Unit-linked funds’ governance review (follow up to PS18/8): findings and next steps

Our Asset Management Market Study (AMMS)[3] found that authorised fund managers generally did not consider robustly whether they were delivering good value. A package of remedies to address this comes into effect later this year. But they will not apply to unit-linked funds.

Insurance companies which provide unit-linked contracts are subject to firm-level and product governance requirements, and the Association of British Insurers’ (ABI) guide to good practice for unit-linked funds[4] provides some additional practical guidance. But there are currently no specific rules which prescribe particular governance practices at the level of individual unit-linked funds. 

As anticipated in PS18/8[5], we have completed an additional review of governance standards for unit-linked funds (funds whose performance determines the benefits due to holders of unit-linked insurance contracts). Our evidence suggests similarities in fund governance practices for unit-linked funds. Unit-linked funds account for approximately £1 trillion of assets, making them similar in size to authorised funds.

Benefits under unit-linked insurance contracts are determined by reference to the performance of underlying linked investments. Unit-linked insurance contracts are often linked to open-ended, pooled investment funds (unit-linked funds). Most UK pension savers who are members of defined contribution pension schemes invest in financial markets via unit-linked funds. Typical investors in unit-linked funds (via a unit-linked insurance contract) might have difficulty in distinguishing this type of investment from investments in authorised funds since both investment types share many common features.

As we found for authorised fund managers of authorised funds, insurance firms’ fund governance for unit-linked funds often does not include considerations that we believe are likely to be important in assessing whether unit-linked funds provide good value for their investors. Specifically, we found limited consideration of unit holders’ interests in decision-making around levels of fees and charges.

Who this review is of interest to

• Insurance company providers of unit-linked insurance contracts, such as pension products and investment bonds, where the benefits of these products are linked to unit-linked funds.
• Investors in unit-linked funds, including pension savers in most defined contribution pension schemes.
• Investors in unit-linked investment bonds.

Why we conducted this review

A key finding of the AMMS was weak price competition in the sector. This was partly because retail investors do not usually negotiate with asset managers and because fund governance bodies acting on their behalf do not typically focus on value.

In response, new rules coming into effect later this year will strengthen and clarify authorised fund managers’ duty to act in the best interests of their investors. This includes requirements for an annual review of value and for increased independence. These new rules will not apply to unit-linked funds. Insurance companies are not subject to the Collective Investment Schemes sourcebook (COLL) or other Handbook rules that impose a specific requirement to apply governance standards considering value at fund level.   

Unit-linked funds offer many similar features (and are of a similar size, in aggregate) to authorised funds. They are the dominant fund structure through which people save for their defined contribution pensions. So, we wanted to find out whether there are similarities between unit-linked funds’ governance practices and those for authorised funds.      

What we did

We reviewed documents provided by firms offering unit-linked insurance products. This was followed by visits involving interviews with firms’ senior management to understand how unit-linked fund governance works in more detail. We focused on how firms assess the value provided by the funds they operate, in the context of the fees and charges paid by investors. Additionally, how they take action to improve value where their assessments conclude this is needed. Where firms have chosen to levy fees and charges at the level of product wrappers rather than within unit-linked funds themselves, we discussed how they assess value at the product wrapper level. We also spoke with members of the independent governance bodies (IGCs and Governance Advisory Arrangements (GAAs)) that oversee firms’ workplace pension products to understand how they consider the value provided by these products.

Findings

How firms think about value is sometimes too limited

Some firms only consider performance net of fees and charges, with limited assessment of how active the manager of a unit-linked fund had been in achieving the net performance. Some funds’ fees were set such that it was likely they would generate outcomes similar to those of low risk products such as risk-free bank deposits, even though the funds were investing in higher risk equities and corporate bonds. A few of the firms had a more comprehensive set of criteria for assessing value. This included the quality of additional benefits and services provided with their unit-linked funds, and the frequency and clarity of their communications and other engagement with investors.

Firms often do not compare fund fees with others in their range

Firms typically do not compare the fees and charges of different funds within their unit-linked fund ranges, even where funds have similar mandates. Firms were generally unable to provide reasons for significant disparities in fees and charges among otherwise similar funds, beyond describing market pricing practices when the unit-linked products offering these funds were sold.

Firms share scale economies with funds only to a limited extent

Where firms appoint asset managers within the same corporate group to manage unit-linked funds, we often found less-extensive efforts to negotiate savings in asset management fees as the funds grew in size, relative to where firms appoint external managers. These firms were also typically less likely to address a fund’s underperformance with timely and meaningful measures, such as changing the fund’s manager.

If firms do identify scale economies and other opportunities to achieve efficiency gains, they often only pass benefits on to unit holders through reduced fees where they are contractually obliged to do so. This can lead to a firm treating groups of funds quite differently depending on how terms and conditions vary between its unit-linked funds. 

Firms comply with regulatory interventions but tend not to go further

Firms have passed on the benefits of default fund workplace pension fund fee caps to unit-linked funds that are within scope of the cap. But they had typically not considered whether they should run other, similarly-managed funds in their range at the same rates to provide better value to all their customers.

Firms have typically responded to other regulatory initiatives, such as our guidance on the fair treatment of long-standing customers[6], by reducing fees for the most expensive funds in their range. Where firms had cut fees, we observed limited ambition in the scale of reductions which were not always calibrated in such a way as to ensure good customer outcomes. For example, we saw that some funds’ charges were reset to ensure that, at maturity, investors received at least their initial investment plus an adjustment for inflation. We saw others that were reset to achieve the same return as a risk-free bank deposit. These were funds that invest principally in equities and bonds, with commensurate levels of investment risk.  

Firms were unable to show us how product features other than asset management were good value

Sometimes, funds’ asset management charges accounted for a very small percentage of the total product charges. But, even in such circumstances, we saw little evidence of substantial assessments of whether other product benefits and services offered good value.    

Firms check their competitors’ prices but not apparently with the aim of competing on price

We observed firms comparing their unit-linked funds’ fees and charges with those of other firms. However, we saw that the aim appeared not to be to undercut their competitors but rather to ensure their pricing structures were within the standard ranges in the market. One firm commissioned consultants to compare its funds’ charges with those of competitors, but required the consultant to do so using assumptions that appeared to flatter the firm’s funds. The firm used the consultants’ output to suggest that its funds are good value.

Institutional customers often drive hard bargains; they may have less need of the investor protection afforded by fund governance

We saw stronger evidence of more effective demand side pressure where decisions on the selection of unit-linked products are made by institutional investors that are advised by an investment consultant (including most large pension funds). We could see that this typically led to significantly lower fees and charges than for similar unit-linked funds sold to retail investors. Institutional investors and/or their investment consultants often push firms to be competitive in the prices they charge, and are also active in assessing on-going performance (switching providers when they experience poor performance).

The impact of independent governance bodies has been positive if limited

IGCs and GAAs have a remit to oversee unit-linked fund performance but only to the extent that funds are used as investment vehicles for workplace pensions. Their oversight does not extend to other products that invest using unit-linked funds, including non-workplace pensions and investment bonds.

Some of the IGC and GAA members we met told us that they saw their role principally as checking that the firm had a reasonable process for assessing value, rather than undertaking their own value assessments. They said they had been successful in tackling ‘quick wins’, typically involving fee reductions for the most expensive workplace pensions where investors were projected to experience very poor outcomes. They’d paid less attention to other funds. A common view was that they had not been inclined to challenge fees if firms had matched fees to relevant charge caps, even where firms appeared to benefit from substantial economies of scale and other efficiency gains. IGCs were not breaking down the total fees of each unit-linked fund or product among the various component parts of the unit-linked service provision (eg asset management, administration, distribution) before assessing their value. This means that the quality and benefit to investors of each component was not being considered in the context of the additional costs investors were incurring for that component.

IGC/GAAs voiced some frustration that their annual reports are not always given sufficient prominence on firms’ websites and in investor communications. We saw at least 1 case of an annual report that was quite critical of the value for money offered by a firm. This did not appear to have affected the firm’s subsequent sales, suggesting that the report’s message had not influenced investors’ decision making.

Next steps

We will assess the findings from this review alongside those from our continuing work on non-workplace pensions, the governance of unit-linked mirror funds and the effectiveness and scope of IGCs. We will then decide whether further remedies are needed.