclosed at all, starkly insufficient.
Consumer Duty’s ‘consumer understanding outcome’ seeks to do something about this. It requires firms to make communications responsive to needs, to ensure clients understand what they’re investing in – and why – and to continue to do so as their circumstances change.
The Consumer Duty rules prompt a firm to ask: Is it clear to these clients what I’m telling them? Can I evidence that they’ve understood it? Have I proactively considered how my comms could go awry?
This is clearly highly relevant to retirement income advice. As the Review states:
The Duty sets out requirements on firms in relation to retail customer understanding. This includes a general requirement that firms ensure their communications meet the information needs of retail customers, are likely to be understood by them, and equip them to make effective, timely and properly informed decisions. This is relevant to how firms communicate the suitability of retirement income advice. Firms must also ensure their communications, for example relating to the features, costs, benefits and risks, are likely to be understood by their customers and, where appropriate, test and monitor communications to identify whether they are supporting good outcomes for retail customers.
You can see how the regulations are getting ever-more explicit. ‘Test and monitor’ communications is a further step forward from a looser encouragement, as the Consumer Duty rules include, to ‘account for’ a client’s ‘needs, needs, characteristics, and objectives’, including ‘how they behave, at every stage and in each interaction’, acknowledging, when doing this, that investors ‘are susceptible to cognitive and behavioural biases’.
The most recent regulatory changes are predominantly behaviourally driven
It's not only disclosures. The Review includes a list of regulatory requirements introduced since pension freedoms to help investors in decumulation. Every one of them is predominantly behavioural:
- earlier and more frequent wake-up packs
- a ‘stronger nudge’ to Pension Wise guidance
- investment pathways to help non-advised drawdown consumers choose investments better aligned with their retirement objectives and reduce the risk of them ‘defaulting’ into an inappropriate option
- retirement risk warnings to be given when a consumer has made a decision in principle on how to access their pension
- cash warnings so that non-advised drawdown consumers invest wholly or predominantly in cash only if they have taken an active decision to do so
These measures all focus on the environment around retirement advice, rather than the advice itself, i.e. they focus on psychologies, not portfolios. Even those that on the surface are still about simple disclosures do – crucially – recognise that behaviourally conscious timing can transform the effectiveness of a ‘warning’, and that active decisions are markedly different to passive ones.
Where will retirement income advice regulations go from here?
The Review identifies several suitability failings. It’s probably a safe bet that the regulatory spotlight will be shining on these, at least in the short-term.
The Review notes that the most serious suitability failings (such as losing valuable pension guarantees on transfer) are uncommon. And, what’s more, the infrequent transgressions are likely outside the ability of any rule-tweaking to do much about.
Other identified failings centre on ‘inconsistently applied, poorly evidenced, or insufficiently robust suitability methodologies’. They give examples of: identifying vulnerable clients; assessing knowledge and experience (‘checklist’ approaches have shown up elsewhere as a prime example of poor practice); and accounting for wider financial circumstances.
These three aspects – inconsistency, lack of evidence, and insufficient robustness – are, incidentally, foundations of Oxford Risk’s suite of suitability tools, which are designed to robustly, reliably, and repeatedly support the suitability process, such that outcomes are automatically consistent and evidenced.
While these issues are more widespread than the failures due to technical incompetence, again, the existing rules are probably sufficient to govern them.
Of far more interest and importance for predicting where the regulations will travel to next, is this:
We do not know, because the research for the Review came prior to the implementation of Consumer Duty, how many additional failings there would have been had the Review looked for failings in customer understanding, for example because while information had been ‘disclosed’ it hadn’t been done so in a way designed to help clients actually understand its message.
What do you think they will look for next time?
To us, it seems clear: a more robust and scientifically sophisticated understanding of, and subsequent accounting for, each investor’s emotional ability to take investment risk – their Behavioural Capacity. As we wrote about in more detail here, Behavioural Capacity is an essential component of suitability that can only be overlooked for so long. Our tools also explicitly enable clear identification of a largely ignored aspect of client vulnerability: behavioural vulnerability – the fact that some investors have Financial Personalities that make them more susceptible to poor and costly decisions than others.
These tools, then, will be essential for any firm to future proof themselves against the likely trajectory of future regulation. To find out more, download our whitepaper: Behavioural Engagement Technology.
Thumbnail image by Towfiqubar bhuiya on Unsplash
