Retail investment strategy – threats to the business and revenue models of asset managers and distributors on the horizon

What is the retail investment strategy and why it is here?

On 24 May 2023, the European Commission published its proposal for a retail investment strategy (RIS). Despite its name, this text is an omnibus directive amending several pieces of existing legislations with the ambition to improve the conditions for greater participation of retail investors in capital markets, which is currently lower in the European Union than in other regions.

In line with the objective of “an economy that works for people”, the Commission is seeking to ensure that the legal framework for retail investments sufficiently empowers consumers, encourages improved and fairer market outcomes and ultimately creates the necessary conditions to grow retail investor participation in capital markets.

The EU RIS Directive aims at addressing the below-mentioned problems along the retail investor journey and better serving the long-term financing needs of EU citizens:

1. Difficulties accessing salient, comparable and easily understandable investment product information
2. Risk of being influenced inappropriately by unrealistic marketing information
3. Conflicts of interest that may arise as a result of inducements paid by product manufacturers to distributors
4. High level of investment product costs not always offering value for money

Some of the items identified are not new and concern disclosures and marketing communications, inducements and value for money. However, the European Commission does not consider the existing regulatory framework to be effective enough to provide for the required level of transparency, to preclude or manage conflicts of interest and to guarantee that investors are sold cost-effective products.

For a concise overview of the details concerning the Retail Investment Strategy, including the scope and timeline, please download our dedicated brochure (PDF) or visit our RIS webpage.

When will the retail investment strategy become applicable law?

On the basis of the proposal from the European Commission, both the European Parliament and the Council will need to reach a compromise at institution level before starting interinstitutional trialogues to reach a final compromise.

Therefore,  proposed rules are still likely to be subject to change. From the date of publication in the Official Journal of the European Union, Member States will have 12 months to transpose the directive in their national law and 18 months to apply the new provisions. Therefore, final requirements should become applicable by the end of 2025 or beginning of 2026 at the earliest. The file may be further delayed if a final compromise is not reached before the end of the current European Commission mandate on 31 October 2024.

How does the retail investment strategy fit into the investment product and distribution regulatory framework?

The RIS will amend level 1 legislation impacting:

• the provision of investment services (MiFID II¹)
• the provision of insurance or reinsurance distribution services to third parties (IDD²)
• the take-up and pursuit of insurance business within the EU (Solvency II³)
• the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS⁴)
• the Alternative Investment Fund Managers Directive (AIFMD⁵)

Value for money: a price regulation?

A key element of the RIS is to strengthen product governance rules and regulate the pricing process with a view to improve value for money for investors. As part of their pricing process,  product manufacturers and distributors will be required to identify and quantify all costs and charges and assess whether such costs and charges could undermine the value which is expected to be brought by the product. Pricing of PRIIPS, UCITS or AIFs would need to consider cost benchmarks, which are relevant for the type of fund and investment strategy. These benchmarks will be developed by the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA). A similar obligation to assess costs and charges vs. a benchmark is also introduced for distributors. Investment firms that both manufacture and distribute investment products will be allowed to implement an integrated pricing process.

In case of deviation from the benchmarks, manufacturers should be able to establish that costs and charges are justified and proportionate in order to obtain authorization. It remains unclear at the moment the level of flexibility left to justify higher costs, for example, in case of innovative, alternative or sustainable products carrying higher research and development, data or due diligence costs. To a certain extent, an overly rigid presumption that costs are too high when deviating from the benchmark could introduce de facto caps on costs, and impact the way manufacturers and service providers along the value chain conduct their business and are able to attract talents or design their product range. The proposal currently states that in the absence of a relevant benchmark, manufacturers and distributors should still demonstrate that costs are justified and proportionate.

Both manufacturers and distributors will be required to report detailed cost information to facilitate the development of these benchmarks. However, insurers will need to report both product and distribution costs while distributors of insurance-based products are required to control whether all distribution costs are reported to and taken into account by the insurer.

Logically, obligations for fund managers not to charge undue costs are integrated in level 1 directives to improve supervisory convergence and enforceability.

A suitability test mainly driven by cost considerations?

The proposal foresees that the need for portfolio diversification should become part of the suitability test performed by distributors who will be expected to obtain information from their clients on their entire holdings. Beyond the additional burden, it remains to be seen how this will be articulated where the advised products are funds which are already subject to diversification such as UCITS or ELTIFs.

A suitability-light regime is also proposed but only for independent advisors recommending a sufficient range of diversified, non-complex and cost efficient products. Such advisors are not required to collect information about client knowledge, experience and their portfolio diversification. This requirement should contribute to make non-independent advice more expensive.

The Directive also foresees more standardized warnings or reports to inform clients of the outcome of the suitability or appropriateness assessments, and ESMA is expected to determine their format and content. 

Tightening conditions to receive inducements as a first step towards a full ban?

If a full ban of inducements is not yet on the table, it could be reintroduced in the future European Parliament compromise and subject to further debate with the Council. However, a significant number of Member States are opposed to the full ban at this point. The European Commission proposal includes a ban on inducements paid from manufacturers to distributors in relation to the reception and transmission of orders or the execution of orders to or on behalf of retail investors.

In case of non-independent advice, investment firms, insurance undertakings and intermediaries will have to perform a client’s best interest test, replacing the MiFID “quality enhancement” and the IDD “consumer detriment” tests. To pass this new test, distributors will have to ensure that they:

1. base their advice on an assessment of an appropriate range of financial products,
2. recommend the most cost-efficient financial product from the range of suitable financial products, and
3. offer at least one financial product without additional features which are not necessary to the achievement of the client’s investment objectives and that give rise to additional costs.

It is worth noting that this test seems to require financial advisors to recommend the cheapest suitable product (2) which is not necessarily the product offering the best value for money. It also remains unclear how the (3) alternative product to be offered without “additional features that give rise to additional costs” should be understood and notably if this means, on the basis of the additional cost of active management, that passive funds should be included in the offer when an active fund is advised, provided the clients’ investment objectives can also be met with such an alternative.

From an administration perspective, distributors have to maintain separate pools of assets when they propose both services allowing receipt of inducements and services allowing only clean shares. In order to keep operations simple and cost efficient, certain banks and distributors may want to concentrate on activities and products which do not require burdensome tests and trailer fee administration.  It should also be noted that the European Commission proposes to remove the possibility for distributors to receive and pass inducements to clients in the context of discretionary management mandates. This means that they must ensure they always subscribe to clean shares or other products that can pay inducements, such as structured products or insurance products.

The European Commission acknowledged that a full ban would be the most effective option but it did not make its way to the proposal, to avoid major disruption of distribution channels. However, the inducement regime will be reviewed three years after is transposition. Distributors and manufacturers should anticipate a full ban in the medium to long term, carefully consider investor demands for transparent and unbiased advice, remain agile in offering pertinent services and propose an appropriate range of products.

Disclosures

To respond to this demand for higher transparency and more comprehensive information, distributors will be required to separately disclose and itemize all third-party payments ex-ante and communicate their purpose and expected compounded impact on returns. ESMA and EIOPA will be mandated to develop draft RTS to set out the standardized terminology and format of such disclosures one year after the Directive’s entry into force.

Inducements will also be further emphasized and standardized in ex-post disclosures. Annual statements on costs and charges should include, inter alia, third-party payments, expressed in an itemized way in monetary terms and percentages, and performance, with the objective of demonstrating the cumulative impact on the net return.

Particularly risky products will also be required to include specific risk warnings in all client information material. European supervisory authorities will be mandated to specify the definition of these products as well as the content and the format of these warnings.

Marketing

The RIS provides for a clear allocation of responsibilities with regard to marketing communications. Product manufacturers are responsible for content and updates while distributors are responsible for the use of manufacturers’ marketing communication and are fully responsible for the communications they prepare themselves.

Member States will also be granted powers to intervene in case of unauthorized online advice or marketing, notably by financial influencers. These intervention powers will include the power to:

• order to remove or restrict access to an online interface
• order the deletion of a fully qualified domain name
• impose risk warnings

Financial literacy, professional status and advisors’ competences

The RIS spells out its ambition to improve financial literacy of the public at large through financial education. The qualification for the professional investors will also include a criterion relating to education and training which will standardize the knowledge criteria while the wealth criterion is proposed to be reduced from EUR 500 000 to EUR 250 000. This can be seen as an improvement to the opt-in conditions to qualify as professional investor but note there is no change to the number of transactions required.

Legal entities will be able to opt in for the professional status where they meet, as a minimum, two of the following criteria: 

• balance sheet total: EUR 10 000 000
• net turnover: EUR 20 000 000
• own funds: EUR 1 000 000

Financial advisors will be required to demonstrate their knowledge and competence to meet their professional obligation and maintain and update that knowledge and competence by undertaking/attending a minimum of 15 hours per year of relevant professional training proven by a certificate. The certification requirement should be key to ensuring good quality advice and to provide assurance to clients, customers and competent authorities that the level of knowledge and competence meet the required standards.

Five areas distributors should look at

Revenue model

Distributors may differentiate their revenue model on client segments across two drivers:

• tailoring fee-based advisory pricing on different clients’ willingness to pay
• leveraging discretionary mandates on additional client segments for new revenue streams

Service model

Focus on intercepting and investing in services highly valued by clients will prove key to justifying fees applied to financial advisory services. Digital and direct client education should be two core levers to sustain this process.

Distribution model

There is a need to balance the distribution mix between mutual funds and ETFs, with the latter having the potential to be employed as “building blocks” in factor-based investment strategies.

It will also be necessary to innovate and streamline distribution target operating models to improve margins and tap into new market segments.

Inducement management

Increased scrutiny over inducement justification will foster the development of new value-added services functional to qualify the increased value brought by inducements received by the distributor.

Innovation and challenges

Investments will be required for the change management on the new regulatory environment, requiring a strong focus on relationship manager training and client education to effectively convey the value of services brought by inducements received by the distributor.