Time for a re-think on FSA fees

Tom Robinson, an economist at RGL Forensics, explains why the FSA has got it all wrong when it calculates IFAs’ contributions to its annual fees…

“The independent advice sector provides a necessary alternative to the big insurers and the high street banks. AIFA`s recent findings on the popularity of such advice support the view that independent advice is valuable and important in an increasingly complex financial world.

AIFA and director general Chris Cummings are concerned the sustainability of an independent intermediary market is threatened by the regulatory burden of FSA fees, RDR, an FSCS levy and new capital requirements.

Indeed, the total fees charged by the FSA have increased in recent years to £454m – a rise of 123% since 2001/2002.

This year, the FSA provided greater detail on its fees allocation process than in its previous consultations and AIFA asked the Regulatory & Competition Finance team at RGL Forensics to review the methodologies employed by the FSA to calculate fees.

We found that the FSA’s approach to determining fees paid by IFAs was disproportionate to their position in the financial services industry, and that there were good arguments for changes to the way fees are calculated which would significantly reduce fees paid by intermediaries.

In order to provide regulated financial services, firms are required by law to obtain the relevant ‘permission’ from the FSA. Firms with advice and intermediation permissions were allocated £127.7m in fees (28% of the total) for 2010/2011 – an amount second only to deposit acceptors.

We estimated that, of this, around £70m in fees would be paid by independent financial intermediary firms – the remainder is paid by firms which also provide financial products, such as banks.

The FSA’s fee block methodology is designed to calculate fees which reflect the costs of regulating different services covered by different permissions. This is done by allocating costs to a series of ‘fee blocks’ (such as fee block A.18 – Home Finance Advisers) and is done via the following process:

• A business plan and annual funding requirement (AFR) is prepared for the coming year for the FSA as a whole;
• The AFR is allocated to the different business units (risk, supervision, operations, executive and enforcement) within the FSA based on the allocation of costs in the business plan;
• Costs of each business unit’s activities are allocated to fee blocks. Where possible, costs are allocated directly to individual fee blocks together with a proportion of overheads (e.g. accommodation costs). The remaining indirect costs (and overheads) are then allocated pro rata to fee blocks in proportion to direct costs;
• The fee blocks are based on permissions rather than company type, so firms with multiple permissions will pay fees for more than one fee block.

In practice, the FSA model only allocates 31% of costs directly to fee blocks. A portion of overheads are added to this so that direct costs and overheads only amount to around 50% of total costs.

The remaining costs comprise indirect costs – which may include things such as industry studies or investigations - which are allocated to fee blocks pro rata to the direct costs and overheads.

This pro rata allocation is an arbitrary methodology and does not consider issues such as affordability, proportionality, the structure of the industry or the importance of IFAs to competition.

When the amount of overhead/indirect costs is small and costs are being allocated to similar firms, a pro rata approach may be a simple and pragmatic solution. However, when there is a high proportion of overheads and indirect costs and the firms to which costs are being allocated are diverse, the basis for their allocation is critical.

Economic theory tells us that the most economically efficient way for a firm to recover overhead/indirect costs is ‘Ramsey Pricing’, which, in layman’s terms, means that those who are willing and able to pay more should do so.

One measure of a firm’s ability to pay is profitability. However, a cost allocation methodology based on profit would suffer from measurement difficulties and volatility in practice. Instead, revenues can provide a useful proxy for the relative profitability of firms for the purposes of cost allocation.

RGL’s report suggested that the fee block system could be overhauled so that the costs and fees are allocated to each product type (e.g. general insurance products, life products etc.) proportionately to the revenues.

So, if intermediaries only earn 5% of total industry turnover from general insurance products, then they (as a sector) should be only charged 5% of the fees of regulating those products. This would arguably lead to more proportionate and fairer regulatory fees for advisory firms.

The FSA announced its final decision on fees in May 2010 and indicated that it would be considering AIFA’s response, including RGL’s proposals, in the consultation for fees for 2011/2012.”