On 18 May 2022 the Financial Markets Authority released the findings of its value for money pilot study, following on from its Managed fund fees and value for money guidance note from April 2021.

In this Financial Law Insight, we take a look at the key findings from the pilot study, and what they may mean at the coal face for fund managers.

Background

In the Managed fund fees and value for money guidance note (Guidance Note) released last year, the FMA outlined its expectations of scheme managers to provide value for money from the fees they charge. The scope of the guidance went beyond the statutory prohibition on KiwiSaver schemes charging unreasonable fees, to focus on value for money for all managed fund fees. Essentially, as managers of registered schemes owe duties to their investors and are subject to broader good conduct expectations, the view articulated by the FMA is that all should be delivering value for money for investors.

Regular reviews

A key message from the Guidance Note was that the FMA expects scheme fees to be formally reviewed at least annually to assess whether fee structures are delivering value for money. Fees should also be reviewed when there are changes in the scheme that materially affect the costs involved. Scheme supervisors are expected to be involved in these reviews.

Helpfully, the Guidance Note sets out four key principles on which reviews should be based, with detailed questions provided for each. The four key principles are:

• risk and return are critical indicators of value for money for members
• the financial value of investment management must be shared
• advice and service contribute to a member’s value for money only if they are received, not just offered
• fund managers should review themselves in the same way they review others.

Pilot study

Following the release of the Guidance Note, the FMA engaged with a small pool of managers to test the Guidance Note’s assumptions and scope. The pilot involved 14 funds ‘chosen and volunteered’.

Managers were provided a self-assessment tool by the FMA to work through. The FMA’s Value for Money Industry Report (‘Report’) released on 18 May 2022 highlights the findings from the pilot study. While there were some positive comments about fund manager competence, the FMA sees plenty of room to improve.

Market index

The FMA’s view is that some managers are using inappropriate market indexes, such as a cash-based index for non-cash exposures provided by the likes of fixed income or equity-based funds.

The Report reiterates the FMA’s view that a fund’s investments and risk should not be significantly different from the investments and risk of the selected market index the manager compares its performance with. For example, a fee should not be paid for an equity fund outperforming a cashed-based benchmark, because there is unlikely to be value added by the manager regarding that ‘outperformance’. Even in the case of an absolute return strategy the FMA suggests cash benchmarks may be inappropriate.

The Report notes industry skepticism about the use of market indices. Despite this, the FMA is seeking further discussion to fully understand the industry position.

In the case of active managers, the FMA’s view is that the use of an appropriate market index eliminates market return from strategy return, i.e. the return attributable to the skill of the manager rather than just luck or market returns.

Advice fees and trail commissions

According to the Report, managers are still paying substantial sums in initial and ongoing trail commissions to third parties to acquire members, even though advice is barely provided. Its concern is that those commissions are effectively paid by all members out of the management fee, rather than just the members receiving advice. Further, where those costs are borne by the manager they are not clearly disclosed to members.

In the Report, the FMA reiterates that for a member to bear the cost of advice, that advice should be received and not just offered. Regardless, the costs of that advice (the sum and who receives it) should be disclosed to members.

That seems a long bow to draw where the cost of advice is being paid by the manager out of its own funds. However, the Report makes it clear the FMA does not accept the widely voiced industry views that trail commissions are paid by the manager, and not members. The rationale for the FMA’s view is presumably that if managers did not need to pay commissions, their cost base would reduce and they could reduce fund fees as a result.

The FMA acknowledges that advice is useful to ensure good investment decisions are made. It is asking for feedback as to what help and advice KiwiSaver members need, how such an offering would be structured to represent ‘value for money’, and how best to disclose such an offer – one which is commonly made available but differently accessed by members. In doing so, it seems to be revisiting ground canvassed in finalising the Guidance Note, perhaps indicating the FMA was not entirely happy with where the Guidance Note landed on this point.

Fee drag

Unsurprisingly, the FMA found that fee drag reduced fund benefits to investors, with fee levels substantially driven by external costs. Of course, some external fees are necessary: this is simply the cost of legally doing business in New Zealand. Mind you, we would say that!

At a certain point the FMA’s focus on continually driving down fees may compromise the ability of managers to fully and competently comply with their ever-expanding obligations under the FMC regime. Or reduce the service levels and fund options they are able or willing to offer investors. More unintended consequences, anyone?

Disclosure is not a cure

From the sentiments expressed in the Report, it appears the FMA is going all in on an interventionist approach. For a regime based on the concept of disclosure, moves to enforce a ‘value for money’ approach suggests individuals signing up for scheme membership on their own volition need more help than the FMC Act disclosure-based regime originally envisioned. What then is the value of cost disclosure? Where is the freedom for consumers to choose a provider based on their own personal considerations and to accept a fee they are comfortable paying?

Regulatory action

Although there is no express legislative basis for the FMA extending the reasonable fees concept into the non-KiwiSaver MIS space, the FMA’s approach ‘is what it is’ for managers. In this context, it would be interesting to see the outcome of the FMA attempting some ‘unreasonableness’ action in respect of a non KiwiSaver MIS. Outside KiwiSaver, there is no express statutory manager obligation regarding ‘value for money’. It is not a given that such a concept clearly falls within the duties applying to manager functions, given fees are provided for under governing deeds, are generally clearly disclosed in accordance with prescribed requirements, and are in essence agreed between the parties when a member enters into the scheme.

Will non-KiwiSaver MIS managers push back if they face direct action on ‘value for money’ matters? It could be a fight worth having, given what is at stake.

Still a chance to engage with the FMA

As noted in its media release publicising the Report, the FMA is keen to hear from industry regarding the use of certain market indices and the extent to which costs should be structured to represent ‘value’ to scheme members. The FMA is also seeking feedback on its value-for-money self-assessment tool.

Even though views may differ, we believe it is useful for MIS managers to continue to openly and constructively engage with the FMA on these points to seek some level of agreement. Failure to do so means tricky rear-guard action might be required later on.

Practicalities

The takeaway for MIS managers not part of the pilot study is to consider the findings in light of their operations. Where are external fees going? What are their costs of delivery? Can they be trimmed any further? Is the correct market index being used?

First reviews due by mid-2023

The FMA expects all MIS managers to have completed an initial value for money review of all their funds by mid-2023.

Concluding thoughts

The FMA has doubled down on the Guidance Note in the face of strong challenges from some quarters. Refer to our previous Financial Law Insight in that regard where we expressed concerns about the one dimensional nature of the Guidance Note.

In asserting that the Guidance Note was simply published to assist all MIS manager and supervisors to meet their existing obligations, the FMA is inferring that a number of MIS managers are still falling short of the mark. However, a number of managers have already taken substantive steps to align or review fee structures in light of the Guidance Note.

The rubber is now hitting the road with the Report. Regardless of whether or not you agree with the FMA’s approach, its expectations are clear and the requirements to keep a check on fees is not going to go away.

It is important for managers not to take umbrage at their previously reasoned arguments being unhelpfully described as ‘a nonsense’ in the Report. It is clear from the Report that the FMA’s door is still open to dialogue. Managers still have a chance to raise points in relation to market index choices and advice fee structures as well as the self-assessment tool. It is important to continue this engagement, as it may be the last chance to influence the direction of the FMA’s views in respect of ‘value for money’.

Start a conversation

If you would like assistance with applying the FMA’s Guidance Note or the Report, or would like to discuss any other aspect of licensee obligations for managed investment scheme managers, please contact Catriona Grover on +64 4 498 0816, David Ireland on +64 4 498 0840, Mark Schroder on +64 9 375 1120, or email the Banking and Financial Markets team.