Topic 1 Flashcards
1.1 How would you define money?
A,a medium of exchange – it can be exchanged for goods and
services;
B, a unit of account – a common denominator against which the
value of goods and services can be measured; and
C, a store of value – money received as payment today can be
stored until required
1.2a What is intermediation?
Companies with surplus liquidity lend to companies with a cash deficit to increase the value of their funds in the future.
A financial intermediary is a middle person for example a bank/building society that borrows from the surplus party to lend to the deficit. The intermediary charges interest on the loan to the deficit company and pays some of that back to the surplus party.
1.2b what is disintermediation?
Lenders and borrowers interact directly rather than through an intermediary.
1.2.1 what are the four elements of intermediation? (Need)
Geographic location
Aggregation –
The lender might not have enough money available to satisfy the borrower’s
requirements. Intermediaries can overcome this size difference
by aggregating small deposits.
Maturity transformation – the borrower may need the funds for a longer period of time than the lender is
prepared to part with them. The majority of deposits are very short term
(eg instant access accounts), whereas most loans are required for longer
periods. Intermediaries are able to overcome this by offering a wide
range of deposit accounts to a wide range of depositors, thus helping to
ensure that not all of the depositors’ funds are withdrawn at the same time.
Risk transformation – individual depositors are generally reluctant to lend
all their savings to another individual or company, mainly because of the
risk of default or fraud. However, intermediaries enable lenders to spread
this risk over a wide variety of borrowers so that, if a few fail to repay (ie
default), the intermediary can absorb the loss.
Risk intermediation?
(Insurance)
Insurance, which can be defined as “a means of shifting the burden
of risk by pooling to minimise financial loss”. Insurance involves individuals
contributing – via their insurance premiums – to a fund from which the losses
of the few who experience certain adverse circumstances are covered. Insurance is an intermediation like banks.
What are product sales intermediaries?
They intermediate between banks and insurance to customers. (Mortgage advisors)
1.3.1what does the Bank of England do?
It acts as a banker to the government, supervises the economy
and regulates the supply of money.
What are the 7 main functions of the Bank of England in the UK economy?
Issuer of banknotes – the Bank of England is the central note-issuing
authority and has a duty to ensure that an adequate supply of notes is in
circulation.
Banker to the government – The Bank provides finance to cover any deficit by making
an automatic loan to the government. If there is a surplus, the Bank may
lend it out as part of its general debt management policy.
Banker to the banks – In
this capacity, the Bank can wield considerable influence over the rates
of interest in various money markets, by changing the rate of interest it
charges to banks that borrow or the rate it gives to banks that deposit.
Adviser to the government - it has built up a
specialised knowledge of the UK economy over many years, is able to advise
the government and help it to formulate its monetary policy. It sets the base rate is to ensure that the government’s
inflation target is met.
Foreign exchange market – the Bank of England manages the UK’s official
reserves of gold and foreign currencies on behalf of the Treasury.
Lender of last resort – the Bank
of England traditionally makes funds
available when the banking system is
short of liquidity to maintain confidence
in the system. This function became very
important in 2007–09 following a run on
Northern Rock and subsequent liquidity
problems for a number of other banks.
Maintaining economic stability – the Financial Policy Committee sits within
the Bank of England. It looks at the economy in broad terms to identify and
address risks that affect economic stability.
What are gilt-edged securities?
They are loans
to the government.
What is the Bank of England role as a Regulator? (In terms of dates and events with the treasury, FCA and PRA)
The Financial Services Act 2012, effective from 1 April
2013, divided responsibility for financial stability between
the Treasury, the Bank of England and two new regulators:
the Financial Conduct Authority (FCA) and the Prudential
Regulation Authority (PRA).
The Bank of England and Financial Services Act 2016 modified
the Financial Services Act 2012 to give more powers to the Bank
by bringing the PRA within it, ending its status as a subsidiary,
and establishing a new Prudential Regulation Committee (PRC).
1.3.2 what is a proprietary and mutual organisation?
The great majority of the large financial institutions are proprietary
organisations, which means that they are limited companies. As well as dividendes and ownership the shareholders can also contribute to
decisions about how the company is run by voting at shareholders’ meetings.
By contrast, a mutual organisation is one that is not constituted as a company
and does not, therefore, have shareholders. The most common types of mutual
organisation are building societies,
A mutual organisation is, in effect, owned by its members, who can determine
how the organisation is managed through general meetings similar to those
attended by shareholders of a company.
What is demutualisation?
Since the Building Societies Act 1986, a building society has
been able to demutualise – in other words, to convert to a bank
(with its status changed to that of a public limited company).
Such a change requires the approval of its members. This is partly because
of the windfall of free shares to which the members have been
entitled following the conversion of the building society to a
company.
A number of building societies demutualised in the late 1980s
and early 1990s as a result of the change in the law.
The possibility of a windfall for members led to a spate of
‘carpetbagging’ in the 1990s. This refers to the practice of
opening an account at a building society that is expected to
soon convert, purely to obtain the subsequent allocation of
shares. In response, societies considering conversion sought
to protect the interests of their long-term members by placing
restrictions on the opening of new accounts.
In the past, some mutual life assurance companies, including
Aviva and Standard Life Aberdeen, have also elected to
demutualise.
1.3.3 what is a credit union?
A credit union is a mutual organisation run for the benefit of its members. In
the past, the members had to share a ‘common bond’, for example, by working for the same
organisation, living in a particular area or belonging to a particular club or
other association.
They changed the Credit Unions Act 1979 and on 8 January 2012 credit unions no longer had to prove that all
members have something in common. As a result, they can now provide services to different groups of people, not just people with this ‘common bond’.
To join a credit union, the member must meet the membership requirements,
pay any required entrance fee and buy at least one £1 share in the union.
Credit unions can choose whether to offer ordinary shares (which are paid up and bring all the benefits of credit union membership), or deferred shares,
which are only payable in special circumstances.
All members of the credit union are equal, regardless of the size of their shareholding.
Traditionally, credit unions operated in the poorer communities as an
alternative to ‘loan sharks’, providing savings and reasonably priced short-
and medium-term loans to their members. In more recent years, it has been Recognised that credit unions have a strong role to play in combating financial
exclusion and delivering a range of financial services and financial education
to those outside the mainstream. The government has therefore supported
a number of initiatives and enacted legislation to widen the scope of the
movement.
Credit unions are owned by the members and controlled through a voluntary
board of directors, all of whom are members of the union. Board members
are elected by members at the annual general meeting (AGM). Although the
directors control the organisation, the day-to-day management is usually
carried out by employed staff. Credit unions are authorised and regulated by
the Financial Conduct Authority (FCA), and savers are protected through the
Financial Services Compensation Scheme (FSCS).
What products and services does a credit union offer?
Credit unions offer simple savings and loan facilities to members. While some
credit unions offer a fixed rate of interest on savings, most offer a yearly
dividend pay-out. Credit unions that choose to pay interest must
show that they have the necessary systems and controls in place and have at
least £50,000 or 5 per cent of total assets (whichever is greater) in reserve.
Members’ savings create a pool of money that can be lent to other members;
the loans typically have an interest rate of around 1 per cent of the reducing
balance each month (with a legal maximum of 3 per cent of the reducing
balance).
They also have basic
bank accounts, insurance services and mortgages.
Top topic in test:
A unique feature of credit unions is that members’ savings
and loan balances are covered by life assurance.
This means that any loan balance will be paid off on death,
and a lump sum equal to the savings held will also be paid,
subject to overall limits.
1.3.4 What is the difference between retail and wholesale banking?
What is an interbank market?
wholesale transactions are much larger than retail ones. the end-users of retail services are normally individuals and small businesses, whereas wholesale services are provided to large companies, the
government and other financial institutions.
Retail banking is primarily concerned with the more common services provided to personal and corporate customers, such as deposits, loans and payment systems.
Wholesale banking refers to the
process of raising money through
the wholesale money markets in
which financial institutions and
other large companies buy and sell
financial assets. This is the method
normally used by finance houses,
but the main retail banks also use wholesale banking in order to top up deposits from their branch networks as necessary very quickly from the interbank market.
Wholesale banking operations are riskier than retail banking. Following the 2007–09 financial crisis, regulators sought to ensure that banks involved
in both retail and wholesale banking did not expose their retail customers’
deposits to risk as a result of their wholesale operations. This approach is
referred to as ‘ring fencing’ and was implemented in the UK banking sector on 1 January 2019.
Building societies are also permitted to raise funds on the wholesale markets,
but are restricted to 50 per cent of their liabilities; the remainder must come
from deposits. For banks, there is no restriction.
Some organisations are clearly based at the wholesale end of the market,
notably product providers such as life assurance companies and unit trust
managers. Other organisations and individuals, such as insurance brokers and financial advisers, are purely retailers of the products and services offered by the providers. That said, the distinction between ‘retail’ and ‘wholesale’
in financial services is much less obvious than it used to be, with many institutions operating in both areas. Product providers that sell direct to the public or through their own dedicated sales forces are, in effect, operating in
both a wholesale and retail capacity.
Interbank market: A very large market which recycles surplus cash held by banks, either directly between banks or more
usually through the services of
specialist money brokers.
1.3.5 what are Libor and Sonia?
The London interbank offered rate (Libor). Libor used to act as a reference rate for the majority of corporate lending, for which the rate is quoted as Libor plus
a specified margin. Libor rates were fixed daily and varied in maturity from
overnight through to one year.
Libor was an average calculated using the information submitted by major
banks in London regarding the interest rates they were paying to borrow from
other banks. It was supposed to be an assessment of the health of the financial system, and the confidence felt by the banks as to the health of that system
was reflected in the rates they submit.
In 2012, it was discovered that banks were falsely inflating or
deflating the rates they claimed to be paying so as to profit
from trades, or to give the impression that they were more
creditworthy than they were.
A review recommended that banks submitting rates to Libor
must base them on actual interbank deposit transactions,
and not on what rates should be or are expected to be. It also
recommended that banks keep records of the transactions
to which the rates relate and that their Libor submissions be
published.
The activity of “administering and providing information
to specified benchmarks” came under the regulation of the
Financial Conduct Authority (FCA) from April 2013. Under the
Financial Services Act 2012, knowingly or deliberately making
false or misleading statements in relation to Libor-setting
became a criminal offence. Responsibility for administering
Libor passed to Intercontinental Exchange Benchmark
Administration in 2014
In 2016, the EU developed a Benchmarks Regulation, which
the UK retained post-Brexit and now forms the backbone of
the UK’s regulatory framework for benchmarks such as Libor
and Sonia.
As a result of the Libor scandal, a shift has been made to Sonia (sterling overnight
index average). Sonia was introduced in 1997 and has been administered by the
Bank of England since 2016, with calculation and publication responsibilities
also passing to the Bank following a reform of Sonia in 2018 (Bank of England,
2021). It is based on actual transactions and reflects the average of the
interest rates that banks pay to borrow sterling overnight from other financial
institutions and other institutional investors. Sonia is an important benchmark
used by financial businesses and institutions to calculate the interest paid on
swap transactions and sterling floating rate notes.
How can a bank involved in wholesale banking raise money quickly
in order to finance business activities?
a) By a further issue of shares.
b) By borrowing from the Bank of England.
c) By calling in their debts.
d) From the interbank market.
d) From the interbank market.
What are the four main reasons why individuals and companies
need financial intermediation?
Geographic location – lenders and borrowers are not necessarily able
to find each other and deal directly with each other.
Aggregation – an individual lender might not have enough funds to
fulfil a borrower’s requirements.
Maturity transformation – the borrower might need funds for longer
than the lender is prepared to lend.
Risk transformation – the lender might be reluctant to lend all their
funds to one borrower, in case that borrower is unable to repay.
What is the key difference between a mutual organisation and
a proprietary organisation?
A mutual organisation is owned by its members – in the case of a building
society, these are savers and borrowers; for a life assurance company
they are the policyholders. A proprietary organisation is owned by its
shareholders and is a limited company.
A financial transaction that is carried out directly between an
organisation with surplus funds to lend and one that needs to
borrow is an example of:
a) demutualisation.
b) disintermediation.
Disintermediation.
Which one of the following is not a role of the Bank of England?
a) To regulate the supply of money and manage gold reserves.
b) To act as financial ombudsman in resolving customer
complaints about banks.
c) To act as adviser to the government.
d) To set interest rates.
To act as financial ombudsman in resolving customer complaints about
banks.
Which institution issues UK banknotes?
a) The Bank of England.
b) The Treasury.
c) The Royal Mint.
The Bank of England. The Royal Mint issues coins.
Credit unions cannot pay interest on savings. True or false?
False. Credit unions can pay interest on savings as long as they have the
necessary systems and controls in place and have at least £50,000 or 5 per
cent of total assets (whichever is greater) in reserve.
Freshfood Ltd supplies fruit and vegetables to market traders
and small shops. The banking transactions it carries out are an
example of:
a) wholesale banking.
b) retail banking.
Retail banking. Wholesale banking involves providing funds to other
financial institutions or very large corporate clients.
Who is responsible for administering Sonia?
a) The FCA.
b) The Bank of England.
c) The Monetary Policy Committee.
d) The Prudential Regulation Authority.
The Bank of England is the administrator for Sonia. The FCA used to
regulate the Wholesale Markets Brokers’ Association as the calculation and
publication agent. In April 2018, the Bank of England assumed calculation
and publication duties.
2.1 what are the four key macroeconomic objectives?
Price stability – involves a low and controlled rate of inflation. It does
not mean, however, that zero inflation is desirable and there is a body
of economic opinion that believes that moderate inflation can stimulate
investment, which is good for the economy.
Low unemployment – involves expanding the economy so that there is
more demand for labour, land and capital.
Balance of payments equilibrium – a situation in which expenditure on
imports of goods and services and investment income going abroad is
equal to (ie in equilibrium with) the income received from exports of goods
and services and the return on overseas investments. The exchange rate
of the country’s currency is linked to the balance of payments, and most
governments aim to keep the price of currency stable at a level that is
not so high that exports will be discouraged but not so low as to increase
inflation.
Satisfactory economic growth – the output of the economy is growing in
real terms over time and standards of living are getting higher.
2.1 The four objectives of macroeconomics tend to fall into two pairs. What are these pairs and why?
How generally do governments trade off objectives against each other?
policies to reduce unemployment will also boost growth;
measures to reduce inflation will also help to improve the balance of
payments.
Governments generally have to trade off objectives against each other, ie they
want price stability but know that the price of getting rid of inflation altogether
would be very high unemployment, so they accept a low inflation rate to avoid
pushing the economy into recession.
What are the four phases of economic activity and what is their pattern?
Recovery and
expansion:
Interest rates, inflation and unemployment are low.
Consumers have money to spend. Demand for goods
and services rises, pushing prices up. Share prices
improve as businesses flourish.
Boom: to prevent the economy from overheating, the Bank of
England may intervene by putting up interest rates to
control consumer spending and dampen inflation.
Contraction or
slowdown:
Once the interest rate rises start to bite, consumer
spending falls. Demand for goods and services falls,
profits fall (as do share prices) and unemployment
rises. Inflation slows down.
Recession: As the economy heads towards its lowest level of
activity, the Bank of England may intervene to reduce
interest rates in a bid to stimulate demand and set the
economy on the path back to recovery.
What is the consumer price index?
A measure of the change in price of
a ‘basket’ of consumer goods and
services over a period. Items to be
included in the ‘basket’ are reviewed
regularly to ensure it provides an
accurate reflection of consumer
spending. It is the equivalent of the
Harmonised Index of Consumer Prices
(HICP) used within the eurozone.
2.2 what is monetary policy?
Measures taken to control
the supply of money in the
economy (eg by raising or
lowering interest rates) in
order to manage inflation.
What is the function of the MPC in relation to interest rates, and how do they go about their role?
Interest rates are set by the Bank of England’s Monetary Policy
Committee (MPC).
Each member of the MPC has expertise in the field of economics
and monetary policy. The MPC usually meets eight times a year
over three days to set the interest rate that it judges will enable
the inflation target to be met. The minutes of the meetings are
published simultaneously with the interest rate decision.
To help produce its projections, the MPC uses a model of
the economy that provides a framework to organise thinking
on how the economy works and how different economic
developments might affect future inflation.
Every quarter, the Bank publishes its Inflation Report, which
gives an analysis of the UK economy and the factors influencing
policy decisions.
2.2.1 what is the impact of interest rate changes?
If the MPC decides to change the Bank rate, the banks and similar
deposit-takers follow suit. Whether lending or taking deposits, a bank will apply a margin between the rate at which it borrows money and the rate at which it lends the money out, in order to cover costs and generate a profit.
2.3 What is a fiscal policy?
The adjustment of levels of taxation and public spending in a way that is
intended to achieve the government’s macroeconomic objectives.
Because the public sector is responsible for taking a large amount of money
from the private sector and for making large amounts of expenditure on its
behalf, any changes have a significant effect on the economy as a whole.
How is the budget for the UK set out?
Each year the Chancellor of the Exchequer makes a Budget
statement to the House of Commons outlining the state of
the economy and the government’s proposals for changes
to taxation. The House of Commons debates the Budget and
scrutinises the subsequent Finance Bill, which enacts the
Chancellor’s proposals.
The Budget also includes forecasts for the economy, which are
provided by the Office for Budget Responsibility (OBR).
What is a public sector net cash requirement?
A government that has a deficit must borrow to finance it. The public
sector net cash requirement (PSNCR) is a cash measure of the public
sector’s short-term net financing requirement.
How does Fiscal Policy have macroeconomic effect on the economy and inflation?
Changes in taxation affect the market for financial services and products in
two main ways. What are they?
Increased general taxation reduces the amount of money available for
investment or to fund loan repayments.
Tightening of the taxation regime in relation to particular products or
activities makes them less attractive to investors. For example, in April
2016 a stamp duty land tax supplement was introduced in respect of the
purchase of second properties. This followed concern that first-time buyers
were being priced out of the housing market as a result of demand from
buy-to-let landlords.
What is the impact of Brexit?
On 23 June 2016, the British public voted in a referendum for
the UK to leave the European Union (referred to as Brexit).
The UK stopped being a member of the European Union (EU)
on 31 January 2020. During a transition period that ran until
31 December 2020, the UK continued to follow all the EU’s
rules and its trading relationship remained the same (BBC,
2020).
As the UK onshored aspects of the EU’s financial regulatory
framework (ie retained certain EU laws and regulations in UK
statue), legislation and wider issues relating to the UK, and its
legacy of membership of the EU covered in this text, remain
important areas within the syllabus for this qualification.
The Retained EU Law (Revocation and Reform) Bill was
introduced in the House of Commons in September 2022. The
Bill provided the government with the required provisions to
allow for the amendment of retained EU law and removal of
most of the special features it had in the UK legal system via a
sunset clause by the end of 2023.
What is the impact of EU legislation on the financial services sector?
Post-Brexit, when the EU changes a regulation or introduces
new regulation, the UK considers whether to adopt the new
regulation or develop an alternative approach; and, in the case
of reformed EU regulation, whether it wishes to amend the
legislation it onshored before Brexit.
Examples of EU directives include the following.
The EU Mortgage Credit Directive (MCD) aimed to
harmonise regulation of the EU mortgage credit market
and promote competition. You will find out more about
the FCA’s regulations in relation to mortgage advice and
product sales in Topic 21.
The deposit protection limits under the FSCS are set in
reference to the European Deposit Guarantee Schemes
Directive. This directive requires that the sterling scheme
is revalued every five years to make sure that the level of
protection remains in line with the €100,000 provided for
under the EU-wide scheme.
What is the impact of Brexit on regulation?
The UK’s financial services regulators – the Prudential
Regulation Authority and Financial Conduct Authority – are
not formally part of the ESFS (European system of financial supervision) post-Brexit. However, the ESAs (European supervisory authority)
still retain some jurisdiction over UK financial institutions as
third-country institutions where they are providing service to
clients in an EU member state. As such, the ESFS remains an
important area within the syllabus for this qualification.
2.4.2 what is the single supervisory mechanism? And what does it do?
The Single Supervisory Mechanism (SSM) is the name for the mechanism by
which the European Central Bank holds responsibility for the supervision and
monitoring of banks in EU member states.
The SSM provides a common approach to banking supervision. The ECB ( European central bank) is
supported by national regulators and it is the ECB that has the final decision
on supervisory matters.
Post-Brexit, which of the following is correct when the EU
changes a regulation or introduces new regulation?
a) The UK is legally required to adopt or implement the new
or reformed EU regulation.
b) The UK is legally required to ignore the new or reformed
EU regulation entirely.
c) The UK should consider whether it adopts a new regulation
or develops its own alternative approach; and, in the case
of reformed EU regulation, whether it wishes to amend the
legislation it onshored before Brexit.
c) The UK should consider whether it adopts a new regulation
or develops its own alternative approach; and, in the case
of reformed EU regulation, whether it wishes to amend the
legislation it onshored before Brexit.
The European Union has issued a new regulation. This means
that each member state:
a) has the choice whether or not to adopt the regulation.
b) must pass legislation to implement the regulation within
two years.
c) is bound by the regulation in its entirety regardless of
existing legislation.
d) has the choice of how to adopt the regulation’s objectives.
c) is bound by the regulation in its entirety regardless of
existing legislation.
What are the four levels of regulatory oversight in UK?
1) Acts of Parliament that set out what can and cannot be done, including
any onshored EU legislation.
2) Regulatory bodies that monitor the regulations and issue rules about how
the requirements of the legislation are to be met in practice. The main
regulatory bodies in the UK are the Prudential Regulation Authority (PRA)
and the Financial Conduct Authority (FCA).
3) Policies and practices of the financial institutions themselves and the
internal departments that ensure they operate legally and competently, eg
the compliance department of a life assurance company.
4) Arbitration schemes to which consumers’ complaints can be referred. In
most cases, this is the Financial Ombudsman Service.
1) What is meant by a ‘macroeconomic objective’?
1) An objective that relates to the economy as a whole, rather than to a
specific sector or individual company.
2) What are the four key macroeconomic objectives that UK
governments generally seek to achieve?
2) Price stability, low unemployment, a balance of payments equilibrium and
satisfactory economic growth
3) What is a potential negative consequence of expanding
economic growth to reduce unemployment?
3) Measures taken to expand the economy (eg reducing interest rates and
taxation) increase the demand for goods and services, which is likely to
result in a rise in inflation.
4) All governments aim to achieve zero inflation. True or false?
4) False. They aim to keep prices stable, but seeking to reduce inflation to
zero is likely to increase unemployment.
5) What is the UK government’s inflation target and how is it measured?
5) The UK government’s inflation target is 2 per cent with a maximum divergence
either side of 1 per cent. It is measured by the Consumer Prices Index
6) Disinflation means that:
a) prices are rising faster than previously.
b) prices are falling.
c) prices are rising but more slowly than previously.
d) prices are staying the same.
6) c) Prices are rising but more slowly than previously.
7) In June, the Monetary Policy Committee (MPC) decides to raise
the Bank rate by half a percentage point. In August, Paul and
Amanda’s mortgage payments increase. Explain how these two
events are likely to be linked.
7) Paul and Amanda must have a variable‑rate mortgage, so the amount they
pay each month is likely to rise and fall broadly in line with changes in the
Bank rate.
8) Which of the following economic measures taken by a
government would not help to achieve a budget surplus?
a) Increasing taxation.
b) Increasing public spending.
c) Reducing public spending.
8) b) Increasing public spending. To achieve a budget surplus a government
must cut public spending, raise taxes, or both.
9) A new piece of EU legislation is being introduced. It is being
implemented at the same time and in exactly the same way
across all member states. This indicates that the legislation is
in the form of:
a) a directive.
b) a regulation.
9) A regulation. Member states have flexibility in the way they introduce directives.
10) Which UK body and which EU body are responsible for
monitoring the financial system for systemic risk and taking
steps to reduce it (refer back to Topic 1 if necessary)?
10) The Bank of England for the UK and the European Systemic Risk Board
(ESRB) for the EU.
3.2.1 how do we decide to tax someone on whether they are classed as residence?
Residence mainly affects income tax and CGT. Any person who is present in
the UK for at least 183 days in a given tax year is regarded as automatically UK
resident for tax purposes.
What is Domicile? And how is it applied?
Domicile is best described as the country that an individual treats as their home, even if they were to live for a time in another country.
Everyone acquires a domicile of origin at birth. This is the domicile of their father on the date of their birth (or the domicile of the mother if the parents are not married).
A person can change to a different domicile (known as domicile of choice) by going
to live in a different country, intending to stay there permanently and showing
that intent by generally ‘putting down roots’ in the new country and severing
connections with the former country. There is no specific process for this.
What is Domicile important?
Domicile mainly affects liability to IHT.
If a person is domiciled in the UK, IHT (inheritance tax) is chargeable on assets anywhere in the world, whereas for persons not domiciled in
the UK, tax is due only on assets in the UK.
People who are not UK‑domiciled but have been resident in the
UK for tax purposes in at least 15 of the previous 20 tax years
are deemed to be UK‑domiciled for IHT purposes.
Which of the following people would be most likely to be a ‘UK resident’?
a) Susan, who normally lives in Spain but spends three months a
year working for the family business in England.
b) Antoine, a French surveyor, whose eight‑month contract in
Devon with a construction company started in May.
c) Max, who moved to London from Cologne on 6 January for a
seven‑month teaching contract.
d) Brenda, who spends 180 days a year in the UK and the remainder
in the USA.
1) b) Antoine. Answer c) is not correct because three months of Max’s contract
are in one tax year and the rest in the following year. He will not spend 183
days in either tax year in the UK.
Which of the following will not be subject to UK inheritance tax
upon death?
a) UK property owned by Paolo, who has lived in the UK for three
years but is not UK domiciled.
b) Overseas property owned by Kavita, who was born in the US (to
American parents) but has lived in the UK for the past 18 years.
c) Overseas property owned by Helena, who is UK resident but
not UK domiciled nor deemed domiciled.
d) Overseas property owned by David, who is UK domiciled but
resident in France.
2) c) As Helena is not UK domiciled she will not pay IHT on overseas assets.
How is the income of a child that arises from a settlement or arrangement made by their parents is normally treated?
It is treated as the parents’ income for tax purposes. In
this situation, the child’s unused allowances cannot be set against this income
For a child, which of the following would be subject to income tax?
a) All earned income.
b) An educational grant.
c) Any earned income that exceeds their personal allowance.
d) A settlement from their parents.
c) Any earned income that exceeds their personal allowance. The
settlement from their parents (answer d) will be taxed as the parents’
income, the educational grant (answer b) is tax‑free, and they would
not pay tax on all of their earned income (answer a), only that which
exceeds their personal allowance.
Who is liable for income tax?
All UK residents, including
children, may be subject to income tax, depending on the type and amount of
income they receive.
3.3.1 what are the 7 allowances in tax?
Personal allowance – the personal allowance threshold usually determines
the rate above which income tax is charged. Individuals whose annual
income exceeds an upper threshold have their personal allowance reduced,
sometimes to zero, depending how much their earnings exceed the
threshold.
Marriage allowance – it is possible for an individual to transfer part of
their personal allowance to their spouse or civil partner, providing the
transferor is not liable to income tax at all and the recipient is not liable to
income tax at the higher or additional rate.
Married couple’s allowance – this allowance is available if one partner in a
marriage or civil partnership was born before 6 April 1935. The allowance is
provided as a tax reduction and is limited to a percentage of the applicable
allowance amount.
Blind person’s allowance – this allowance is available to those registered
as blind with a local authority. If the allowance cannot be used by the
individual, it can be transferred to their spouse or civil partner.
Personal savings allowance (PSA) – is a tax-free allowance that enables
savers to earn interest on savings without paying tax on that interest. The
allowance depends on the individual’s income tax band. There is no PSA for
additional-rate taxpayers.
Dividend allowance (DA) – individuals receive a dividend allowance each
year. Any dividend income above the DA is taxable, but special rates apply.
Dividends on any shares held in an ISA are also tax-free.
Allowances for property and trading income – so‑called
‘micro‑entrepreneurs’ who supplement their main income with property
or trading income are entitled to an additional allowance. There are two
separate allowances, one for trading income and one for property income.
The allowances apply to those who, for example, make small amounts of
money by selling on eBay or by renting a room in their house or a parking
space. If trading/property income is less than the allowance, then no tax is
payable on that income; if it is more than the allowance, then the individual
has the choice to either deduct the allowance from trading/property income
or calculate profit in the usual way and deduct allowable expenses
What are the three deductions that can be taken from the gross amount before tax?
certain pension contributions (within specified limits) – for example, a
scheme set up by an employer;
certain charitable contributions;
allowable expenses – such as costs incurred in carrying out one’s
employment.
How are deductions made more self employed people?
allowable expenses can only be incurred “wholly and
exclusively for the purpose of trade”, while for employed persons they must
be incurred “wholly, exclusively and necessarily” while doing the job.
When all the relevant deductions have been made from a person’s gross
income, what remains is their taxable income. This is the amount to which the appropriate tax rate(s) is applied in order to calculate the tax due.
3.3.3 If someone’s income comes from different sources, what is the set order in which income tax is applied?
1) First, tax is calculated on non‑savings income, such as earned income,
self‑employed net profits, pension income and rent received.
2) Second, it is applied to savings income, ie interest received.
3) Third, income tax is calculated on dividends.
4) Finally, any chargeable gains on non‑qualifying life assurance policies are
brought into the calculation.
3.4.1 explain and give an example of income tax taken at source?
In some cases, HMRC collects income tax at source, ie from the person who
makes the payment, not the recipient.
An example of where tax is deducted at source is PAYE.
Employers deduct tax weekly or monthly (as appropriate) from wages and
salaries, which are then paid to the employee net of tax.
Some other types of income are taxed at source, such as income from certain
trusts.
What are the two categories savings income will fall into?
Tax‑free – including income from ISAs and some National Savings and
Investments accounts.
Paid gross without deduction of tax but subject to tax in the hands of the
individual – including interest from bank and building society accounts – if
in excess of the personal savings allowance.
Explain the four stage process which broadly explains the calculation of personal liability to income tax
1) Work out the total income.
2) Make appropriate deductions, eg allowable expenses or
certain pension contributions.
3) Deduct the personal allowance and other reliefs (eg blind
person’s allowance) to arrive at the taxable income.
4) Apply tax at the current rates to the appropriate bands of
income.
3.5.1 explain gift aid and it’s effect on tax
When a gift is made using Gift Aid, the charity can recover the basic‑rate
tax (20 per cent) that is assumed to have been paid on the amount of the gift, increasing the value of the net gift. For example, a gift of £80 from an
individual who pays income tax is treated as a gift of £100: the donor pays £80
and the charity reclaims £20 from HMRC. Effectively, this is an uplift of 25 per cent (as £20 is 25 per cent of £80).
In addition, the donor making the gift has their basic‑ and higher‑rate tax
thresholds extended by the value of the gross gift.
3.5.2 explain payroll giving
This enables employees to make tax‑efficient gifts by having a charitable gift
deducted from their salary before income tax is charged. By making a gift in
this way, tax relief is granted on the value of the gift at the individual’s highest
rate of income tax.
Explain class one national insurance contributions
Paid by employees at a percentage on earnings between
certain levels, known as the primary threshold and the
upper earnings limit with a reduced percentage payable on
earnings above the upper limit.
They are also paid by employers on most employees’
earnings above a lower limit called the secondary threshold
– but with no upper limit.
No employer NICs are paid in respect of employees and
apprentices under a certain age on earnings between the
primary threshold and the upper earnings limit.
Explain class 2 national insurance contributions
Flat‑rate contributions paid by the self‑employed if their
annual profits exceed the small profits threshold or
deemed paid if their annual profits exceed the small profits
threshold but are below the lower profits threshold.
They are quoted as a weekly amount.
They are collected through self‑assessment in a single
lump sum.
Explain class three national insurance contributions
Voluntary contributions that can be paid by people who
would not otherwise be entitled to the full state pension or
sickness benefits.
This can occur because a person has, for instance, taken a
career break or spent some time working overseas.
They are flat‑rate contributions.
Explain class four national insurance contributions
Additional contributions payable by self‑employed people
on their annual profits between specified minimum and
maximum levels, with a reduced rate payable above the
upper limit, as for Class 1.
They are paid to HMRC in half‑yearly instalments by
self‑assessment.
explain who issues individuals with their tax code and how the
tax code is used?
In order to deduct the right amount of
tax, the employer is supplied with a tax code for each employee: the tax code
relates to the amount that the employee can earn without paying tax. The employer then supplies it to the employee.
describe how a self‑employed person pays income tax?
People who are self‑employed
pay income tax directly to HMRC on the basis of a declaration of net profits. For a self‑employed person, net profits are
broadly the equivalent of the gross income of an employee, ie they are the
amount on which income tax is based. They are calculated by taking the total
income of the business and deducting allowable business expenses and capital
allowances.Many taxpayers calculate their own liability and submit their figures online to
HMRC for approval. HMRC will perform the tax calculation for those sending
in their figures on paper, although the submission deadline for this is earlier.
This process is called self‑assessment. Some self‑employed people use an
accountant to prepare their accounts and to deal with HMRC on their behalf.
Self‑employed people pay their income tax and Class 4 NICs in two equal
parts. The first payment is due on 31 January of the tax year in which their
business year ends; the second is due on 31 July, six months later. Any under
or overpayment is then rectified on the 31 January following the end of the tax
year. Class 2 NICs are also due in one lump sum on this date.
explain how the starting‑rate band and personal savings
allowance work?
Personal savings allowance (PSA) – is a tax-free allowance that enables
savers to earn interest on savings without paying tax on that interest. The
allowance depends on the individual’s income tax band. There is no PSA for
additional-rate taxpayers.
1) A person who is UK resident for tax purposes only pays income
tax on earnings generated in the UK. True or false?
1) False. They are liable for income tax on income generated anywhere in the
world, but the UK has reciprocal tax treaties (double taxation agreements)
with many countries to ensure that people are not taxed twice on the same
income.
2) A person may become UK domiciled once they have been
settled in the UK for a number of years. True or false?
2) True, as long as their actions indicate that their change of residence is
permanent and they have severed links with their original country of
domicile.
3) Which of the following is not assessable for income tax purposes?
a) Tips.
b) Interest from bank and building society deposits.
c) Lottery prizes.
d) Rents from land and property.
3) c) Lottery prizes.
4) In what order of priority is income taxed?
4) Non‑savings income, then savings income, then dividend income.
5) Blind person’s allowance can be transferred to a spouse or
civil partner if the blind person does not use the allowance.
True or false?
5) True. Blind person’s allowance can be transferred to a spouse/civil partner
if the original recipient does not pay tax or use all their allowance.
6) Emma worked abroad for five years but is now back working in
the UK. What class of National Insurance contributions could she
pay to improve her contribution record for the state pension?
6) Class 3.
7) Mike earns £22,000. He also receives £500 interest on his
savings from a building society deposit account. Calculate the
income tax payable.
7) On earnings:
£22,000 – £12,570 (personal allowance) = £9,430
£9,430 × 20% = £1,886
There is no tax to pay on savings income because, as a basic‑rate taxpayer,
Mike has a personal savings allowance of £1,000.
8) Roopa is a company director. In the current tax year, she draws
a salary of £12,570. She has dividend income of £27,000.
Calculate the income tax payable.
8) Total income is £39,570
Salary falls within personal allowance of £12,570 so no tax is paid on this.£2,000 of dividend income is taxable at 0 per cent.
The remaining £25,000 all falls within the basic rate tax band and is taxed
at 8.75 per cent.
Total tax is £2,187.50 (£25,000 × 8.75%).
9) Jemma is self‑employed and is in receipt of blind person’s
allowance of £2,870. In the current tax year, her gross profit
is £20,000 and she has allowable expenses of £2,500. She has
to pay Class 4 NICs at 9 per cent on her taxable profit above
£12,570. Calculate the income tax and Class 4 NICs payable.
9) Income tax:
£20,000 Gross profit
(£2,500) Allowable expenses
(£12,570) Personal allowance
(£2,870) Blind person’s allowance
Taxable income: £2,060
Tax: £2,060 × 20% = £412
Class 4 NICs:
£20,000 – £2,500 = £17,500 taxable profit
£17,500 – £12,570 × 9% = £443.70
10) Ashok’s salary is £75,000 and he is paid savings interest of
£650. He also has dividend income of £7,000. Calculate the
income tax payable.
10) Tax on earned income:
£75,000 Income
(£12,570) Personal allowance
£62,430 taxable earned income
£37,700 × 20% = £7,540
£62,430 – £37,700 = £24,730 × 40% = £9,892
Savings interest:
£500 (PSA) × 0% = £0
£150 × 40% = £60
Dividend income:
£2,000 (DA) × 0% = £0
£5,000 × 33.75% = £1,687.50
How do people pay tax on their savings and investments income?
Interest on deposits is paid gross to all customers, and individuals have to
advise HMRC to deduct tax via their tax code or pay via self‑assessment.
For those on low incomes a starting rate of 0 per cent applies to the first £5,000
of savings income. The starting-rate band reduces as taxable non‑savings
income is received, and the starting rate does not apply at all where income
received exceeds an individual’s personal allowance plus the starting‑rate
band.
Additionally, there is a personal savings allowance (PSA) for basic‑rate taxpayers
and a lower allowance for higher‑rate taxpayers: savings income falling within
these limits is subject to 0 per cent tax. In calculating eligibility for the PSA, all
of an individual’s income is taken into account in assessing whether they are
a basic‑ or higher‑rate taxpayer.
What is bed and breakfasting in terms of capital gains tax?
One issue with CGT is that it becomes due on the whole gain
in the year it is realised, even where the gain has been made
over a longer period. Only one annual exempt amount can be set
against what may be many years’ worth of gain.
Historically, holders of shares and unit trusts could minimise
the effect of this by ‘bed and breakfasting’: selling their holding
each year and repurchasing it the following day, thus realising a
smaller gain that could be covered by that year’s allowance.
Nowadays, any shares and unit trusts that are sold and repurchased
within a 30‑day period are treated, for CGT purposes, as if those
two related transactions had not taken place, rendering this
loophole ineffective.
4.1.1what kind of assets are exempt of capital gains tax?
CGT applies to gains made since 6 April 2015 by individuals or trustees who
are not UK resident on residential property located in the UK. Gains made
during ownership prior to this date are ignored.
Gains that accrue to non‑UK residents on non‑residential property have been
subject to tax since 6 April 2019.
A non‑resident individual might still be able to claim private residence relief if they live in the property for at least 90 days during a tax year.
What happens if a loss is made on disposal of asset?
the loss can be offset against gains made elsewhere. It must be offset first against gains in the year the loss occurred.
Residual losses may then be carried forward to future
years. A capital loss cannot be carried back to a previous year.
Given that capital losses can be carried forward but the annual exempt amount
cannot, capital losses brought forward are used only to the extent necessary
to reduce gains to the level of the annual exempt amount. Residual losses are
then carried forward.
How do you calculate CGT liability?
1) Calculate the amount of the gain.
2) Deduct the CGT annual exempt amount (if this has not been
used against other gains in the same tax year).
3) Deduct any losses that can be offset against the gain.
4) What remains is the taxable gain.
5) Add taxable gain to taxable income to establish what rate(s)
of CGT should be paid.
6) Apply tax at appropriate rates. There may be different rates
for taxable gains that fall in the basic‑rate income tax band
and those that fall outside it. There may also be a surcharge
where the gain results from the sale of property not subject
to private residence relief.
What is private resistance relief?
This is available when someone sells the property they have lived in as their main or only residence. The ‘main residence’ does not have to
be a house or flat – it could be a houseboat, or a fixed caravan.
If someone has more than one property and shares their time between each,
they may nominate the property on which they want to claim private residence
relief.
There are rules relating to how long an individual may spend away from the
property and still be eligible for the full relief. For example, if someone owns
a house but spends part of the year living away in accommodation provided
with their job, the house is treated as their main residence for private residence
relief purposes.
There are also rules relating to the use of the property for business purposes
and to the size of the garden on which full relief can be claimed.
What is business asset disposal relief?
Business owners are required to pay capital gains tax when they sell (dispose of)
trading businesses or assets used in those businesses and from certain disposals of shares in trading companies.
However, they may be able to pay a lower rate of
tax on gains on qualifying assets if they meet certain conditions. This is commonly
known as business asset disposal relief (previously entrepreneurs’ relief) and is
available to both sole traders and limited companies.
For owners of limited companies, eligibility depends on holding at least 5 per cent of the ordinary share capital of the business, which enables them to exercise at least 5 per cent of the voting rights in that company. In addition, they must also
be entitled to at least 5 per cent of the distributable profits and net assets of the company. Most property letting businesses do not qualify for this relief.
Business asset disposal relief also applies to gains resulting from investment into unlisted
companies.
What is roller over relief?
roll‑over relief may be
claimed if the assets disposed of are replaced by other business assets. This
means that, instead of CGT falling due on the original disposal, it is deferred
until a final disposal is made.
The replacement asset must be bought within a period of one year before and
three years after the sale of the original asset.
Relief can be claimed up to the lower of either the gain or the amount reinvested.
What is hold over relief?
What gains may be wholly or partly passed on in the case of a gift or sale at under value?
CGT on any gain arising on the gift of certain assets can normally be
deferred until the recipient disposes of it.
Gains may be wholly or partly passed on to the recipient in the case of gifts (or
sale at under value) of the following broad categories of assets:
assets used by the donor in their trade or the trade of their personal
company or group;
shares in the transferor’s personal company or in an unlisted trading company;
agricultural property that would attract relief from inheritance tax;
assets on which there is an immediate charge to inheritance tax.
What is residence nil rate band?
If part of the estate includes a residence that is being left to children or other
direct descendants an additional residence nil‑rate band
(RNRB) applies.
When calculating IHT due on the estate, the RNRB is deducted from the
estate’s value on death.
Where the RNRB is unused, in full or in part on death, the unused balance
can be carried forward for use upon the death of a surviving spouse or civil
partner. the unused percentage is
carried forward rather than the unused value.
This means that the maximum amount exempt from IHT between married
couples or civil partners is effectively £1m (ie £175,000 × 2 RNRB and £325,000
× 2 NRB).
What is a potentially exempt transfer for inheritance tax?
IHT is also payable in certain circumstances when assets are transferred from a person’s estate during their lifetime (usually in the form of gifts). Most gifts
made during a person’s lifetime are potentially exempt transfers (PETs) and
are not subject to IHT at the time of the transfer.
If the donor survives for seven years after making the gift, these transactions become fully exempt and no IHT is payable.
In July 2019, Joan made a gift to her daughter of £350,000. She
had made no other gifts in her lifetime. Joan died in October 2023
leaving a total estate worth £420,000. Let’s say the full rate of IHT
is 40 per cent on estates over the nil-rate band of £325,000. How
much IHT is due on the gift?
a) £5,000
b) £6,000
c) £8,000
d) £10,000
b) £6,000. The gift uses the available nil‑rate band of £325,000, leaving an
excess of £25,000 above the nil‑rate band. Joan died between four and five years after the gift, so the £25,000 excess is liable for IHT at 60 per cent of the
full rate (ie 40% × 60%).
What is a chargeable lifetime transfer?
Some lifetime gifts – notably those to companies, other organisations and
certain trusts – are not PETs but chargeable lifetime transfers, on which IHT
at a reduced rate is immediately due.
The reduced rate of IHT is only applied to the excess over the nil‑rate band. As with PETs, the full amount of IHT is due
if the donor dies within seven years (subject to the same taper relief).
What gifts and transfers are exempt from inheritance tax?
transfers between spouses and between civil partners both during their
lifetime and on death, provided that the receiving spouse/civil partner is
UK domiciled;
small gifts of up to £250 (cash or value) per recipient in each tax year;
donations to charity, to political parties and to the nation;
wedding/civil partnership gifts of up to £1,000 (increased to £5,000 for
gifts from parents or £2,500 from grandparents, or from one spouse/civil
partner to the other);
gifts that are made on a regular basis out of income and which do not affect
the donor’s standard of living;
up to £3,000 per tax year for gifts not covered by other exemptions. Any
part of the £3,000 that is not used in a given tax year can be carried forward
for one tax year, but no further.
An advantage of registering is that VAT paid out on business expenses can be
reclaimed.what are two disadvantages?
the firm’s goods or services are more expensive to customers
(by the amount of the VAT that the firm must charge);
the additional administration involved in collecting, accounting for and
paying VAT.
What is stamp duty and stamp duty reserve tax?
Stamp duty is payable on paper documents that transfer the ownership of
financial assets, such as shares and bearer instruments over a certain amount.
Stamp duty reserve tax (SDRT) is charged on transfers that are completed
electronically. If the transaction is carried out through CREST, which is an electronic settlement and registration system, SDRT is deducted automatically
and passed to HMRC.
What is stamp duty and land tax relief for first time buyers?
First‑time buyers can claim a discount (relief), which is
tapered depending on the price of the residential property.
For properties below a certain amount, first-time buyers will
not be liable for any SDLT and for properties in excess of a
certain amount, the relief is not applicable.
The relief was extended to qualifying shared-ownership
property purchasers in the 2018 Budget.
What is withholding tax?
The phrase ‘withholding tax’ refers to any tax on income that is levied at
source before that income is received. So, technically, income tax paid by UK
employees is a withholding tax.
However, the phrase is normally understood to apply to tax that is levied in
a particular country on income received in that country by those who are
non‑resident in that country (eg non‑resident entertainers and professional sportspeople); this could be earned income or investment income.
The aim is to ensure that the income does not leave the country without being
taxed. The UK has reciprocal tax treaties (double taxation agreements) with
over 100 other countries to prevent the same income from being taxed twice.
1) Melanie bought a painting in a charity shop for £40. It turned
out to be by a well‑known artist, and she sold it three years
later for £2,000. She had to pay CGT on the gain she made.
True or false?
1) False. Gains made on ‘chattels’ (movable objects such as jewellery, antiques
and paintings) are exempt from CGT if their value is £6,000 or less.
2) For how many years can the annual exempt amount for CGT be
carried forward?
2) The CGT annual exempt amount cannot be carried forward at all.
3) To qualify for roll‑over relief, a business must replace an asset
not more than five years from the date of disposal. True or
false?
3) False. Assets must be replaced within three years after the date of disposal.
4) Inheritance tax would be charged on which of the following?
a) The total value of the deceased’s estate.
b) The total value of the estate above the available nil‑rate band.
c) The value of the estate less any gifts that have been made
in the previous seven years.
4) b) Inheritance tax would be payable on the total value of the estate above
the available nil‑rate band.
5) Tax on a chargeable lifetime transfer in excess of the available
nil‑rate band is payable:
a) immediately, at the full rate.
b) only if the transferor dies within seven years of the transfer.
c) immediately, at a reduced rate.
5) c) Immediately, at a reduced rate of 20 per cent.
6) What kind of tax is payable when shares are purchased
electronically?
6) Stamp duty reserve tax.
7) Sanjay, a basic‑rate taxpayer with taxable income of £12,000,
purchased UK listed company shares for £11,300 in May 2017.
He sold them for £25,400 in August 2023. He has no other
gains or losses (current or carried forward) in the current tax
year. Ignoring any costs, calculate his capital gains tax liability
assuming an annual exempt amount of £6,000 and a basic rate
of 10%.
7) Gain: £25,400 – £11,300 = £14,100
Taxable gain: £14,100 – £6,000 = £8,100
Capital gains tax payable: £8,100 × 10% = £810
8) Sarah, a basic‑rate taxpayer with taxable income of £17,000,
bought some shares in May 2018 for £15,000 and sold them in
October 2018 for £10,100, making her a loss of £4,900 in the tax year 2018/19. She made no gains in the same tax year. In the current tax year she sold her holiday flat in Devon, which made
her a profit of £47,600. She had spent £14,000 on renovations,
and it cost her £3,500 in estate agent’s commission to sell it.
Calculate the capital gains tax due for the current tax year
assuming an annual exempt amount of £6,000 and a rate of
18% for gains on residential property.
8) Gain on flat £47,600
Less cost of renovations (£14,000)
Less cost of disposal (commission) (£3,500)
Less carried‑forward loss from 2018/19 (£4,900)
Less annual exempt amount (£6,000)
Taxable gain = £19,200 × 18% = £3,456 capital gains tax
9) Luis sold his house, which has been his main residence since
he bought the house in 2020, and downsized to a one-bedroom
flat, making a gain of £325,000. Is the capital gain made from
this sale eligible for private residence relief?
a) Yes, because the house was Luis’s main residence the
gain from the property’s sale will be eligible for private
residence relief.
b) No, because Luis has not lived in the house long enough to
qualify for private residence relief.
c) We do not have enough information to decide if the gain is
eligible for private residence relief or not.
9) c) In this instance, we do not have enough information to decide if the
gain is eligible for private residence relief. For example, the gain may
not be eligible for private residence relief if:
Luis has spent money renovating the house and is now selling it to
release a profit;
Luis sold some or all of the grounds that originally came with the house
after he sold the house;
any part of the house has been used exclusively for business purposes
while Luis has owned it.
10) A company makes an annual profit of £1.2m. When would the
company’s corporation tax normally be payable?
10) Nine months after the end of the relevant accounting period.
What are the two ways that state benefits affect financial planning?
1) State benefits can affect the need for financial protection. The amount of
additional cover needed by a client can be quantified as the difference
between the level of income or capital required and the level of cover
already existing. Existing provision includes not only any private insurance
that the client already has, but also any state benefits to which they or their
dependants would be entitled.
2) Financial circumstances can affect entitlement to benefits. Certain benefits
are means‑tested – in other words, the amount of benefit is reduced if
the individual’s (or sometimes the household’s) income or savings exceed
specified levels. This might mean, for example, that a financial plan that
increased a person’s income or the value of their assets might be less
attractive than it seemed at first sight, if it also had the effect of reducing
entitlement to, for instance, Universal Credit.
What is universal credit and how is it applied?
Universal Credit is not specifically an ‘in work’ or ‘out of work’ benefit; it is
one benefit for people whatever their employment status. The intention is
that people will not need to keep transferring from one type of benefit to
another as their circumstances change. The structure is intended to be much
simpler than that of the current system, where separate benefits (which often
overlap) are administered by different agencies, with different methods of
means testing.
From April 2013, Universal Credit began to replace the following benefits:
Income Support;
Income‑based Jobseeker’s Allowance;
Income‑related Employment and Support Allowance;
Working Tax Credit and Child Tax Credit;
Housing Benefit.
The amount of Universal Credit awarded to claimants depends on their income
and personal and financial circumstances. There is a basic allowance with
different rates for single claimants and couples (and a lower rate for younger
people), and additional amounts available for those with a disability, caring
responsibilities, housing costs, and children and/or childcare costs.
There is an ‘earnings disregard’, which is based on the claimant’s needs. There is also a maximum cap amount you can receive for specific benefits.
The benefits that remain outside of Universal Credit include:
Carer’s Allowance;
new style Jobseeker’s Allowance and new style Employment and Support
Allowance;
Disability Living Allowance/Personal Independence Payment;
Child Benefit;
Statutory Sick Pay;
Statutory Maternity Pay;
Maternity Allowance;
Attendance Allowance
What are working tax credits?
Working Tax Credit is designed to top up the earnings of employed or
self‑employed people who are on low incomes; this includes those who do not
have children. There are extra amounts for:
working households in which someone has a disability; and
the costs of qualifying childcare.
Working Tax Credit has now been replaced by Universal Credit and new claims
can only be made for those already receiving Child Tax Credit.
What is income support and how is it applied?
Income Support is a tax‑free benefit which was designed to help people aged between 16 and state pension age whose income was below a certain level and who were working less than 16 hours per week (if they had a partner, their
partner must work less than 24 hours per week). It was available to people
with no income at all or it could be used to top up other benefits or part‑time
earnings.
Existing claims continue for those who continue to meet the eligibility
requirements. New claims for Income Support can no longer be made, but
those on low incomes can apply for Universal Credit.
What is job seekers and how was it applied?
Jobseeker’s Allowance (JSA) is a benefit for people who are unemployed or
working less than 16 hours and actively seeking work. There are two forms
of JSA: new style and income‑based. Income‑based JSA is being replaced by
Universal Credit.
People are eligible for new style JSA only if they have paid sufficient Class
1 National Insurance contributions. It is paid at a fixed rate, irrespective of
savings or partner’s earnings, for a maximum of six months. Payments are
made gross but are taxable. Claimants are usually credited with National
Insurance contributions (NICs) for every week that they receive JSA.
How is the support of a mortgage interest loan applied?
Those in receipt of Income Support, Jobseeker’s Allowance, Universal Credit or
Pension Credit can apply for assistance to pay the interest on their mortgage.
Support for Mortgage Interest (SMI) was a pure state benefit until April 2018
but now takes the form of a loan that must be repaid. For eligible claimants, SMI will pay interest on a mortgage up to an upper threshold
(with a lower threshold if a claim is being made for Pension Credit). SMI does not pay for associated mortgage costs, such as the repayment of capital, insurance
premiums or mortgage arrears. Payment is made direct to the mortgage lender at a standard mortgage rate that may be more or less than the actual rate on the mortgage.
The SMI loan is secured on the property by way of a second charge and is
subject to interest. The loan is repaid when the property is sold or ownership
of the property is transferred.
What is a benefits cap?
An often‑voiced complaint about the benefits system is that
people can be better off out of work (by claiming state benefits)
than in work. In response to this, a cap on the maximum weekly
income that can be received from benefits was introduced in
2013. In broad terms, the intention is to limit the maximum
paid to the level of the average UK wage.
The following benefits are subject to the cap.
Employment and
Support Allowance
Income Support
Jobseeker’s
Allowance
Housing Benefit
Maternity
Allowance
Child Benefit
Child Tax Credit
Bereavement
Allowance
Incapacity Benefit
Severe
Disablement
Allowance
Universal Credit
(unless deemed
unfit for work)
Widowed Parent’s
Allowance
What is statutory maternity pay and how is it applied?
Women who become pregnant while employed may receive Statutory Maternity
Pay (SMP) from their employer, providing that:
their average weekly earnings are above a certain threshold;
they have been working for their employer continuously for 26 weeks prior
to their ‘qualifying week’, which is the 15th week before the week in which
their baby is due.
SMP is payable for a maximum of 39 weeks. The earliest it can begin is 11
weeks before the baby is due and the latest is when the baby is born.
There are two rates of SMP: for an initial period, the amount paid is equal
to a percentage of the employee’s average weekly earnings; after that, the
remaining payments are at a standard flat rate or set percentage of the
employee’s average weekly earnings, whichever is the lower.
SMP is taxable and NICs are due on the amount paid.
What is a maternity allowance and how is it applied?
Some women who become pregnant are not able to claim SMP, including those
who are self‑employed or have recently changed jobs or stopped working. They
might be able to claim an alternative benefit called Maternity Allowance. This
is paid by the Department for Work and Pensions (DWP) and not by employers.Maternity Allowance is not a benefit available to all women who become
pregnant; an individual must meet the relevant eligibility criteria in order to
claim.
Maternity Allowance is paid at a lower rate than SMP but it is not subject to
tax or NICs on the amount paid. Like SMP, it is payable for a maximum of 39
weeks. The earliest it can begin is 11 weeks before the baby is due and the
latest is when the baby is born.
What is child benefit and how is it applied?
Child Benefit is a tax‑free benefit available to parents and others who are responsible for bringing up a child. It does not depend on having paid NICs. It is not affected by receipt of any other benefits.
Child Benefit is available for each child under age 16. It can continue up to
and including age 19 if the child is in full‑time education or on an approved
training programme. A higher rate is paid in respect of the eldest child and a
lower rate in respect of every other child.
Child Benefit is means‑tested in the form of an income tax charge if either of a
couple has individual adjusted net annual income over the threshold. If both have adjusted net income above the threshold, it is assessed on the higher of the two incomes. The tax charge is collected through self-assessment and is applied at a rate such that, where adjusted net income reaches a specified level above the threshold, the tax charge equals the Child Benefit paid.
What is child tax credit and how is it applied?
Child Tax Credit is designed to provide financial assistance to people who are
responsible for bringing up children and are on low incomes. A claim may be
made by an individual who is responsible for:
a child aged under 16;
a child under 20 in eligible education or training.
Child Tax Credit is made up of a number of different payments called
‘elements’. How much is received depends on an individual’s income, the
number of children, and whether any of the children are disabled.
Child Tax Credit is being replaced by Universal Credit and is not open to new
claims except for individuals who are already claiming Working Tax Credit.
Jane and John have two young daughters and claim Child Benefit.
John earns £48,000 per year and Jane earns £57,000 per year. If
the threshold is £50,000, they will:
a) become ineligible for Child Benefit, as one of their incomes is
over the threshold.
b) not be liable to an income tax charge as one of their incomes is
still under the threshold.
c) be liable to an income tax charge as one of their incomes is
over the threshold.
d) be entitled to an increased amount of Child Benefit as one of
their incomes is under the threshold.
1) c) Tax is charged through self-assessment for any income above the
threshold, offsetting the amount of Child Benefit received.
What is statutory sick pay and how is it applied?
Statutory Sick Pay (SSP) is paid by employers to employees who are off work
due to sickness or disability for four days or longer, providing their average
weekly earnings are above the level at which Class 1 NICs are payable.
SSP is paid for a maximum number of weeks in any spell of sickness. Spells of
sickness with less than a minimum number of weeks between them count as
one spell. Amounts paid as SSP are liable to income tax and to Class 1 NICs,
just as normal earnings would be.
What is employment and support allowance and how is it applied?
People who are ill or disabled may be able to claim Employment and Support
Allowance (ESA). There are two forms of ESA. For new style ESA, eligibility
depends on a person’s NIC record. New style ESA is not means‑tested and the
payments are taxable. In contrast, income‑based ESA does not depend on NICs
and is means‑tested but not taxable. A key feature of ESA is the work capability assessment, which looks at the
impact that a claimant’s health condition has on their ability to work. As a result of the assessment, people are put in either a work‑related activity
group or a support group. Those in the former group are deemed capable of
working in some capacity and required to take steps to help them move into
employment. For those in the support group, it is recognised that their health
condition severely limits their capacity to work.
Different rates of benefit are payable to the two groups; there is also a lower rate during the initial assessment period.
What is attendance allowance and how is it applied?
Attendance Allowance is a benefit for people who have reached state pension age and need help with personal care as a result of sickness or disability. This
benefit is not means‑tested and it does not depend on NICs.
There are two levels of benefit: a lower rate for people who need help with
personal care by day or by night and a higher rate for those who need help
both by day and by night. Some other state benefits (ie Pension Credit, Housing
Benefit and Council Tax Reduction) are paid at a higher rate if the claimant is also receiving Attendance Allowance.
What is disability living allowance and personal independence payment and how is it applied?
Disability Living Allowance (DLA) is a tax‑free benefit for people who need
help with personal care and/or need help getting around. It is currently
replaced by Personal Independence Payment (PIP) for people aged between
16 and state pension age. People born on or before 8 April 1948 can continue
to claim DLA, but those born after that date will need to apply for PIP or
Attendance Allowance depending on their age.
There are two components to both benefits, and people may be eligible for
either or both:
Care component: this component is for people who need help in carrying
out activities of daily living such as washing, dressing, using the toilet or
cooking a meal.
Mobility component: this component applies if a person has difficulty in
walking or cannot walk at all.
What is a carer’s allowance and how is it applied?
Carer’s Allowance (CA) is a benefit for people who are caring for a sick or
disabled person; they do not have to be a relative of the person they are caring
for in order to qualify.
The right to receive CA does not depend on having paid NICs. It is taxable and
must be declared on tax returns. It is important to be aware that claiming CA can affect the other benefits
the claimant receives, as well as the benefits the person they are caring for
receives.
People in hospital or receiving residential/nursing care. What support do they get and how is it applied?
When people are in hospital, some of the needs normally met by state benefits
or pensions are instead met by the NHS. In general terms, state benefits that were being claimed will continue to be paid when someone goes into hospital.
Which form(s) of Employment and Support Allowance is/are
means‑tested?
a) New style ESA only.
b) Income‑based ESA only.
c) Both new style and income‑based ESA.
d) Neither new style nor income‑based ESA.
2) The correct answer is b). Income‑based ESA is means‑tested; new style ESA
is based on National Insurance contribution record so is not means‑tested.
What support is available for people in retirement?
State pensions are payable from state pension age (SPA). The SPA is subject
to a system of regular reviews based on changes in life expectancy. The basis of the reviews is the principle that people should spend one‑third of their adult life (regarded for these purposes as beginning at age 20) in retirement.
The first review was published in March 2017 and recommended that state
pension age be increased from age 67 to age 68 between 2037 and 2039.
The system of state pension benefits changed from April 2016 with the
introduction of the new state pension. Before this date, state pension provision consisted of a basic state pension with an additional earnings‑related element
for those who were employed. The new state pension has no earnings‑related
element.
Those reaching SPA before 6 April 2016 have their state pension benefits
paid under the system of basic + additional state pensions.
Those reaching SPA on or after 6 April 2016 receive the new state pension, 9
with an adjustment paid to compensate them if they would have been better off under the previous system.
State pensions are designed to provide a basic standard of living in retirement.
The system operates on a pay‑as‑you‑go basis, with National Insurance contributions from the current working population being used to pay pensions
to those entitled to receive them. It is readily apparent that, with the number
of pensioners increasing and the numbers in employment decreasing, there is
little scope for making generous increases to state pensions.
What is the basic state pension and how is it applied?
Originally, the basic state pension was paid only to employed people on their
retirement and was not related to their earnings. It was later extended to
include self‑employed people and others who have made sufficient National Insurance contributions – which means that they have contributed for at least
30 years. Benefits are scaled down for lower contribution rates.
Those who had not made enough NI contributions of their own to qualify for a
full basic state pension might be in receipt of a ‘Category B’ pension based on their spouse or civil partner’s pension entitlement.
What is the additional state pension and how is it applied?
Some employees who reached state pension age before 6 April 2016 are entitled
to an additional state pension, on top of their basic state pension.
The first earnings‑related state pension scheme was the graduated pension
scheme that operated from 1961 until 1975.
It was replaced by the state earnings‑related pension scheme (SERPS), which
came into operation in 1978.
SERPS was itself replaced in 2002 by the state second pension (S2P).
These schemes are now collectively referred to as the ‘additional state pension’.
Unlike the basic state pension, additional state pension was available only
to employed people who paid Class 1 National Insurance contributions.
Self‑employed people could not build entitlement to additional state pension
benefits.
Employed people had the option to ‘contract‑out’ of SERPS/S2P and have the
NICs that would have been used to provide SERPS/S2P reduced or redirected
to an alternative form of pension.
What is pension credit and how is it applied?
Pension Credit is made up of two elements:
Guarantee Credit – this tops up an individual’s weekly
income to a specified minimum amount.
Savings Credit – this is an additional payment for some
people who reached state pension age before 6 April 2016
who have saved some money towards their retirement.
Pension Credit is not taxable.
What is the new state pension and how is it applied?
The complexity of the state pension system led to the introduction of a
simplified state pension for those reaching retirement age on or after 6 April
2016. There is a single level of benefit with no additional earnings‑related
element. Pension benefits are determined by a person’s NIC record. To be
eligible for the maximum pension, an individual needs to have made or been
credited with 35 years’ NICs; those with under 10 years’ NICs are not usually
eligible for any state pension. Carers are credited with NICs.
One of the features of the new state pension is that it is based solely on an
individual’s personal National Insurance record.
What is the triple lock guarantee for benefits?
Once in payment, both the basic state pension and the new
state pension are guaranteed to increase each year by the
higher of:
earnings (measured by the Average Weekly Earnings Index);
inflation (as measured by the Consumer Prices Index); or
2.5 per cent.
This is referred to as the ‘triple lock guarantee’.
A major difference between the basic state pension and the new
state pension is:
a) The basic state pension is paid at a later age than the new state
pension.
b) The new state pension is paid at a later age than the basic state
pension.
c) The new state pension has no facility for an individual to claim
a state pension based on National Insurance contributions paid
by the spouse or civil partner.
d) Lower levels of National Insurance contributions are required
to claim a full new state pension.
3) The correct answer is c). With the basic state pension it is possible to claim
a Category B pension based on the NICs of a spouse or civil partner, but
this is not possible with the new state pension.
1) Why is it important for a financial adviser to have a working
knowledge of state benefits?
1) Financial advisers need to understand what state benefits a person
is entitled to or already claiming in order to give appropriate financial
advice. For instance, when working out the level of life assurance cover
that a family needs, the income that would be available from state benefits
if a family wage earner were to die has to be taken into account.
2) Once Universal Credit is fully implemented, parents who are
eligible for Child Benefit will have to claim Universal Credit
instead. True or false?
2) False. Universal Credit will eventually replace Child Tax Credit, not Child
Benefit.
3) Which of the following is not a feature of new style Jobseeker’s
Allowance?
a) It is only available to claimants who have made National
Insurance contributions.
b) It is only available for claimants who have savings of less
than £6,000.
c) Benefits are taxable.
d) Claimants are credited with NICs.
3) b) New style Jobseeker’s Allowance (JSA) is paid irrespective of savings or
partner’s earnings.
4) James has been working in IT support for 12 years. His current
job is a fixed‑term contract and ends next month. Assuming
James has made NICs throughout his working life, what benefit
is he likely to be able to claim while he is unemployed?
a) Working Tax Credit.
b) Income Support.
c) New style Jobseeker’s Allowance.
d) New style Employment and Support Allowance.
4) c) New style Jobseeker’s Allowance.
5) Aliyah has been working for Abbots Transport for 16 weeks.
She is 24 weeks pregnant. Which of the following state benefits
may she be entitled to?
a) Statutory Maternity Pay.
b) Income Support.
c) Child Tax Credit.
d) Maternity Allowance.
5) d) Maternity Allowance. She is not entitled to Statutory Maternity Pay
because she will not have been with her employer for 26 weeks by her
qualifying week.
6) When is the earliest that Aliyah can begin claiming this benefit?
6) Eleven weeks before the baby is due.
7) Malcolm, who is 42 and self‑employed, has fallen ill and cannot
work. Which benefit might he be entitled to?
a) Disability Living Allowance.
b) Statutory Sick Pay.
c) Employment and Support Allowance.
d) Attendance Allowance.
7) c) Employment and Support Allowance. He cannot claim Statutory Sick Pay because he is self-employed.
8) Lucy earns £52,000 per year and her partner Howard has an
annual salary of £29,000. Let’s say the threshold for Child
Benefit is £50,000. They have three children, one at primary
school and two at secondary school; their eldest son, Ethan, is
18 and studying for three A levels. For how many children are
Lucy and Howard able to claim Child Benefit?
a) Two; they cannot claim for Ethan because he is over 16.
b) All three, because Ethan is still in full‑time education.
c) None, because Lucy earns more than £50,000 a year.
d) None, because their combined household income exceeds
£50,000 per year.
8) b) All three: they will be able to claim for Ethan up until his twentieth
birthday while he remains in approved education.
9) Ian retired in the current tax year at the age of 66. He had made
NICs for 33 years while he was working but he had had a career
break of three years to care for his sick partner. Is Ian eligible
for a full, new state pension?
a) No, because he was not continuously employed throughout
his working life.
b) No, because he retired too early to claim the new state
pension.
c) Yes, because he had paid NICs for more than 30 years.
d) Yes, because he was credited with NICs while he was a
carer.
9) d) Yes. Although 35 years’ NICs are needed to be eligible for the full new
state pension, Ian would have been credited with NICs for the three
years that he was a carer.
10) Lydia is 22 and has just begun a new job on a permanent,
full‑time contract. Her employer will offer her the opportunity
to contract‑out of the state second pension. True or false?
10) False. The state second pension was available only to those who reached
state pension age before 6 April 2016. Lydia’s National Insurance
contributions will build entitlement to the new state pension, which has
no additional earnings‑related element, therefore it is not possible for
Lydia to choose to contract out.
6.1 what are the main investment asset classes?
Property, cash (money held in deposit accounts), fixed interest securities (gilts and corporate bonds), equities(shares), alternative investments(antiques)
6.2 Why do people choose deposit based investments?
Security of capital –
However, inflation could reduce the value of the savings. There is also the risk of
loss of capital if the institution
becomes insolvent.
Convenience – banks and building societies are readily accessible.
What is a basic bank account?
A basic bank account is a simplified current account designed to encourage
people who have not previously had an account to open one. These accounts
are aimed at people (typically those on low income or receiving state benefits)
who might not otherwise be able to open a current account.
Cash can be obtained with
a card from ATMs and in-branch over the counter.
Payments can be made by
direct debit but no cheque books are issued on these accounts and there is no overdraft facility.
What is a packaged current account? (Exam question)
A packaged current account offers the holder a range of ancillary benefits such as breakdown cover, mobile phone
insurance and travel insurance in return for a monthly or annual fee. A packaged current account may also enable the
holder to open other accounts that offer preferential rates of interest.
What protection do depositors have?
(Exam question)
Savings in UK bank and building society accounts are protected
by the FSCS, up to a level of £85,000 per investor per financial
services provider.
Can you remember how interest from savings is taxed?
Interest on deposits is paid gross to all customers, and individuals have to
advise HMRC to deduct tax via their tax code or pay via self‑assessment.
For those on low incomes a starting rate of 0 per cent applies to the first £5,000
of savings income.
The starting-rate band reduces as taxable non‑savings income is received, and the starting rate does not apply at all where income received exceeds an individual’s personal allowance plus the starting‑rate band.
Additionally, there is a personal savings allowance (PSA) for basic‑rate taxpayers
and a lower allowance for higher‑rate taxpayers: savings income falling within
these limits is subject to 0 per cent tax. In calculating eligibility for the PSA, all
of an individual’s income is taken into account in assessing whether they are
a basic‑ or higher‑rate taxpayer.
What are national savings and investments?
National Savings and Investments (NS&I) are a range of saving and investment
products backed by the government.
The risk associated with the products is
very low because the government guarantees the return of capital invested.
What is a cash ISA?
(Exam question)
Individual savings accounts (ISAs) are a form of tax‑free personal savings scheme. One form of ISA is cash (also known as a cash ISA): it is a means of obtaining tax‑free interest on a bank or building society deposit account, subject to certain limits and
regulations.
What are HMRC and offshore accounts?
(Exam question)
Offshore accounts are often perceived as a vehicle to hold
monies that are not declared to the tax authorities. Under
legislation introduced to support implementation of the US
Foreign Account Tax Compliance Act, and effective from 2016,
British Crown dependencies and overseas territories exchange
financial information with HMRC. This includes the names and
financial details of those holding accounts.
What is the redemption date and coupon of gilts?
REDEMPTION DATE
The date on which the government must redeem the gilt by paying back
its original issue value or par value, normally quoted as a nominal £100.
This works in the same way as redeeming an interest‑only mortgage.
COUPON
The interest rate payable on the par value of a gilt. It is a fixed rate, paid
half‑yearly, gross but taxable.
What are index linked gilts?
Index‑linked gilts are gilts where the interest payments and the capital value
move in line with inflation. For the investor, this means that the purchasing power of their capital and interest received remain constant, unlike all other fixed‑interest investments where inflation erodes the purchasing power of
fixed‑interest payments.
A higher‑rate taxpayer buys £100,000 par value of Treasury
5% 2025 at a price of 80.0. how much stock does she pay?
She receives half-yearly interest of £2,500 (ie £5,000 annually),
which represents a yield of 6.25 per cent on her investment of
£80,000.
The interest is paid gross but she must pay tax of 40 per cent
on any interest in excess of her personal savings allowance of
£500.
Later she sells the stock for £90,000. is there capital gains Tax to pay on her gain of £10,000?
(Exam question)
She pays 80000 for her stock
She pays no capital gains tax
How do interest rate movements affect gilt yields?
(Exam question)
Rising interest rates
Robert owns £10,000 of gilts with a coupon of 3 per cent. This
means that he receives £300 per year interest.
He wants to sell the gilts, which have six years to run until their
redemption date. However, interest rates have risen since he
bought them and new six‑year gilts are now being offered with
a coupon of 5 per cent.
Carmen offers to buy Robert’s gilts from him, but she won’t
offer him £10,000 for them because she can buy new six‑year
gilts for £10,000 that gives her a coupon of £500 per year,
instead of the £300 that Robert’s pay.
She offers him in the region of £9,000 for his gilts. The effect
of rising interest rates is that the price on Robert’s gilts has
fallen. Although a price of £9,000 would reflect a return of 3.33
per cent (ie £300 interest on £9,000 invested) in terms of the
income provided by the gilts, it is important to remember that
if Carmen buys the gilts and holds them until redemption she
will also make a capital gain of £1,000 as £10,000 is returned
on redemption.
Falling interest rates
Imagine if, instead of rising, interest rates have fallen and
new 6‑year gilts are only paying a coupon of 2 per cent. An
investment of £10,000 would only return £200 per year,
compared with the £300 per year that Robert’s gilts are paying.
Carmen may therefore pay Robert substantially more than
£10,000, in which case Robert will make a profit (which is
exempt from capital gains tax).
Carmen will need to bear in mind that if she pays more
than £10,000 she will make a loss if she holds the gilts to
redemption.
How do you work out yield and capital gains of a gilt?
CALCULATE
Mark is considering buying gilts and is attracted to 5% Treasury
2025. He finds that this gilt is currently trading at a price of
£130.73. Mark understands that, should he buy this gilt, he will get
income of £5 per year (par value of £100 x 5%) every year to 2025.
He also understands that, should he hold the gilt until redemption
date, he will suffer a loss of £30.73 on each one as only £100 will
be paid on redemption.
To understand whether the income offered is a good rate it is
necessary to calculate the running yield as follows.
Running yield = coupon ÷ price paid
£5 ÷ £130.73 = 3.82%
The 3.82% rate of income looks reasonably attractive, based on
current interest rates, but it should be remembered that if the gilt
is held to redemption it will lose £30.73 of capital value, which
reduces the overall return.
What is a local authority bond?
Like the government (gilts) , local authorities can borrow money by issuing stocks
or bonds, which are fixed‑term, fixed‑interest securities. They are secured on
local authority assets and offer a guaranteed rate of interest, paid half‑yearly.
The bonds are not negotiable and have a fixed return at maturity.
Return of capital on maturity is promised, but these are not quite as secure as gilts since there is no government guarantee.
What is permanent interest bearing shares?
Permanent interest‑bearing shares (PIBS) were once issued by building
societies to raise capital. They pay a fixed rate of interest on a half‑yearly
basis. Interest is paid gross, although it is taxable as savings income according
to the investor’s tax status.
Investors should note that PIBS rank below ordinary accounts in priority of
payment, should a building society become insolvent. As a result, they are
higher risk, because depositors will be paid before shareholders.
If a building society converts to a bank by ‘demutualising’, the PIBS it has issued are converted to perpetual subordinated bonds (PSBs). Perpetual subordinated bonds have similar characteristics to PIBS in that they have no redemption or maturity date and will provide a fixed income stream.
What are corporate bonds?
Generally, a company will seek to finance its activities by using its profits, but
there are situations in which profits, even if retained over many years, will
not be sufficient to meet the company’s requirements and it has to seek other
sources of finance. The two main ways in which a company might seek to raise
additional money are by issuing shares and/or by borrowing. It can, of course,
borrow from banks or other lenders. It can also issue corporate bonds to meet
its long‑term financing needs, or commercial paper if funds are needed over a shorter period.
Corporate bonds are similar to gilts issued by the government. The bond is
issued with the promise to pay a fixed rate of interest until redemption date,
with the loan repaid in full at redemption date. The borrowing is usually over
the longer term, which helps the company to make long‑term business plans.
The bonds can be bought by institutional investors (such as life companies and pension funds) and by private investors.
A bond may be secured or unsecured. If it is secured, a charge is made on
company assets. This means these assets could be taken by the creditor and
sold in the event that the company defaults on interest payments or repayment
at redemption date.
A bond that is backed by security is typically referred to as a debenture. The
security is provided by a charge over company assets. A bond that is not backed by security is generally referred to as loan stock.
Some corporate bonds are convertible, giving the holder the right to convert
the loan into ordinary shares of the issuing company. There is no obligation to do so and if the option is not exercised, the loan continues unchanged.
Interest, rather than dividends, is payable and the company is obliged to
pay the interest promised, whether or not sufficient profit has been made by
the company. Whether the bond is secured or not, the holder is a creditor of
the company so, in the event of the company being wound up, would have
priority over shareholders. If the lending is unsecured, the bondholder ranks
with ordinary creditors.
The risks associated with corporate bonds relate to the viability of the issuing company, its prospects and financial strength. Corporate bonds are riskier than gilts because gilts are backed by the government. Corporate bonds will therefore pay higher rates of interest than similar gilts. A bond that is
unsecured presents a greater level of risk to the investor than one that is
secured.
Why does the fact that corporate bonds are regarded as riskier
than gilts mean that they generally pay higher rates of interest
than similar gilts?
Corporate bonds pay higher rates of interest than similar gilts because of
the relationship between risk and reward – the riskier the investment is
considered to be, the greater the reward the investor expects.
What are Eurobonds?
A Eurobond is a bond issued or traded in a country that uses a currency other
than the one in which the bond is denominated. This means that the bond
operates outside the jurisdiction of the central bank that issues that currency.
Eurobonds are a form of borrowing used by multinational organisations and
governments. For example, a UK company might issue a Eurobond in Germany,
denominating it in US dollars. It is important to note that the term has nothing to do with the euro currency, and the prefix ‘euro’ is used more generally to refer to deposits outside the jurisdiction of the domestic central bank.
Taxation of savings income in relation to bonds , how does it work?
Local authority bonds, corporate bonds, PIBS and Eurobonds pay interest gross
(without deduction of tax).
The interest paid is classed as savings income so would be free of tax if it fell
within an individual’s starting‑rate band for savings income or their personal
savings allowance (see Topic 3, section 3.4.4). If the gross interest, when
added to other savings income, falls outside the starting‑rate band for savings
and exceeds an individual’s personal savings allowance it will be taxed at 20
per cent, 40 per cent or 45 per cent with the actual rate determined by the
individual’s gross income.
What is a structured deposit?
The return from a bank account is generally in the form of interest and linked
to general interest rates. With a structured deposit, the return paid is linked
to the performance of an index measuring the performance of equities, such
as the FTSE 100. The investment is normally arranged over a fixed term, five
years for example.
Unlike a traditional fixed‑rate savings account, the return generated through
a structured deposit is variable because it is linked to the performance of
a particular stock market index or indices. The benefit of using structured
deposits is access to equity‑based returns with a promise that, regardless
of stock market performance, depositors will always get back their initial
investment. This reduction in risk is offset by the lowered potential for reward,
meaning investors probably will not receive the full benefit of any index rise and they will not receive dividend payments. Structured deposits are complex
and are normally purchased via a financial adviser.
6.9 What is ‘alternative finance’?
Alternative finance refers to any form of financial activity or lending that
takes place outside of the traditional banking system. A prime example of
this is crowdfunding. Crowdfunding is a way that individuals, charities and
businesses (including start-ups) can raise money from the public.
Crowdfunding can be donation-based (contributors do not expect anything
in return) or reward-based (contributors expect a reward, for example a free
trial of the product or service being developed). Neither of these types of
crowdfunding are regulated by the FCA.
In contrast, both loan-based crowdfunding (more commonly known as peer-
to-peer [P2P] lending) and investment-based crowdfunding are regulated. Due
to the risks involved, firms are only allowed to promote these to experienced or sophisticated investors, or to ordinary investors who confirm that they will
not invest more than 10% of their net investable assets.
What is P2P lending?
P2P lending involves a saver placing their money with a P2P lender who will
then lend the money out to businesses that are seeking funding. This type of
lending is usually arranged via loan-based crowdfunding platforms.
P2P lending is not a deposit proposition but has a number of elements in
common with deposit‑based savings, notably that funds are aggregated and
distributed, normally for a return, and it is possible to arrange both on an easy
access and fixed‑rate basis over an agreed term. P2P lenders are regulated by
the FCA.
In some cases, returns can be very competitive compared with traditional
deposits but there are more risks. While the lender will perform due diligence
on the businesses to which funds are being lent, there is a risk that loan
repayments might be missed, in which case the returns to the saver would
reduce. Importantly, P2P lenders are not covered by the Financial Services
Compensation Scheme (see Topic 25).
What is investment based crowdfunding?
With investment-based crowdfunding, contributors invest money typically in
exchange for a share of a company or a return on their investment. Investment-
based crowdfunding platforms enable lots of small investors to pool their
funds in one or more start-up companies. On its website, the FCA advises that these investors are very likely to lose their
investment given the significant risk of a start-up company going bust and the
shares becoming worthless.
1) A bank deposit account is a good place to hold a ‘rainy day
fund’. True or false?
True. Deposit accounts allow instant access to funds and they are low risk
because savings are protected by the Financial Services Compensation
Scheme up to a limit of £85,000.
2) What, if any, is the minimum age at which a person can take
out an NS&I Direct Saver?
a) There is no minimum age.
b) 16.
c) 18.
b) 16.
3) Interest on NS&I Income Bonds is tax‑free. True or false?
3) False, interest is paid gross but is taxable.
4) State two reasons why offshore bank accounts might be more
risky than similar UK deposit accounts.
4) If the investment is held in a currency other than sterling, its value might
be affected by adverse exchange rates if it has to be converted to sterling.
Accounts held offshore might not be covered by investor protection
schemes to the same extent as onshore UK investments.
5) In relation to gilts, what is the ‘coupon’?
5) The coupon is the interest rate payable on the par value of a gilt.
6) Jane has invested in short‑dated gilts. According to the UK
Debt Management Office (DMO) definition, this means that:
a) the gilts will have a redemption date within the next seven
years.
b) interest on the gilts will not be paid to her until the end of
the term.
c) the gilts will have a redemption date within the next ten years.
d) she will be unable to access her capital until the end of the
term.
6) a) The gilts will have a redemption date within the next seven years.
7) Rubina is considering buying a gilt, 3% Treasury 2025. The gilt
is currently trading at a price of £107. What is the running yield?
7) The running yield is £3 (coupon) ÷ £107 (price paid) = 2.8%.
Running yield = coupon ÷ price paid
8) The main difference between corporate bonds and gilts is that
corporate bonds:
a) usually pay a variable rate of interest.
b) are usually for larger amounts of money.
c) normally have no specified redemption date.
d) are considered to be higher‑risk investments.
8) d) Corporate bonds are considered to be higher‑risk investments.
9) The main difference between a debenture and other types of
corporate bond is that a debenture:
a) carries the right to vote at the company’s annual general
meeting.
b) is usually secured on the assets of the company.
c) can be converted to ordinary shares of the company.
d) pays a fixed rate of interest.
9) b) A debenture is usually secured on the assets of the company.
10) A Eurobond is the equivalent of a gilt, but issued by a
government within the eurozone. True or false?
10) False. A Eurobond is a bond issued or traded in a country that uses a
currency other than the one in which the bond is denominated, and they
can be issued by large companies, not just governments.
11) Jack opens an account so that his wages can be paid into it. He
can use his account to pay bills such as utilities and rent via
direct debit, and he can use his debit card to make purchases
online and in shops, but he cannot have an overdraft. What
kind of account does Jack have?
a) Packaged account.
b) An interbank account.
c) A basic bank account.
d) A debit account.
11) c) A basic bank account.
What are four factors affecting share prices?
Company profitability, strength of the market sector, strength of the UK and global economy and supply and demand for shares and other investments
How are shares brought and sold?
The London Stock Exchange (LSE). Shares, issued by UK and overseas companies, gilts, corporate bonds and options are all traded on this market. There are two
markets for shares: the main market (for which full listing is required) and the
Alternative Investment Market.
What is the main market for the stock exchange and how is it setup?
To be listed on the main market, companies must conform to the stringent
requirements of the Listing Rules laid down by the Financial Conduct Authority
(FCA).For a full listing, a considerable amount of accurate financial and other
information must be disclosed. In addition:
the applicant company must have been trading for at least three years;
at least 25 per cent of its issued share capital must be in the hands of the
public.
The LSE, like most stock markets, is both a primary and secondary market.
The primary market is where companies and financial organisations can raise finance by selling securities to investors. They will either be coming
to the market for the first time, through the process of ‘going public’ or
‘flotation’, or issuing more shares to the market. The main advantages of
listing include greater ease with which shares can be bought or sold, and
the greater ease with which companies can raise additional funds.
The secondary market is where investors buy and sell existing securities.
It is much bigger than the primary market in terms of the number of
securities traded each day.
What is the alternative investment market?
The Alternative Investment Market (AIM) is mainly intended for new, small
companies with the potential for growth.
In addition to shares companies will enjoy a wider public audience and enhance their profiles by joining the AIM.
Rules for joining the AIM are fewer and less rigorous than those for joining
the official list (the main market) and were designed with smaller companies
in mind.
Name and explain the four shares indices
(Exam question)
It is possible to measure the overall performance of shares by
using one or more of the various indices that are produced.
These include the following:
FTSE 100 Index (commonly known as the Footsie) – this is
an index of the top 100 companies in capitalisation terms;
each company is weighted according to its market value.
FTSE 250 Index – the next 250 companies by market
capitalisation after the FTSE 100.
FTSE 350 Index – the FTSE 100 and FTSE 250 companies
combined.
FTSE All‑Share Index – this is an index of around 600
shares, split into sectors. It measures price movements and
shows a variety of yields and ratios as well as a total return
on the shares.
Explain over the counter trading.
(Exam question)
OTC trading is not very common between individual private
investors, but is common between institutions. They trade
large blocks of securities with little publicity about the price
paid or the company (or companies) whose shares are being
traded. This form of trading is sometimes called ‘dark pools’.
MiFID II introduced stricter requirements for all trading venues
to ensure the fair and orderly functioning of financial markets.
New reporting requirements have increased the amount of
information available and are expected to reduce the use of
dark pools and OTC trading.
Explain the return from shares
Shareholders in a limited liability company do not have a liability for the debts of the company. The company is, legally, a separate entity from its owners and is liable for its own debts. Shareholders do, however, run the risk that the value of their investment in the company could go down; if the company goes into liquidation they could lose their investment altogether.
So, given that those who invest in equities run the risk of potentially losing all
their investment, we might expect that they would also expect to receive higher returns than they could get from investing in deposit‑based investments,
where their capital is protected. It is certainly true that, on average and over
the longer term, equity markets have generally outpaced the returns available on secure deposit‑based investments.
Explain ex dividend shares.
(Exam question)
Dividends are usually paid half‑yearly. Because of the
administration involved in ensuring that all shareholders
receive their dividends on time, the payment process has to
begin some weeks before the dividend dates. A ‘snapshot’
of the list of shareholders is made at that point, and anyone
who purchases shares between then and the dividend date
will not receive the next dividend (which will be paid to the
previous owner of the shares). Once the date has passed when
the administrative process of paying the dividend starts, the
shares are said to be ex‑dividend (or xd). The share price would
normally be expected to fall by approximately the dividend
amount on the day it becomes xd.
Alternatively, a share may be paid cum‑dividend, which means
that it is purchased before it goes xd, and the purchaser
receives the next dividend payment.
How do you calculate EPS, dividend cover and Price/earning ratio?
Earnings per share (EPS) = post‑tax net profit ÷ number of
shares
Dividend cover = how much of company profits are paid as
dividends
P/E ratio = share price ÷ earnings per share
How do you work out taxation of dividend income?
Sophie has taxable earned income of £31,700 and receives dividend
payments of £9,000 in the current tax year.
The tax payable is worked out in a set order of priority:
1) Earned income.
2) Dividend income.
Let’s assume higher‑rate income tax is paid on taxable income
above £37,700, that dividend income is taxed at 8.75% for basic-
rate taxpayers and 33.75% for higher-rate taxpayers, and that the
DA is £1,000.
Sophie’s tax is calculated as follows. (Remember that taxable
income is after the personal allowance has been deducted.)
Her earned taxable income all falls within the basic‑rate tax band
and there is £6,000 of the basic‑rate tax band remaining (£37,700 –
£31,700 = £6,000).
So, the first £6,000 of her dividend income falls in the basic‑rate
tax band. However, the first £1,000 is covered by the DA, so no tax
is payable on that amount.
The remaining £5,000 within the basic‑rate band is taxed at 8.75
per cent = £437.50.
This leaves £3,000 in the higher‑rate tax band, which is taxed at
33.75 per cent = £1,012.50.
The total tax payable on Sophie’s dividend income is £1,450.
Note that the dividend income falling within the basic‑rate band,
even where covered by the DA and not taxed, does use up a portion
of the basic‑rate band. Therefore, in the example, £3,000 is subject
to higher‑rate tax rather than a further £1,000 of Sophie’s dividend
income being taxed at the basic rate.
%
Explain rights issue of shares
to raise further capital by issuing more shares, those shares must first be offered to the existing shareholders. This is done by means of a rights issue offering, for example, one new share per three shares
already held, generally at a discount to the price at which the new shares are
expected to commence trading Shareholders who do not wish to take up this right can sell the right to someone else, in which case the sale proceeds from
selling the rights compensate for any fall in value of their existing shares (due
to the dilution of their holding as a proportion of the total shareholding).
What are script issues for shares?
A scrip issue is an issue
of additional shares, free of charge, to existing shareholders. No additional
capital is raised by this action – it is achieved by transferring reserves into the
company’s share account. The effect is to increase the number of shares and
to reduce the share price proportionately.
What are preference shares?
As with ordinary shares, holders of preference shares are entitled to dividends
payable from the company’s profits. They differ from ordinary shares in
that they are generally paid at a fixed rate, and holders of preference shares
are eligible for any dividend payout ahead of ordinary shareholders. Many
preference shares are cumulative preference shares, which means that if
dividends are not paid, entitlement to dividends is accumulated until such a
time as they can be paid.
Preference shares do not normally carry voting rights, although in some cases
holders may acquire voting rights if their dividends have been delayed.
If a company has to be wound up, there would generally be only a limited
amount of money available to repay debts and shareholders. In this situation, the claims of creditors are repaid in a set order of priority. Shareholders rank
lowest in the order of priority and are therefore most at risk of receiving
nothing at all; however, holders of preference shares have a higher claim than holders of ordinary shares.
Convertible preference shares
Convertibles are securities that carry the right to be converted at some later
date to ordinary shares of the issuing company. Traditionally they were issued as corporate bonds (with a lower rate of interest than conventional corporate
bonds because of the right to convert to equity).
Warrants
Warrants give the holder the right to buy shares at a fixed price at an agreed future date. The attraction is that they give the holder rights at a fraction of the cost of
the shares themselves. At the date when the warrant can be exercised, it will be exercised if the share price is above the price at which the shares can be bought
under the terms of the warrant. If the share price is at or below the terms offered
by the warrant, it will not be worth exercising the warrant and it will lapse.
Please explain 5 benefits of property investment.
Please explain different rules surrounding property for tax.
Please explain alternative ways to get into the property investment market.
Property investment can have benefits, including the following:
Property is a very acceptable form of security for borrowing purposes.
The UK property market is highly developed and operates efficiently and
professionally.On the other hand, there are a number of pitfalls of which inexperienced
investors in particular should be made aware, including the following:
Location is of paramount importance and a badly sited development may
prove a problem.
The property market is affected by overall economic conditions – in times of
recession, letting properties may be difficult and property prices may fall.
Property is a less liquid form of investment than most others.
As with direct investment in shares, direct investment in property can be risky
for the small investor, although buy‑to‑let mortgages (see section 7.6) have made
it easier. For those with smaller amounts of capital and those who wish to spread
the risk, property bonds might be appropriate: the underlying fund is invested in
a range of properties and shares in property companies.
The purchase of property is subject to stamp duty land tax and a premium
applies where the property is not the only one owned.
Income from property, after deduction of allowable expenses, is subject
to income tax. It is treated as non‑savings income for tax purposes. On the
disposal of investment property, any gain is liable to CGT, but any capital
expenditure on enhancement of the property’s value can be offset against
taxable gains.
What are 4 points why property letting is attractive to investors?
What are 6 risks?
Regular and increasing revenue streams to hedge against inflation, easy access to BTL mortgages, well developed market, easy access to ancillary services such as property management services.
Accessing the market can be difficult, as investment costs are high and
there are additional costs associated with arranging a mortgage, legal fees
and stamp duty land tax.
Property is an illiquid investment, meaning that it may be difficult to access
funds if they are required at short notice.
There may be void periods when the property is untenanted, meaning that
income is reduced or ceases.
There is the risk that tenants may damage the property, leading to additional
costs.
Legal fees may be incurred to remove unsatisfactory tenants.
The property will require ongoing management and maintenance; these
services can be outsourced but the costs would reduce overall yield.
Please name three ways that the government has tried to make property less attractive
Tax relief – previously, a BTL landlord could deduct the full cost of
mortgage interest from their BTL income when calculating profits. This
effectively gave tax relief at the landlord’s highest marginal income tax
rate in respect of the interest costs. Tax relief is now limited to a tax credit
at the basic rate only.
Wear and tear – the annual wear‑and‑tear allowance on the cost of
furnishings in the property has been replaced by a furniture replacement
relief that only allows the actual cost of replacing furnishings to be offset
against profits.
Stamp duty land tax – as mentioned in section 7.5, second properties are
now subject to an SDLT surcharge purchase.
Name four advantages of commercial property.
Name three drawbacks.
Commercial property tends to provide reasonably high rental income together
with, in general, steady growth in capital value. The main advantages are:
regular rent reviews, with typically no more than five years between each;
longer leases than for residential property;
more stable and longer‑term tenants;
typically lower initial refurbishment costs.
Drawbacks may include the following:
the higher average value means that spreading the risk is more difficult;
commercial property does not generally show the spectacular growth in
value that can sometimes be achieved in residential property;
if the investment is to be funded by borrowing, interest rates may be higher
than for residential loans.
Name three investigations lenders often carry out before lending for the purchase of commercial property.
quality of the land and property;
reputation of builders, architects and other professionals involved;
suitability of likely tenants.
Outline agriculture property investment?
(Exam question)
A further category of property investment is agricultural
property – farmland. An investor may buy the land and run
the farm themselves to generate income or let out all or some
of the land to a third party, thus providing rental income.
There is the prospect of capital growth but the market for
agricultural land is highly specialised and demand limited;
liquidity is therefore a major concern.
One of the benefits of owning agricultural property is
agricultural relief for inheritance tax. This relief applies to
the land, growing crops and farm buildings. Relief is available
for up to 100 per cent of the inheritance tax liability for
owner‑occupied farms, or 50 per cent where the owner has let
out the land.
Explain what a treasury bill is and how it works.
Explain two ways they differ from gilts.
Who are treasury bills generally for?
Treasury bills are short‑term redeemable securities issued by the Debt
Management Office (DMO) of the Treasury.
Like gilts, they are fundraising instruments used by the UK government, but they differ from gilts in a number
of ways.
Two major differences are:
Treasury bills are short term, normally being issued for a period of 91
days, whereas gilts can be long term or even undated;
Treasury bills are zero‑coupon securities, ie they do not pay interest.
Instead, they are issued at a discount to their face value or par value (the
amount that will be repaid on their redemption date).
As with gilts, Treasury bills are considered to be very low‑risk securities, the
risk of default by the borrower (the UK government) being so low as to be
effectively zero.
For example, a Treasury bill may be issued for £9,850 with a
‘par value’ of £10,000. The investor makes a guaranteed £150 on their £9,850
investment over 91 days, representing just over 6 per cent pa return, with no
risk (£150 ÷ £9,850 x 100 = 1.52% over three months).
Because they are such short‑term securities, changes in market rates of interest
have little impact on the day‑to‑day prices of Treasury bills unless the changes are significantly large.
Throughout their term, Treasury bills can be bought and sold, and there is a
strong secondary market, provided mainly by financial institutions as there
is no centralised marketplace. The
price tends to rise steadily from the
issue price to the redemption value
over the 91‑day period, but prices
can also be affected by significant
interest rate changes, or by supply
and demand.
Treasury bills are purchased in large amounts, and they are not, therefore,
generally of interest to small, private investors. They are held in the main
by large organisations (particularly financial institutions) seeking secure
short‑term investment for cash that is temporarily surplus to requirements.
Explain what a certificate of deposit is.
Certificates of deposits (CDs) are issued by banks and building societies.
They are in effect a receipt to confirm that a deposit has been made with the
institution for a specified period at a fixed rate of interest.
The interest is paid with the return of the capital at the end of the term. Terms are typically three months or six months, although depositors who require a longer term can
often obtain CDs that can be ‘rolled over’ for a further three or six months on
specified terms. The amounts deposited are typically £50,000 or more.
There are significant penalties for withdrawals before the end of the term.
However, because certificates of deposit are bearer securities, they can be
sold to a third party if the depositor needs the funds before the end of the
term.
Banks may also hold CDs issued by other banks, and they can issue and hold
CDs to balance their liquidity positions. For example, a bank would issue CDs
maturing at a time of expected liquidity surplus, and hold CDs maturing at a
time of expected deficit.
Please explain what a commercial paper is. And how it works.
Businesses need to borrow for a variety of purposes. When they need funds
for investment in their longer‑term business plans, they may issue corporate
bonds. When they wish to borrow for working capital purposes, however, they
can issue commercial paper. The transactions are for very large amounts,
with most purchasers being institutions such as pension funds and insurance
companies. Commercial paper can be placed directly with the investors, or
through intermediaries.
The commercial paper market offers cheaper borrowing opportunities for
companies that have good credit ratings, but even companies with lower credit
ratings can issue commercial paper if it is backed by a letter of credit from a
bank that guarantees (for a fee) to make repayment if the issuer defaults.
Direct investment in shares is low risk for individual investors
because, over the long term, equity markets have outpaced
inflation. True or false?
1) False. Direct investment in shares is regarded as high risk because if the
company fails, the entire investment is at risk. It is difficult for most investors
to spread the risk effectively between a large number of companies and sectors.
2) Name three factors that can affect share prices.
2) Factors include company profitability, the strength of the global and UK
economy, the strength of the market sector and the supply of and demand
for shares.
3) What are the implications for the purchaser of buying shares
ex-dividend?
3) They will not be eligible for a dividend payment in the first dividend
distribution following their acquisition of the shares. The previous owner
of the shares will receive this dividend payment.
4) A share with a low P/E ratio is likely to be more expensive than
other shares in the same market sector. True or false?
4) False. A low P/E ratio indicates that the share is not in high demand and it
is likely to be less expensive than other shares.
5) If a company distributes 25 per cent of its profits in the form
of dividends to its shareholders, what would the dividend
cover be?
a) 4.
b) 8.
c) 10.
d) 25.
5) a) 4 – the profit is four times the dividend paid out.
6) What is the difference between a rights issue and a scrip issue?
6) A rights issue involves offering existing shareholders the opportunity to
buy additional shares in order to raise additional capital. A scrip issue
involves issuing additional shares to shareholders free of charge, the
effect being to increase the number of shares in issue and reduce the
share price proportionately; no additional funds are raised.
7) Elliott is considering investing in a buy‑to‑let property. He
thinks this is a good way to achieve a high return. What are the
main drawbacks that Elliott should be aware of?
7) Suitable tenants may be hard to find.
Properties must be in desirable locations (eg good transport links,
access to local amenities, etc).
In times of recession, letting properties may be difficult and property
prices may fall.
Property is less easy to realise than most other forms of investment.
Investment costs tend to be high and can include management fees,
legal charges and stamp duty.
Government measures to discourage BTL have made the tax position
less advantageous.
8) How can a buy‑to‑let investor claim relief for wear and tear on
furniture?
8) They are allowed a furniture replacement relief, which allows the actual
cost of replacing furnishings to be offset against profits.
9) Treasury bills are zero‑coupon securities. What does this
mean?
9) They do not pay interest; instead they are issued at a discount to their par
value.
10) Commercial paper is generally issued for a term of between
three and six months. True or false?
10) False. Commercial paper is generally issued for between 5 and 45 days,
with 30–35 days being typical. Certificates of deposit are generally issued
for between three and six months.
What is the most common amount of days a commercial paper is issued.
Most commercial paper is issued for periods of between 5 and 45 days, with an
average of around 30 to 35 days. Firms that need to retain funds for longer than
this regularly roll over their commercial paper – the advantages of this are:
flexibility; and
the fact that the rate of interest is not fixed for a long period.
Why do collective investments appeal to investors?
The services of a skilled investment manager are obtained at a cost that is
shared among the investors. Individual investors do not need to research
particular companies – nor do they need to understand and deal with the
decision‑making and administrative work arising from events such as
rights issues.
Investment risk can be reduced because the investment manager spreads the fund by investing in a large number of different companies; thus if one
company fails, the investor loses only a small part of their investment,
rather than all of it. This is referred to as ‘diversification’. Such a spread
of investments could not normally be achieved with small investment
amounts.
Fund managers handling investments of millions of pounds can negotiate
reduced dealing costs.
There is a wide choice of investment funds, catering for all investment
strategies, preferences and risk profiles.
Collective investment schemes enable investors to gain exposure to assets
they would not otherwise be able to access due to minimum lot/investment
size (eg corporate bonds)
What is diversification in investments?
(Exam question)
Diversification is an important concept for investors. It
involves creating a portfolio of investments that are spread
across different geographical areas, asset classes and sectors
of the economy. The aim is to spread risk, in the hope that poor performance of one investment will be offset by better performance in another. It is the opposite of ‘putting all your
eggs in one basket’. For example, if you only hold shares in a company that sells sunscreen, you are likely to make more
money in a hot summer. If you only hold shares in a company making umbrellas, you will make more money if it rains. By diversifying to hold shares in both companies, you would have the opportunity to make money whatever the weather.
How are investment characterised?
location, eg UK, Europe, America, Far East;
industry, eg technology, energy;
type of investment, eg shares, gilts, fixed interest, property;
other forms of specialisation, eg recovery stocks, ethical investments.
Many funds are based on more than one categorisation; for example, a UK
equity fund is categorised by both location and type of investment.
A further categorisation is possible:
funds that aim to produce a high level of income (perhaps with modest
capital growth);
those that aim for capital growth at the expense of income; and
those that seek a balance between growth and income.
Funds can also be categorised according to their management style:
Actively managed funds (sometimes referred to simply as ‘managed funds’)
use the services of a fund manager(s) to make decisions on asset selection
and when holdings should be bought or sold.
Passively managed or tracker funds will seek to replicate the performance
of a particular stock market index, such as the FTSE All‑Share. A manager
may be used but it is also possible that asset selection is computerised.
Define managed funds.
(Exam question)
The term ‘managed’ fund can also be used as a marketing term
to describe a fund that is comprised of holdings allocated across some or all of the other funds a company offers. Most
companies offer one or more managed funds – for example, ‘managed growth’ or ‘managed income’. In this context the
manager’s role in a company’s managed fund tends to involve
deciding on the way fund investments should be allocated
between the company’s other funds.
What is a unit trust?
A unit trust is a pooled investment created under trust deed. They can invest a lump sum in the
unit trust, make regular contributions, or a mixture of both.
A unit trust is categorised as an equity trust where the underlying assets
are mainly shares, or as a fixed‑income trust where investment is mainly in
interest‑yielding assets. An equity trust pays a dividend, while a fixed‑income
trust pays interest.
A unit trust is divided into units, with each unit representing a fraction of
the trust’s total assets. It is ‘open‑ended’, so if lots of investors want to buy
units in it, the trust manager can create more units.
Unit trusts may offer the following types of unit:
Accumulation units automatically reinvest any income generated by the
underlying assets. This would suit someone looking for capital growth.
Distribution or income units split off any income received and distribute
it to unit holders. The units may also increase in value in line with the value
of the underlying assets.
The unit trust aims to produce a return by selecting investments that will grow
in value and/or generate income. If this happens, the unit price will increase,
meaning that the investment, when encashed, will be worth more than it was
at outset. A key role of the manager is to select investments that will achieve the trust’s objectives in terms of income and/or growth.
What is a trust?
(Exam question)
In general law, a trust is an arrangement whereby one person
gives assets to another (the trustees) to be looked after in
accordance with a set of rules (specified in the trust deed).
A unit trust is similar in that the trust deed details the investment rules and objectives of the scheme. The investor
effectively gives their money to the trustees who will in turn
allow the fund manager to use it to meet the trust’s objectives.
The trustees will ensure that the manager is fulfilling their
obligations under the trust deed.
How are units priced?
What are the four important prices in relation to unit trust transactions?
To price the fund, the manager will calculate the total value of trust assets,
allowing for an appropriate level of costs, and then divide this by the number of units that have been issued.
On a daily basis, managers calculate the prices at which units may be bought and sold, using a method specified in the trust
deed. Unit prices are directly related to the value of the underlying securities that make up the fund.
There are four important prices in relation to unit trust transactions:
The creation price is the price at which the unit trust manager creates
units.
The offer price is the price at which investors buy units from the managers.
The bid price is the price at which the managers will buy back units from
investors who wish to cash in all, or part, of their unit holding.
The cancellation price is the minimum permitted bid price, taking into
account the full costs of buying and selling. At times when there are both
buyers and sellers of units, the bid price is generally above this minimum
level, since costs are reduced because underlying assets do not need to be
traded.
What is a bid offer spread?
Some unit trusts use bid and offer prices, with the difference between them
(known as the bid–offer spread)
being between 3 per cent and 5 per
cent.
Which is single pricing unit trusts?
(Exam question)
In a single-price system the price is arrived at through
consideration of the net flows of the fund – in other words
whether, on a net basis, more subscriptions are being made
into the fund or whether more redemptions are being taken
from the fund. Where the value of subscriptions is greater than
redemptions, the fund is said to be in net inflow. Similarly,
where redemptions are greater than subscriptions, the fund is
said to be in net outflow.
The net flow of the fund is relevant in determining the single
price because a fund that has a net inflow will need to purchase
assets with the net subscription proceeds and so will be priced
closer to the offer price to reflect the cost of purchasing these
assets. Similarly, where the fund has a net outflow, the single
price will tend towards the bid price to reflect the cost of the
fund selling assets in its portfolio to generate cash, which can
be used to pay redemption proceeds.
In cases where the value of subscriptions and redemptions is
similar and the fund is receiving neither significant inflows
or outflows, the single price will tend towards the mid-price.
Although rare, they may impose an exit charge if units are sold
within, for instance, three or five years of purchase.
What is forward and historic pricing?
(Exam question)
The purchase of units in a unit trust is not an instant process
as application forms need to be completed, sent off or emailed,
and then administered before the investment is made. Units
are generally priced on a forward pricing basis. Under forward
pricing, clients buy or sell in each dealing period at a price
that will be determined at the end of the dealing period. The
prices published in the financial press are therefore only a
guide to investors, who do not know the actual price at which
their deal will be made.
Before forward pricing became standard practice there was a
system of historic pricing: the price of units was determined
by the closing price at the end of the previous dealing period.
Fund managers are still permitted to use historic pricing if they
wish, subject to the proviso that they must switch to forward
pricing if an underlying market in which the trust is invested
has moved by more than 2 per cent in either direction since
the last valuation.
How are units brought and sold? (Trusts)
Unit trust managers are obliged to buy back units when investors wish to sell
them. There is consequently no need for a secondary market in units and they
are not traded on the Stock Exchange. This adds to the appeal as the buying and selling of units is a relatively
simple process.
Units can be bought direct from the managers or through intermediaries. They
can be purchased in writing, by telephone or online: all calls to the managers’ dealing desks are recorded as confirmation that a contract has been established.
Purchasers may receive two important documents from the managers:
The contract note – this specifies the fund, the number of units, the unit
price and the amount paid. It is important because it gives the purchase price, which will be needed for capital gains tax (CGT) purposes when the
units are sold.
The unit certificate – this specifies the fund and the number of units held,
and is the proof of ownership of the units.
In cases where investors subscribe to a unit trust through an intermediary,
their holdings may be confirmed on a non‑certificated basis. Instead, investors
will receive a regular statement outlining the number of units held and their current value from the intermediary (eg a fund supermarket) rather than directly from the unit trust manager.
In order to sell units, the holder signs the form of renunciation on the reverse of the unit certificate and returns it to the managers. If only part of the
holding is to be sold, a new certificate for the remaining units is issued. If the
holding is non‑certificated, the investor may be asked to sign a separate form
of renunciation.
How are units of trust regulated and managed?
In the UK, unit trusts are primarily regulated under the terms of the Financial Services and Markets Act 2000, and must be authorised by the Financial Conduct
Authority (FCA) if marketed to retail investors.
The FCA specifies rules aimed
at reducing the risks associated with unit trusts. The rules require that a unit
trust fund is suitably diversified and specify that the fund cannot borrow an
amount of more than 10 per cent of the fund’s net asset value and, even then,
only for a temporary period.
The trust deed places obligations on both the manager and the trustees. The
manager aims to generate profit for the unit trust provider from the annual
management charge and dealing in units. The trustees’ overall role is to ensure investors are protected and that the manager is complying with the terms of
the trust deed. The role of trustee is usually carried out by an institution such
as a clearing bank or life company.
Manager’s responsibilities
— Managing the trust fund in line with the trust deed
— Valuing the assets of the fund
— Fixing the price of units
— Offering units for sale
— Buying back units from unit holders
Trustees’ responsibilities
— Setting out the trust’s investment directives
— Holding and controlling the trust’s assets
— Ensuring that adequate investor protection procedures are in place
— Approving proposed advertisements and marketing material
— Collecting and distributing income from the trust’s assets
— Issuing unit certificates (if used) to investors
— Supervising the maintenance of the register of unit holders
What are the two types of charges applied to unit trusts?
(Exam question)
The initial charge covers the costs of purchasing fund
assets. The initial charge is typically covered by the bid–
offer spread.
The annual management charge is the fee paid for the use
of the professional investment manager. The charge varies
but is typically between 0.5 per cent and 1.5 per cent of
fund value. Although it is an annual fee, it is commonly
deducted on a monthly or daily basis.
How are units trusts taxed?
Authorised unit trusts fall into two main categories:
If more than 60% of the underlying investments within a unit trust are
cash or fixed-interest securities, such as UK gilts or corporate bonds, the
fund will be classed as a fixed-income or non-equity fund and all income
distributions will be treated as interest payments.
If less than 60% of the underlying investments are cash or fixed-interest
securities, the fund will be classed as an equity fund and all income
distributions will be treated as dividends.
In both cases there is no tax on gains within the fund, meaning that the
investor may be liable to capital gains tax if they make a gain when encashing
the investment.
Equity‑based funds
For equity‑based unit trust funds, the tax treatment is the same as for shares.
Income is paid without deduction of tax. Where an investor’s total dividend in
a tax year is less than the dividend allowance (DA), there is no income tax on
the dividend.
Where dividend income is in excess of the DA, then the income is taxed at
different rates based on which tax band it falls into.
Fixed-income (or non-equity) funds
Interest from a fixed‑income fund is classed as savings income. The income
is paid gross, without deduction of tax. Where the interest is received by a
non‑taxpayer, falls within the starting‑rate band for savings, or falls within the
PSA of a basic‑ or higher‑rate taxpayer, then no tax is payable. Taxpayers who
have used their PSA are taxed on the excess income and are required to declare
the income to HMRC through self‑assessment.
What is the risk of investing in a unit trust?
The legal constitution of a unit trust helps to mitigate risk of fraud because
the trustees have a responsibility to ensure there is proper management.
The risks involved in investing in a unit trust are lower than those for an
individual investing directly into equities on their own behalf because a unit
trust is a pooled investment.
The wide range of
choice means that there are unit trusts to match most investors’ risk profiles.
A cash fund will carry similar risks to a deposit account, while specialist funds
that invest in emerging markets, for instance, are high risk by their very nature.
Overseas funds carry the added risk of currency fluctuations.
Unit trusts provide no guarantee that the initial capital investment will be
returned in full or that a particular level of income will be paid.
What are investment trusts?
Investment trusts are collective investments that are not unitised funds. they are not trusts.
They are public limited companies whose business is investing (in most cases) in
the stocks and shares of other companies. As a company, an investment trust is established under company law and operates as a listed plc; its shares are
listed on the stock exchange. An investment trust, by contrast, must meet FCA requirements
to gain a stock market listing, and it is governed by rules in its memorandum
and articles of association.
As with all companies, shares are sold to investors. The number of shares
available remains constant – the company does not create more just because
investors want them – so an investment trust is said to be ‘closed‑ended’ (in
contrast to the open‑ended nature of unit trusts and OEICs).
How do you invest in a investment trust?
Investing in an investment trust involves purchasing shares in the investment
trust through:
a stockbroker;
a financial adviser; or
direct from the investment trust manager.
Similarly, to cash in the investment, it is necessary to sell these shares, via a
stockbroker or back to the investment trust manager directly.
The shares trade at a single price but dealing fees are added to any purchase
and deducted from any sale. An annual management charge is also payable,
typically between 0.5 per cent and 1.5 per cent.
The share price of an investment trust depends to some extent on the value of
the underlying investments, but not so directly as in the case of a unit trust:
the price can also depend on a number of other factors that affect supply and
demand.
The share price of an
investment trust may be more
or less than the net asset value
(NAV) per share. Where the
share price is less than the
NAV the trust is said to be
trading at a discount, and this
suggests a lack of demand for
the shares. Where the share price is higher than the NAV, the investment trust
is said to trade at a premium, indicating demand for the shares.
How to calculate net asset vale per share?
Total value of the investment fund’s
assets less its liabilities, divided by
the number of shares issued.
Explain the term gearing.
The level of debt as a percentage
of a company’s equity. It is a
way of measuring the extent to
which a company’s operations
are funded by borrowing rather
than by shareholder capital.
Gearing and it’s relation to invesent trusts
Because investment trusts are constituted as companies, they can borrow
money to take advantage of investment opportunities – this is known as gearing. This facility is not open to unit trusts or OEICs, which are only
permitted to borrow money over the short term and against known future cash
inflows.
Gearing enables investment trusts
to enhance the growth potential of a
rising market, but investors should be
aware that it can equally accentuate
losses in a falling market.
The ability
to ‘gear up’ is one of the reasons
why investment trusts are viewed as
being riskier than a similar unit trust
or OEIC. Some investment trusts are
described as being ‘highly geared’ or
‘highly leveraged’, which means they have a high level of borrowing relative
to the assets they hold; the investment trust will be pursuing high returns
but there is the risk of being unable to service interest and/or repayments on
borrowings.
How are investment trusts taxed?
At least 85 per cent of the income received by the fund managers of investment trusts must be distributed as dividends to shareholders. As it is constituted
as a company, an investment trust pays income in the form of dividends. The
taxation situation is the same as that described for equity unit trusts.
As with unit trusts, fund managers are exempt from tax on capital gains.
Investors are potentially liable to CGT on the sale of their investment trust
shares, in the event that their gain, when added to the value of their other gains
realised in a tax year, exceeds the CGT annual exempt amount.
What is a split capital investment trust?
Sometimes known as split‑level trusts or simply as splits, split‑capital
investment trusts are fixed‑term investment trusts offering two or more
different types of share.
The most common forms of share offered are:
income shares – these receive the whole of the income generated by the
portfolio but no capital growth;
capital shares – these receive no income but, when the trust is wound up at
the end of the fixed term, share all the capital growth remaining after fixed
capital requirements have been met.
Most companies will also offer shares with differing balances of income and
growth, so as to meet different investor objective
What is a real estate investment trusts
Real estate investment trusts (REITs) are tax‑efficient property investment
vehicles that allow private investors to invest in property while avoiding
many of the disadvantages of direct property investment. One
particular advantage is that stamp duty reserve tax is charged at 0.5 per cent
on purchase; the rates of stamp duty for direct property purchase are much
higher.
In the UK, REITs pay no cooperation tax on income or growth for the property rental potion of there investments. They have to meet the requirements of reits.
What are the basic 5 requirements of REITS?
R:
• At least 75 per cent of their gross income must be derived from property rent.
• The remainder can come from development or other services but corporation tax is
charged on income and gains made here.
E:
• At least 90 per cent of their profits must be distributed to their shareholders net of basic-rate
tax. Higher- and additional-rate shareholders will have to pay additional income tax.
• Dividends can be paid in cash or as stock dividends (ie the allocation of further shares)
and are taxable at dividend rates.
I:No individual shareholder can hold more than 10 per cent of the shares.
T: Single-property REITs are only allowed in special cases – such as, for example, a shopping
centre with a large number of tenants.
S:They can be held in ISAs, Junior ISAs, Child Trust Funds and self-invested
personal pensions.
Some students find it challenging to get to grips with these
products. To help you, note down at least three ways in which an
investment trust differs from a unit trust.
A unit trust is constituted as a trust; an investment trust is actually a
company.
A unit trust is subject to FCA rules on diversification; an investment
trust is not.
A unit trust issues units to customers and these represent the customers’
holdings of the assets in the pooled fund. An investment trust issues
shares in a fund.
Units must be bought back by the fund manager so no secondary
market is needed; shares in an investment trust must generally be sold
via a stockbroker.
An investment trust can borrow funds to take advantage of investment
opportunities whereas a unit trust cannot.
Unit trusts are open‑ended (ie the unit trust manager can create more
units to meet demand); an investment trust is closed‑ended (ie the
number of shares available is fixed).
A unit trust can be established as an equity trust paying dividends
or a fixed‑interest trust paying interest. As an investment trust is a
company, it only issues shares and pays income as dividends.
What is an OEIC?
An OEIC is an ‘open‑ended investment company’ – a limited liability company
that pools the funds of its investors to buy and sell the shares of other
companies and deal in other investments.
To invest in an OEIC, the investor buys shares in the company; there is no limit
to the number of shares that can be issued, which is why it is described as
‘open‑ended’. The open‑ended nature of an OEIC means that the fund can expand
or contract, depending on whether new shares are being issued in response to
demand, or being redeemed if investors wish to sell. The value of the shares
varies according to the market value of the company’s underlying investments.
An OEIC may be structured as an ‘umbrella’ company that is made up of several
sub‑funds. Different types of share can be made available within each sub‑fund.
OEICs share a number of characteristics with unit trusts and investment trusts.
For instance, as with unit trust and investment trusts, investments can be made by lump sum, regular contribution or a combination of both. One difference
to note, however, is that while both investment trusts and OEICs operate as
companies, an investment trust can borrow money to finance its activities but
an OEIC can only borrow for short‑term purposes.
How are OEICs regulated and managed?
An OEIC is established as a limited liability company under a structural
framework set by HM Treasury (not under trust) under the Open-Ended
Investment Companies Regulation 2001 (as amended) and associated FCA
rules. Unlike an investment trust (unless it is self-managed), OEICs must be
authorised by the FCA; there is a great deal of common ground between the
FCA’s regulations for OEICs and those that apply to unit trusts
The role of overseeing the operation of the company and ensuring that it
complies with the requirements for investor protection is carried out by a
depositary, who is authorised by the FCA. The role of the depositary is similar
to that of the trustee of a unit trust.
An authorised corporate director, whose role is much the same as the manager
of a unit trust, manages the OEIC. The role of the corporate director is to:
manage the investments;
buy and sell OEIC shares as required by investors;
ensure that the share price reflects the underlying net asset value of the
OEIC’s investments.
What is SINGLE PRICING – OEICS?
(Exam question)
The share price of an OEIC is established by dividing the total
value of its assets by the number of shares currently in issue.
This is, essentially, the same approach as that used to establish
the unit price of a unit trust.
In many unit trusts, the units have a different bid and offer
price. Shares in an OEIC are single priced. Some OEICs opt
to use ‘swing pricing’, which is a method through which the
single quoted price of an OEIC ‘swings’ towards a de facto bid
or offer price. The swinging of the price takes account of the
transaction costs the OEIC incurs buying assets when there are
net inflows (ie net subscriptions into the OEIC) or net outflows
(ie net redemptions from the OEIC). The bid price takes account
of the cost of the OEIC selling assets to generate cash to pay
redemptions, whereas the offer price takes account of the cost
of the OEIC buying assets with subscription cash. You might
recall from your reading on unit trusts that some of these now
offer single pricing, too.
What’s are the charges associated with OEIC?
(Exam question)
In addition to the cost of buying the shares, the OEIC will levy:
an initial or buying charge – which is added to the unit
price and is normally in the region of 3 per cent to 5 per
cent of the value of the individual’s investment;
annual management charges based on the value of the
fund – the range of annual management charges is typically
between 0.5 per cent for indexed funds and 1.5 per cent for
more actively managed funds;
a dilution levy – this may be added to the unit price on
purchase of shares or deducted from the price on sale of
shares in situations where there are large flows of funds
into or out of the OEIC.
Other administration costs may also be deducted from the
income that is generated.
How are OEICs taxed?
The tax treatment of UK‑based OEICs is exactly the same as that for unit trusts.
In terms of income, an OEIC will be classified as either fixed‑income or
equity‑based.
If it is fixed‑income, the interest is paid without deduction of tax but is
subject to income tax as savings. There will be a liability to income tax
for basic‑ and higher‑rate taxpayers if total savings income exceeds the
investor’s starting-rate band for savings income (where available) and
personal savings allowance. Additional-rate taxpayers will be liable to
income tax on the full amount paid.
If an OEIC is equity‑based, a dividend is paid, again without deduction of
tax. There will be a further liability for income tax for basic‑, higher‑ and
additional‑rate taxpayers if total dividend income exceeds the investor’s
dividend allowance.
Fund managers are not subject to tax on capital gains, although individual
investors may be liable to pay CGT when their shares in the UK OEIC are
encashed.
How are offshore funds treated for OEIC?
(Exam question)
Where a fund, whether a unit trust or an OEIC, is based
offshore, a UK resident investor will still be liable for taxation
on income and gains.
If the offshore fund reports all the annual income attributable
to an investor, whether the income is distributed or not, it is
referred to as a ‘reporting fund’. The tax treatment is as above:
the investor will be liable for income tax on the income and
CGT on any gain on disposal.
If the offshore fund does not report the attributable income,
it is referred to as a ‘non‑reporting fund’ and the investor will
pay income tax, rather than CGT, on any gain on disposal.
8.4.3 What are the risks of investing in OEICs
The risks associated with investing in an OEIC are similar to those of investing
in a unit trust:
An OEIC is subject to the same FCA rules on diversification and fund
borrowing as apply to unit trusts, and these rules help to reduce risk.
As an OEIC is a pooled investment employing the services of professional
investment managers, the degree of risk is lower than it would be for an
individual investing directly in equities.
Risk is also mitigated by the spread that can be achieved for a relatively
small investment.
There is, however, no guarantee that the value of the original capital investment
will be maintained, nor is there any guarantee as to the level of income that
will be generated.
Make sure you understand the key differences between unit trusts,
investment trusts and OEICs. Create a table like the one below and
fill in the missing information. You will find a completed version
at the back of this book.
What are endowments in relation with life insurance and regular savings
Endowments are a type of investment based on life assurance. They combine
life assurance and regular savings. A lump sum is either paid if the life assured
dies during the term or, if they survive to the end of the term, it is paid at
maturity.
The introduction of schemes such as ISAs has reduced their popularity but
some plans remain in existence.
Endowments vary according to the nature of the underlying investment
structure, and common types are with‑profits and unit‑linked. As long as
premium payments are maintained, with‑profits endowments are comparatively
low risk as they offer the guarantee of at least a minimum value at maturity.
Unit‑linked plans do not carry such a guarantee and the value at maturity
depends on how the underlying investments perform.
What is a friendly society plan?
Friendly societies date from the eighteenth century when they were established
as mutual self‑help organisations. Over time they have evolved, with many
now offering a range of financial services.
A friendly society is able to market a tax‑exempt savings plan, effectively an
endowment with tax benefits, because the friendly society pays no corporation
tax on its investment returns. This can be compared with a conventional
endowment on which the life assurance company would pay corporation tax
on some income and gains within the fund.
As there is preferential tax treatment, the amount that can be saved is limited
to £270 per year (as a lump sum),£25 per month or £75 per quarter. The plan
is set up over an initial ten‑year term and there is no tax upon encashment.
Friendly society plans are often marketed as savings plans that enable parents
and grandparents to save on behalf of their children and grandchildren
What are investment bonds?
Investment bonds are collective investment vehicles based on unitised funds;
although they often appear similar to unit trusts because of their unitised
structure, they are actually very different.
Investment bonds are available from life assurance companies and are set up
as single‑premium, whole‑of‑life assurance policies. An individual who wants to invest does so by paying a single (lump sum) premium to the life company.
If an investment bond is unit‑linked, the investor then receives a policy
document showing that the premium has purchased (at the offer price) a
certain number of units in a chosen fund, and that those units have been
allocated to the policy. To cash in the investment, the policyholder accepts
the surrender value of the policy, which is equal to the value of all the units
allocated, based on the bid price on the day when it is surrendered.
Investment bonds are attractive to investors because of the:
relative ease of investment and surrender;
simplicity of the documentation; and
ease of switching from one fund to another – companies generally permit
switches between their own funds without charging the difference between
bid and offer prices.
The range of available funds is similar to those offered by unit trusts and
investment trusts.
investment a with‑profits
bond is cashed in within a specified period after commencement (typically
five years), the amount received is likely to be less than the value of the units.
In the event of the death of the life assured, the policy ceases and a slightly
enhanced value (often 101 per cent of the bid value on the date of death) is
paid out.
How are investment bonds taxed?
The funds in which the premiums are invested are an insurance company’s
life funds and their tax treatment is different from that of unit trusts. In
particular, they attract internal tax at 20 per cent on capital gains (whereas
unit trust funds are exempt) and this tax is not recoverable by investors even
if they themselves would not pay capital gains tax.
The taxation system for policy proceeds in the hands of the policyholder is
complex. Policies may be qualifying or non-qualifying with tax consequences,
particularly for higher- and additional-rate taxpayers as 20 per cent tax is
deemed to have already been paid within the fund. Investment bonds are
non‑qualifying policies.
Explain:
QUALIFYING AND NON‑QUALIFYING LIFE POLICIES
(Exam question)
Life assurance policies are designated as ‘qualifying’ or
‘non‑qualifying’ policies for tax purposes. The benefit of
a qualifying policy is that there is no tax liability on the
proceeds of the plan on death or maturity; a non‑qualifying
plan may result in a tax liability for higher‑ and additional‑rate
taxpayers. The criteria for qualifying policies is summarised
in Figure 8.5.
What is the key feature of investment bonds that makes them
non‑qualifying policies?
4) To be a qualifying policy for income tax purposes, premiums would have
to be paid annually, half‑yearly, quarterly or monthly over a period of
at least ten years. Investment bonds involve making a single lump sum
payment at the outset. As regular premiums are not made, an investment
bond will be non‑qualifying.
Explain Tax and investment bonds
Broadly speaking, a higher-rate taxpayer will pay an additional 20 per cent
income tax on their gain and an additional-rate taxpayer an extra 25 per cent.
The gain is the surrender value plus any withdrawals previously made that
have not already been taxed, less the original investment.
Top slicing, which enables the gain to be averaged over the term of the policy,
is used to facilitate use of the personal savings allowance (where available).
Top slicing is also used where the gain takes a basic-rate taxpayer into a higher
tax band. Where top slicing results in the gain remaining in the basic-rate tax
band, no further income tax is payable as the liability of a basic-rate taxpayer
is deemed to have been met at source.
Unlike investment trusts and unit trusts, investment bonds do not normally provide
income in the form of dividends or distributions, but it is possible to derive a
form of ‘income’ from them by making small regular withdrawals of capital (ie by
cashing in some of the units allocated to the policy). Investors can withdraw up to
5 per cent of the original investment each year without incurring an immediate tax
liability, regardless of whether the investor is a basic‑, higher‑ or additional‑rate
taxpayer. This 5 per cent allowance can, if not used, be carried forward and
accumulated, up to an amount of 100 per cent of the original investment.
Please see qualifying criteria for tax purposes below:
Explain none mainstream pooled investments
Collective investment schemes may only be sold to the general public in the UK
if they adhere to regulations relating to investment and promotion set out in
the FCA Handbook.
Schemes that do not fulfil the criteria for regulated collective investment
schemes are classified as non‑mainstream pooled investments (NMPIs).
The
FCA Handbook defines an NMPI as:
a unit in an unregulated collective investment scheme (UCIS);
a unit in a qualified investor scheme;
a security issued by a special vehicle, unless an excluded security;
a traded life policy;
rights or interest in any of the investments listed above.
NMPIs may invest in non‑traditional assets. Such investments carry a higher
risk. Also, if the provider is based abroad, an investor may have limited
recourse to the Financial Ombudsman Scheme and the Financial Services
Compensation Scheme. For these reasons, NMPIs are only
considered suitable for a very small group of high‑net‑worth individuals.
The
FCA does not generally permit the marketing of NMPIs to retail customers
What are structured investment products?
The defining characteristic of structured products is that they offer some
protection of the capital invested (up to 100 per cent in some cases), while
enabling investment in underlying assets that have the potential for higher returns but are also higher risk (such as ordinary shares).
8.8.1what are Structured capital‑at‑risk products (SCARPs)?
A SCARP is defined as a product other than a derivative that provides an agreed level of income or growth over a specified investment period and displays the
following characteristics:
a) The customer is exposed to a range of outcomes in respect of the return of
initial capital invested.
b) The return of initial capital invested at the end of the investment period is
linked by a pre‑set formula to the performance of an index, a combination
of indices, a ‘basket’ of selected stocks (typically from an index or indices),
or other factor or combination of factors.
c) If the performance in b) is within specified limits, repayment of initial
capital invested occurs. If it is not, the customer could lose some or all of
the initial capital invested.
8.8.2 what is a Non‑SCARP structured investment product?
A non‑SCARP investment is one that promises to provide a minimum return of
100 per cent of the initial capital invested as long as the issuer(s) of the financial
instrument(s) underlying the product remain(s) solvent. This repayment of
initial capital is not affected by the market risk factors.
8.8.3 what are the risks associated with structured products?
There are a number of risks associated with structured products including:
counterparty risk;
market risk;
inflation risk.
The products are also complex, with terms varying widely between providers.
Before investing in a structured product, an individual should ensure they
understand the risks involved and how the product works, particularly in terms of the returns offered and the conditions that need to apply for specific
returns to be provided.
What are wraps and platforms?
The basic premise of a ‘wrap’ account is that one provider sets up an
internet‑based platform to hold all of the investor’s investments within one
framework, enabling the investor to see all relevant information in one place.
The wrap account allows the investor to analyse and quantify the holdings
according to value, tax treatment and product type.
Wraps are generally offered by independent financial advisers, who levy
charges in addition to any individual fund management charges that apply to the investments held in the framework. Most wraps are able to hold any class of asset or fund on behalf of the investor.
A fund supermarket is designed to provide access to a wide range of funds,
such as OEICS, unit trusts and ISAs, but not investment trusts. The investor
has a ‘general investment account’, which is exposed to the UK tax regime
(apart from any ISAs that are included, as they are tax‑free). The investors pay
a charge for the service: either a flat fee or a percentage of funds held – this is
how the fund supermarket makes its money.
Both wraps and fund supermarkets are often referred to as ‘platforms’,
but they are different. A wrap offers all the same investments as a fund
supermarket, plus a range of other investments, such as investment trusts,
offshore investments and direct equities (shares).
What is sustainable Sustainable finance
The terms ‘sustainable finance’, ‘socially responsible investing’, ‘ethical
investing’ and ‘green investments’ appear frequently in the media and are
often used interchangeably.
In short, sustainable finance is about taking into account environmental, social
and governance (ESG) material factors when making investment decisions. A material factor is one that is likely to affect the profitability of a firm. For
example:
A material environmental factor could be paper recycling for a publishing
house.
Material social factors could relate to how a firm treats its employees. Are
they an inclusive employer? Do they pay a fair salary?
Governance factors relate to how a firm is run. Does it pay its fair share of
taxes? Does it have an ethics code? Is it transparent in its communications?
What are the advantages and disadvantages of sustainable development
What is green washing and sustainable development ?
Exam question
The FCA has concerns that firms are making exaggerated or
misleading sustainability-related claims about their investment
products (known as greenwashing).
CP22/20 introduces a package of measures to clamp down
on this, including sustainable investment labels, disclosure
requirements and restrictions on the use of sustainability-
related terms in product naming and marketing.
How do crypto assets work?
Transactions are recorded using distributed ledger technology (DLT).
Distributed networks eliminate the need for a central authority to check for
invalid transactions. Participants around the world, connected through a peer-
to-peer network, compete to solve complex puzzles to validate transactions.
All verified transactions are recorded on an electronic ledger.
Blockchain is the most widely known DLT network. It comprises transaction
entries called ‘blocks’ that confirm and record users’ transactions. Each block
is cryptographically connected to the previous block in the blockchain through
a ‘hash’ (a digital fingerprint). This creates an auditable trail of the transaction.
Blockchains are generally publicly available and transparent. Transactions are time-stamped on the blockchain and mathematically related to the previous
ones; they are irreversible and impossible to alter.
8.11.2 how do you regulate cryptoassets?
While the FCA has oversight to check that cryptoasset firms have effective
anti-money-laundering (AML) and terrorist financing procedures, generally
cryptoassets are not regulated by the FCA.
The FCA has confirmed that some cryptoassets, such as security tokens, may
fall within its regulatory remit depending on how they are structured.
The UK Cryptoassets Taskforce (CATF) report identified three different
categories of cryptoasset:
Exchange tokens – these are not issued or backed by any central authority
and are intended and designed to be used as a means of exchange. They
tend to be a decentralised tool for buying and selling goods and services
without traditional intermediaries. These tokens are usually outside the
regulatory perimeter.
Utility tokens – these tokens grant holders access to a current or prospective
product or service but do not grant holders rights that are the same as
those granted by specified investments. Although utility tokens are not
specified investments, they might meet the definition of e-money in some
circumstances (as could other tokens). In this case, activities involving
them may be regulated.
Security tokens – these are tokens with specific characteristics that mean
they provide rights and obligations akin to specified investments, like a
share or a debt instrument as set out in the Regulated Activities Order
(RAO). These tokens are within the regulatory perimeter.
(FCA, 2019)
Cryptoassets are considered very high-risk, speculative investments and
the FCA has banned the sale of crypto-derivatives to retail customers due
to concerns surrounding the volatility and valuation of the underlying
cryptoassets.
1) With regard to unit trusts, what does the term ‘open‑ended’ mean?
a) Clients can buy more units.
b) The fund manager can create an unlimited amount of units
according to demand.
c) The fund manager does not need to value the units.
d) There is flexibility in the taxation of units.
1) b) The fund manager can create an unlimited amount of units according
to demand.
2) A unit trust fund’s assets are owned and controlled by the
fund manager. True or false?
2) False. They are owned and controlled by the trustees.
3) Who is responsible for payment of capital gains tax on any
gain realised on the encashment of a unit trust?
a) The unit holder.
b) The trustees.
c) The unit trust company.
d) The fund manager.
3) a) The unit holder.
4) An investment trust is best described as:
a) a unit‑linked, single‑premium whole‑of‑life policy investing
solely in shares.
b) a trust that invests solely in fledgling companies.
c) a company that invests in the shares of other companies.
d) a partnership that invests in gilts.
4) c) A company that invests in the shares of other companies.
5) How can a private individual invest in an investment trust?
a) The investment trust manager creates more units.
b) By purchasing shares of the investment trust company on
the stock exchange.
c) The fund manager issues new shares.
d) By completing an application form for a share account and
submitting it to the investment trust trustees.
5) b) By purchasing shares of the investment trust company on the stock
exchange.
6) What potential benefit does gearing offer to an investment
trust that is not available to a unit trust or OEIC?
6) An investment trust can borrow in order to take advantage of investment
opportunities. Unit trusts and OEICs cannot do this.
7) How are shares in an open‑ended investment company priced?
a) There is a bid and offer price based on the underlying value
of the shares.
b) Shares are based on a historic valuation.
c) There is one price, based on the value of the assets divided
by the number of shares.
d) There is a cancellation price at which all shares are traded.
7) c) There is one price, based on the value of the assets divided by the
number of shares.
8) What rate of tax is deemed to have been deducted from the
investment fund underlying an investment bond?
a) 0 per cent.
b) 10 per cent.
c) 20 per cent.
d) 40 per cent.
8) c) 20 per cent is deemed to have been taken within the investment with a
potential further liability of 20 per cent for higher‑rate taxpayers or 25
per cent for additional‑rate taxpayers.
9) Investment bonds are attractive to investors because
withdrawals are tax‑free. True or false?
9) False. The investor may withdraw up to 5 per cent of the value of the original
investment per annum without paying tax at the time of withdrawal but a
tax liability may arise when the bond matures, on encashment of the bond
or on death of the bondholder.
10) Noah is a higher‑rate taxpayer and is considering a range of
investments. He wants to know which investment, out of unit
trusts, investment trusts or OEICS, would be most likely to
help him meet his objective of achieving capital growth. What
would you advise?
a) A unit trust.
b) An investment trust.
c) An OEIC.
d) Any of the above.
10) d) Noah could choose any of the above. The fact that he is a higher‑rate
taxpayer has no bearing on his decision – they are all taxed in the same
way.
What are the two stages of an investments life what they are taxed?
What are the main taxes that affect investments?
Give an example of a tax wrapper what what does it do?
(Exam question)
TAX WRAPPERS
In considering the different types of investment that can
be held, either directly or indirectly, through collective
investments, the tax treatment is an important factor. Tax can
be charged at two stages in an investment’s life:
while the funds are invested;
when funds are drawn or income is paid out.
The main taxes that affect investments are income tax and
capital gains tax (CGT).
Using a tax wrapper, such as an ISA, changes the way the
investor is taxed on income and gains from the underlying
investment.
What are the five different types of ISA?
A stocks and shares ISA can include:
— shares and corporate bonds issued by companies listed on a recognised
stock exchange anywhere in the world, including Alternative Investment
Market (AIM) shares;
— gilt‑edged securities and similar stocks issued by governments of
countries in the EEA;
— UK‑authorised unit trusts and OEICs;
— UK‑listed investment trusts;
— life assurance policies on the sole life of the ISA investor;
— units in a stakeholder medium‑term investment product;
— shares acquired in the previous 90 days from an all‑employee
savings‑related share option scheme (SAYE).
A cash ISA can include:
— bank and building society deposit accounts;
— units or shares in UK‑authorised unit trusts and OEICs that are
money‑market schemes;
— stakeholder cash deposit products.
An innovative finance ISA involves investing via a peer‑to‑peer (P2P) lender
(P2P lending was discussed in Topic 6).
A Help-to-Buy ISA (now closed for new applications) was to help those
saving for their first UK home by adding a bonus to any savings they make.
A Lifetime ISA can be used to buy a first home
What are the eligibility rules for ISAs?
(Exam question)
ELIGIBILITY RULES FOR ISAS
The minimum age for investing in a stocks and shares ISA,
innovative finance ISA or Lifetime ISA is 18 years (Lifetime
ISAs also have a maximum age of 40); a cash ISA can be
opened by anyone aged 16 or over.
An ISA investor must be generally resident in the UK for tax
purposes.
An ISA can only be held in a single name, ie joint accounts
are not permitted.
What are subscription limits on ISAs and why are they used?
The purpose of granting tax benefits on investments held within an ISA is
to encourage people who might not otherwise have saved funds to do so.
To ensure that the tax benefits meet that objective, there are limits on the
maximum amount that may be saved each tax year. The limit means that those who already have adequate savings cannot benefit further by switching their
savings into ISAs to gain greater tax benefits.
Provided the overall annual subscription limit is not exceeded, an individual
investor can choose to invest the full annual amount into a stocks and shares ISA, or a cash ISA or an innovative finance ISA, or split their investment in any proportion they wish.
What are ADDITIONAL PERMITTED SUBSCRIPTIONS to ISAs?
(Exam question)
On death of an investor on or after 6 April 2018, ISA holdings
are designated as a “continuing account of a deceased investor”
and remain so until the earlier of the:
administration of the estate;
closure of the account; or
third anniversary of the death of the account holder.
While no further funds can be added, the holding continues to
benefit from the tax advantages of an ISA.
An ‘additional permitted subscription’ (APS) allowance applies
when an individual’s spouse or civil partner dies. The purpose
of the APS is to protect the tax benefits around savings held
within an ISA. It allows the surviving spouse/civil partner
to make an additional ISA subscription to the value of the
deceased’s ISA holdings.
The right to make a cash APS applies for three years from the
date that the person died, or 180 days after administration
of the estate is complete, whichever is later. For stocks and
shares, the time limit is simply 180 days after administration
of the estate is complete. The additional subscription can be
made with the manager who held the deceased’s ISA or with
another manager who agrees to accept the subscriptions. Its
value can either be the value of the deceased’s ISA at the date
of their death or at the point the ISA ceased to be a continuing
account of a deceased investor.
9.1.3 explain withdrawals and transfers for ISAs
ISA providers have the option to offer flexibility, allowing funds withdrawn
from a cash or innovative finance ISA, or the cash element of a stocks and shares ISA, to be replenished during a tax year. However, providers are not
obliged to offer this flexibility.
Many ISA providers allow no‑notice withdrawals to be made, although there are
some fixed‑rate cash ISAs that do not permit withdrawals during the fixed‑rate
period.
Funds may be transferred between different types of ISA without contravening
the ISA limits. ISAs can be transferred between providers.
9.1.4 explain Tax reliefs on ISA investments
Investors are exempt from income tax and CGT on their ISA investments.
As a comparison, an investment held in a unit trust is potentially liable to CGT
on encashment. If the unit trust is held within an ISA there is no liability to
CGT.
9.1.5 explain a Help‑to‑Buy ISA
It was designed to help those saving for their first
UK home by adding a bonus to any savings they make.
The scheme was open
to those aged 16 or over, and joint purchasers were able to open individual
accounts that each earn a bonus payment. Anyone who opened an account
by 30 November 2019 will be able to use the funds invested and the bonus
payment towards the purchase of a first home by 1 December 2030.
Account holders could make an initial deposit of up to £1,200. Monthly savings
of between £1 and £200 can be made until 30 November 2029. Each £200 paid
in attracts a bonus payment of £50, subject to the ISA being worth at least
£1,600 when funds are withdrawn for home purchase. The minimum bonus
size is £400 and the maximum £3,000. The bonus is available on purchases of
up to £450,000 in London and £250,000 elsewhere in the UK and is paid when
the home purchase is completed. Savings into a Help‑to‑Buy ISA form part of the annual ISA allowance, rather than being in addition to it.
9.1.6 explain a Lifetime ISA and it’s rules?
A Lifetime ISA was introduced from 6 April 2017, with the aim of encouraging
younger people to save for their first home in the UK, to a value of up to
£450,000, and/or for their retirement. The main rules are as follows:
A Lifetime ISA can be opened by those aged between 18 and 40.
Savings made before the age of 50 attract a bonus of 25 per cent (paid by
the government).
The bonus is paid monthly, which enables interest to be earned on the
bonus.
A maximum of £4,000 may be saved per tax year; there is no monthly
savings limit.
The underlying investment choices are the same as those in the cash and
stocks and shares ISAs.
Savings into a Lifetime ISA form part of the annual ISA allowance, rather
than being in addition to it.
Savings can be used to purchase a first home and/or retained to provide
benefits in retirement from the age of 60.
Savings, including the bonus, can also be withdrawn when the accountholder
is terminally ill.
A 25 per cent penalty is applied if funds are withdrawn for reasons other
than the purchase of a first home, the holder reaching age 60 or the holder
suffering a terminal illness.
An individual may contribute to both a Help‑to‑Buy ISA and a Lifetime ISA,
but the bonus payment from only one of these ISAs can be used towards
the purchase of a first home.
9.2 explain Junior ISAs
Junior ISAs (JISAs) became available in November 2011 when their predecessor
the Child Trust Fund (CTF) scheme closed.
Children cannot have both a JISA and a CTF, but CTFs can be transferred into
JISAs on request. JISAs confer the same tax benefits as an adult ISA. Stocks
and shares and cash JISAs are available, and investment can be made into one
type or split between each. As with other ISAs, there is a maximum annual
investment limit.
Where a child is aged under 16, a JISA can only be opened and managed by
the child’s parent (or another adult with legal responsibility for the child).
An eligible child aged 16 or over can open and manage a JISA on their own
behalf; if a JISA has already been opened for them, they become responsible
for managing it.
Funds cannot be accessed until the child reaches 18; once the child is 18, the
account becomes a conventional adult ISA.
9.3 explain Child Trust Funds
Child Trust Funds (CTFs) are no longer available to new savers, although
existing CTFs can continue to receive subscriptions up to the annual limit.
Alternatively, as already mentioned, a CTF may be transferred into a Junior
ISA (see section 9.2).
A CTF remains in force until the child’s 18th birthday. At this point, no further
contributions can be made but the account keeps its tax-exempt status until
it is closed. A maturing CTF can be transferred into an ISA without affecting
the child’s ISA subscription limit. There is no access to money in the account
before the child’s 18th birthday.
There were three general types of CTF:
deposit‑type savings accounts;
share accounts; and
stakeholder CTF accounts.
Stakeholder CTF accounts invest in a range of company shares, subject to
certain government rules designed to reduce the risk.
The maximum annual charge permitted on a stakeholder CTF is 1.5 per cent.
9.4 explain Venture Capital Trusts and the Enterprise
Investment Scheme
Newly established companies, particularly those not listed on a stock exchange,
can find it difficult to raise the funds they need to grow. To encourage private
investors to provide funds to such companies, the government offers various
schemes that incentivise investment through the award of tax benefits. The
two main types of scheme are Venture Capital Trusts (VCTs) and the Enterprise
Investment Scheme (EIS).
The main difference between the two types of scheme is that a VCT is an
investment in its own right, a collective investment, whereas the EIS is a system
of tax reliefs that an individual company applies for; if a company is eligible
for the EIS an investor in the company can claim the available tax reliefs.
9.4.1 explain Venture Capital Trusts
A Venture Capital Trust (VCT) is a company whose shares are listed (and can
therefore be traded) on the stock exchange; it is run by an investment manager.
The VCT normally spreads the monies raised from investors over a range of
different companies.
Investment into a VCT is normally viewed as high risk, so income tax reliefs
are granted to make the proposition more attractive:
Income tax relief at up to 30 per cent is given on an investment of up to
£200,000 per tax year.
Any dividends paid by the VCT from the £200,000 permitted maximum
investment are tax free.
Any capital gains are exempt from CGT.
A VCT must be approved by HMRC and must meet certain conditions to
gain approval.
9.4.2 Enterprise Investment Scheme
In a similar way to a VCT, the Enterprise Investment Scheme (EIS) is designed to
encourage investment in certain smaller, high risk companies by the provision
of tax relief. The main difference is that whereas a VCT is a listed company
that undertakes the investment on the behalf of the investor, the EIS involves
direct investment in a company that is eligible for the scheme.
As with VCTs, EIS investment is seen as high‑risk so tax reliefs are offered:
Income tax relief at up to 30 per cent is given on an investment of up to
£1,000,000 (£2,000,000 if the amount invested in excess of £1,000,000 is
made in knowledge‑intensive companies) per tax year.
The CGT on any capital gains that are reinvested is deferred.
Capital gains from investment in the EIS are exempt from CGT, provided
that the EIS shares have been held for at least three years.
As with the VCT, there are a number of conditions that must be met for the tax
reliefs to be granted.
There is also the Seed Enterprise Investment Scheme (SEIS), which offers
even higher tax reliefs than the EIS, as it is targeted at raising funds for small
start‑up companies.
1) Stella, aged 24, has invested £4,000 per year into a cash ISA
for the past 3 years. In the current tax year, she received an
inheritance and invested the full subscription limit into her
cash ISA, but now she would like to split the money between
her cash ISA and a stocks and shares ISA. Is she able to do this
in the current tax year?
1) Yes, she can transfer money between different ISAs without contravening
the maximum subscription limit.
2) In what circumstances is an additional permitted subscription
(APS), over and above the usual investment limit, allowed in
respect of an ISA?
2) An APS is allowed for someone who has died: the spouse/civil partner of
the deceased is able to make an additional ISA contribution to the value of
the ISA holdings of the deceased.
3) Following someone’s death, the right to make a cash additional
permitted subscription (APS) lasts for the later of 180 days or
what length of time from the date of death?
a) 6 months.
b) 12 months.
c) 2 years.
d) 3 years.
3) d) The right to make a cash APS lasts for three years from date of death,
or 180 days from grant of administration, whichever is later. For stocks
and shares, the time limit is simply 180 days after administration of
the estate is complete.
4) In the current tax year, Jane invested £10,000 into a stocks and
shares ISA that does not offer a flexible investment facility.
Later in the current tax year, she withdrew £1,760. Given an
annual ISA investment limit of £20,000, how much would Jane
be able to pay into ISAs during the remainder of the current
tax year?
a) £10,000.
b) £12,240.
c) Nil.
d) £20,000.
4) a) The withdrawn amount counts towards Jane’s ISA allowance because
her provider does not offer a flexible investment facility, so she could
invest a further £10,000 (£20,000 less the £10,000 initially invested).
5) The advantage of holding investments in a stocks and shares
ISA, rather than holding collective investments directly, is that
the ISA investment is free of what taxes?
5) Investments held within an ISA are free from income tax and capital gains
tax.
6) Existing Help-to-Buy ISA customers can continue saving up to
£200 per month until:
a) 30 November 2023.
b) 30 November 2025.
c) 30 November 2027.
d) 30 November 2029.
6) d) Customers who owned Help-to-Buy ISAs before 30 November 2019, can
save a maximum of £200 per month until 30 November 2029.
7) What is the purpose of the Lifetime ISA?
7) The Lifetime ISA aims to encourage people to save for the purchase of
their first home and/or for their retirement.
8) An investor can increase their annual ISA investment limit by
taking out a Lifetime ISA, a Help‑to‑Buy ISA and a standard ISA.
True or false?
8) False. The annual investment limits for Lifetime and Help‑to‑Buy ISAs
count towards the overall annual ISA investment limit; they are not in
addition to it.
8) An investor can increase their annual ISA investment limit by
taking out a Lifetime ISA, a Help‑to‑Buy ISA and a standard ISA.
True or false?
8) False. The annual investment limits for Lifetime and Help‑to‑Buy ISAs
count towards the overall annual ISA investment limit; they are not in
addition to it.
9) Aaron, aged 12, has a Child Trust Fund. His mother wants to
open a Junior ISA for him instead, but she is unable to transfer
the Child Trust Fund into a Junior ISA and Aaron cannot hold
both types of account. True or false?
9) False. Aaron’s mother can transfer the Child Trust Fund into a Junior
ISA. However, it is true that Aaron cannot hold both types of account
concurrently.
10) Which type of investment normally represents a higher risk:
an investment trust or a venture capital trust?
10) A Venture Capital Trust would normally represent a higher risk to the
investor than an investment trust because VCTs invest in newly established
companies, which tend to be higher risk.
10.1.1 for pension provision.
How is the threshold income calculated?
How is adjusted income calculated?
Threshold income is calculated through the following steps:
Calculate total net income for the tax year.
Deduct any gross pension contributions that benefited from relief at source
(but excluding any employer contributions).
Deduct any lump sum death benefits from registered pension schemes.
Add any reduction of employed income for pension provision through
salary sacrifice schemes and flexible remuneration arrangements made
after 8 July 2015.
Adjusted income is calculated through the following steps:
Calculate total net income for the tax year.
Add claims made for tax relief on pension savings paid before tax relief
was given.
Add pension savings made to pension schemes where tax relief was given.
Add any tax relief claims on pension savings made to overseas pension
schemes (for non-domicile individuals).
Add employer pension contributions.
Deduct any lump sum death benefits received from registered pension
schemes.
Can you carry forward an annual allowance for pensions and if so how many years?
An individual can carry forward any unused annual allowance from the
previous three tax years to the current tax year.
The unused allowance is
added to the current year’s annual allowance and only if pension contributions
exceed this amount is the annual allowance charge payable.
Name two further allowances for pensions
Two further allowances are important:
Lifetime allowance – if the total value of an individual’s pension benefits
exceeds the lifetime allowance at the point when benefits are taken, there
is a lifetime allowance tax charge. The pension provider will deduct the
tax before any benefits are issued. There are different tax rates charged
depending on how the money is paid out, with lump sums attracting a
higher charge than funds taken as income or withdrawals.
Money purchase annual allowance (MPAA) – this applies where a pension
scheme member draws benefits from their pension using flexi‑access
drawdown income or takes an uncrystallised funds pension lump sum
(UFPLS).
Reading:
In respect of contributions to personal pensions, tax relief is given at source at
the basic rate with any higher‑/additional‑rate relief claimed via an individual’s self‑assessment tax return. Relief at the individual’s highest rate is given at
source on contributions to occupational pensions as any pension contribution
is deducted from gross, pre‑tax, income.
Within a pension fund there is no tax on gains or on savings or dividend
income.
WHAT IS THE ‘MARGINAL RATE’ OF TAX? In terms of pension taxation relief
(Exam question)
A person’s highest marginal rate of tax is the highest rate
that they pay on their income. For example, a person whose
taxable income falls within the higher-rate band would pay 20
per cent on their income up to the basic-rate threshold and 40
per cent on any income that lies above that. As they only pay
higher‑rate income tax on part of their earnings, they would
only receive tax relief at the highest rate (40 per cent) on that
amount of their pension contributions (eg if £5,000 of income
was within the higher-rate band, then £5,000 of pension
contributions would be eligible for an additional 20 per cent
tax relief). Any contribution in excess of that amount would
receive tax relief at the basic rate.
Explain Collective defined-contribution pension schemes
There is a demand for a third type of scheme, which can provide more
predictability for scheme members than defined contribution, without the
cost volatility for employers associated with defined benefit. The Pension
Schemes Act 2021 provides a framework for the UK’s operation and regulation
of collective money-purchase schemes (commonly known as collective
defined‑contribution pensions). The new collective defined-contribution
(CDC) pension will see both the employer and employee pay into a joint fund,
with pensions paid out from this shared pot. The benefits of the new scheme include that it offers predictable costs for the employer and is more resilient
against economic shocks. The Royal Mail and Communication Workers Union
will be the UK’s first CDC scheme and a case study will be done on how UK
workers receive the new scheme and how successful these schemes can be in
practice.
Explain Topping up defined-benefit schemes
As people are now living longer and spending a longer period in retirement,
employers are finding defined‑benefit schemes increasingly expensive to
run. As a result, many are reducing their commitment and transferring
responsibility for pension provision to individuals. Many people may therefore
wish to supplement their retirement income by contributing more to their
occupational schemes, or contributing to private arrangements.
The following
are tax‑efficient pension arrangements:
additional voluntary contributions (AVCs);
free‑standing additional voluntary contributions (FSAVCs);
personal/stakeholder pension plans.
AVCs and FSAVCs are available to employees who are members of occupational
schemes. Personal/stakeholder pensions are generally available to anyone
under the age of 75.
Funds do not pay tax on income or gains.
10.2.1 explain Additional voluntary contributions to pensions
AVCs are additional contributions to an occupational scheme. Sometimes,
such contributions purchase additional years’ service in a final salary scheme.
However, most AVCs operate as defined-contribution arrangements and the
employee will only have a limited choice of funds.
The employer will usually cover some or all of the administration and fund
management costs. Contributions to AVCs are deducted from gross salary and
the employee therefore receives full tax relief at the same time.
10.2.2 explain Free‑standing additional voluntary contributions for pensions
As an alternative to an AVC, an individual might choose to contribute to an
FSAVCs defined-contribution fund provided by a separate pension provider.
FSAVCs are available from a range of financial institutions, including insurance
companies, banks and building societies.
Contributions to FSAVCs are made from taxed income. Tax relief at the basic
rate of 20 per cent is claimed by the pension provider and added to the
individual’s pension fund. Higher‑ and additional‑rate taxpayers need to claim
additional relief separately through their income tax self‑assessment. Up until 2006, FSAVCs were potentially attractive to employees who wished
to keep their financial arrangements independent from their employer and
because they offer a wider range of investment funds than AVCs. Their drawback
is that they tend to be more expensive than AVCs because the employer is not
bearing the costs. Once personal/stakeholder pensions became available to all
employees in April 2006, FSAVCs became much less popular.
10.2.3 explain the background to Workplace pensions and how the government tried to make more people have them ect
Successive UK governments have been concerned that people are not saving
enough for retirement. In 2009, for example, only 50 per cent of UK employees
were members of their employer’s pension scheme, and not all employers
offered a pension scheme. Workplace pensions and auto‑enrolment, introduced
in 2012, are an attempt to address this problem.
Under auto‑enrolment, employers must enrol ‘eligible’ workers in a qualifying
workplace pension and contribute a specified minimum amount to the scheme.
Many existing occupational pensions already qualified as a suitable pension
scheme for this purpose; those employers who did not have a scheme already
could set one up, or enrol their employees in the National Employment Savings
Trust (Nest).
Explain NEST pensions
(Exam question)
NEST
As an alternative to setting up or using their own pension
scheme, employers can meet their obligations by enrolling
their employees in Nest.
Nest is a trust‑based occupational pension scheme established
to support workplace pension provisions; it can be used by an
employer either alongside or instead of its own occupational
pension scheme.
Nest offers a range of investment funds from which the
member can choose, and there are default fund selections for
members who do not wish to make their own choice. Charges
are capped. Benefits can be taken from age 55 and must be
taken no later than age 75.
What is the criteria for auto-enrolment in pensions?
The criteria for auto‑enrolment are that the employee:
is not already in a pension at work;
is aged 22 or over;
is under state pension age;
earns more than £10,000;
works in the UK.
Reading
An employee can choose to opt out of the scheme, but only after they have
automatically been made a member.
A minimum of 8 per cent of an employee’s earnings have to be paid into the
scheme, made up of an employer contribution of 3 per cent, an employee
contribution of 4 per cent and tax relief of 1 per cent.
How to calculate direct benefits pensions?
He then worked for ten years at Brooks Bakery until his retirement
and paid into their 1/60th scheme. His final salary with Brooks was
£25,000.
10/60ths of £25,000 = 10/60 x £25,000 = £4,166.67
Pat has been employed by Telephonics plc for just over 35 years
and has been a member of the company’s 1/60th pension scheme
for the whole of that period. His salary is now £81,000 and he is
due to retire next month. What will his pension entitlement be?
a) £54,000.
b) £28,350.
c) £47,250.
d) £81,000.
2) c) £47,250 (35 ÷ 60 × £81,000). Answer a) is not correct because £54,000
represents 40/60ths of his final salary, which is what Pat could have
earned under the scheme had he worked for Telephonics for 40 years, not
35. Answer b) is not correct because £28,350 represents 35 per cent of his
final salary, not 35/60ths. Answer d) is not correct because, although he
can pay in to his pension a maximum of 100 per cent of his UK earnings,
his pensionable service does not justify that level of pension.
10.3 explain What is a personal pension is
All forms of non‑occupational pensions are arranged on a defined‑contribution
basis. Personal pensions are individual arrangements provided by financial
services companies such as life assurance companies, banks and building
societies. Contributions receive basic‑rate tax relief at source, even for
non‑taxpayers. A higher‑ or additional‑rate taxpayer needs to claim additional
relief separately through self‑assessment.
10.3.1explain What is a group personal pension?
Providing an occupational pension is expensive and may be unaffordable for
a small or medium‑sized employer that lacks the financial resources to set
up and run a scheme. An alternative is to arrange a group personal pension: a collection of individual personal pension plans all administered by an
insurance company on behalf of a single employer.
The arrangement is very much the same as each employee arranging a personal
pension individually with access to the insurance company’s range of pension
funds. Each member has their own plan, which they can take with them if
they leave the employer. However, as there are a number of members, the
insurance company normally offers a discount on the set‑up and management
charges, meaning each employee gets better value than setting up a scheme
on an individual basis. It is also possible that the employer will enter into a
‘direct pay’ arrangement whereby they collect pension contributions from each
employee’s gross salary and pay them over in bulk to the pension provider.
10.3.2 What is a self‑invested personal pension (SIPP)?
A SIPP is a personal pension arrangement that gives access to a wider range of
investment options than would be available through a conventional personal
pension. For example, it may be possible to hold a direct shareholding or
commercial property within a SIPP. While access to a wide range of investments
is permitted, a SIPP will also allow a scheme member to use the provider’s
range of conventional pension funds.
A SIPP may appeal to someone who has the confidence to make their own
investment decisions.
Explain what a stakeholder pensions is
The stakeholder pension has been available since 6 April 2001 and is a type
of personal pension. The government’s aim in introducing it was to encourage
more individuals to contribute to their own pension arrangement, particularly
those at lower earnings levels, who traditionally did not have pension provision
and relied on the state pension.
Stakeholder pensions were designed to be simple, low‑cost options. Key
standards that a product must meet in order to be designated a stakeholder
pension are as follows:
Charges cannot exceed 1.5 per cent of the fund value per annum for the
first ten years of the term and cannot exceed 1 per cent after that time.
Entry and exit charges are not permitted.
The minimum contribution required cannot be more than £20.
The restriction on the level of charges meant that advisers generally found
it uneconomic to give advice on stakeholder pensions. To overcome the
lack of access to advice, the government prepared a set of decision‑making
flowcharts, known as decision trees, which people can use to determine
whether stakeholder pensions are appropriate to their own circumstances.
It was partly because of the failure of stakeholder pensions to achieve a
large‑scale take‑up that auto‑enrolment into qualifying workplace pensions
was introduced in 2012.
What are the two phases of retirement planning?
Retirement planning has two phases:
an accumulation phase when savings are made into a pension to build up
a fund;
a decumulation phase when benefits are drawn.
The way in which pension contributions are invested during the accumulation
phase very much depends on the type of scheme.
What are the two phases of retirement planning?
Retirement planning has two phases:
an accumulation phase when savings are made into a pension to build up
a fund;
a decumulation phase when benefits are drawn.
The way in which pension contributions are invested during the accumulation
phase very much depends on the type of scheme.
10.4.1 explain Defined‑benefit pension schemes
In respect of a defined‑benefit scheme there is, generally, a pension fund
operated by or on behalf of the employer into which contributions are paid.
Investment decisions are taken at scheme level, with the objective being
to ensure that the scheme can continue to pay pension benefits already in
payment and the benefits of current members who will reach retirement age/
draw benefits in future. The scheme will usually be invested in a mixture
of equities, gilts, corporate bonds and cash; individual members are unable
to make decisions on how their contributions are invested but have the
reassurance of the promise of a certain level of pension benefits.
10.4.2 explain Defined‑contribution pension schemes
Within defined‑contribution arrangements, the scheme member has much
more choice and control over how their contributions are invested. The
pension provider usually offers a wide range of investment funds from which
the member can select, and pension benefits depend, in part, on the value of
the fund when benefits are taken.
When an individual is many years from taking benefits they may choose
investment funds aimed at maximising growth, such as equity funds; as retirement approaches the preference may be for lower‑risk funds such as
cash or fixed interest. The member is able to choose a mix of funds to meet
their needs, objectives and circumstances.
If the pension is an individual arrangement, such as a personal pension, a
financial adviser can guide on fund choice. Where a defined‑contribution
pension is an occupational scheme there may be a more limited range of funds
to choose from, with the employer selecting what they believe to be the most
suitable funds.
Explain PUBLIC SECTOR/PUBLIC SERVICE SCHEMES
(Exam question)
These schemes are operated by the government and most of
them are ‘unfunded’. There is no pension fund as such and
contributions form part of general government revenues. The
schemes do provide a promise in terms of pension benefits
and this is provided by the government out of its funds.
10.5 How can benefits be taken from a pension?
Up to 25%
tax-free
Annuity
Uncrystallised
funds pension
lump sum
Flexi-access
drawdown
10.5.1explain Annuity purchase
Annuity purchase involves the payment of a lump sum from the pension fund
in exchange for an income.
The benefit of an annuity is certainty: the annuity provider promises a
guaranteed rate of income – an annuity rate – based on the annuitant’s
circumstances. It is not necessary to buy the annuity from the company used
during the accumulation phase: pension providers must inform their clients
that they can ‘shop around’ for the most appropriate benefits structures and/
or higher annuity rates. This is known as the open‑market option.
Once an annuity has been purchased, investment risk is removed but there is
no longer any prospect of further investment growth.
10.5.2explain Flexi‑access drawdown for DC pension
Flexi‑access drawdown (FAD) involves drawing the pension fund, after any
PCLS has been taken, and reinvesting it into a fund to provide income. The
fund remains invested so there is potential for further growth but there is also
the risk that the fund value might fall and, consequently, income levels may
not be maintained.
The withdrawals can be structured however the member wishes: as smaller,
regular payments to provide an income, or as larger, perhaps one‑off payments.
As any payment beyond the PCLS is taxable, care must be taken not to trigger
a large tax charge.
10.5.3 explain a Uncrystallised funds pension
lump sum
Opting for a UFPLS means the pension fund remains invested. Unlike FAD,
none of the fund is drawn or reinvested and no PCLS is drawn. The member is
able to use their pension fund to draw a series of lump sum payments to meet
their income/capital needs.
10.5.4 explain The money purchase annual allowance
Pensions are almost unique as an investment because of the tax relief they offer on
contributions: tax relief that is provided to encourage people to save for retirement.
With the ability to draw sums from a defined‑contribution (ie money‑purchase)
pension via FAD or UFPLS, there is a risk that those who already have adequate
retirement income draw funds and then reinvest them into a defined-contribution
pension to benefit from tax relief, effectively getting two lots of tax relief.
To limit the extent to which people can do this, a lower annual allowance applies
once an individual has started to access their funds via FAD income or UFPLS.
Instead of being able to receive tax relief on pension contributions up to the full
annual allowance, they have an MPAA. The MPAA only applies to contributions
to defined‑contribution schemes: a member can still pay up to the full annual
allowance into a defined‑benefit pension scheme (although that total is reduced
by the amount of any contribution into a defined‑contribution scheme).
Explain the CAPPED AND FLEXIBLE DRAWDOWN for pensions
(Exam question)
Capped drawdown was an option for those who reached pension
age before 6 April 2015. Income benefits were drawn direct from
a designated drawdown fund, with an upper limit (ie a cap), on
the amount that could be drawn. Capped drawdown is no longer
available for those reaching minimum pension age, but those
already using a capped drawdown arrangement can add further
pension funds. Alternatively, they can convert to FAD.
Flexible drawdown was another option available until 6 April
2015. This form of drawdown allowed unlimited withdrawals. All
flexible drawdown arrangements have been converted to FAD.
10.6 explain Death benefits for pensions
Pensions can provide a range of benefits when a member dies, with the options
available depending on the type of scheme and whether death occurred before
or after retirement. When seeking to understand the nature of death benefits
provided, it is always important to check the scheme rules.
10.6.1 explain Defined‑benefit schemes and the affects of death
If a member dies before retirement age, referred to as death in service, a lump
sum death benefit is usually available. This can be a multiple of earnings
or a fixed sum. Additionally, there might be a spouse’s and/or dependant’s
pension, paid from the scheme to the spouse, civil partner or dependants of
the deceased. This can be a proportion of the member’s pension rights. On death after retirement, a defined‑benefit scheme may:
continue to pay the pension income for a period of time, a ‘guaranteed
period’; or
pay a spouse’s/dependant’s pension as a proportion of the pension that
was being paid to the member.
10.6.2 explain the affects of death on Defined‑contribution schemes
On death before crystallisation, the pension fund can be used to provide
income and/or lump sum benefits.
On death after retirement, there are a range of ways in which a
defined‑contribution scheme will be able to provide benefits to the spouse/
civil partner or dependants of the deceased:
continuing scheme pension;
lifetime annuity continuing for an agreed period post‑death;
lifetime annuity paying an annuity protection lump sum – this would be the
balance of the funds used to buy the annuity as compared with how much
had already been paid out as income at date of death; or
continuing drawdown income.
10.7 explain pension scams
While pensions confer a number of tax benefits, there are limitations in terms
of the benefits not being accessible until age 55 and only 25 per cent of the
fund value being available as a tax‑free PCLS. The large sums of money invested
in pensions have proved attractive to criminals who attempt to ‘scam’ people
out of their pensions.
An approach will often be made via a cold call or text message on the pretext
of an offer to transfer the pension to a scheme that will enable all funds to be
drawn immediately as a tax‑free lump sum. The reality is that no such type of
scheme exists and the intention is to take control of the pension.
Pensions are by no means the only area in which attempts will be made to
scam people out of money. Criminals are also active in promoting investment
schemes that promise high rates of return, the sale of shares that in reality
do not exist and in taking fees to arrange consumer credit which is never
provided.
An adviser’s role is to be aware of such schemes and to advise a customer
considering one to be mindful of the potential risk. The general rule is that, if
it looks too good to be true, it probably is.
Explain PENSIONS DASHBOARDS
(Exam question)
PENSIONS DASHBOARDS
The government is working to introduce pensions dashboards
that will allow consumers to see the current value of their
pensions, administrative details about their pots, and their
estimated income in retirement, all in one place for all pensions
that are not yet being paid. This will include their state pension
entitlement, workplace pensions and personal pensions from
all providers. The aim is to make it easier for people to plan
for their retirement and ensure they have enough money to
support them in later life.
The implementation date of pensions dashboards has suffered
several setbacks, so you should keep an eye on developments
in this area.
1) Marta is 37 and pays 3 per cent of her salary into a pension
scheme each month. The benefit that she will receive at
retirement depends solely on the investment performance of
the fund. Marta’s pension scheme is:
a) a defined‑benefit personal pension.
b) a final‑salary occupational pension.
c) a defined‑benefit occupational pension.
d) a defined‑contribution occupational or personal pension.
1) d) Marta’s scheme is a defined‑contribution scheme, which could be
either an occupational or a personal pension.
2) Explain what is meant by the term ‘lifetime allowance’.
2) The lifetime allowance is the total amount that an individual may hold in
retirement benefits at the point where the benefits are crystallised without
incurring a tax charge.
3) What rate of tax relief is applied to contributions to an
individual’s pension plan?
a) Basic, higher or additional rate depending upon the
contributor’s marginal rate of tax.
b) Always basic rate.
c) Always higher rate.
d) Basic, higher or additional rate depending upon the pension
provider’s own rules.
3) a) Basic, higher or additional rate depending upon the contributor’s
marginal rate of tax.
4) Contributions to AVCs are deducted from gross income. True
or false?
True
5) Which of the following statements is correct?
An individual may be auto‑enrolled in a workplace pension
scheme providing they:
a) were born in and are currently working in the UK.
b) are aged between 18 and 55.
c) earn in excess of £10,000 a year.
d) are not liable to higher‑rate tax.
5) c) Individuals must earn in excess of £10,000 per year to be auto‑enrolled
into a workplace pension scheme.
6) Since April 2015 personal pension providers have been obliged
to allow scheme members to access their retirement benefits in the form of an uncrystallised funds lump sum if the member
wishes to do so. True or false?
6) False. Pension providers are not obliged to offer this facility, although
scheme members are free to move to a different provider if they wish to
access their funds in this way.
7) Which of the following in relation to stakeholder pensions
is correct?
a) Charges must not exceed 2 per cent of the fund.
b) There must not be any entry or exit charges.
c) The minimum monthly contribution is £50.
d) The maximum contribution is £3,600 per annum in all cases.
7) b) There must not be any entry or exit charges.
8) John is using an uncrystallised funds lump sum to provide his
pension benefits. The amount of each payment he takes that
is free of tax is:
a) 50 per cent.
b) 100 per cent.
c) 25 per cent.
d) Nil.
C/ 25%
9) What previous form of income drawdown was converted to
flexi-access drawdown from 6 April 2015?
9) Flexible drawdown arrangements were all converted to FAD on 6 April
2015.
10) Nicky is 60 years old and has a low appetite for risk. She is
considering options for taking benefits from her pension fund
and would like to be able to receive a guaranteed income, with her
pension fund no longer exposed to any investment risk. Which
method of providing retirement benefits should Nicky take?
10) An annuity provides a guaranteed income and there is no investment risk,
so this would be a suitable option for Nicky.
What are the KEY FEATURES OF TERM ASSURANCE?
KEY FEATURES OF TERM ASSURANCE
The sum assured is payable only if the death of the life
assured occurs within a specified period of time (the term).
The term can be anything from a few months to, say, 40
years or more.
If the life assured survives the term, the cover ceases and
there is no return of premiums.
There is no cash‑in value or surrender value at any time.
If premiums are not paid within a certain period after the due
date (normally 30 days), cover ceases and the policy lapses
with no value. Most companies will allow reinstatement
within 12 months provided all outstanding premiums are
paid and evidence of continued good health is provided.
Premiums are normally paid monthly or annually, although
single premiums (one payment to cover the whole term) are
allowed.
Premiums are normally level (the same amount each month
or year), even if the sum assured varies from year to year.
What is the surrender value?
The sum payable by the insurance company to the policyholder if the
policyholder chooses to terminate the policy before the end of the term,
or before the insured event occurs.
What is the surrender value?
The sum payable by the insurance company to the policyholder if the
policyholder chooses to terminate the policy before the end of the term,
or before the insured event occurs.
11.1.1 What is the difference between level term and decreasing
term assurance?
With level term assurance, the sum assured remains constant throughout the
term. Premiums are normally paid monthly or annually throughout the term,
although single premiums can be paid.
Level term assurance is often used when a fixed amount would be needed on
death to repay a constant fixed‑term debt such as a bank loan.
It can also be used to provide family cover; in these circumstances, the term
might run until the children are expected to have completed their full‑time
education, for example. If it is used for this purpose, the policyholder should
bear in mind that the amount of cover in real terms would be eroded by the
effect of inflation.
With decreasing term assurance, the sum assured reduces to nothing over the
term of the policy. Premiums may be payable throughout the term, or may be
limited to a shorter period such as two‑thirds of the term. This policy could be
used to cover the outstanding capital on a decreasing debt.
The most common use of decreasing term assurance is to cover the amount
outstanding on a repayment mortgage. It is usually known as a mortgage
protection policy, or mortgage protection assurance. The sum assured is
calculated in such a way that it is always equal to the amount outstanding on
a repayment mortgage of the same term, based on a specified rate of interest.
The sum assured (like the mortgage) decreases more slowly at the start of the
term than towards the end.
11.1.2 What is gift inter vivos cover?
Gift inter vivos cover is a term assurance policy designed to cover certain
inheritance tax liabilities. Gifts inter vivos are gifts made during a person’s
lifetime, as opposed to on death.
If a person makes an outright gift during their lifetime that, either on its own
or when added to gifts made in the previous seven years, exceeds the current
nil‑rate band for inheritance tax, provision needs to be made for the tax that
may become due if the donor does not survive for seven more years. Using a
gift inter vivos policy, the sum assured is set at the outset as the amount of tax
that is due. It remains level for three years and then reduces in line with the
tapering relief on taxation of gifts; seven years after the gift has been made it
becomes exempt from tax and so the cover ceases.
Additional cover should also be arranged to protect the remainder of the
estate.
11.1.3 What is convertible term assurance?
Convertible term assurance includes an option to convert the policy into a
whole‑of‑life or endowment assurance, at normal premium rates, without the
life assured having to provide evidence of their state of health at the time of
conversion.
The cost is an addition of, typically, around 10 per cent of the premium.
Certain rules and restrictions apply to the conversion option:
The conversion is normally carried out by cancelling the term assurance
and issuing a new whole‑of‑life or endowment policy. A new endowment
can extend beyond the end of the original convertible term policy.
The option can only be exercised while the convertible term assurance is
in force.
The sum assured on the new policy cannot exceed the sum assured of the
original convertible term assurance: if a higher level of cover is required
after conversion, the additional sum assured will be subject to normal
underwriting.
The premium for the new policy is the current standard premium for the
new term and for the life assured’s age at the conversion date.
11.1.4 What are increasing and renewable term assurances?
Some companies offer increasing term assurance where the sum assured
increases each year by a fixed amount or a percentage of the original sum
assured.
This type of policy can be used where temporary cover of a fixed amount is
required but where the cover needs to increase to take some account of the
effects of inflation on purchasing power.
Renewable term assurance includes an option to renew the policy at the end of
the initial term for the same sum assured, without the need to provide further
medical evidence.
The new term is of the same length as the initial term and the new policy itself
includes a further renewal option. However, there is a maximum age, usually
around 65, after which the option is no longer available.
The premium for the new policy is based on the life assured’s age at the date
when the renewal option is exercised.
Renewable and increasing term assurance is similar to the renewable policy,
with the added option to increase the sum assured by a specified amount
on renewal. The increase is often either 50 per cent or 100 per cent of the
previous sum assured, and again no further evidence of the life assured’s
state of health is required.
Some companies offer renewable, increasing and convertible term assurances,
combining all three of the options described above.
11.1.5 What is family income benefit?
Often, when people are seeking to protect their family finances, taking out life
assurance that provides a lump sum on death of a wage earner might not be
ideal. Such a sum might quickly be spent, or it might have to be invested and
managed to provide an income. A more useful solution might be a product that
is designed to provide a regular income to replace the income lost on death.
Family income benefit (FIB) policies are designed to meet this need.
Usually, these policies pay a tax‑free regular income (monthly or quarterly)
from the date of death of the life assured until the end of the chosen term.
As an alternative to regular income payments, beneficiaries may choose to
receive a lump sum payment, which is calculated as a discounted value of the
outstanding regular instalments due.
Since, usually, the cover reduces as time passes, this policy can be described
as a form of decreasing term assurance. However, policies can be arranged
with escalating instalments, to combat the effects of inflation; the premiums
for these policies are higher, to reflect the higher level of cover provided.
11.2 What is whole‑of‑life assurance?
Whole‑of‑life assurance is designed, as the name implies, to cover the life
assured for the whole of their lifetime.
It will pay out the amount of the
life cover in the event of the death of the life assured, whenever that death
occurs, provided that the policy remains in force. Like all protection policies,
therefore, the overall benefit of this type of assurance is that it provides peace
of mind. It can be used in personal and business situations, and for certain
taxation purposes. Examples include to:
protect dependants against loss of financial support in the event of the
death of a breadwinner;
provide a tax‑free legacy;
cover expenses on death;
provide funds for the payment of inheritance tax.
Premiums may be:
payable throughout life (ie for the full term of the policy, whatever that
turns out to be); or
limited to a fixed term (eg 20 years) or to a specified age (such as 60 or 65).
If limited premiums are chosen, the minimum term is normally ten years.
Because whole‑of‑life assurance (unlike term assurance) will definitely pay out
sooner or later, life companies build up a reserve to enable them to pay out
when the life assured dies. This enables companies to offer surrender values
on whole‑of‑life policies if the client cancels them during their lifetime. These
surrender values are, however, generally small in relation to the sum assured.
In fact, in the early years of a policy, the surrender value will be less than
the premiums paid. This emphasises the fact that whole‑of‑life policies are
protection policies and not investment plans, even though they have often
been used for investment purposes.
What are JOINT‑LIFE SECOND‑DEATH POLICIES?
(Exam question)
When a whole‑of‑life policy is used to provide the funds likely
to be needed to pay inheritance tax on the death of a married
couple or civil partners, it is normal to use a policy that will
pay out when the second spouse or partner dies. These types
of whole‑of‑life policies are known as ‘joint‑life second‑death’
or ‘last survivor’ policies.
The reason for this is that, in most families, the estate of the first
spouse/partner to die passes to the surviving spouse/partner (free
of IHT), and the IHT becomes due only when the surviving spouse/
partner dies and the estate passes to the family or to others.
These policies are ‘written under trust’: ownership passes to
the trustees to ensure that the proceeds of the policy are used
to meet the IHT liability and do not pass into the value of the
estate, thus becoming liable for IHT in their own right.
11.3 what are the WHOLE‑OF‑LIFE ASSURANCE POLICIES?
11.3 what is Flexible whole‑of‑life in terms of life cover?
The key to flexibility is the method of paying for the life cover
by cashing in units at the bid price:
The policyholder pays premiums of an amount that they
wish to pay – or feel that they can afford to pay.
The premiums are used to buy units in the chosen fund or
funds, and these units are allocated to the policy.
The policyholder selects the level of benefits that they wish
to have:
— If a high level of life cover is required, a larger number of
units will be cashed each month, and a correspondingly
lower number will remain attaching to the policy. This
means that the investment element of the policy (which
depends on the number of units) is also lower.
— Conversely, a low level of life cover means fewer units
are cancelled and hence the policy offers a higher level
of investment.
Other options are often available. These include an option to
take income, indexation of benefits (for automatic adjustment
of death benefits) and the ability to add another life assured.
11.4 what is Universal whole‑of‑life assurance?
11.4 Universal whole‑of‑life assurance
The flexibility of unit‑linked whole‑of‑life assurance is sometimes extended
further by adding a range of other benefits and options to the policy.
When that is done, the policy is usually referred to as universal whole‑of‑life assurance.
Most
of the additional benefits will be at extra cost, the additional cost being met
by cashing more units.
What is the fixed term, death benefit, surrender value, tax treatment of benefits of level term assurance, non profit whole life, decreasing term assurance, with profit whole of life,unit linked whole of life, increasing term insurance, convertible terms assurance, low cost whole life, renewable term assurance, fixed whole life, family income benefit and universal whole life?
11.5what are Endowment policies?
11.5 Endowment policies
Endowment policies combine life assurance and savings.
In the past they were
often used as savings plans and were very popular as a method of funding
interest‑only mortgages because the savings element can be used to build a
fund to repay the mortgage, while the life cover provides a lump sum if the
borrower dies during the mortgage term.
There are various types of endowment, with the plans varying according to
the underlying investment structure.
The range of investment structures is similar to those for a whole‑of‑life
plan; the difference between an endowment and a whole‑of‑life plan is that
an endowment runs over an agreed term. If death occurs during the term, the
sum assured is paid out, while if the plan runs for the full term and ‘matures’
an investment value is paid out. During the term, the policyholder undertakes
to maintain payment of regular premiums.
11.5.1 what is a Non‑profit endowment?
A non‑profit endowment has a fixed sum assured, which is payable on maturity
(ie at the end of the policy term) or on earlier death; premiums are fixed for the
term. Because the return is fixed and guaranteed, the policyholder is shielded
from losses due to adverse stock market movements; on the other hand, they
are equally unable to share in any profits the company might make over and
above those allowed for in calculating the premium rate (hence the name,
non‑profit). For that reason, non‑profit policies are rarely used today.
11.5.2 what is Full with‑profits endowment?
Like its non‑profit equivalent, a with‑profits endowment has a fixed basic
sum assured and a fixed regular premium.
The premium, however, is higher
than that for a non‑profit policy of the same sum assured, and the additional premium (sometimes called a bonus loading) entitles the policyholder to share
in the profits of the life assurance company.
The company distributes its profits among policyholders by declaring bonuses
that increase the value of the policy and are payable at the same time and in
the same circumstances as the sum assured.
There are two types of bonus.
Reversionary bonuses – these are normally declared each year and,
once they have been allocated to a policy, they cannot be removed by the
company, provided that the policy is held until the end of the term or
earlier death. Some companies declare a simple bonus, where each annual
bonus is calculated as a percentage of the sum assured; others declare
a compound bonus, with the new bonus being based on the total of the
sum assured and previously declared bonuses. Most companies set their
reversionary bonuses at a level that they hope to be able to maintain for
some time, in order to smooth out the short‑term variations of the stock
markets.
Terminal bonuses – these are bonuses that may be added when a death or
maturity claim becomes payable. Unlike reversionary bonuses, a terminal
bonus does not become part of the policy benefits until the point of a death
or maturity claim, thus allowing the company to change the terminal bonus
rate – or even remove the terminal bonus altogether. Terminal bonuses are
intended to reflect the level of investment gains that the company has made
over the term of the policy, so the rate of bonus often varies according to
the length of time that the policy has been in force.
The term ‘with‑profits’ is used generally to describe a policy that pays bonuses
to the plan. In the context of mortgages, a full with‑profits policy describes a
policy set up with an initial sum assured equal to the mortgage debt. On death
or at the end of the term, the worst‑case scenario is that the mortgage is repaid
in full. If bonuses are added then these will generate an additional sum over
and above the mortgage when the policy pays out.
What is the PRINCIPLES AND PRACTICES OF FINANCIAL MANAGEMENT?
Exam question
The FCA requires life companies that carry out with‑profits
business to publish a document called Principles and Practices
of Financial Management (PPFM). This sets out how a firm
manages its with‑profits business. Each year, the insurance
company has to certify to the FCA that its with‑profits funds
have been managed in accordance with the PPFM.
11.5.3 Low‑cost with‑profits endowments
The guarantees offered by a full with‑profits policy mean that it has high
premiums. A low‑cost endowment overcomes this by having a sum assured
that is payable on death, whenever it occurs, that is made up of two elements:
with‑profits; and
decreasing term assurance.
The policy offers a guaranteed death benefit equal to the mortgage, ensuring
that it is fully protected on death. The basic with‑profits sum assured is lower
than the overall level of mortgage to be funded, meaning that full repayment
is not guaranteed at maturity. Bonuses are added over time with the aim
of building a sum equal to the mortgage by the end of the term. Until the
with‑profits sum assured plus the bonuses are equal to the mortgage amount,
any shortfall on death of the life assured is made up by a decreasing term
assurance. Once the basic sum assured plus bonuses increases beyond the
mortgage amount, the decreasing term assurance element ceases.
This policy is suitable for anyone seeking a with‑profits plan but finding that
the costs associated with the full with‑profits plan are prohibitive.
What is the difference in calculating full with profits policy and low cost endowment policy?
The policy will pay out a minimum of £100,000 on death. It is not
until the value of the with‑profits element part of the policy reaches
£100,000 with bonuses that this figure starts to grow (whereas
with a full with‑profits policy, the £100,000 would increase after
one year).
What is ENDOWMENT MIS‑SELLING?
(Exam question)
Mis‑selling of endowment policies linked to interest‑only
mortgages was a significant problem for the financial services
industry, particularly in the 1980s and 1990s. The following
problems recurred:
The inherent risks of this type of policy were not adequately
explained.
The plans were sold to people with a low/cautious attitude
to risk.
Prospective investment returns were overstated and/or
customers were promised that the plans were guaranteed
to repay their mortgage in full.
Many customers complained, and insurance companies were
required to contact all endowment customers and advise them
whether or not their endowment was on target to repay their
mortgage. If it was not, they were required to outline corrective
action that could be taken.
Where mis‑selling was proven, the customer could claim
compensation from the insurance company.
If the total of sum assured plus bonuses is not equal to the
amount of the loan at the end of the term, it is, of course,
the borrower’s responsibility to fund the difference. Life
companies help their policyholders to avoid this situation
by including regular progress reviews of mortgage‑related
endowments, to check whether the policy is on target to reach
the required amount by the end of the term. If the policy does
not seem to be on target, the company may either recommend
an increase in premium, possibly without further medical
evidence being required, or suggest other ways of addressing
the problem. On the other hand, if the total benefit at maturity,
including bonuses, proves greater than the amount required to
repay the loan, the surplus will provide a tax‑free windfall for
the borrower.
11.5.4 Unit‑linked endowments
Unit‑linked endowments work on the basis that, when a premium is paid, the
amount of the premium – less any deductions for expenses – is applied to the
purchase of units in a chosen fund. A pool of units gradually builds up and,
at the maturity date, the policyholder receives an amount equal to the total
value of all units then allocated to the policy. Most unit‑linked endowments
also provide a fixed benefit on death before the end of the term. The cost of
providing this life cover is taken from the policy each month by cashing in
sufficient units from the pool of units.
The value of the plan is determined by the value of the underlying units; this in turn depends on the investment returns produced by the fund. Each unit‑linked
fund is run by a fund manager whose role it is to select investments and
invest the policyholders’ premiums.
Unit‑linked policies have the potential to
produce higher returns than with‑profits policies as the manager can be more
adventurous when selecting investments. Unlike with‑profits endowments,
however, unit‑linked policies do not provide any guaranteed minimum return
at maturity; they are, therefore, a good illustration of the maxim that greater
potential return generally goes hand‑in‑hand with the acceptance of greater risk.
When a unit‑linked endowment policy is to be used for mortgage purposes,
the premium required is calculated as the amount that will prove sufficient
to repay the loan at the end of the term if unit prices increase at a specified
rate of growth. This rate of growth is usually set at quite a conservative level
and features on illustrations provided at the point of sale. Policyholders can
choose which fund or funds to use for their investment. Should the life insured
die before the end of the term, the full amount of the mortgage is protected.
This is normally achieved by building in a variable term assurance plan which
adjusts in line with the value of the underlying units.
The growth rate is not guaranteed, and it is the borrower’s responsibility to
ensure that the policy will provide sufficient funds to repay the loan. The life
company will review the policy’s progress at regular intervals and inform the
borrower of the need to increase the premiums (or make other provisions) if
the policy is not on target. Most companies also provide the facility to switch
to a cash fund, or similar, to protect the policy value from sudden market falls
towards the end of the term.
One potential advantage of the unit‑linked policy as a mortgage repayment
vehicle is that, in a strongly rising market, the value of the policy may reach
the required amount before the end of the term. In that event, the policy can
be surrendered and the loan repaid early – thus saving on future interest, and
freeing the repayment amounts for the borrower to use for other purposes.
What is VARIABLE TERM ASSURANCE?
(Exam question)
A variable term assurance works by the value falling and rising
to compensate for changing investment values. For example, if
a customer has a £100,000 mortgage and the investment value
of the unit‑linked endowment is £30,000, then the variable
term assurance is £70,000. If, a month later, the plan value is
£29,900, then the variable term assurance increases to £70,100
to ensure the full value of the debt is always protected on death.
11.5.5 Unitised with‑profits
Unitised with‑profits endowments were introduced to combine the security
of the with‑profits policy with the greater potential for reward offered by the
unit‑linked approach. As with unit‑linking, premiums are used to purchase
units in a fund, and the benefits paid out on a claim depend on the number of
units allocated and the then‑current price of units.
The difference from a standard unit‑linked policy lies in the fact that unit prices
increase by the addition of bonuses which, like the reversionary bonuses on
a with‑profits policy, cannot be taken away once they have been added. This
means that unit prices cannot fall and the value of the policy, if it is held until
death or maturity, is guaranteed. If the policy is surrendered (ie cashed in
before its maturity date), however, a deduction is made from the value of the
units. This deduction, the size of which depends on market conditions at the
time of the surrender, is known as a market value reduction (MVR).
What is ASSIGNING POLICIES (in terms of assurance)?
(Exam question)
One feature of life policies, such as endowments, is that
they can be legally assigned to a third party, who effectively
becomes the owner of the policy and is entitled to receive
the benefits in the event of a claim. If an endowment is being
used as the repayment vehicle for an interest‑only mortgage
(see Topic 13), some lenders require the endowment to be
assigned to them as part of the mortgage deal; others may
simply require that the policy document be passed into their
possession, without a formal assignment.
1) Where a claim is made on a term assurance policy the benefits
payable are always free of income tax. True or false?
1) True – term assurances have no investment element so proceeds are paid
tax‑free.
1) Where a claim is made on a term assurance policy the benefits
payable are always free of income tax. True or false?
1) True – term assurances have no investment element so proceeds are paid
tax‑free.
2) What is the main benefit of a convertible term assurance?
2) A convertible term assurance allows conversion of some or all of the plan
to a different type of plan, at a later date, without the life assured having
to provide evidence of their state of health.
3) Which of the following statements relating to term assurance
is correct?
a) A decreasing term assurance will pay benefits only if the
insured dies within the policy term.
b) Gift inter vivos cover is maintained at the same level for
seven years.
c) A convertible term assurance policy can be converted to
an endowment or whole‑of‑life assurance only within two
years of the date of the original policy.
d) If a convertible term assurance policy is converted to an
endowment, the maturity date of the new policy must
not be more than five years later than that of the original
policy.
3) a) A decreasing term assurance will pay benefits only if the insured dies
within the policy term.
4) Which of the following is true of a whole‑of‑life policy?
a) It is designed to provide protection rather than investment.
b) Premiums are always payable throughout the full term of
the policy.
c) It can only be used on a with‑profits basis.
d) It will pay out only on the death of the insured and cannot
be surrendered.
4) a) It is designed to provide protection rather than investment.
5) Duncan and Alice, who are married, are taking out a whole‑of‑life
plan to provide for payment of inheritance tax liabilities on
their deaths. The policy would normally be set up in which of
the following ways?
a) Two single lives.
b) Single life.
c) Joint‑life first‑death.
d) Joint‑life second‑death.
5) d) Transfers between husband and wife are free of IHT so any liability
generally arises on second death. A plan being set up to provide the
funds to pay IHT would be set up on a joint‑life second‑death basis.
6) The main advantage of writing a life assurance policy in trust
is to:
a) increase personal allowances.
b) ensure the policy obtains qualifying status.
c) create a tax‑exempt fund.
d) ‘ring‑fence’ the proceeds outside the individual’s estate.
6) d) ‘Ring‑fence’ the proceeds outside the individual’s estate.
7) Which type of whole‑of‑life policy offers a fixed level of life
cover at outset that may be increased by the addition of
bonuses?
a) With‑profits.
b) Non‑profit.
c) Unit‑linked.
d) Low‑cost.
7) a) A with‑profits whole‑of‑life plan has a certain level of life cover at
outset that can then be increased as bonuses are added during the
term.
8) What other type of life assurance is combined with a with‑profits
plan in a low‑cost whole‑of‑life plan?
a) Non‑profits.
b) Decreasing term assurance.
c) Level term assurance.
d) Increasing term assurance.
8) b) A low‑cost whole‑of‑life plan combines with‑profits with a decreasing
term assurance.
9) If a policy benefits from ‘waiver of premium’, what does it
mean?
a) No premiums are paid for the first 12 months of a life
assurance plan.
b) Reduced premiums are paid for the first 12 months of a
life assurance plan.
c) No premiums are payable if the life assured is unable to
work as a result of accident or sickness.
d) Any increase in premium as a result of medical underwriting
is added as a debt to the policy.
9) c) Waiver of premium cover means that premiums are not payable (ie
they are waived) in the event that the insured is unable to work due to
accident or sickness.
10) Which of the following is incorrect in respect of low‑cost
endowment policies?
a) The basic sum assured increases with the addition of
bonuses.
b) The basic sum assured is lower than the amount borrowed.
c) The policy is made up of a with‑profits endowment and a
decreasing term assurance.
d) The policy is guaranteed to repay the mortgage in full at
the end of the term.
10) The answer is d). The policy is not guaranteed to repay the mortgage in
full at the end of the term.
12.1 What is critical illness cover?
Life assurance can mitigate the financial impact of someone dying, but serious
illness can also create a significant financial burden. Critical illness cover
provides a tax‑free lump sum to meet the additional costs that someone may
face if they find themselves in this situation. The illness need not be terminal.
The range of illnesses and conditions covered can vary from one insurer to
another but would typically include the following:
most forms of cancer;
heart attack;
stroke;
coronary artery disease requiring surgery;
major organ transplant;
multiple sclerosis;
kidney failure.
Other conditions that are sometimes covered are:
paralysis;
blindness;
loss of limb(s).
Many policies also make provision for payment of the sum assured in the event
of total and permanent disability. Again, the definition of total and permanent
disability varies between companies. Some providers define it as being a total and permanent disability that prevents the policyholder from doing any job
to which they are suited by virtue of status, education or experience. Other
companies employ a tighter definition that requires that the disability prevents
the person from doing any job at all.
12.2 What is income protection insurance?
Income protection insurance (IPI) pays an income when accident or illness
prevents someone from earning a living by carrying out their normal
occupation. Many insurers also offer IPI to people whose main responsibilities
are in the family home, for example looking after children, rather than earning
money outside it. This is because, although they may not actually earn an
income, costs may be incurred if they are ill or injured – for example, childcare
fees or payment for housekeeping services.
12.2.1 What factors affect premium rates?
A major factor in determining the premium to be charged is the occupation of the life insured. Table 12.1 provides an example of a typical classification of
occupations by an IPI provider.
TABLE 12.1 EXAMPLE OF OCCUPATION CLASSIFICATION FOR IPI PURPOSES
Class 1 Lowest risk, covering those in clerical, professional or
administrative roles, eg accountants and civil servants
Class 2 Occupations carrying a low risk of an accident, eg hairdressers,
pharmacists
Class 3 Occupations carrying a moderate risk of an accident, eg
farmers, electricians
Class 4 Occupations with highest risk of a claim because of risk of
health problems or accident, eg manual labourers, industrial
chemists
Certain occupations will be excluded from IPI cover altogether on the basis
that they represent too great a risk.
The occupation class that a person is deemed to fall within will determine the
level of premium (Class 1 occupations get the cheapest rates) and may also
influence the terms on which cover is offered.
Other factors that will influence the premium rate are:
the age of the life insured;
the amount of benefit;
current state of health;
past medical history;
the length of the deferred period (see section 12.2.3).
12.2.2 How are premiums on IPI structured?
There are two types of income protection premiums available – reviewable
and guaranteed.
Reviewable premiums – a reviewable premium means that premiums may
start off relatively low, but will be reviewed in the future and may go up
every few years or so. In some cases, the premium may be reviewable every
year, or every five years, to take into account changing circumstances.
Guaranteed premiums – the nature of guaranteed premiums means that
these tend to be more expensive at outset than reviewable premiums, but the premiums are guaranteed for the life of the policy, which may be 25
years or even longer.
It is the insurer’s choice as to what premium charging methodology is used.
Some may only offer one type.
A waiver of premium option may also be provided whereby premiums for the
IPI policy are not paid while benefits are being paid from the policy, but the
policy cover continues as normal. The premiums are ‘waived’.
12.2.3 When and how are benefits paid? For ipi
A period of time, called the deferred period, must elapse between the onset of
the illness/injury and the point at which benefits begin to be paid. Typical
deferred periods are 4, 13, 26, 52 and 104 weeks. The minimum four‑week
deferred period is to prevent multiple claims for minor ailments such as colds.
A self‑employed person, who typically would suffer a loss of income after a
very short period of illness, should opt for a short deferred period. Conversely,
an employed person may wish to
opt for a long deferred period if
they have sickness benefits paid
by their employer. If this is the
case, the deferred period should
be set to match the date on which
the employer’s sick pay ceases. The
longer the deferred period chosen,
the cheaper the premium will be.
Benefit levels are set so that the claimant is unable to receive a higher income
when they are not working than they could from working. The maximum
benefit payable from an IPI policy varies between providers, but is normally
in the range of 50 per cent to 65 per cent (individual policies) or 75 per cent
(group policies) of pre‑disability earnings. If the provider allows a benefit level
towards the top end of this range, they are more likely to make a deduction
to allow for any state benefits to which the claimant may be entitled. These
limits apply to total benefits from all IPI contracts held by the individual.
Where the policy includes a ‘proportionate benefit’ feature, benefits are paid
pro‑rata if a person can return to work but are earning less than they did
before they suffered the illness/disability. For example, they might be able to
work only part‑time, or in a lower‑paid job.
Cover is permanent in the sense that the insurer cannot cancel the cover simply
because the policyholder makes numerous claims; in fact IPI used to be known
as ‘permanent health insurance’. The policy can be cancelled, however, if the
customer fails to keep up their premium payments or takes up a hazardous
job or pastime. Some policies will allow benefits to be index‑linked either before or during a
claim. The rate of increase may be at a fixed rate, perhaps 3 per cent to 7 per
cent, or based on a published measure of inflation.
Benefits are normally paid until death, return to work (or, in the case of
proportionate benefits, return to their original role on the same basis as before
their incapacity), retirement or the end of the policy, whichever event occurs
first.
IPI is available as a standalone policy, usually as a pure protection plan or
occasionally on a unit‑linked basis. Additionally, IPI can be available as an
option on a universal whole‑of‑life plan.
12.2.4 How are Income Protection Insurance benefits taxed?
Where income protection insurance (IPI) is taken out on an individual basis the
benefits are tax‑free.
IPI can be arranged by an employer on a group basis and in this case the
income is taxable as earned income. The employer pays the premium, which
is a tax‑deductible business expense. From the employee’s point of view, the
premium paid by the employer is not taxable as a benefit in kind, ie they do
not have to pay income tax on the premium paid, provided that the employer
has discretion as to whether to pay the proceeds to the employee. In practice,
the employer does have such discretion and pays the proceeds to the member
concerned. The scheme member pays income tax and National Insurance on
the proceeds.
12.3 How does Accident, Sickness and Unemployment
insurance differ from IPI?
Accident, sickness and unemployment insurance (ASU) plans are a type of
general insurance that may be considered as an alternative to income protection
insurance (IPI).
ASU insurance is typically used to cover mortgage repayments if illness,
accident or loss of employment prevents the policyholder from earning
a living. A level of income equal to monthly mortgage repayments is paid
for a limited period, usually a maximum of two years. Additional cover can
sometimes be included to cover other essential outgoings.
As with IPI, there will be a deferred period, normally one month, which must
elapse before benefit payments can commence. Lump sums may be paid in certain situations (death, disablement, and loss of a limb).
In contrast to IPI, these plans should be viewed as short term to protect
mortgage repayments rather than as providing total protection of earned
income.
It would be more accurate to describe these policies as accident, sickness and
redundancy insurance, as they do not offer protection from unemployment
when the insured is dismissed, or resigns voluntarily. The policy will often
include the following restrictions.
The proposer must have been actively and continuously employed for a
specified minimum period prior to starting the plan.
Any redundancy that the proposer had reason to believe was pending when
they took out the policy will be excluded.
No benefit will be payable if redundancy occurs within a specified period
of the cover starting.
A person may have to have been
employed for a minimum period
either before they can take out
this type of plan or before the
unemployment cover becomes valid.
ASU policies are renewable annually
at the discretion of the insurer. This
means that the insurer could increase
premiums if a policyholder makes a
large number of claims, or might even
withdraw the cover offered. This is a
major difference from IPI.
12.3.1 How are ASU benefits taxed?
All benefits are tax‑free.
There is no tax relief on contributions to an ASU plan when it is arranged on a
personal basis.
If the scheme is set up on a group basis, any employer contribution will be
allowed as an expense against corporation tax. Any employer contribution will
be classed as a benefit in kind.
12.4 what is Private medical insurance?
Private medical insurance (PMI) is a pure protection plan designed to provide
cover for the cost of private medical treatment, thus eliminating the need to
be totally dependent on the NHS.
The range of cover normally provided includes reimbursement of:
in‑patient charges including nursing fees, accommodation, operating fees,
drugs, and the cost of a private ambulance;
surgical and medical fees including surgeon’s fees, anaesthetist’s fees,
pathology, and radiology;
out‑patient charges including consultations, pathology, radiology, and
home nursing fees.
Some policies offer additional benefits such as the payment of a daily rate if
treatment is delivered within an NHS hospital and involves an overnight stay.
Plans can be arranged on an individual basis or as part of a group scheme
established by an employer.
Employer‑sponsored schemes currently account
for the vast majority of PMI provision in the UK. The way in which benefits are
paid varies between providers. Some will offer a full refund of charges with
payment direct to the healthcare provider. Other plans impose an upper limit
on the amount that can be reclaimed in any one year.
12.4.1 What factors affect the cost of cover for medical care?
Premium rates depend on a number of factors, including:
location – this is mainly because the cost of medical care varies throughout
the country (costs are particularly high in London);
type of hospital to which the individual is allowed access under the terms
of the plan – again, treatment in the postgraduate teaching hospitals in
London is more expensive and is reflected in higher premiums;
standard of accommodation available to the patient under the terms of
the plan.
A major factor will be the type of scheme that is taken out. For example, many
providers offer a budget scheme, which may limit the patient’s choice of
hospital or require treatment on the NHS if the waiting list does not exceed a
maximum period, eg six weeks. Any limit on the range of cover provided will
reduce the premium payable. The limit may take the form of a financial limit
on the amount of benefit that is provided or limits on the range of treatment
covered.
One other significant factor is the age of the person applying for cover. The
morbidity (likelihood of illness) risk increases with age and consequently so
does the probability of a claim being made under the terms of the plan.
What are the exclusions of PMI cover?
(Exam question)
PMI cover will not be provided for any pre‑existing medical
conditions. Other general exclusions are the costs of:
routine optical care (such as the provision of glasses or
contact lenses);
routine dental treatment;
routine maternity care;
chiropody;
the treatment of ailments that are self‑inflicted, for example,
the consequences of drug abuse and alcohol;
cosmetic surgery;
alternative medicine.
12.4.2 How are premiums and benefits taxed for PMI?
Premiums are subject to insurance premium tax but the benefits are paid
out tax‑free. Employers who contribute to PMI on behalf of their employees
are able to claim the cost as an allowable deduction against corporation tax.
Contributions paid by an employer are regarded as a benefit in kind as far as
the employee is concerned and are taxable.
12.5 What is long‑term care insurance?
The purpose of long‑term care insurance (LTC) is to provide the funds to meet
the costs of care that may arise in later life, when a person is no longer able
to perform competently some of the basic activities involved in looking after
themselves each day.
The need for this cover has increased because:
families are less able to take care of elderly relatives than they were in
earlier generations (eg because they live further away from each other, there
are competing pressures on their time, or because their accommodation is
unsuitable);
people are living longer;
expectations in relation to quality of life in later years are higher;
some people are concerned about the standard of care that the state and
the NHS can realistically be relied upon to provide.
12.5.1 How is the level of benefits determined
The amount of benefit paid from an LTC plan depends on the degree of care
required by the insured. This is established by ascertaining the person’s ability
to carry out a number of activities of daily living (ADLs). Typical ADLs would be:
washing;
dressing;
feeding;
using the toilet;
moving from room to room;
preparing food.
Each LTC insurer has its own definitions of what constitutes an inability to
carry out an ADL. Many follow the definitions laid down by the Association of
British Insurers.
The greater the number of ADLs that cannot be performed without assistance,
the greater the amount of care required and, therefore, the higher the level
of benefit paid. It is normal for insurers to require that the person must be
incapable of performing at least two or three of the ADLs before a claim can
be accepted.
A person need not be in a nursing home to receive LTC benefits: for example,
they might need help with dressing and with preparing and eating meals. In this
situation, the support they would need might be limited to a person coming in
at certain points during the day to help with those specific activities.
12.5.2 How are benefits taxed for LTC?
If an annuity is purchased for immediate long‑term care needs benefits will be
tax free if paid direct to the care provider. Furthermore, the annuity must have
qualified as an immediate needs annuity when it was taken out.
In other words, the benefits from an ordinary purchased life annuity cannot
be paid tax‑free just because they are being used to fund long‑term care.
If an annuity does not qualify as an immediate needs annuity, ie if its benefits
can be paid to the policyholder, only the interest element is taxable as savings
income. Tax rates applicable are as follows:
Tax at a rate of 20 per cent is deducted at source.
Non‑taxpayers or individuals not liable to tax on their savings income can
reclaim any overpaid tax.
Higher‑rate taxpayers having a further liability of 20 per cent.
Additional‑rate taxpayers have a further liability of 25 per cent.
Where an immediate needs annuity is established on a ‘life of another’ basis,
the benefits can still be paid tax‑free, provided that they are paid direct to the
care provider and are used solely for the care of the person protected under
the policy. If any part of the annuity benefits are paid to anyone other than
the care provider, or for any purpose other than for the care of the person
protected under the policy (including payments that may be due on the death
of the protected person), the interest element of that portion of the benefits
is taxable. Benefits are also tax‑free if the long‑term care policy is prefunded, ie where
there is no annuity but, instead, premiums are paid to an insurance company
(out of tax‑paid income) to insure against a possible future event. For prefunded
long‑term care policies, it does not matter whether the benefits are paid direct
to the care provider or to the protected person.
Julie wants to make sure that she can meet all of her essential
outgoings if she is unable to work due to medium‑ or long‑term
illness. Which of the following products would be most suitable
for her?
a) Accident, sickness and unemployment insurance (ASU).
b) Critical illness cover (CIC).
c) Income protection insurance (IPI).
d) Private medical insurance (PMI).
1) The correct answer is c) income protection insurance. Answer a) is incorrect
because ASU cover is usually designed to cover only mortgage repayments
and usually for a maximum of two years. Answer b) is incorrect because
critical illness cover is restricted to specific conditions and is usually paid
as a lump sum, which may not cover outgoings over a prolonged period
of time. Answer d) is incorrect because PMI only covers costs directly
associated with medical treatment.
12.6 What is general insurance?
The types of loss that are covered by general insurance can be categorised
in five broad bands. The first two relate to both personal and commercial
situations:
property loss – loss, theft or damage to static and moveable assets (from
diamond rings to houses to supertankers);
liability loss – resulting from a legal liability to third parties, eg personal
injury or damage to property.
The remaining three are restricted to commercial situations. They are:
personnel loss (due to injury, sickness or death of employees);
pecuniary loss (as a result of defaulting creditors);
interruption loss (when a business is unable to operate due to one of the
other losses occurring, eg because its premises have suffered fire damage).
Some policies may combine protection against two or more types of risk.
Comprehensive motor policies, for example, cover damage to the policyholder’s
property and to third parties’ property.
What is an INDEMNITY in terms of general insurance?
(Exam question)
General insurance policies are contracts of indemnity. The
principle of indemnity is that:
in the event of a claim, insured persons should be restored
to the same financial position after a loss that they were
in immediately before the loss occurred.
In particular, this means that an insured person should not be
able to benefit from the event that caused the loss.
Life and personal accident policies, on the other hand, are not
contracts of indemnity. They are benefit policies since it is
much more difficult to measure accurately in financial terms
the impact of a loss of life or of a serious injury.
It is usually up to the insurer to determine how to restore the
claimant to the financial position they were in before the loss
occurred.
There are four main methods:
cash (normally by cheque or electronic transfer);
repair (used very commonly with motor insurance);
replacement – this can be a cost‑effective option for
the insurer as it has greater purchasing power than an
individual consumer and so can negotiate better prices;
reinstatement – for instance, where the insurance company
arranges for a damaged building to be restored to its former
condition.
AVERAGE
It is not uncommon for policyholders to underinsure: in other
words, to insure for a smaller amount than is actually required
to replace or repair the lost or damaged property. This may be
because:
they are unaware of the appropriate figure;
inflation has increased the amount required;
they are deliberately understating the figure in order to
keep the premium down.
In the event of a complete loss, eg where a whole house is
destroyed by fire, the amount paid out would be limited to the
sum insured, even if the actual cost were considerably more.
Many losses are only partial, however. In these circumstances,
it would be unfair if a policyholder who had paid less premium
than was really appropriate were indemnified in full, even if the
actual amount claimed were less than the overall sum insured.
In such cases, the principle of average is applied, which means
that the claim is scaled down in the same proportion that the
premium actually paid bears to the premium that should have
been paid for the full appropriate sum insured. So, for example, a
policyholder who insured contents for £10,000, when their true
insurance value was £15,000, would find that if they claimed
£300 for a damaged carpet, the insurer would pay only £200.
EXCESS
Many general insurance policies are subject to an excess: in
other words, a deduction is made from any claim payment. For
instance, a homeowner might have an excess of £100 on claims
for accidental damage under their contents insurance policy. For
the insurer, this avoids the high administrative costs of dealing
with a lot of small claims, since there is no point in a policyholder
claiming for an amount less than the excess. Sometimes, an excess
is a compulsory element of the policy; policyholders might also
choose a voluntary excess or an excess above the compulsory
level in exchange for a reduction in premium.
12.7 What is buildings insurance?
Buildings are defined as “anything on the premises that would normally be left
behind if the property were sold”. This generally includes sheds, swimming
pools, walls, fitted furniture and all fittings and decorations.
Cover is normally provided against:
fire and lightning strikes;
explosions, subsidence and earthquakes;
storms and floods;
damage by vehicles and aircraft, and even by animals;
damage by falling trees/branches or television aerials
Policies normally also cover the costs of alternative accommodation during
repairs.
Some types of cover are subject to the property not being left unoccupied for
more than a specified period, typically 30 or 60 days. These include cover
against damage caused by:
riot, civil commotion and vandalism;
theft or attempted theft;
burst water pipes or oil leakages.
Most policies also cover property owners’ liability.
What is UNDER‑INSURANCE in terms of buildings insurance?
(Exam question)
Harry insured his property for £100,000 when he bought it in
2000. He has never increased his insurance. In 2019, his house
is completely destroyed in a fire. The ‘reinstatement value’
of his property is £150,000. However, the maximum that the
insurance company will pay out is £100,000. (Note that if the
property had a mortgage on it, the lender would have required
adequate buildings insurance.)
If a smaller claim were made, the claim would be averaged. If
Harry were to lose roof tiles in a storm and claim £1,000 for
the cost of replacing them, then the claim would be reduced
as follows.
The value of the insurance cover taken out is divided by the
actual value:
£100,000 ÷ £150,000 = 66.67%
This calculation shows that Harry’s property is only insured
for 66.67 per cent of its true value and so Harry’s premiums
are less than they should be. The insurance company would
only pay 66.7 per cent of his claim, ie £667.
12.8 What is contents insurance?
Contents can be defined as “anything you would normally take with you if
the property were sold”. Cover would typically be provided against the
same events and circumstances as described above for buildings insurance.
Additional cover might include:
accidental damage to goods while being removed by professional removers;
extended contents cover for specified personal property outside the home;
damage to freezer contents due to electricity failure.
12.8.1 What is all‑risks cover?
The aim of an all‑risks policy (sometimes known as extended contents cover)
is to indemnify the policyholder for loss, damage or theft of items that are
regularly taken out of the home. Cover is normally split into two categories:
unspecified items – these need not be specifically named but each item
must have a value below a specified amount;
specified items – these items are above the single‑item value limit and are
individually listed.
Both of the above categories require the policyholder to take reasonable care
of the property.
The contents of Charlene’s home are insured for £25,000 when they
are actually worth £50,000. She is burgled and loses £2,000‑worth
of computer equipment. Using the ’average principle’, calculate
how much the insurance company will pay her.
2) The insurance value is divided by the actual value, then multiplied by the
value of the claim:
(£25,000 ÷ £50,000) × £2,000 = £1,000 (less the ‘excess’ under the policy).
12.9 What types of private motor insurance are
available?
Third party, third party fire and theft, comprehensive
12.9.1what is third party cover motor insurance?
The Road Traffic Act 1988 makes it unlawful to use a motor vehicle on a public
road unless there is in force a policy of insurance in respect of third‑party
risks.
Third‑party‑only policies typically provide cover for:
death or bodily injury to third parties, including passengers in the car –
hospital charges and emergency medical treatment charges are also covered;
damage to property;
legal costs incurred in the defence of a claim.
Death, injury and damage cover is extended to include occasions when the
policyholder is using another vehicle, and also to other drivers using the
policyholder’s car with permission.
Whatis CERTIFICATE OF INSURANCE in terms of motor insurance?
(Exam question)
Motor insurance differs from other personal insurances in that
a policy of motor insurance is of no effect unless a certificate
of insurance is given to the policyholder. The certificate is
what provides evidence of the existence of the contract of
insurance and, as third‑party motor insurance is compulsory,
this is very important.
12.9.2 what is third party, fire and theft cover?
In addition to third party cover, a third party, fire and theft policy provides
cover against:
fire, lightning or explosion damage to the vehicle;
theft of the vehicle, including damage caused during theft or attempted theft.
12.9.3what is Comprehensive cover in terms of motors insurance?
In addition to the third party, fire and theft cover, a typical comprehensive
policy would include some or all of the following:
accidental damage to the vehicle on an all‑risks basis;
loss of or damage to personal items in the vehicle;
personal accident benefits;
windscreen damage.
The private motor insurance market is large and extremely competitive, and
many other extensions to the cover are offered in order to attract business.
These may include:
roadside breakdown assistance;
legal protection services;
provision of a courtesy vehicle while repairs are carried out;
out‑of‑pocket expenses resulting from an accident.
12.10 What cover does travel insurance provide?
12.10 What cover does travel insurance provide?
Travel insurance is available for individual journeys (typically from five days
to one month) or on an annual basis. A typical policy might include cover
against the following:
cancellation due to illness or injury of the policyholder or a close relative;
missed flights or sailings due to transport failure;
delayed departures;
medical expenses;
personal accident;
loss of personal possessions or of a passport;
personal liability;
legal expenses.
Because of the increased risk of injury, cover for winter sports holidays is
usually more expensive.
What is INSURANCE PREMIUM TAX?
(Exam question)
Some general insurance premiums payable in the UK are subject to
insurance premium tax (IPT). The standard rate of IPT is charged
at a percentage of the premium on most general insurance that
relate to risks for which the period of cover begins on or after that
date.
Travel insurance premiums are taxed at the higher rate of IPT.
There is no premium tax at present in respect of long‑term
insurance such as life assurance and income protection
insurance.
IPT is paid by the policyholder as part of the premium; it is
collected by the insurer and passed on to the tax authorities.
Check the GOV.UK website for current rates and further
information: www.gov.uk/government/publications/rates-
and-allowances-insurance-premium-tax/insurance-premium-
tax-rates.
12.11 What is payment protection insurance?
Payment protection insurance (PPI) can cover monthly loan repayments if the
policyholder’s salary is reduced due to accident, sickness or unemployment.
The policy will pay out only for a fixed period of time, usually 12 months.
This insurance is linked to the repayments of a specific lending product and
may be offered at the same time as the loan itself.
PPI can be extremely useful, although many PPI policies have been mis‑sold
alongside loans, credit cards and mortgages over the years to people who did
not need it, were ineligible to claim its benefits, or did not even realise it had
been included as part of their loan repayments. Some lenders developed sales
scripts for their customer services advisers that included a statement that the
loan was ‘protected’, without mentioning the fact that this protection was in
the form of an insurance policy – a policy that the customer should have been
given the opportunity to opt out of taking.
A number of companies, including high‑street lenders, have incurred fines
for mis‑selling this product; compensation for customers runs into billions
of pounds. Many customers have been encouraged (mainly through TV
advertising campaigns or cold‑calling) to make a claim against their lender
if they feel they were wrongly sold this product. People whose claims are
successful are not only given back the insurance premiums they have paid,
they are also able to claim the interest that this money would have earned had
it been in a savings account.
A deadline of 29 August 2019 was applied to PPI claims against companies
that are still trading. However, customers may still be eligible to claim
compensation with the Financial Services Compensation Scheme (FSCS) for
financial firms that have failed. The FSCS can only accept a PPI claim if the
advice was received on or after 14 January 2005. Read more on this area at:
www.fscs.org.uk/what-we-cover/ppi/.
1) When Gary was diagnosed with bowel cancer at the age of
50, he was able to use the lump sum he received under his
insurance policy to pay off his outstanding mortgage. Which
of the following types of insurance did Gary have?
a) Private medical insurance.
b) Income protection insurance.
c) Critical illness insurance.
d) Long‑term care insurance.
1) c) Critical illness insurance. Private medical insurance covers costs
associated with treatment while income protection insurance pays a regular income rather than a lump sum. Long‑term care insurance is
designed to meet the costs of care in later life.
1) When Gary was diagnosed with bowel cancer at the age of
50, he was able to use the lump sum he received under his
insurance policy to pay off his outstanding mortgage. Which
of the following types of insurance did Gary have?
a) Private medical insurance.
b) Income protection insurance.
c) Critical illness insurance.
d) Long‑term care insurance.
1) c) Critical illness insurance. Private medical insurance covers costs
associated with treatment while income protection insurance pays a regular income rather than a lump sum. Long‑term care insurance is
designed to meet the costs of care in later life.
2) Marco, a self‑employed painter and decorator, is considering
taking out income protection insurance. He should opt for as
short a deferred period as possible. True or false?
2) True. Marco’s income will reduce very rapidly if he is unable to work. He
should opt for a short deferred period rather than a long one.
3) Marco’s partner Lydia, an HR manager, already has income
protection insurance. If she claims under her policy, she will
have to pay tax and NICs on the income she receives. If Marco
goes ahead and buys income protection, he will not pay tax or
NICs if he has to claim benefits under the policy. This is likely
to be because:
a) Marco’s earnings are below the personal allowance for
income tax.
b) Marco’s policy will be arranged on an individual basis
whereas Lydia’s policy has been arranged as part of a
group scheme.
c) Marco is self‑employed whereas Lydia is an employee.
d) The insurance provider from whom Marco is thinking of
buying his policy has different rules to Lydia’s insurance
provider.
3) b) Marco’s policy will be arranged on an individual basis whereas Lydia’s
policy has been arranged as part of a group scheme
4) Adaeze, an office administrator, hurts one of her hands,
causing permanent damage, and has to be re‑employed on a
lower salary. What effect would her return to work have on her
IPI benefits?
a) Full benefits would be paid until Adaeze has fully recovered.
b) Proportionate benefits would be paid, but no other claims
under the policy would be accepted by the insurance
company.
c) Benefits would cease immediately.
d) Proportionate benefits would be paid until retirement,
death or the end of the policy.
4) d) Proportionate benefits would be paid until retirement, death or the end
of the policy.
5) Annette, who retired last year, has developed arthritis and
needs a hip replacement. Under which of the following types
of insurance policy might she be eligible to claim benefits?
a) Critical illness cover.
b) Accident, sickness and unemployment insurance.
c) Private medical insurance.
d) Income protection insurance.
5) c) Private medical insurance, to cover the cost of treatment. Critical illness
cover would not cover a hip replacement, while accident, sickness and
unemployment insurance and income protection insurance provide
cover for people who are working.
6) Vanessa is unhappy in her current job and has decided to
resign. She will be able to claim benefits under her ASU policy
to tide her over until she finds a new post. True or false?
6) False. ASU benefits are not available to policyholders who resign voluntarily.
7) Roger, who is 78, is finding it difficult to look after himself
at home and is planning to move into residential care next
month. He has purchased an immediate needs annuity so his
fees will be paid direct to his care provider, once tax has been
deducted. True or false?
7) False. With an immediate needs annuity, the benefits are paid directly to
the care provider but they are tax‑free.
8) General insurance policies operate on the principle that
policyholders should be restored to the position they were in
before the event occurred that led to their claim. True or false?
8) True. This is the principle of indemnity.
9) Steve’s home contents were insured for £25,000. Last winter
his kitchen was flooded and he claimed under his contents
insurance for £6,000 damage to kitchen appliances and
contents. His insurers established that his home contents
should have been insured for £32,000. Calculate how much
Steve actually received once his insurers had taken account of
the fact that he was underinsured.
9) (£25,000 ÷ £32,000) × £6,000 = £4,687.50 (less any excess).
9) Steve’s home contents were insured for £25,000. Last winter
his kitchen was flooded and he claimed under his contents
insurance for £6,000 damage to kitchen appliances and
contents. His insurers established that his home contents
should have been insured for £32,000. Calculate how much
Steve actually received once his insurers had taken account of
the fact that he was underinsured.
9) (£25,000 ÷ £32,000) × £6,000 = £4,687.50 (less any excess).
10) It is illegal to drive a vehicle on public roads in the UK unless
you have insurance that covers damage to your car or injury to
yourself. True or false?
10) False. It is a legal requirement to have third‑party motor insurance, which
covers injury to other people and their property.
13.1 How does secured lending differ from unsecured
lending?
Lending is ‘secured’ when the borrower gives the lender the right to take
possession of a specific asset if they (ie the borrower) fail to keep up repayments
on a loan. In the event that repayments are missed and the matter cannot
be resolved in any other way, the lender can then sell the asset to recoup
the money it is owed.
Security for a loan does not always take the form of a property. With commercial
loans, the loan might be secured on business premises or equipment. It could
also be a financial asset such as shares or other investments.
With unsecured borrowing, the lender does not have the reassurance of an
asset that they can sell to recoup the loan if the borrower fails to repay it.
The lender has to rely on the borrower’s agreement to repay. For this reason,
unsecured borrowing represents a greater risk to the lender, and thus interest
rates on unsecured loans tend to be higher than those for secured loans.
What is LTV ratio?
The amount of the loan in relation to the value of the asset used for
security, expressed as a percentage. For a mortgage loan of £80,000 on a
property valued at £100,000, the LTV is 80 per cent.
Explain MORTGAGE INDEMNITY GUARANTEES AND HIGHER
LENDING CHARGES
(Exam question)
A mortgage indemnity guarantee (MIG) is an insurance policy
that protects the lender in situations where the loan has a
high loan‑to‑value ratio (generally over 75–80 per cent). If the
borrower defaults on repayments and the property is sold,
the lender might not get back the full amount that it lent.
The insurance is designed to make up any shortfall in these
circumstances.
Although the lender is the beneficiary of the policy, it is the
borrower who pays the premium; it can either be a one‑off
payment when the loan is taken out or can be added to the
amount borrowed. Note that, even if the lender fully recoups
the money owed by claiming under the MIG, the insurance
company (MIG insurer) is still entitled to pursue the borrower
for the shortfall arising from the default.
‘Higher lending charge’ is the term the FCA requires providers
to use in explaining a MIG to a customer, but the term is not
exclusive to MIGs. Some lenders will, for example, make a
higher lending charge but, rather than arrange a MIG, simply
place the money into a fund that can be drawn upon if required.
13.2 What is a repayment mortgage?
With a repayment mortgage, the borrower makes monthly repayments to the
lender. Each monthly amount consists partly of capital repayment (ie the
original amount borrowed) and partly of interest on the amount borrowed.
The higher the interest rate (for any given mortgage amount and term), the
higher the monthly repayment.
The repayment is calculated in such a way that it is evenly spread throughout
the term of the mortgage. Thus if interest rates do not change over the whole
term, the repayment will be the same each month. However, if interest rates
do go up or down, then the monthly repayment increases or decreases, or
alternatively the mortgage term can be extended or shortened.
The relative proportions of capital and interest vary throughout the term. At
the beginning, when most of the original amount borrowed has yet to be repaid,
most of the monthly repayment is just paying the interest on the loan. Later
in the term, when more of the capital has been repaid, the interest proportion
of the repayment decreases and a larger proportion of the repayment goes
towards repaying the capital.
Providing that all the repayments have been made when due, and that the
repayments have been adjusted to reflect changes in the interest rate, the
mortgage will be repaid at the end of the term.
If the borrower dies before the end of the mortgage term, the repayments still
have to be made or the loan has to be repaid in full. Borrowers need to take out
life assurance cover to make sure these conditions can be met.
What is COVENANTS in terms of mortgages?
(Exam question)
A lender’s security depends on the property being maintained
in an acceptable condition. For that reason, borrowers have to
covenant (ie promise under the terms of the mortgage deed) to
maintain the property in good condition.
They also have to covenant to insure the property adequately.
A lender is permitted by law to:
insist that a property subject to a mortgage is continuously
insured by means of a policy that is acceptable to the lender;
have its interest as mortgagee noted on the policy;
secure a right over the proceeds of any claim and to insist
that the proceeds be applied to remedy the subject of the
claim or to reduce the mortgage debt.
13.3 What is an interest‑only mortgage?
With an interest‑only mortgage, the monthly payments made to the lender are
solely to pay interest on the loan. The capital amount outstanding therefore
does not reduce at all. For this reason, the monthly payments are lower than
those for a repayment mortgage. However, the borrower still has to repay the
original amount borrowed at the end of the term.
The FCA’s Mortgages and Home Finance: Conduct of Business (MCOB)
Sourcebook rules relating to interest‑only mortgages changed in April 2014,
following the Mortgage Market Review, which was a major investigation into the
mortgage market by regulators. New rules were introduced following concerns
that, among other issues, people were being encouraged to borrow more
than they could afford and borrowers were able to arrange an interest‑only
mortgage without being required to make arrangements to fund repayment.
An interest‑only mortgage can now only be arranged if the lender has obtained
evidence that the borrower has a credible repayment strategy in place. A
credible repayment strategy could be, for instance, a cash or stocks and shares
ISA, a pension, an investment bond, shares, unit trusts or regular savings
plans. In addition, lenders must contact the borrower at least once during the
term of the mortgage to establish whether the repayment strategy remains in
place and still has the potential to repay the capital.
In response to these changes, many lenders stopped offering interest‑only
mortgages to new borrowers. More recently, lenders have started offering
interest‑only mortgages again, and there are many borrowers who have
interest‑only mortgages that were taken out before the MCOB rules changed.
When an interest‑only mortgage is taken out, the two main issues to be
addressed are:
putting in place a funding mechanism to repay the debt at the end of the
term; and
ensuring there is sufficient protection to enable the debt to be repaid
should the mortgagor die before the end of the term.
Level term assurance is a popular way of providing protection in the event that
a borrower dies during the mortgage term.
13.3.1wgat are Pension mortgages?
One of the benefits of a personal pension plan or stakeholder pension is that
up to 25 per cent of the accumulated fund can be taken as a tax‑free pension
commencement lump sum (PCLS). Depending on the rules of the pension
provider, it may also be possible for holders of a personal or stakeholder
pension plan to draw an additional amount, over and above the 25 per cent
PCLS, as a taxable sum. The availability of a lump sum from normal minimum
pension age means that these pension plans have the potential to be used as
mortgage repayment vehicles.
The plans have other financial benefits in comparison with endowment
policies:
Pension contributions qualify for tax relief at a person’s highest rate of
tax, up to the annual maximum contribution limit. There is no tax relief on
endowment policy premiums.
The fund in which the contributions are invested is not subject to tax
on income or capital gains, meaning that it should grow faster than an
equivalent endowment policy fund, which is taxed on both income and
capital gains.
On the other hand, there are a number of factors a borrower might feel are
possible drawbacks to the use of a pension plan for mortgage repayment
purposes.
Lifetime allowance – this is the maximum tax‑privileged pension investments
an individual is able to accrue during their lifetime. It effectively limits the
amount of tax‑free PCLS that can be taken to 25 per cent of the lifetime
allowance. For example, if the lifetime allowance was £1,000,000, the
maximum tax‑free cash that could be taken would be £250,000. Therefore,
someone who wanted to use a pension plan for mortgage repayment must
either restrict themselves to a capital repayment of no more than £250,000,
or be prepared to take a further taxable lump sum beyond the 25 per cent
from their pension.
Minimum pension age – in most cases, the minimum age at which benefits
can be taken from a pension is 55, but this will increase to 57 in 2028
and may increase further in the future. This means that the term of the
mortgage must run until the mortgagor reaches minimum pension age and
the mortgage cannot be paid off earlier, even if the fund has grown to a
sufficient value. A longer mortgage term will add to the total cost of the
mortgage as a result of the additional interest payments incurred.
Provider restrictions – not all providers offer the facility to take a taxable
lump sum in excess of the tax‑free PCLS (although it is possible to switch
to a provider that does). If only 25 per cent of the fund can be taken as a
tax‑free PCLS, a fund of four times the loan value must be built up. This
may mean that total contributions are more than the borrower can afford
or more than are permitted by the pension scheme regulations. Impact on income in retirement – using a portion of the pension fund to
repay a mortgage means there is less money available to provide an income
in retirement.
Need for separate life assurance – a personal pension or stakeholder
pension, unlike an endowment assurance, does not automatically carry
with it any life assurance, so a separate policy will be required to cover the
repayment of the loan in the event of death during the term.
Assignment – as with all pension contracts, personal pensions and
stakeholder pensions cannot be assigned to a third party as security for a
loan or for any other purpose. The lender cannot, therefore, take possession
of the plan or become entitled to receive benefits directly from it, as it can
with an endowment policy. This is a potential disadvantage to a lender but
has not, in practice, prevented the majority of them from moving into the
pension mortgages market.
13.3.2 Individual savings accounts mortgages
In order to use an ISA as a mortgage repayment vehicle, ISA managers calculate
the amount of regular investment that would be required to produce the
necessary lump sum at the end of the mortgage term, based on an assumed
growth rate and on specified levels of costs and charges. All managers allow
investments to be made on a regular monthly basis, provided, of course, that
the overall annual limits are not exceeded.
The main benefits of using an ISA as a mortgage repayment vehicle are that
the:
funds grow free of tax on income and capital gains, thus reducing the cost
of repaying the mortgage;
mortgage can be repaid early if the fund’s rate of growth exceeds that
assumed in the initial calculations.
If, on the other hand, growth rates do not match the initial assumptions, the
final lump sum will fall short of the mortgage amount. Performance needs to
be monitored and adjustments made to the amount of regular investment if
necessary.
Another drawback of using an ISA is that, should the borrower die during the
mortgage term, the value of the ISA investment is unlikely to be sufficient to repay
the loan. Additional life assurance cover is required to meet this eventuality.
The limits on annual contributions can make it difficult to build a sum sufficient
to pay back a large loan or one with a short term. This is less of an issue for
couples, as each individual has an ISA allowance. Also, as we saw in Topic
9, the government has introduced schemes such as the Help-to-Buy ISAs (no
longer available for new applications) and Lifetime ISAs, which are intended to
help those looking to purchase a property to fund their deposit.
13.4 what areMortgage interest rate options?
A distinction can be made between the way a lender charges interest to the
mortgage account and the different interest rate options that can be applied
to the mortgage.
For both repayment and interest‑only mortgages, there is a variety of ways in
which interest can be charged to the mortgage account. For instance, some
lenders charge interest on an annual basis, some on a monthly basis, and
some on a daily basis. It is the lender who decides how interest is charged,
and this can vary between different mortgage products with the same lender.
Lenders will generally offer a range of different interest rate options or
‘mortgage products’ such as fixed or variable rates, and the ability to defer
interest or take an interest payment ‘holiday’.
CASHBACK in terms as to what is offered by lenders.
(Exam question)
Cashback is a relatively common incentive offered by many
lenders. A lump sum is paid to the borrower immediately
after completion of their mortgage, either as a fixed amount
or as a percentage of the advance. Generally, the lower the
loan‑to‑value ratio (LTV), the higher the cashback, as the risk
of the lender losing money is reduced and a lower LTV makes
the borrower a more attractive proposition for the lender.
It is usually a condition of the mortgage that some or all of the
cashback must be repaid if the loan is repaid within a specified
period.
Discounted rates and cashbacks are sometimes used by lenders
either to tempt borrowers away from competitors or as a
loyalty bonus to persuade them to stay. Payment of legal fees
is another offer that is commonly made to encourage switching
of the loan between lenders while incurring minimum costs.
13.5 what are Flexible mortgages?
The flexible mortgage gives the borrower some scope to alter their monthly
payments to suit their ability to pay, as well as the opportunity to pay off
the loan more quickly. Although there is no precise definition of a flexible
mortgage, it is generally considered that such a product should offer the
following basic features:
interest calculated on a daily basis;
the facility to make overpayments at any time without incurring an early
repayment charge;
the facility to underpay, but only within certain parameters set out by the
lender when the mortgage was arranged;
the facility to take a payment holiday, again within certain parameters laid
down at the outset.
Two key benefits of these features are as follows:
The combination of a daily interest calculation and occasional, or regular,
overpayments will result in considerably less interest being paid overall
and the mortgage term being reduced
The ability to reduce monthly payments, or suspend them entirely, for
a limited period will benefit a borrower who is experiencing temporary
financial difficulties. If required, a borrower in this situation can borrow
back overpayments made earlier in the term.
Many lenders now offer flexible mortgages with a fixed, discounted or capped
rate for an initial period. Early repayment charges do not normally apply to
these products but an arrangement fee may be payable and, in some cases, it
may be a condition of the loan that a particular insurance product is purchased
from the lender.
Most flexible mortgages allow the borrower to draw down further funds as and
when required, although the lender will have set a limit on total borrowing at
the outset. Flexible mortgages involve a much easier administrative process
than is usual when dealing with further advances. The wording of the mortgage
deed generally used for flexible mortgages is such that all additional funds
withdrawn, within the limit on total borrowing, will automatically take priority
over any other subsequent charges registered against the property.
What are CURRENT ACCOUNT AND OFFSET MORTGAGES?
(Exam question)
An increasingly popular version of the flexible mortgage is the
current account mortgage. This enables the borrower to carry
out all of their personal financial transactions within a single
account. The account is able to receive salary credits and pay
standing orders and direct debits in exactly the same way as a
conventional current account. The borrower will be provided
with a cheque book and a debit/credit guarantee card.
The combination of salary credits and the calculation of
interest on a daily basis considerably reduces the amount of
interest payable and consequently also the mortgage term.
A more recent development is the offset mortgage. This
requires the borrower to have savings or other accounts with
the lender and enables the interest payable on such accounts
to be offset against the mortgage interest charged. For
example, if a borrower has an offset interest‑only mortgage
for £80,000 and £25,000 in a savings account with the lender,
they can opt to waive payment of interest on their savings,
enabling interest to be charged on a net loan of £55,000. This
calculation is repeated on a daily basis.
13.6 explain Shared ownership
Shared‑ownership schemes are designed to help people on relatively low
incomes to become owner‑occupiers, even though they cannot afford a
conventional mortgage. These schemes are usually arranged by housing
associations.
Shared‑ownership schemes enable a borrower to buy a stake in the property
and pay rent on the remainder. For example, a borrower can purchase a 25 per
cent stake in the property, funded by a mortgage, with the option of buying
further 25 per cent shares in the future. As the borrower increases their
share in the property, the mortgage element increases and the rental element
reduces. This process of increasing the mortgage element is sometimes called
staircasing. Note that not all lenders offer mortgages for shared‑ownership
arrangements.
13.7 What is equity release?
In a mortgage context, ‘equity’ is the excess of the market value of a property
over the outstanding amount of any loan or loans secured against it. Equity
release plans are designed to enable older homeowners with limited pension
income who typically do not have a mortgage on their property to release
some of the equity in order to provide capital or supplement their income. A
homeowner with a small mortgage may also be eligible; the existing mortgage
would have to be paid off as part of the arrangement. Most of the schemes
are available only to property owners over the age of 60, and many have a
minimum age of 70.
Explain a EQUITY RELEASE COUNCIL
(Exam question)
The Equity Release Council represents all participants in the
equity release market including product providers, advisers,
lawyers and surveyors. Its Standards Board formerly existed
as a body called SHIP – Safe Home Incomes Plans, which was
incorporated into the Equity Release Council. The Council’s
role is to ensure that equity release products are safe and
reliable for customers. Members sign up to its Statement of
Principles, which sets out standards of conduct, particularly
in relation to product standards and the information provided
to customers, and to its Rules and Guidance.
13.7.1 How does a lifetime mortgage work?
For a lifetime mortgage, a lender will usually be prepared to lend up to a
maximum of 55 per cent of the property value, depending on the borrower’s
age. The majority of lifetime mortgages are on a fixed‑rate basis and take into
account the fact that, unlike with a standard mortgage product, the term of
the loan is unknown.
Interest is charged at the lender’s lifetime mortgage rate, but generally no
regular payments of capital or interest are made. Instead, the interest is added
to the loan (rolled up). When the borrower dies or moves into long-term care,
the property is sold and the mortgage loan plus rolled‑up interest is repaid to
the lender. If any of the sale proceeds remain once the loan has been repaid,
the borrower, or their estate, receives the balance. If the property is owned
jointly, the mortgage continues until the second death or vacation of the
property.
Most lenders provide a ‘no‑negative‑equity’ promise, which means that the
borrower cannot owe more than the value of the property when the loan is due
to be repaid.
A lifetime mortgage can be arranged on a drawdown basis. The lender agrees a
maximum lending limit and the borrower can borrow an initial minimum loan
and subsequently draw down lump sums as they wish, subject to a minimum
withdrawal, typically £2,000 to £5,000. Interest is charged on the amount
outstanding, but is rolled up rather than paid each month. The benefit of this
type of loan over a standard lifetime mortgage is that interest only accrues on
the amount actually borrowed, so the borrower has a degree of control and
the debt will not increase as rapidly. It will allow the borrower to provide an
annual ‘income’ while maintaining control over the speed at which the debt
builds up.
13.7.2 How does a home reversion plan work?
Home reversion plans involve the homeowner selling a percentage or all of
their property to the scheme provider. The customer(s) retains the right to live
in the house, rent‑free (or for a nominal or partial rent), until their death(s) or
until they move into permanent residential care. At that point the property
is sold and the provider receives a share of the proceeds equivalent to their
share of ownership. Thus if they owned 40 per cent of the property, they
would receive 40 per cent of the sale proceeds.
13.7.3 How are equity release schemes regulated?
Equity release schemes, defined as lifetime mortgages and home reversion
plans, are regulated by the FCA under the Mortgages and Home Finance:
Conduct of Business (MCOB) rules. MCOB 8 and 9 are the sections of MCOB
specifically directed at equity release and lifetime mortgages, although the
general MCOB rules regarding suitability and affordability also apply.
Anyone who advises on or arranges equity release must hold a specialist
qualification. The requirements are detailed in the FCA Training and
Competence sourcebook.
13.7.4 what are Retirement interest-only mortgages?
Retirement interest-only mortgages are similar to equity release schemes
insofar as the outstanding debt is repaid from the proceeds of the sale of the
property when the borrower dies or moves into long-term care.
The main difference is that the borrower must repay the interest during the
term of the mortgage and must be able to prove to the lender that they can
afford to do so.
Retirement interest-only mortgages are available from traditional mortgage
lenders and, as the name suggests, are generally aimed at older borrowers.
13.8 what are Other secured private lending?
With all secured loans, the borrower offers something of value as security for
the loan so that, in the event of default, the lender can take and sell that asset
(or, in financial services terminology, ‘realise the security’) and be repaid out
of the proceeds.
The most common form of secured personal lending is, of course, the mortgage
loan for house purchase, the security being a first charge on the borrower’s
private residence.
When property values increase significantly, it is common for people to borrow
against the increased equity in their property. For instance, they might take
out a further loan from their existing mortgage lender (ie a further advance),
arrange a second mortgage from a different lender or remortgage for a larger
amount. They then use the loan to fund purchases that are not related to the
house purchase but which improve their lifestyle in other ways.
Sometimes, bridging finance is required to enable a homeowner to bridge the
funding gap that arises when they complete on the purchase of a property
before they have received the funds from the sale of their existing property.
Most secured lending, therefore, is secured on ‘bricks and mortar’, even where
its purpose is not directly – or even indirectly – related to house purchase or
improvement.
What do the terms bridging finance, first charge and second charge mean?
BRIDGING FINANCE
Can be used by those arranging a loan to finance a new purchase before
they have sold their existing property in order to ‘bridge’ the finance gap.
FIRST CHARGE
A legal right to have ‘first call’ on a property if a borrower defaults on
repayment of the mortgage loan.
SECOND CHARGE
A legal call on a property after all the liabilities to the holder of the first
charge have been settled.
13.8.1 explain the implications of a Second mortgage
A second mortgage is one that is created when the borrower offers the property
for a second time as security while the first lender still has a mortgage secured
on the property. The new lender takes a second charge on the property; the
original lender’s charge takes precedence over subsequent charges. This
means that, in the event of a sale due to default, the original lender’s claim
will first be met in full (if possible) and, if sufficient surplus then remains, the
second mortgagee’s charge will be met.
Lenders will, of course, only offer a second mortgage if there is sufficient equity
in the property and, since second mortgages represent a higher risk to lenders,
they are likely to be offered at higher rates of interest than first mortgages.
Second charge mortgages have been regulated by the FCA under MCOB since 21
March 2016; prior to that date they were regulated under the Consumer Credit Acts.
13.8.2 explain Bridging finance
Bridging finance may be required when a borrower wishes to move house but
has not managed to sell their existing property, or the funds from the sale
will not be available at the time completion of the new purchase is due. It is
short‑term lending that is repaid when the original property is sold and the
owner is able to secure a mortgage on their new home.
There are two types of bridging finance:
Closed bridging – the borrower has a feasible plan for repaying the loan
within an agreed timescale. Typically, this is through the sale of the existing
property and requires the borrower to have a firm buyer.
Open bridging – the borrower needs finance to buy the new property, but
does not yet have a firm buyer for their existing property.
Open bridging represents a higher risk to the lender than closed bridging. Interest
rates for open bridging are therefore higher than those for closed bridging
13.9 explain Commercial loans
There is an extensive market for what might be called commercial lending, ie
loans to businesses of all sizes, from sole traders and partnerships to family
companies to multinational traders. Loans may be required to start up or expand
businesses, to purchase shops, factories or hotels, or to refurbish premises.
All the high‑street retail banks have departments operating in this field, and
there is also a wide range of companies that specialise in commercial lending.
Such lending is normally secured on the company’s property or other assets,
with the interest rate set at a specified margin above the lender’s base rate. The
exact interest rate will depend on the risk that the lender believes is involved in lending to the particular company; this will be assessed by looking at the
company’s past performance (where applicable), business plans, projected profits
and management quality, as well as the business sector in which it operates.
3.10 explain Unsecured borrowing
In contrast to secured loans, an unsecured loan relies on the personal promise,
or covenant, of the borrower to repay. Unsecured loans are, therefore, generally
higher risk than secured lending, with the consequence that they are subject
to higher rates of interest and are normally available only for much shorter
terms. For example, while a mortgage secured on a property will be available
for 25 years or even longer, a personal loan is rarely offered over much more
than six or seven years.
Unsecured personal lending takes a number of forms, the most common of
which are described below
13.10.1 explain Personal loans
Personal loans are offered by banks, building societies and some finance
houses. They are normally for a term of one to five years; the interest rate
is generally fixed at the outset and remains unchanged throughout the term.
Many of the larger lenders assess loan applications on a centralised basis,
using a form of credit scoring to assess the suitability of the borrower.
A customer can use a personal loan for any (legal) purpose: typically, it might
be used to purchase a car, fund a holiday, or consolidate existing higher‑cost
borrowing such as a credit card balance.
The purpose of the loan determines whether it is regulated under the terms
of the FCA’s Consumer Credit (CONC) rules. Most loans are regulated under
CONC unless they are for house purchase or home improvement, and therefore
subject to FCA regulation under MCOB rules
13.10.2 explain Overdrafts
An overdraft is a current account facility that enables the customer to continue
to use the account in the normal way, even though its funds have been
exhausted (although the provider does set a limit on the amount by which the
account may be overdrawn). It is a convenient form of short‑term temporary
borrowing, with interest calculated on a daily basis, and its purpose is to
assist the customer over a period in which expenditure exceeds income – for
instance, to pay for a holiday or to fund the purchase of Christmas gifts.
Overdrafts are offered by all banks and some building societies. Because it is
essentially a short‑term facility, the agreement is usually for a fixed period,
after which it must be renegotiated or the funds repaid. Overdrafts that have
been agreed in advance with the provider are known as arranged overdrafts.
Where an arranged overdraft limit is exceeded, or not agreed in the first place,
the resultant overdraft is unarranged. Previously, unarranged overdrafts were
liable to higher rates of interest than arranged overdrafts.
However, since April 2020, banks and building societies can only charge
overdraft users a single annual interest rate. As a result, many now only offer
arranged overdrafts.
13.10.3 explain Credit cards
Credit cards enable customers to shop without using cash or debit cards in
any establishment that is a member of the credit card company’s scheme.
Most retailers have terminals linked directly to the credit card companies’
computers, enabling online credit limit checking and authorisation of
transactions.
As well as providing cash‑free purchasing convenience, credit cards are a
source of revolving credit. The customer has a credit limit and can use the card
for purchases or other transactions up to that amount, providing that at least
a specified minimum amount (usually 3 per cent of the outstanding balance)
is repaid each month. The customer receives a monthly statement, detailing
recent transactions and showing the outstanding balance. If the balance is
repaid in full within a certain period (usually 25 days or so), no interest is
charged; if a smaller amount is paid, the remainder is carried forward and
interest is charged at the company’s current rate.
Credit cards are an expensive way to borrow, with rates of interest considerably
higher than most other lending products. There is also normally a charge if
the card is used to obtain cash either over the counter or from an ATM, or if
the card is used overseas.
Credit card companies charge a fee
to retailers for their service. This is
deducted as a percentage (typically
around 3 per cent) of the value of
transactions when the credit card
company makes settlement to the
retailer. Despite the fee, credit cards
offer a number of advantages to
retailers:
the retailer might achieve more sales if the convenience of payment by
credit card is available to customers (and facilities to accept card payments
of some kind are of course essential for most online retailers);
payment is guaranteed if the card has been accepted in accordance with
the credit card company’s rules;
the retailer can reduce their own bank charges because the credit card
vouchers paid into a bank account are treated as cash.
Explain revolving credit
An arrangement whereby the
customer can continue to
borrow further amounts while
repaying existing debt.
Explain CHARGE CARDS AND DEBIT CARDS
(Exam question)
Although a charge card is used by the customer in the same way
as a credit card to make purchases, the outstanding balance on
a charge card must be paid in full each month. The best‑known
examples are American Express and Diners Club. Thus a charge
card is a form of unsecured lending only in a very limited sense.
Like credit cards, debit cards can be used to make payments
for goods and services, and to withdraw cash from ATMs.
They are operated in the same way: a cardholder makes a
payment by inserting the card into a card‑reader and entering
a PIN (alternatively, most debit cards can be read by contactless
card‑readers for transactions below a threshold). However, a debit
card is not a credit facility. The effect of the transaction is that
funds equal to the amount spent are transferred electronically
from the cardholder’s current account to the account of the
retailer. This is known as EFTPOS (electronic fund transfer at
point of sale).
1) Define a) a mortgagor and b) a mortgagee.
1) The mortgagor is the borrower and the mortgagee is the lender.
2) Which of the following is not true in relation to a repayment
mortgage?
a) The higher the interest rate, the higher the monthly
repayment to the lender.
b) Life cover is built in.
c) The loan is guaranteed to be fully repaid at the end of the
term, providing monthly repayments are maintained.
d) At the beginning of the term most of the monthly repayment
is paying interest on the loan.
2) b) Life cover is not built in, therefore a separate life assurance policy
would be needed to ensure that the mortgage could be repaid if the
borrower were to die before the end of the mortgage term.
3) For what reason might an ISA not be suitable for someone
who is arranging an interest‑only mortgage of £300,000 over
a five‑year term?
3) An ISA has an annual investment limit which might make it difficult to
fund a large mortgage and/or one arranged over a short term.
4) It is not the responsibility of the lender to ensure that a
borrower has a repayment vehicle in place for an interest‑only
mortgage. True or false?
4) False – MCOB rules require the lender to confirm at the outset that a
credible repayment strategy is in place and then reconfirm this at least
once during the mortgage term.
5) Chris is 53 and is pleased to see from his annual personal
pension statement that his pension pot has grown enough to
enable him to take a tax‑free pension commencement lump sum
and pay off his interest‑only mortgage. Will this be possible?
5) Not yet, because Chris cannot access his pension funds until he is at least 55.
6) An advantage of a flexible mortgage is the ability to take further
advances up to the lender’s prearranged limit. True or false?
6/ true
7) What is the main advantage of a capped‑rate mortgage?
a) If interest rates go up, the mortgage interest rate will not
exceed a prearranged limit.
b) The mortgage interest rate will never exceed Bank rate.
c) The amount payable is fixed for the duration of the capped
rate.
d) There is a discount off the normal variable mortgage
interest rate.
7) a) If interest rates go up, the mortgage interest rate will not exceed a
pre‑arranged limit, in other words, the ‘cap’.
8) Describe how a home reversion plan works.
8) Home reversion plans involve the homeowner selling a percentage or all
of their property to the scheme provider. The customer(s) retains the right
to live in the house, rent‑free (or for a nominal or partial rent), until their
death(s) or until they move into permanent residential care. At that point
the property is sold and the provider receives a share of the proceeds
equivalent to their share of ownership.
9) Which form of borrowing is likely to have the highest interest
rate: a 25‑year repayment mortgage or a personal loan with a
5‑year term?
9) The personal loan – interest rates on unsecured borrowing are generally
higher than on secured borrowing because it represents a greater risk to
the lender.
10) What is revolving credit?
10) A facility that allows you to borrow more before you have paid off the initial
amount borrowed. Credit card borrowing is the most common example.
What is the financial life cycle?
14.1 Beginning the process
Providing appropriate, ethical financial advice is not simply a matter of
understanding the features of all the products that we have studied so far in
this course – although product knowledge is important. An understanding of
the regulatory and legal duties imposed on financial advisers is critical too:
later in your studies, we will look at contract law and agency law (Topic 16),
data protection (Topic 24) and consumer protection (Topic 25). The regulation
of firms, individuals and the advice process is covered in Topics 18, 20 and 21.
The precise financial needs of clients vary from person to person, but it is
possible to identify financial needs that are typically associated with the life
stage that an individual is in, and from there to establish the type of products that
might be relevant to them. Demonstrating an understanding of the situations in
which clients might find themselves over the course of their life, and the real
or perceived financial needs that they might have as a result, is an important
factor in developing the client’s trust. Maintaining confidentiality is another.
There is a well‑established pattern to the way in which most savers and
investors build up and hold their assets (summarised in Figure 14.2). It begins
with savers’ attitudes to the need for liquidity and safety and then, as income
and savings grow, moves gradually away from liquidity and towards an
acceptance of greater risk.
The first stage in the saving pattern is cash; after that, a current account with
a debit card is virtually as good as cash. People do not generally hold any
other form of asset until their cash requirements are met. The next stage is
secure, short‑term investment such as instant access (or short‑notice) bank
and building society deposits.
With a sufficient balance in short‑term savings, investors look next at products
with less flexibility but a greater return, such as fixed‑term bonds.
Further down the line, individuals may be attracted to products that offer
greater long‑term potential but at the risk of short‑term loss. Shares and other
equity‑linked investments, such as unit trusts, are good examples. In times of
stock market volatility, however, these investments may prove considerably
less popular.
Similar patterns can be recognised in relation to other types of financial
products, though perhaps to a less pronounced extent: for example, the first
type of bank account that most people open is a personal current account,
often out of necessity to enable receipt of their wages or salary. It is only later,
as their financial situation improves, that they begin to use a wider range
of accounts and other banking products; similarly with insurance products,
where the first experience is often of compulsory cover, particularly for motor
insurance, and of travel insurance.
In terms of borrowing, many people begin with short‑term unsecured
borrowing, by way of credit cards or personal loans, to pay for holidays or a
car.
14.2 What is a factfind?
Advisers must take reasonable steps to ensure that any advice offered is
suitable for the client, based on the client’s circumstances, relevant knowledge
and experience, financial situation and objectives. This is a requirement under
FCA rules (COBS 9.2.2R).
Advisers build a clear picture of a client’s circumstances, experience, needs
and objectives by obtaining personal and financial information about the client
through a fact-finding process. FCA rules do not prescribe the method by which
advisers obtain information from clients. Firms design a process which meets
the FCA’s requirements for assessing suitability, taking account of the market in
which they transact business. Advisers record the information they obtain from
the client through factfinding in a document often referred to as a factfind. Fees
for services that the adviser intends to provide to the client are usually disclosed
and agreed prior to the factfind.
To gather appropriate information, it is necessary to ask questions in respect
of the client’s:
financial situation;
existing and future needs;
ability to provide for them;
attitude towards providing for them;
objectives;
knowledge and experience of investment (where relevant to the service the
adviser will provide). This will support an assessment of the client’s ability
to understand and accept investment risks.
This means, in practice, that any factfind should look at both the client’s
circumstances and their preferences.
14.3 Establishing the customer’s situation
14.3 Establishing the customer’s situation
The following basic information is needed.
14.3.1 Personal and family details
Full name, postal and email addresses and telephone number(s).
Date and place of birth – dates of birth for all those included in the
factfind. The client’s place of birth may be important for underwriting or
to establish domicile.
Relationship status – single, married, civil partners, cohabiting, divorced,
widowed, etc. It is usually preferable to have both partners of a relationship
involved in the financial planning process, since the decisions made will
often affect both partners. Some couples, however, prefer to keep their
financial affairs separate.
Family details – the client’s family details are important for a number of
reasons:
— there may be family members who are, or will be, financially dependent
on the client;
— the client may become the beneficiary of gifts or trusts;
— the client may wish to become a donor, now or in the future;
— from a marketing viewpoint, there may be an opportunity for referrals
to family members.
The most important group of family members is usually the children. In order
to give appropriate advice about protection against death and disability, as
well as about savings for school or university fees for example, it is necessary
to know how old the children are. This may include children from previous
relationships.
14.3.2 Financial situation
Employment status – is the client employed, self‑employed, unemployed
or retired? If the client is a director or a partner, it may be necessary to delve
deeper and establish basic information about their business arrangements.
It also helps to know whether their status is part‑time or full‑time, temporary
or permanent, as well as gaining details of the client’s profession or trade.
Income and benefits – it is often useful to establish an exact breakdown of
income by its component parts, eg basic, commission, bonus and overtime,
together with the average level of overall earnings (net profits in the case
of self‑employed clients). Similarly, an adviser must establish the exact
nature of benefits provided, eg private medical insurance, company cars,
pension and/or death‑in‑service details, subsidised loans, etc.
Previous and/or additional employment – details of previous employment
(especially if the client has preserved pension entitlement), share‑option
schemes, profit‑related pay schemes, details of additional employment. It
may be helpful to obtain copies of payslips, P60s, tax returns and notices
of tax coding.
Income and expenditure – analysing a client’s income and expenditure
makes it possible to identify more easily the implications of, for instance,
premature death on the family income and spending patterns. It is also
possible to identify any surplus income that could be used to fund the
purchase of any additional products recommended.Calculating a household’s income is usually relatively straightforward.
Analysis of clients’ expenditure can be more difficult. Certain items are
easily determined, ie those paid by standing order, such as rent and some
household bills. It is usually more difficult to pin down how much is spent
on, for example, food and drink, holidays or cars.
How to assess assets from a client ?
The adviser should obtain details of all the client’s assets, from their home (if
they own it) to all their various bank accounts. Depending on the type of asset,
the following details are required:
ownership, ie single ownership or jointly owned;
purpose of the investment;
type of investment, eg property, deposit in a bank account, pension policy
or fund;
size of original investment and date;
current value and/or projected future value;
rate of return (if any);
type of return, eg capital growth or income, and whether that return is
fixed, guaranteed or variable;
tax status of the investment or other asset;
options available and/or penalties;
sum assured and/or lives assured and maturity dates;
name of the institution providing the asset.
Liabilities
The following information should be obtained in relation to the client’s borrowing:
lender;
amount of loan;
balance outstanding;
original term and term remaining;
type of loan, eg secured, unsecured (and if secured, on what);
amount of monthly or other periodic payment;
rate of interest;
repayment method;
protection of capital or payments.
Clients are often unaware of the details of any arrangements that they have.
It is an adviser’s responsibility to try to obtain this information, and clients
should be asked to bring full details with them.
14.4 Understanding plans and objectives for clients
Completing the first two sections of the factfind – the personal and family
details and the financial situation – involves gathering hard facts, ie about
tangible items and people. The client’s plans and objectives tend to be more
intangible; here the aim is to find out “why?”, “how?” or “do you feel that?”;
in other words, to discover the client’s feelings about what they have, what
they want and where they want to go from a financial point of view. These are
known as soft facts.
Figure 14.3 summarises the soft facts that the adviser needs to establish for
each area.
Knowing the client’s feelings about their situation, their aspirations for the
future and their existing arrangements will help build understanding in a
number of ways:
Discovering the reasons behind the client’s existing arrangements may in
turn indicate the client’s level of understanding of their finances.
Determining the level of the client’s interest in their situation will indicate
their motivation to improve their situation and the likelihood of their
taking action.
Ascertaining the client’s views on a number of possible alternative solutions
will help in constructing acceptable recommendations.
To find out how a person feels about improving their financial situation, the
adviser needs to ask questions like these:
14.5 Establishing attitudes and preferences
It is essential to establish the client’s attitude to risk when making
recommendations. The client must understand what the risk involved in a
proposal is. This may involve providing explanations to distinguish between
the degrees of risk – for example, whether there is a risk to the capital that
is invested, the fact that the value of an investment may fall as well as rise,
and that the amount of income or capital growth may not be guaranteed.
Historically, many so‑called low‑risk investments, such as bank or building
society accounts, have provided a safe haven and a relatively stable level of
income, but the adviser must make sure the client is aware that inflation will
cause the value of the investment to fall and explore their attitude towards
this risk. A client’s attitude to risk is often assessed by psychometric testing (a questionnaire, typically online, designed to uncover a client’s risk tolerance),
with a risk score being allocated from the answers given.
Another important factor, linked to risk, is a client’s ‘capacity for loss’. The
FCA describes this as “the client’s ability to absorb falls in the value of their
investment”. If any loss of capital would have a materially detrimental effect
on the client’s standard of living, this should be taken into account in assessing
the risk that they are able to take.
It is important to take note of a client’s stated preferences, but advisers have a
duty of care: this means recognising that, while a client may have a clear view
on what they want to do, their appreciation of what they ought to do can be less
than clear. This means that an adviser may have an educational role in helping a
client to explore their own financial circumstances and make the right choices.
As environmental considerations become more important to people, it may
also be pertinent to find out their sustainability preferences, ie to what extent
they would like to invest in environmentally sustainable products.
14.6 Identifying needs and objectives of the client
Clients often have a range of financial needs, even when they approach an
adviser with one particular need in mind. To give the most appropriate advice,
advisers must be aware of the broad range of needs that clients might have –
and must be able to recognise those needs even where clients themselves are
not aware of them.Every client is different but, in general terms, an adviser should first seek to ensure
that there is adequate protection of their lifestyle in the event of death or illness.
Retirement planning would then be the next priority as it is effectively protecting
income for a time when a person either does not want to or is no longer capable
of working. Once the client’s current and future positions are protected, attention
can then be made to enhancements through savings and investment planning.
In seeking to assess any of these areas, an adviser should look for examples
of typical things that clients either do wrong or fail to do at all. This might
include the following:
A young family, with little or no savings, relying solely on mortgage
protection cover as their only form of life assurance. It would repay the
mortgage but is not designed to meet the ongoing costs of running the
house and bringing up the family.
A low level of life assurance premiums being paid, suggesting that cover
might need to be increased for the required protection to be adequate.
Unnecessarily large amounts being held on deposit in bank and building
society accounts over the long term and so not gaining access to better
returns available elsewhere.
Substantial taxable savings/dividend income, in excess of allowances,
being received by an individual who pays higher‑rate income tax.
A non‑taxpayer holding investments where tax is taken while funds are
invested and where the tax deducted cannot be reclaimed.
A client with many small holdings of shares over a wide range of companies,
causing administration and monitoring difficulties.
A married couple owning most of their assets in an individual’s sole name
and paying more tax as a result.
A client not making any pension contributions, or making only very small
pension contributions as a percentage of total earnings, which will mean
being dependent upon state benefits unless action is taken.
People who have not made a valid will, whose assets on death may, therefore,
not be distributed as desired.
The adviser’s role is to define the client’s needs and objectives accurately,
to enable the client to see the key issues facing them and to recommend and
discuss a priority order for action.
14.7 Agreeing order of priority with the client
Failing to establish a priority order with the client can result in a client ignoring
an adviser’s recommendations. The client’s priorities may well differ from
those that the adviser feels appropriate, and so the process is one of discussion
and agreement rather than straightforward selection by any single person. In
the end, however, deciding a plan of action and agreeing its priority order
remains the client’s decision, assisted by the adviser’s recommendations.
14.8 Recommending solutions to clients
Once an adviser has gathered all of the necessary information about the client’s
circumstances and preferences, has a clear appreciation of their ability to
pay, and has obtained agreement on priorities, then the process of matching
solutions to requirements can begin.
The advisor objectives are first put the right amount of money, second in the right form, third in the right hands, fourth at the right time.
In practice, these four aims mean that advisers will look in detail at a number
of specific areas:
State benefits – the nature and level of state benefits to which a client may
be entitled.
Existing arrangements – there is no point in recommending products that
satisfy needs already met by the client’s existing arrangements or by state
provision.
Affordability – any recommendations made must not, in terms of total
cost, jeopardise the client’s current and likely future financial situation.
Taxation – one purpose of the recommendations may be to mitigate tax but
it is also important to ensure that any course of action recommended does
not unnecessarily add to or create a tax burden.
Risk – there must be a close correlation between the risk inherent in the
product recommended and the client’s risk profile and capacity for loss.
Timescale – the product recommended should meet the client’s needs
within a defined timescale.
Flexibility – recommendations should display the flexibility to deal with
possible changes in the client’s circumstances.
It is a good idea to have a clear plan for how to present each recommendation
to the client, not least because some details may be mandatory under the
Financial Services and Markets Act 2000 and related FCA rules.
Explanations that should always be included are:
the purpose of the product and the client’s needs that the product will
address;
the benefits that the client will enjoy;
the risks and limitations inherent in the product;
any options that exist within the product that may be appropriate to the
client;
a summary of reasons why the product is being recommended.
For each product, part of the presentation should involve a features and
benefits analysis. This means going through the product and identifying each
of its features, and then putting into simple terms what specific benefits
these features provide to the client. The adviser should check that the client
understands, perhaps by asking a few simple questions.
14.9 Completing the sale
Obtaining a commitment from the client in the form of a completed application
form will depend on how effectively all of the earlier stages of the sales
process have been carried out. Attempting to close a sale too early is clearly
not sensible, and deciding when to close a sale is determined by two factors:
the reaction of the client; and
their understanding of the proposal.
Closing the sale simply involves asking the client if they are happy to complete
the application. Sometimes the client may expect the adviser to complete the
form on their behalf. It is permissible to do this, but only with the client’s
permission. If the adviser does complete the proposal form, the client must
read it thoroughly, checking what has been written before signing it.
In particular, the client must be made aware of the consequences of deliberate
or reckless misrepresentation. If the contract is later made void because of
information that the client misrepresented then the client may not be protected
and could also incur a loss of premiums.
A key features document (or key information document ‘KID’ or key investor
information document ‘KIID’, depending on the product sold), together with
a key features illustration (for some products), must be given to the client
before the sale is closed. These documents provide the client with all the
information they need in order to make a decision. The client should also be
provided with a product brochure explaining product details and features in
full. The adviser must also explain the cancellation notice, which sets out the
client’s right to withdraw from any arrangements within a defined period.
The adviser should provide the client with their business card during the
meeting. This gives the client a clear route back to the adviser should there be
any queries later on.
HANDLING OBJECTIONS of the client
(Exam question)
The first point in handling an objection is to qualify it. This
means finding out whether it is a genuine statement of concern
about the recommendation or whether it is masking another
issue that is on the client’s mind. For example, if a client states
“that is too expensive”, is that the real issue or is it that the
adviser has not really explained the need or the benefits of the
recommendation?
If an objection is made, it is essential to understand how
important it is. This can be done by trying to understand the
objection as specifically as possible, ie by clarifying exactly
what the client means by what they are saying. A good way
of doing this is by paraphrasing what the client has said: “So
what you’re saying is . . .?”
Once the nature of the objection and its importance are clear,
then an attempt can be made to solve the problem. If the
problem lies in the client’s understanding or interpretation
of what they have heard, then it should be straightforward to
solve. If the problem lies in something specific and the client
is not willing to move, then the obstacle should be put into
perspective and other compensating factors stressed.
The handling of objections or queries is another step in helping
the client to buy something for which they have seen a clear
need and of which they can now see the full benefit.
RETENTION OF RECORDS
(Exam question)
Once the arrangements have been put in place there is a
regulatory requirement to keep records to demonstrate what
advice and information was given and why.
Product type Retention period
Life policies, pension contracts 5 years
Pension transfers, opt‑outs, FSAVCs Indefinite
MiFID‑related business 5 years
Other eg mortgage related contracts 3 years
These retention periods relate to the FCA’s conduct of business
requirements, which we cover in more detail in Topic 20. There
are other retention rules relating to the prevention of money
laundering and to complaints handling – we look at these in
Topics 23 and 25 respectively.
14.10 After‑sales care of the client
Providing a professional service means more than selling a product to meet
needs: it means ensuring that proper after‑sales care is given and that reviews
are carried out. This will include ensuring that, where the acceptance procedure
involves any delay, the client is kept fully informed. It will also mean dealing
with other related matters such as direct debits, policy delivery, cancellation
notices, standard reviews and any requests to alter the plan.
After these general areas, client servicing falls into two categories: proactive
and reactive servicing.
14.10.1what is Proactive servicing of the client?
Proactive servicing involves instigating action by contacting the client to
discuss further needs. This might be on a matter previously agreed, such as
the next salary review, a job change, or even the taking up of recommendations
of which the client was unable to take advantage originally.
Even where there is no known future event or requirement, it is a good idea to
agree a time to review the client’s position. At a review, an adviser can find out
if there have been any changes to the client’s circumstances and can update
the appropriate records. By doing this, an adviser is in a strong position to
identify opportunities to recommend new products appropriate to the client’s
needs, or to recommend changes to existing products.
14.10.2 what is Reactive servicing of the client?
Reactive servicing happens as the result of a request from the client, for example
a request to discuss the recommendation after comments made in the media
or by competitors. The client’s circumstances might change unexpectedly,
resulting in a request for advice. The request might not be received directly
from the client: it might be notification of non‑payment of premiums or a
request by the next of kin to sort out a death claim.
In order to be fully prepared for all eventualities, clear and concise records
must be maintained. Keeping appropriate records will not only comply with
the requirements of the Financial Services and Markets Act 2000, but may also
lead to more business.
1) Which of the following would usually be a priority need for a
client taking out their first mortgage?
a) An emergency fund.
b) Income protection.
c) Medium‑term investments.
d) Pension planning.
1) b) Income protection, to ensure that they can continue to make their
mortgage repayments if they are unable to earn an income. An
emergency fund would be useful but, at least at the beginning, would
be unlikely to be big enough to cover mortgage repayments except in
the very short term.
2) Why is it important to establish a client’s place of birth as part
of the factfind?
2) It is important to establish the client’s domicile for tax purposes and it
may be a factor in underwriting decisions.
3) Which of the following would normally be regarded as the
priority financial need for a client who has surplus cash for
the first time?
a) A unit trust.
b) An emergency fund.
c) A stocks and shares ISA.
d) A pension plan.
3) b) An emergency fund. Once people have enough cash to cover their
day‑to‑day needs, the usual approach is to build up savings in an
easy‑access deposit account.
4) When completing a factfind for a client in relation to investment
advice, which of the following should always be taken into
account?
The client’s:
a) levels of indebtedness.
b) employment details.
c) attitude to risk.
d) mortgage arrangements.
4) c) Attitude to risk.
5) Which of the following ought to be the highest financial priority
for a retired couple?
a) Pension accumulation.
b) Protection advice.
c) Generating income.
d) Mortgage advice.
5) c) Generating income. It is not a) pension accumulation as this would take
place before retirement.
6) What is meant by ‘capacity for loss’ and why is it important?
6) ‘Capacity for loss’ is “the client’s ability to absorb falls in the value of their
investment”, ie the extent to which the client would be adversely affected
should they make a loss on their investments. This must also be taken into
account when assessing attitude to risk.
7) List the factors that an adviser might take into account when
deciding on an appropriate solution for a client.
7) Eligibility for state benefit; existing arrangements; affordability; taxation;
attitude to risk; capacity for loss; anticipated changes in circumstances;
timescale; flexibility.
8) List five points that should be included when presenting a
recommendation to a client.
8) The purpose of the product and the needs that it will address; the benefits
to the client; risks and limitations inherent in the product; any product
options that might be appropriate; a summary of reasons for recommending
that product.
9) For how long must records relating to pension transfers be
retained?
9) Indefinitely.
10) What is the difference between proactive and reactive servicing?
10) Proactive servicing is instigated by the adviser, perhaps on the basis of
information obtained during the factfind about a forthcoming promotion
or inheritance. Reactive servicing is instigated by the client in order to
address a need, or by the client’s representatives, eg the executors of an
estate.
15.1 Why is budgeting important?
The need to budget underpins all other forms of financial planning. At
its simplest, it reflects the need to have sufficient funds to purchase the
necessities of daily living. It also enables people to determine how much they
can spend on other items, for instance large‑scale purchases, leisure pursuits
and holidays, and provision for a secure retirement.
Many savings products can be used to help people budget for future
expenditure, whether this is for a major purchase or to provide regular
income. However, advisers must be careful not to put pressure on the client’s
current and future income when selling products paid for out of that income.
An increase in mortgage interest rates, for example, could push a family’s
expenditure beyond its means.
It might be argued that the need to balance the budget on a weekly/monthly
basis is not as great as it once was, as a result of the easy availability of
credit. Nevertheless, all borrowing must be repaid at some point, and advisers
should exercise caution when considering clients’ likely future income and
expenditure levels.
5.2 What family protection needs might clients have?
Life involves exposure to many risks and it is not possible to avoid all the
dangers and difficulties that it can bring. It is, on the other hand, possible to
take sensible precautions against the impact of the risks that affect people,
their lives, their health, their possessions, their finances, their businesses,
and their inheritances.
Many people, however, make little or no provision for minimising the financial
consequences of death or serious illness. This may be because they are not
aware of the size of the risk or because they believe that they cannot afford
to provide the cover, not realising how cheap it can be, especially if taken out
when young.
15.2.1 explain Protection against the financial impact of death
For most families, it is income rather than savings that enables them to enjoy
their standard of living. Loss of that income on the death of an earner usually
causes a reduction in a family’s standard of living.
State benefits may be available but they generally do little more than sustain
a very basic lifestyle, and increasing pressure on funding means that they are
more likely to reduce than increase in real terms in the future. The surviving
spouse/partner may, therefore, have to increase their income, for instance by
working full‑time instead of part‑time. If they have young children, they may
have to fund the cost of childcare.
Another consequence of the death of an earner is that surviving family
members may no longer be able to maintain loan repayments, particularly
mortgage repayments. If the mortgage cannot be serviced, the property might
have to be sold and the family rehoused in less suitable circumstances.
It is equally important for the life of a financially dependent spouse/partner
to be insured, even though they are not in paid employment. In the event of
their death, the surviving spouse/partner may have to give up work in order
to look after any young children, or may have to pay the cost of full‑time
childcare. There might also be additional housekeeping costs.
How might you advise a client to address the protection issues
outlined above? What protection products might be suitable?
1) In relation to the protection of debts, term assurance (level term for an
interest‑only mortgage; decreasing term for a repayment mortgage) would
provide a lump sum to pay off the outstanding mortgage loan.
Family income benefit could provide a monthly income to replace that
lost or to cover additional expenditure; alternatively the benefit from
this type of policy could be taken as a lump sum.
A level term assurance can also be used to protect living standards but
would pay a lump sum which would then have to be invested in order
to provide the required income.
15.2.2 explain Protection against accident, sickness or unemployment
Many of the arguments for protection against the adverse financial
consequences of death apply equally to the need for protection against the
impact of long‑term illness. In fact, there may be an even stronger argument
for protection against financial loss as a result of sickness, not just because
the likelihood of suffering a long‑term illness is greater than that of premature
death, but also because the financial impact on a family of long‑term sickness
can be even more severe than that resulting from a death.
Protection against the impact of sickness may fall into a number of categories:
an income to replace lost income (for instance when the main earner suffers
a long‑term illness);
an income to pay for someone to carry out the tasks normally undertaken
by a person who is ill;
an income to pay for continuing medical attention or nursing care during
an illness or after an accident;
a lump sum to pay for private medical treatment;
a lump sum to pay for changes to lifestyle or environment, such as
alterations to a house or a move to a more convenient house.
As in the case of protection against death, there may be a requirement to cover
not just a main breadwinner, but also a dependent spouse.
The problems resulting from unemployment/redundancy are, in many ways,
similar to those caused by illness, but it is much more difficult for insurers to
predict statistically the likelihood of loss of employment than it is to predict
loss of health or loss of life. Unemployment cover is, consequently, much more
difficult to obtain as a stand‑alone insurance and, when it is available (normally
only in conjunction with sickness cover and often only in relation to covering
mortgage repayments), it is usually subject to a number of restrictions.
15.3 What protection needs might businesses have?
15.3.1 Death of a key employee
Loss of a colleague as a result of death, injury or long‑term sickness can have
severe implications for the financial health of a business. Life or sickness
insurance can be used to mitigate the financial loss that may result. Some of
the more common circumstances are described below.
The death of an important employee, particularly in a small company, can
have a devastating effect on a business’s profits. Key personnel can be found
at all levels of a business, not just within senior management. For example,
they might be a:
managing director with a strong or charismatic personality;
research scientist with specialised knowledge;
skilled engineer with detailed understanding of the company’s machinery;
salesperson with a wide range of personal contacts.
Determining the level of cover that is required can be difficult. A simple method
is to use a multiple of the key person’s salary, say five or ten times. Another
method is to relate the cover to an estimate of the key person’s contribution to
the business’s profits. This contribution can be calculated by multiplying the
amount of current annual profit by the ratio of the key person’s salary to the
business’s overall wage bill. This estimate of the key person’s contribution is
then multiplied by the length of time that the business would take to recover
from the loss, often assumed to be five years.
The business would then take out a term assurance on the life of the employee,
for the period during which the employee is expected to be a key person. This
may be until retirement, or until the end of a contract or a particular project. If
a term assurance of five years or less is chosen, the premiums are likely to be
allowed as a business expense, which the business can set against corporation
tax. In the event of a claim, however, the policy proceeds will then be taxed as
a business receipt and subject to corporation tax.
Calculate and explain COVER REQUIRED FOR A KEY EMPLOYEE
Goran is the production director of a firm whose last published
gross profits were £4m.
Goran is paid £50,000 pa. The firm’s total wage bill is £2m.
The length of time that the business would take to recover from
the loss of Goran is assumed to be five years.
The sum assured for a policy on Goran’s life could be calculated
as:
(£50,000 ÷ £2,000,000) × £4,000,000 × 5 = £500,000.
15.3.2 explain the implications of the Death of a business partner
A partnership is defined in the Partnership Act 1890 as “the relationship that
exists between persons carrying on a business in common with a view to
profit”. Groups of professionals such as solicitors and accountants normally
work together as partners.
In the absence of any formal partnership agreement, the Act stipulates that a
partnership is dissolved upon the death of a partner, with the business assets
realised and distributed to the remaining partners and the beneficiaries of the deceased partner’s estate. The surviving partners might want to carry on the
business but might find that they lack the funds to do so, particularly if much
of the business’s value is in the form of goodwill.
The solution is to put in place an arrangement that specifies what should
happen to each partner’s share of the business on death. The arrangement
needs to be supported by an appropriate level of life insurance, to provide
the required funds, and a suitable trust detailing distribution of the proceeds
from the life assurance (see Topic 16 for more information about trusts).
There are three main types of scheme that are used for this purpose.
Automatic accrual method – all partners enter into an agreement under which,
on the death of a partner, their share is divided among the remaining partners
in agreed proportions. The deceased partner’s family is compensated by the
proceeds of a life policy written in trust for their benefit. Where automatic
accrual is used there is normally 100 per cent business relief for inheritance
tax in respect of the deceased partner’s share of the business.
Buy‑and‑sell method – all partners enter into an agreement under which,
on the death of a partner, the deceased’s legal representatives are obliged
to sell the partner’s share to the other partners, who are obliged to buy it.
To enable them to do so, each partner takes out a life policy on their own
life in trust for the other partners. One problem is that the person who
inherits the share is deemed to receive cash rather than business assets, so
in that situation business relief from inheritance tax is not available.
Cross‑option method – this is basically the same as the buy‑and‑sell method,
except that the agreement specifies that the deceased partner’s estate has the
option to sell their business share to the remaining partners, who have the
option of buying it. There will almost always be an agreement for the deceased’s
estate to sell the business share and the remaining partners to buy it but
because there is no legal obligation to do so, those who inherit are deemed to
receive business assets, and relief from inheritance tax may be available.
Explain Shareholder PROTECTION.
(Exam question)
Small businesses are often run as private limited companies
with a small number of shareholders, who are often family
members or friends. In the same way that partners may
wish to buy out the share of a deceased partner, surviving
shareholders in a small business will probably want to buy
the shares of a deceased shareholder to prevent the shares
from going out of the close circle of existing shareholders.
The same types of scheme available for partnerships can be
used for shareholder protection.
15.3.3 explain Sickness of an employee
If sickness prevents a key employee from working, the effect on profits can
be just as serious as in the case of that employee’s death. The company may
need funds with which to recruit and pay the salary of a replacement who can
supply the skills and attributes lost through sickness. A critical illness cover
plan can be used.
15.3.4 explain what happens when there is a Sickness of a business partner
If a partner falls ill, they may be able to continue to draw income from
the partnership for some time, even if not contributing their skills to the
partnership’s earning capacity. There will be a need to provide a replacement
income to avoid the partner becoming a drain on the partnership’s resources.
This need could be met by income protection insurance. In the event of the
partner being unable to return to work, the remaining partners may even wish
to buy the sick partner’s share of the business. Depending on the nature of the
illness, critical illness cover could be used to generate the lump sum required.
15.3.5 explain what happens with a Sickness of a self‑employed sole trader
Although sole traders may employ others to work for them, they often do
much of the key work themselves, including accounting and decision‑making.
If a sole trader ceases working, their income is likely to stop very quickly.
Worse still, their customers may be lost to competitors, causing the business
to collapse. The pressure and anxiety resulting from such a situation is likely
to hinder recovery from the very illness by which it was caused. For a sole
trader, income protection with a short deferred period can ensure that an
income continues to be received.
15.4 What are the key considerations in relation to
borrowing?
House purchase is, for the majority of people, the largest financial transaction
of their lives and, since most people are not able to fund the price of a
house out of their own capital, a loan from a bank, building society or other
source is normally required. Since a mortgage is such a large and long‑term
commitment, the consequences of making a mistake can be very serious. It is
therefore particularly important for an adviser to choose wisely and to match
the products chosen to the client’s needs. The regulations relating to mortgage
advice are contained in the FCA’s Mortgages and Home Finance: Conduct of
Business (MCOB) Sourcebook, and we look at them in more detail in Topic 21.
The primary consideration is that the mortgage is affordable. If a borrower
fails to maintain payments on a loan secured on their property then they risk
the lender taking possession of the property and losing their home. The MCOB
rules make clear that the affordability of the mortgage is a key element in
determining whether the product recommended is suitable. Nor is it enough
to establish that a mortgage is affordable in the client’s current circumstances:
mortgage payments must be stress tested over at least five years to ensure
their ongoing affordability in light of expected interest rate changes.
Beyond ensuring that the mortgage is affordable, there are further
considerations. Choosing the wrong lender or the wrong interest scheme could
lead to the borrower paying more than is necessary for the loan. Choosing the
wrong investment product as a vehicle for repaying an interest‑only mortgage
can lead, at worst, to the mortgage not being repaid in full at the end of the
term. At best, it might mean that the client misses out on possible surplus
funds.
The exact nature of what constitutes good advice in a particular case will
depend on a variety of factors, including the term for which a loan is required
and the tax situation of the borrower.
Failing to protect the outstanding capital or the repayments against sickness,
death or redundancy can leave a client’s family destitute or lead to them
having to leave their home. Many clients are unaware of the magnitude of the
risk or of the ease with which it can normally be mitigated.
A low level of interest rates coupled with strong house price inflation has led to a
large increase in individual and family indebtedness in the UK, with many people
increasing the proportion of their net income that they spend on mortgage and
other loan repayments. Any increase in interest rates or reduction in income can
leave people unable to service the high levels of debt that they have taken on.
A number of products and services are available to assist people who can no
longer afford their loan repayments. A consolidation loan usually takes the
form of a remortgage for an increased amount, the new loan incorporating
the existing mortgage plus the individual’s unsecured loans, such as personal
loans and credit card balances. The advantage of this is that the overall monthly
repayments are reduced, because the unsecured loans are now subject to a
lower rate of interest and a longer repayment term. There is, however, a serious
downside to the arrangement, which is that the formerly unsecured loans are
now secured against the property, adding to the borrower’s problems if the
borrower defaults on the repayments of the consolidated loan. In addition, this approach may cost more in the long term due to interest being paid over
a longer period than originally planned. An arrangement fee may also be
payable.
Various options are available for clients who are unable to maintain payments
in respect of their liabilities, including debt relief orders (DROs), individual
voluntary arrangements (IVAs) or, in extreme circumstances, bankruptcy.
Advice on dealing with debt is available from a number of agencies, and clients
should be advised to consult a specialist in this area, such as Citizens Advice
or StepChange Debt Charity. Further information on the legal aspects of IVAs
and bankruptcy is outlined in Topic 16.
Citizens Advice
The stated aim of Citizens Advice is “to provide the advice people need for the
problems they face, and improve policies and practices that affect people’s
lives”. Citizens Advice gives advice on a wide range of different matters, the
most relevant to financial services being state benefits, debt and money,
and consumer law. Advice is provided online, over the phone and through
an extensive branch network. More information is available online at: www.
citizensadvice.org.uk/.
15.5 What are the key considerations relating to
Investment?
Broadly speaking, there are two reasons why people invest:
to provide income (either now or in the future); or
to provide a capital sum.
Saving and investment needs change over the course of a lifetime, as explained
in Topic 14. The financial services industry provides a very extensive range
of savings and investment products to meet the needs of a wide spectrum of
customers, and these products can be categorised in a number of different
ways. Some of the categories are outlined here.
15.5.1explain Regular savings or lump sum
Most people build up their savings by small regular amounts from their
disposable income. They may use regular savings schemes such as deposit
accounts, ISAs or unit trusts, pay regular premiums to endowment policies, or
make contributions to pension plans.
The need to invest a lump sum may arise from the receipt of a legacy or other
windfall, or it may result from the desire to move money from one form of
investment to another.
15.5.2 explain Level of risk for different investments
The level of risk ranges from products where there is virtually no risk to the
capital, such as bank deposit accounts, to those where the customer accepts
the risk of loss of some or all of the capital in the hope of achieving higher
returns. Most stock‑market‑related investments fall into the latter category to
some degree. The relationship between risk and reward is very important. As
a general rule, products that carry a greater risk also have a greater potential
for higher returns.
15.5.3 Accessibility to deposit accounts
Many deposit accounts offer instant access or require only short notice of
withdrawal. At the other end of the scale, some investments are not directly
accessible until a fixed maturity date: most gilt‑edged securities fall into this
category, although they can be sold prior to their redemption date (but without
any guarantee of the price that may be obtained). Shares and some gilt‑edged
stocks (and other investments) are irredeemable, ie they have no maturity or
redemption date. Where an investment is irredeemable, an investor who requires
access to their money must sell the securities to an investor who wishes to buy.
15.5.4 Taxation and identify client needs
The main UK taxes affecting investors are income tax and capital gains tax. With
many investments, tax is payable by investors both on the income received
and on any capital gain made on eventual sale. Shares and unit trusts fall into
this category. Some investments, eg gilt‑edged securities, are taxed on income
but are exempt from capital gains tax.
It is important to consider the tax regime of the product in conjunction with
the tax position of the investor: for instance, an investor who does not pay
income tax will not benefit from the tax advantages of taking out an ISA, but
a taxpayer wil
15.5.5 whatis the effect of inflation advising for client needs
One of the factors that is least understood by clients is the impact of inflation
on investment returns. As long as there is inflation, the purchasing power of a
given amount of money will fall. For example, the purchasing power of £1,000
after 10 years of 3 per cent inflation will have fallen to under £750. Before an
investment can grow in real terms it must first increase in line with inflation:
the aim of any investment should be to provide a real return. Over the long
term, equity‑linked and property‑based investments have proved most likely
to offer growth rates over and above the rate of inflation.
It is important that advisers educate customers about the impact of low and high
levels of inflation on potential returns from investments. The significant measure
for an investment is the real rate of return, which reflects the extent to which the
purchasing power of invested funds is maintained.
The real rate of return can be approximated by subtracting the rate of inflation
from the interest/growth rate obtained on the investment: an investment
paying 4 per cent interest at a time when inflation is 3 per cent is providing
a real rate of return of only about 1 per cent. If the rate of interest is less
than the rate of inflation, the real
rate of return will be negative and
the purchasing power of the invested
funds will fall in real terms.
Low inflation and low interest rates
tend to go together, and one effect of
this is that people tend to suffer from the so‑called money illusion, ie they
tend to think of interest rates in terms of the headline rate only and fail to
adjust their thinking to allow for inflation. Both savers and borrowers can be
affected.
Savers
Savers often feel that the low interest rates paid on savings are a poor return
for their money. They may, therefore, react to lower inflation by putting their
money into riskier assets in order to seek higher returns. But if people on
average incomes lose money as a result of riskier investments, it may have a
very detrimental impact on their financial security – retirement planning, for
example. If large numbers of people find themselves in this position, it may
have adverse effects on the wider economy and society.
Borrowers
When interest rates are low, borrowers (particularly those repaying mortgage
loans) may feel that they are gaining from the lower monthly repayments
that have resulted from interest rate falls. This may persuade them to take
out a larger mortgage since they feel they can more easily afford the monthly
repayments. This is a misconception as, although less cash flows out in interest
payments at the start of the mortgage term, a higher proportion of cash flow
will be necessary to repay the capital. Again, problems may be stored up for
the future as people take on debt they cannot afford, especially if interest rates
then rise. In the meantime, an increased demand for houses can push up house
prices and threaten price stability.
Identify the importantce of PURCHASING POWER
(Exam question)
If £1,000 is invested in a savings account and the interest rate
is 5 per cent, the interest will be £50. The account will have
£1,050 in it at the end of 12 months.
If, before the money was invested, £1,000 would buy a
three‑piece suite, but after one year, the same three‑piece
suite costs £1,100, then the money hasn’t increased in real
terms. It has increased in ‘actual’ terms by £50 to £1,050 but
it is actually worth less in ‘real’ terms because the effects of
inflation have eroded its purchasing power.
How do you calculate the real rate of return?
Nominal interest/growth rate
minus inflation rate.
15.6 Why is retirement planning so important?
Changes in the demographic structure of the population make it increasingly
difficult for the state to provide pensions at the level needed to maintain people’s lifestyles but at a realistic and acceptable cost to the taxpayer.
Encouraging people to save more for their retirement is one of the great
challenges facing the UK government in the early twenty‑first century.
State pension – set at about one quarter of the level of national average earnings –
is clearly inadequate for anything more than subsistence living, yet many people
are continuing to reach retirement age with little or no pension provision apart
from a state pension. This is particularly – although by no means exclusively –
true of people at the lower end of the earnings scale. There is an added risk
that they are financially unsophisticated and unaware of products such as
stakeholder pensions that could be used to boost their pension. Even when
they are aware of retirement solutions, people in the lower earnings brackets
generally have more immediate demands on their income and, moreover, may
have been put off by talk of high charges or product mis‑selling.
The inability of many people in the UK to make adequate provision for their
retirement has been referred to as a ‘pensions crisis’. The problem has been
increased by the accelerating trend for employers to move away from final salary
schemes (also known as defined‑benefit schemes) and towards money‑purchase
(or defined‑contribution) schemes, where the size of the individual’s pension pot
is based on the performance of the assets in which the pension funds are invested.
Successive governments have introduced measures to attempt to address
the savings gap, for example, with the introduction of stakeholder pensions
and the rules requiring that certain employees are automatically enrolled in a
workplace pension.
15.7 How can the adviser assist with estate planning?
There are two main questions to consider in advising on estate planning:
Has the client made a (valid) will?
Has the client taken steps to mitigate inheritance tax liabilities?
Financial advisers should not generally become involved in writing a will, but
should strongly advise that the client consult a legal adviser to ensure that a will is in place. If necessary, the financial adviser can provide a document
explaining any financial objectives that the will should help to achieve.
In relation to inheritance tax, there are basically two approaches that people
can take:
try to avoid having to pay it; or
make provision for paying it when it is due.
To avoid paying IHT, it is necessary to reduce the value of the estate to
below the nil‑rate thresholds. This can be done by making use of the various
exemptions described in Topic 4 to make tax‑free, or potentially exempt, gifts
during one’s lifetime. Another method is to place assets in trust, since trust
property no longer forms part of the settlor’s estate. The largest component of most people’s wealth is the property in which they
live. It is usually not possible to avoid IHT by giving the property away while
continuing to live in it, as this is highly likely to be caught by HMRC’s gift
with reservation (GWR) rules. In simple terms, the GWR rules prevent assets
(eg a property) that are gifted to non-exempt beneficiaries from being treated
as potentially exempt transfers (PETs) if the transferor continues to receive a
benefit from the asset (eg by continuing to live in the property).
In the past, many people avoided this restriction by the device of placing
their property (known technically as a pre‑owned asset) in a trust. The tax
authorities closed this loophole by means of Schedule 15 of the Finance Act
2004, which introduced rules for the taxation of pre‑owned assets that came
into force from 6 April 2005. Under these rules, people are liable to an income
tax charge each year on the benefit of occupying or using any asset previously
owned but disposed of after 17 March 1986.
The tax charge is based on a realistic annual rental for the property they occupy,
although if the deemed rental amount is less than a de minimis amount then
no tax charge may be levied. Some people may decide that cancelling their
schemes (with the loss of the benefits and some, or all, of the set‑up costs) is
better than paying the future tax bills.
Married couples and civil partners are now able to use the whole of both
their nil‑rate bands to pass property tax‑free to their relatives or others. The
percentage of nil‑rate band unused on the first death can be carried forward
and used to increase the nil‑rate band on second death. The residence nil‑rate band, introduced on 6 April 2017, also helps to further mitigate the impact of
IHT if the property is passed down to lineal descendants.
If avoiding the tax is not a realistic option, a life assurance policy for the
anticipated amount of the IHT should be taken out. To avoid the policy
proceeds becoming part of the deceased’s estate – and therefore themselves
subject to IHT – the policy should be written in trust for the benefit of the
beneficiaries of the will.
15.8 What is the role of the adviser in tax planning?
The recommendation of a financial product should always take account of the
product’s impact on the client’s tax situation, but not in isolation: it should
be considered in context, in conjunction with other features of the product.
For instance, contributions to a pension arrangement are often the most
tax‑efficient way for an individual to invest, but this should never be the main
reason for recommending a pension product.
Just as it is wise to leave the writing of wills to solicitors, complex tax‑planning
schemes should be left to taxation experts. However, it is important to be able
to choose appropriate products that can complement and improve a client’s
current tax situation:
Clients should normally consider the use of ISAs, pensions and friendly
society policies to maximise the advantage of tax‑free income or growth.
Clients who are non‑taxpayers may consider investing in funds such as
offshore bonds, which are free from UK tax.
Clients who expect to exceed their CGT annual exempt amount might
consider investments that are CGT‑free, such as gilts.
Advisers should be aware of circumstances where tax that has been paid (in
effect on behalf of the investor) cannot be reclaimed even if the investor is
not a taxpayer. An example of this would be an endowment policy or a UK
investment bond, where gains made within the life company’s funds are
taxed at 20 per cent: a policyholder who is not a taxpayer cannot reclaim this
deduction. An offshore bond (which is free from UK tax on its fund) may be
more attractive to a non‑taxpayer.Unit trust managers are not taxed on gains within their funds; holders of units
are liable for CGT if they sell their units at a profit but they may be able to
avoid this by use of their CGT annual exempt amount.
15.8.1 what are the Offshore considerations for clients?
Where an individual is either leaving the UK (emigrating) or coming to live in the UK
(immigrating), consideration should be given as to whether existing investments
should be encashed before the move or retained. The decision could be driven in
part by which option results in the more favourable tax treatment.
15.9 Why are regular reviews important?
At any given time, one or more of the advice areas described above might be
the most significant for a particular client. However, circumstances can change
very quickly and the financial needs of a client and their family may change
dramatically. Births, marriages, divorces, deaths, moving home, changing
jobs, losing a job and many other events can change people’s attitudes and
objectives, as well as their assets and liabilities. Advisers should take account
of this by allowing (as far as possible) flexibility in the products recommended
and also by making plans to review the client’s situation at regular intervals.
1) What main factors affect the calculation of the level of sickness
cover needed by a working parent with children?
1) The extent of any sickness benefit from an employer; the nature and
amount of available state benefits; the number and ages of the children;
and the availability of any help from family and friends with childcare and
housekeeping.
2) What is the purpose of key person insurance?
2) To mitigate the adverse impact on a business’s profits caused by the death
or long‑term illness of an important member of staff.
3) Hegley Surveying Services wants to take out key person
insurance on their senior surveyor, Simone. Her annual salary
is £47,000. The company’s total annual salary bill is £400,000
and its latest published gross profit was £1.5m. Calculate the
appropriate sum assured, assuming the estimated time to
recover from the loss of Simone would be five years.
3) (£47,000 ÷ £400,000) × £1,500,000 × 5 = £881,250
4) How does the cross‑option method differ from the buy‑and‑sell
method of partnership protection?
4) It comprises an option to purchase the deceased partner’s share rather
than a binding contract; as a consequence, the deceased’s family or heirs
are deemed to receive business assets rather than cash, so business relief
from inheritance tax can be claimed.
5) For which of the following borrowers might a fixed‑rate
mortgage be most suitable?
a) Ruth, who feels that interest rates will stay the same for
the next few years.
b) Sean, who feels that lenders should never charge
arrangement fees.
c) Aditya, who is convinced that interest rates will fall sharply
in the short term.
d) Nigel, who believes that interest rates will rise significantly
in the near future.
5) d) Nigel – a fixed‑rate mortgage is most suitable for ensuring that, over a
specific period, repayments do not increase as a result of interest‑rate
rises.
6) Which one of the following repayment vehicles would be
suitable for a client who wants an interest‑only mortgage, but
insists that the product must guarantee to pay off the mortgage
at the end of the term?
a) Full with‑profits endowment.
b) Low‑cost endowment.
c) ISA.
d) Unit‑linked endowment.
6) a) The sum assured on a full with‑profits endowment is set at a level
equal to the mortgage debt so, as long as payments are maintained, it
will guarantee to repay the mortgage at the end of the term.
7) If the cost of living is rising, what is likely to be the main
priority of a customer making an investment?
a) To avoid incurring any further income tax liability.
b) To protect money against the effects of inflation.
c) To be able to access it immediately.
d) To invest money securely.
7) b) To protect money against the effects of inflation.
8) If the rate of inflation is 2.5 per cent, what yield must an
investor obtain on their deposit account in order to achieve a
real return of 3 per cent?
a) 0.5 per cent.
b) 2.5 per cent.
c) 5.5 per cent.
8) c) 5.5%
Real rate of return = nominal interest/growth rate – inflation
3% (real rate of return) = x% (nominal interest/growth rate) – 2.5% (rate of
inflation)
Therefore: 3% + 2.5% = 5.5%
9) Nina is a basic‑rate taxpayer. She pays £162 pm by direct debit
into her personal pension plan. How much is actually invested
in her plan each month including tax relief?
a) £194.40.
b) £202.50.
c) £283.50.
d) £270.00.
9) b) £202.50. The £162 is the ‘net’ contribution. To work out the ‘gross’
contribution, divide the net contribution by 80 and multiply by 100 (do
not add 20 per cent to the net contribution).
£162 ÷ 80 × 100 = £202.50
10) What rule does HMRC apply in relation to gifts with reservation?
10) If a donor receives any benefit from a gifted asset, the asset is treated for
IHT purposes as remaining in the donor’s estate.
16.1 What is a ‘legal person’?
A ‘legal person’ is a body that has a legal existence and can, therefore, enter
into contracts, sue or be sued in a court of law. It is important to remember
that this includes not just an individual acting in a personal/private capacity
but also an individual acting in a formal capacity such as that of executor, as
well as groups of individuals such as trustees. It also includes bodies such as
limited companies.
16.2 what does it mean to be a Sole trader?
As a sole trader, the owner is not considered a separate legal person from the
business, meaning that they are personally liable for their business’s debts.
This also means that they are entitled to keep all of the profits generated by
the business, after income tax and National Insurance contributions have been
paid.
16.3 what are the key features to work as a company?
As noted in section 16.1, a company is a legal person (although, often, the
term ‘legal entity’ is used instead). In other words, the company is legally
separate from its shareholders and its individual employees.
The certificate of incorporation provides evidence of the company’s formation,
and details about the company are held on the central registry at Companies
House. The information held includes the shareholding and shareholders, as
well as listing the names and addresses of the directors and company secretary.
The nature of the company, and the rules about what it can and cannot do,
are set out in its memorandum and articles of association. For example, the
memorandum normally includes the power to borrow, but may place limits or
restrictions on that power in terms of amounts or purpose. Such limits will be
significant if the company is considering taking out a mortgage or other form
of loan.
When entering into a contract with a company, it is prudent to check that the
persons entering into the contract are authorised and empowered to do so. For
example, when a company director is seeking to raise funds for the company,
it would be advisable to check that the company is able to borrow and also
that the director in question is able to arrange a loan on the company’s behalf.
Shareholders of a limited liability company cannot be held personally
responsible for the debts of the company, the limit of their liability being
the amount that they have invested in company shares. This is the most they
could lose if the company were to become insolvent.
16.4 what are the Key features of working in a partnership?
A partnership is an arrangement between people who are carrying on a business
together for profit. Unlike a company, a partnership is not a separate legal
entity and the partners jointly own the assets. They are jointly and severally
responsible for the liabilities of the partnership. This means that each partner
is liable by themselves to pay back the entire amount owed to any creditor.
Partnerships should have a written agreement that sets out in detail the
relationship between the partners, including proportions in which they share
the partnership’s profits and what will happen when a partner leaves, retires
or dies.
16.4.1 explain Limited liability partnerships
A limited liability partnership (LLP) is one where partners have a limited
personal liability if the business should collapse: their liability is limited to the
amount that they have invested in the partnership, together with any personal
guarantees they have given – for example, to a bank that has made a loan to
the business.
As with companies, LLPs have to be registered with Companies House; they
are clearly more like companies than they are standard partnerships, but the
taxation of LLPs is not the corporation tax regime that applies to companies.
LLPs are taxed in the same way as other partnerships: each partner is taxed on
a self‑employed basis, with their individual share of the profits being treated
as their own personal income and subject to income tax.
16.5 What are the requirements for a binding contract?
Most business agreements, particularly in the world of financial services, are
established as legally binding contracts. Some are made orally, some in writing
and some by deed. Not all contracts can be made orally but all contracts
generally are subject to certain basic requirements for them to be binding.
Figure 16.1 summarises these, and an explanation of the terms is provided.
Offer and acceptance – there must be an offer made by one party (the
offeror) and there must be an unqualified acceptance by the other. This
acceptance must be communicated to the other party. In practice there
may be a number of counter‑offers before agreement is reached.
Consideration – the subject of the contract (often a promise to do something
or supply something) must be matched by a consideration (which is
frequently, but not necessarily, the payment of money). A promise to pay
is valid consideration.
Capacity to contract – each of the parties to the contract must have the
legal capacity, or power, to enter into the contract. Certain parties have
only limited powers to enter into a contract, for example, minors (under
18s) and those who are deemed to lack the mental capacity to safely make
their own decisions. For financial institutions such as insurance companies,
capacity to contract depends on being authorised by the FCA/PRA.
Contract terms – these must be certain, complete and free from doubt. For
example, when a customer engages an independent financial adviser (IFA),
the IFA’s commitments are detailed in a terms of service agreement.
Intention to create a legal relationship – as distinct from a merely informal
arrangement.
Legality of object – contracts cannot be made for illegal or immoral purposes.
Misrepresentation, duress or undue influence – if any of these factors are
involved in leading someone to enter into a contract, the contract is not
binding.
Explain CONTRACTS INVOLVING LAND
(Exam question)
Note that all agreements for the sale of land must be made
in writing and conveyances of land (the actual transfer of
ownership) must be performed by deed.
16.5.1explain Disclosure of information
Generally, there is no duty of disclosure between parties to a contract; most
contracts are based on the principle of caveat emptor (‘let the buyer beware’).
In other words, it is the responsibility of each prospective party to the contract
to satisfy themselves that they have all the information they need on which to
base their decision to enter into that contract.
However, there are exceptions. For example, insurance contracts were, for
many years, based on the principle of ‘utmost good faith’ (uberrima fides),
whereby all material facts had to be disclosed by both parties. For an insurance
policy, this meant that the person applying for the policy was required to
supply all the facts that a prudent underwriter would need to decide the terms
on which the policy could be issued. Non‑disclosure by the customer rendered
the contract voidable at the option of the insurance company.
From 2000 onwards there was growing concern from regulators and consumer
groups that some insurers were rejecting claims on the basis that the
policyholder failed to disclose information that they should have realised
was relevant and important, even though no direct question asked for the
information. The problem was exacerbated by a growing tendency for insurers
to reduce the level of pre‑application underwriting and effectively ask medical
underwriting questions when a claim was made, at which point problems
might arise.
The situation regarding rejection of claims eventually led to the Consumer
Insurance (Disclosure and Representations) Act 2012, which came into force on
6 April 2013. In simple terms the Act more clearly defines the responsibilities
of insurance customers. It abolishes the duty of consumers to volunteer
material facts when applying for insurance and instead requires them to take
reasonable care to answer the insurer’s questions fully and accurately. If they
do volunteer information, they must take reasonable care to ensure that the
information is not misleading or misrepresented.
For example, section 2(2) of the Act states that “it is the duty of the consumer
to take reasonable care not to make a misrepresentation to the insurer”. The
representations will be based on responses to specific insurer questions,
because there is no duty on the consumer to volunteer information that is not
asked for. The Act defines, as far as possible, the meaning of “reasonable” in
this context, which depends on a number of factors including, “how clear, and
how specific, the insurer’s questions were”. Section 2.3 states that “a failure
by the consumer to comply with the insurer’s request to confirm or amend
particulars previously given is capable of being a misrepresentation”.
In the case of misrepresentation, the Act also indicates what actions the insurer
may take:
If the consumer has taken reasonable care, and the misrepresentation was
honest and reasonable, the insurer has no right to refuse a later claim.
In the case of misrepresentation due to carelessness, detailed rules allow
the insurer to apply a ‘compensatory remedy’ to the claim, based on what
the insurer would have done had the applicant answered all questions
completely and accurately. So, for example, if the insurer would have
refused cover completely if it had been in full possession of all the facts,
the claim could be rejected; if it would have excluded certain illnesses,
then claims relating to those illnesses would not be met. If the claim is
rejected, then the insurer must refund the premiums paid.
If careless misrepresentation is identified in situations other than a claim,
the insurer and the policyholder have the right to terminate the contract
with reasonable notice. The exception to this is a policy that wholly or
mainly relates to life insurance where the insurer may advise the consumer
of their rights to terminate the contract by giving reasonable notice and
stating that they may receive a refund of premiums paid for the terminated
cover in respect of the balance of the contract term (if any).
In the case of deliberate or reckless misrepresentation, the insurer may
reject the claim completely as if the contract never existed and is not
required to refund premiums paid, unless there is a good reason to do so.
Explain the REJECTION OF CRITICAL ILLNESS CLAIMS
(Exam question)
Many of the cases in which insurance companies rejected
claims on grounds of non‑disclosure involved critical illness
policies where applicants failed to disclose a condition for
which they had previously visited a doctor. In many cases
the doctor had confirmed that there was not a problem,
or had diagnosed a minor problem that was successfully
treated. On later suffering from a specified critical illness, the
policyholder’s claim was declined due to the non‑disclosure at
the application stage, even when the condition not disclosed
was unconnected to the illness that prompted the claim.
In many cases, the Financial Ombudsman determined that the
insurance company’s rejection was unreasonable and found in
favour of the policyholder. One major issue was the reliance on
the applicant to decide what was relevant to disclose. Typical
questions on the application form would be along the lines
of: “Have you ever visited a doctor or suffered from a medical
condition requiring treatment?” This required the applicant to
remember all such occasions and decide which, if any, to include
16.5.2 explain the Remedies for breach of contract
Breach of contract occurs when a party fails to perform its side of the contract
and does not have a legal justification for doing so. Several court remedies are
available in these circumstances; the most common ones are as follows:
Damages – the injured party seeks to obtain financial compensation for
their loss. The intention is to put them in the position they would have
been in had the contract not been breached by the other party, insofar as it
is possible to do so with money.
Order for specific performance – such an order compels the other party
to complete the contract.
Injunction – this is a court order preventing someone from doing something.
Of these, by far the most frequently sought is damages.
16.6 What is the law of agency?
An agent is a person who acts on behalf of another, who is called the principal.
The agent can conclude contracts on behalf of the principal. In law, the acts of
the agent are treated as being those of the principal. In the context of financial
services, an IFA is an agent of their client and given specific powers under the terms of engagement. Another example is an estate agent, who is the agent of
a person looking to sell their property.
In any kind of agent–principal relationship, it is important to ascertain
how much power and authority has been granted to the agent, just as it is
important that the agent is fully aware of what they can and cannot do. Some
agents are given very wide authority while some are severely restricted. For
example, an IFA may only be required to give advice, on which their client can
choose whether or not to act; alternatively, they may be given discretionary
investment powers to buy and sell investments on the client’s behalf.
An agent should only act within the authority given to them by their principal.
This should be strictly observed, because, if an agent exceeds their power, it
could result in their principal being liable on the contract. This happens when,
although the agent acts outside of their actual authority, they act within what
is known as their apparent authority.
Another result is that the agent may be made liable. This protects the third
party to the agreement, who – if they are unable to rely on the agent’s claim
to have authority – must be able to hold the agent personally responsible. It
would otherwise be unfair to the third party, who would have entered in good
faith into the contract only to find themselves without recourse either to the
principal (if there is no apparent authority) or the agent.
If the agent does exceed their authority, the principal can, if they choose,
agree after the event to what the agent has done. This is called ratification.
This very brief introduction cannot cover all the detail of agency law but
serves to illustrate how important it is for advisers to know, understand and
act within the extent of their authority.
Key terms
AGENT
Acts on behalf of the principal, within specific boundaries, to conclude
contracts.
APPARENT AUTHORITY
Something either done or said by the principal that leads to the impression
that they have authorised the agent’s actions.
PRINCIPAL
The party granting permission to the agent to act on their behalf.
RATIFICATION
A retrospective agreement by the principal to actions taken by the agent
that exceed the latter’s authority.
Joanne lives in London and her property in Brighton is on the
market for £300,000. The property is currently unoccupied. Joanne
is going away on business for six weeks and explains to her estate
agent, Martin, that it might be difficult to contact her during that
time. She tells him to do whatever is necessary to sell the property,
as she is desperate for the money.
While Joanne is away, Martin receives an offer of £285,000 on the
property from Mr and Mrs Peters. They explain to Martin that they
are moving from Devon because Mrs Peters is starting a new job;
they need to move immediately and will rent a property until they
can sell their Devon home and buy in Brighton. In Joanne’s absence,
Martin accepts their offer on Joanne’s flat and arranges for them to
move in immediately as tenants until the purchase can go ahead.
Did Martin have authority to make this decision?
1) There is no cut‑and‑dried answer to this question. Martin certainly didn’t
have ‘actual authority’ to make that decision, but he might have had
‘apparent authority’. Would it be reasonable to assume that in saying “do
whatever is necessary” Joanne accepted that this might include creating a
tenancy and accepting an offer that is £15,000 less than the asking price?
If the property had been on the market for a long time, Joanne might
decide to ratify Martin’s decision. If, on the other hand, this was the first
offer, or she had already rejected an offer around £285,000, she might
feel differently about the way Martin acted.
16.7 explain Property and property ownership
The law of England and Wales defines two distinct types of property; in this
context, the word ‘property’ is used to refer to all types of asset, rather than
its narrower sense of ‘land and buildings’. The two types are as follows:
Realty – property is deemed to be real if a court will restore it to a
dispossessed owner and not merely provide compensation for loss. Real
property tends to be distinguished by being immovable, eg land and what
is attached to it, also known as real estate.
Personalty – all other property is called personalty.
In relation to joint ownership of property, there are two types:
Joint tenants – each joint owner owns 100 per cent of the property – there is
no division of the property. On the death of any joint owner, the surviving
joint owner(s) will take over legal ownership of the property. The transfer
is automatic and cannot be overridden by any provisions made by a joint
tenant in a will or through the laws of intestacy.
Tenants in common – the joint legal owners are regarded as one single
owner but are trustees of the land. However, each legal owner is also the
beneficial (or equitable) owner of a defined interest (share) of the equity in
the property, as agreed between them. If one owner dies, their share of the property passes to whoever is entitled to inherit it under the terms of their
will or the law of intestacy.
Explain RESPONSIBILITY FOR DEBTS
(Exam question)
Banks, building societies and other commercial lenders
usually insist that joint mortgages are written on a joint and
several liability basis, which means that all parties are equally
responsible for carrying out the full terms of the agreement.
Therefore, whether a jointly owned property is held as joint
tenants or tenants in common, each owner is responsible for
the mortgage, so if one person cannot make their payment, it
is the responsibility of the other(s) to make up the shortfall.
16.8 What is power of attorney?
An attorney is a person who is given the legal responsibility to act on behalf
of another person. Examples of situations in which the need for an attorney
might arise include:
a person who, while currently in good health, is concerned about how their
affairs will be run should they become unable to manage their own finances
(for instance if they develop an illness such as dementia); or
someone with affairs in the UK who is moving abroad.
A person who does not have the legal capacity to enter into a contract (eg a
minor or a mentally incapacitated person) cannot appoint someone else as
their attorney.
16.8.1 What is an enduring power of attorney?
An ordinary power of attorney automatically ceases if a person becomes
mentally incapacitated. This can create problems for those responsible for
managing the individual’s affairs. An enduring power of attorney (EPA) can
continue if the donor becomes mentally incapacitated, although it has to be
registered with the Office of the Public Guardian (OPG) if the attorney believes
that the donor is losing mental capacity. An EPA can be revoked only with the
consent of the Court of Protection.
Key terms
DONOR
Person who makes a power of attorney.
DONEE
Person who is given power of attorney. Often, they are simply referred
to as the attorney.
16.8.2 What is a lasting power of attorney?
From 1 October 2007, under the provisions of the Mental Capacity Act 2005,
enduring powers of attorney were replaced by lasting powers of attorney (LPAs).
EPAs made before that date can remain in force, but all new arrangements
must be lasting powers of attorney.
There are two types of LPA:
Health and welfare – this gives the attorney power to make decisions over
issues such as medical care or moving into residential care. It can only be
used once the donor can no longer make decisions for themselves.
Property and financial affairs – this gives the attorney power to manage
the donor’s bank accounts, collect benefits and sell property. It can be used
even if the donor has mental capacity, as long as the donor gives permission.
In both cases, the LPA must be registered with the OPG before it can come into
effect.
16.8.3 What happens if no power of attorney is in place?
The Mental Capacity Act 2005 supports and protects individuals who lack the
capacity to make their own decisions. It promotes supported decision‑making,
which is the process of providing support to those who need help making
their own decisions. It also makes provision for substituted decision‑making,
where decisions are made on behalf of the individual in their best interests
(for instance, by a court-appointed deputy).
If a person loses mental capacity and does not have a valid LPA or EPA in place,
the Court of Protection can appoint a deputy. This process can take some time
and a deputy’s powers are much more restricted when compared to those of
an attorney. It is for these two reasons that all clients should be encouraged to
draw up an LPA if they have not done so already.
16.9 explain Wills
A will is a written declaration of an individual’s wishes regarding what they
want to happen after they have died. Although primarily concerned with how
the person wishes to dispose of their assets, a will can also deal with other
matters, such as giving instructions about burial.
In the UK, approximately seven out of ten people die intestate, meaning that
they die without leaving a valid will. Writing a will is the first step in gaining
control over an estate and is, therefore, a vital part of financial planning.
it is important that clients understand the benefits of a valid will and the
risks of not having one. If the client has no will, the financial adviser should
recommend that they seek professional advice from a solicitor; the adviser
should not become involved in writing the will themselves.
To make a valid will, two formalities must be followed:
the will must be in writing;
the will must be properly executed.
The minimum age for making a valid will under English law is 18.
The will should be a clear and unambiguous statement of the deceased’s
wishes in respect of their estate, and must be signed by the testator in the
presence of two witnesses.
It is important that the witnesses chosen must not be beneficiaries under the
will (or the spouses of beneficiaries). If a beneficiary were to be a witness, they
would not be able to inherit under the terms of the will.
The terms of a will only take effect on the death of the testator, the person
who made the will. Before then, the testator can revoke (cancel) or modify the
will at any time. Modifications are recorded in a document known as a codicil.
In the event of marriage, remarriage or entering into a civil partnership, a will
is automatically revoked, unless specifically written in contemplation of the
change of status.
Key terms
TESTATOR
Person who makes the will.
BENEFICIARY
A person or organisation that receives benefits under the terms of a will.
CODICIL
Document that formally amends a will.
16.9.1 explain Distribution of the estate
The people who carry out the procedures necessary to distribute the estate
of someone who has died are known as the deceased person’s legal personal
representatives. The exact procedure depends on whether or not there is a valid
will. The following comments apply to the law of England and Wales (Scottish
law differs both in the procedures involved and in the terminology used).
If there is a valid will, it will name the person or people the testator has chosen
to be executors. The role of the executors is to ensure that the actions specified
in the will are carried out. The duties of an executor can be time‑consuming and
onerous and it is not uncommon for executors to appoint a solicitor to carry
out all or part of their duties. Note that an executor can also be a beneficiary
of the will.
Before they are able to distribute the estate, the executor(s) must apply for
a grant of probate. This gives them legal authority to carry out the testator’s
instructions, as set out in the will.
If there is no will (or the will is invalid), an appropriate person (such as a
spouse or other close relative) acts as an administrator and applies for the
grant of letters of administration, rather than probate. The administrator’s
responsibility is to deal with the estate as prescribed by the rules of intestacy
(see section 16.8.2).
In certain circumstances it may be advantageous, following the death of the
testator, for the beneficiaries under a will to vary the way the estate has been
allocated. This can be achieved by executing a deed of variation. All those
who would be affected by the deed must be over 18 years of age and must
be in agreement on the terms of such a variation. A deed of variation is often
executed for tax purposes: a change in beneficiaries or in the relative shares
received that could reduce the inheritance tax liability, for example. To be
effective for tax purposes, the deed of variation must be executed within
two years of the death, and HMRC must be informed within six months of its execution. The variation must not be entered into for any consideration of
money or money’s worth.
Key terms
EXECUTOR
Person named by the testator as being responsible for carrying out the
wishes expressed in a valid will.
GRANT OF PROBATE
Legal authority for executors to distribute an estate according to the
terms of a valid will.
DEED OF VARIATION
Legal agreement by the beneficiaries to alter the terms of a will, after the
death of the testator.
MONEY’S WORTH
Provision of goods/services in lieu of a cash payment.
16.9.2 explain Intestacy
A person who has died without having made a valid will is said to have died
intestate. This includes the situation where the deceased has left a will that
turns out to be invalid. If a will makes valid provision for the distribution of
some of the assets of the estate, but not of others, this is referred to as partial
intestacy.
The distribution of the estate of a person who has died intestate is determined
by a complex set of rules known as the rules of intestacy. They are very specific
and there is no flexibility or discretion for their variation by the person dealing
with the estate. In many cases – especially if the estate is a large one – the
distribution of the assets may not be as the deceased would have wished. In
particular, it is not necessarily true – as many people believe – that a surviving
spouse or civil partner will receive the whole estate.
The main rules are as follows. Please note that for the purpose of these rules,
the word ‘spouse’ includes civil partner and ‘children’ includes more distant
descendants, eg grandchildren or great‑grandchildren, and so on.
If the deceased leaves a spouse but no children – the spouse inherits the
deceased’s entire estate.
If there is both a spouse and children – the spouse inherits the deceased’s
personal chattels, plus the first £270,000, plus half of the residue above £270,000 absolutely; the other half of the residue in excess of £270,000 is
divided equally between the children.
If there are children but no spouse – the estate is shared equally among
the children.
If there is neither spouse nor children – the estate goes to the parents of
the deceased, or (if they are dead) to the deceased’s brothers and sisters.
This is just a summary of the main rules (Figure 16.2 provides further details)
and, ultimately, if no blood relative can be found, the estate will pass to the
Crown.
Key terms
INTESTATE
Having died without leaving a valid will.
ADMINISTRATOR
Person given the role of distributing the estate according to the rules of
intestacy.
LETTERS OF ADMINISTRATION
Legal authority to distribute the estate of a person who has died without
leaving a valid will.
a) Marian was married but had no children, although her parents
were still alive. She died without leaving a will. The value of her
estate was £600,000. How much did her husband inherit?
b) Ian, who made no will, left an estate of £350,000. How much
did his wife and each of his two children inherit?
2) a) Marian’s husband inherited her entire estate. Parents only inherit if
there is no spouse or children.
b) Ian’s wife inherited £310,000 (ie the first £270,000 plus half the
excess above that figure); Ian’s children inherited £20,000 each (ie the
remaining £40,000 of the estate shared between them).
16.10 explain Trusts and trustees
16.10 Trusts and trustees
A trust (also known as a settlement) is a method by which the owner of an
asset (the settlor) can distribute or use that asset for the benefit of another
person or persons (the beneficiaries) without allowing them to exert control over the asset while it remains in trust. Depending on the nature of the trust,
the beneficiaries may eventually become the absolute owners of the asset.
The settlor is the person who creates the trust and who originally owned the
assets placed in the trust (the trust property). Once it is placed in trust, the
asset is no longer owned by the settlor (unless the settlor is also a trustee – see
below).
The beneficiaries are the people or organisations that will benefit from the
trust property. They may be named individually or referred to as a group, eg
“all my children”.
The trustees are the people, appointed by the settlor, who take legal ownership
of the trust property and administer the property under the terms of the trust
deed. The trustees, who can include the settlor, are named in the trust deed.
Trustees must be aged 18 or over and have mental capacity. If a trustee dies,
the remaining trustees, or their legal personal representatives, can appoint a
new trustee.
Trustees have a number of duties:
They must act in accordance with the terms of the trust deed. If the trust
deed gives them discretion to exercise their powers (eg discretion over
which beneficiaries shall receive the trust benefits), the agreement of all
the trustees is required before a course of action can be taken.
They must act in the best interests of the beneficiaries, balancing fairly the
rights of different beneficiaries if these should conflict. For example, some
trusts provide income to certain beneficiaries and, later, distribution of capital to other beneficiaries; in such a situation the chosen investment must preserve
a fair balance between income levels and capital guarantee/capital growth.
Under the Trustee Act 2000, trustees who exercise investment powers are
required to:
be aware of the need for suitability and diversification of assets;
obtain and consider proper advice when making or reviewing investments;
keep investments under review.
Key terms
SETTLOR
The person who creates the trust and originally owned the assets held
within it.
TRUST DEED
Document that sets out how the trust is to be managed, by whom and for
whose benefit.
TRUSTEE
Person named in the trust deed as legal owner of the trust property, with
responsibility to look after and distribute the trust property in line with
provisions in the trust deed.
Explain CREATING AND ADMINISTERING A TRUST
(Exam question))
George is 65 years old. He has two grandchildren, Chloe aged
seven and Mark aged five. He puts £500,000 in trust for his
grandchildren’s education. Once the money has been put into
the trust, it no longer belongs to him – he has made a gift. He
names his daughter Sue and his friend Bob as trustees. The
money has got to last a long time (16 years until Mark finishes
university) so it must be invested and used wisely. Sue and Bob
will decide how to invest the money (shares, property, gilts,
accounts, etc) and what it is spent on (school fees, uniform,
books, school trips, etc). They must agree all their decisions
together.
16.11explain Insolvency and bankruptcy
Insolvency arises when:
a person’s liabilities exceed their assets; or
a person cannot meet their financial obligations within a reasonable time
of them falling due.
Bankruptcy takes the position a stage further and arises when a person’s state
of being insolvent is formalised under the terms of a bankruptcy order.
The primary UK legislation on insolvency is the Insolvency Act 1986, but this
has been subject to amendments over the years.
16.11.1 explain Bankruptcy
A person can apply to have themselves declared bankrupt, or a creditor may
petition to have someone else declared bankrupt if they owe (or are owed jointly
with other creditors) £5,000 or more. Most bankruptcy orders remain in force
for 12 months, during which time the person is said to be an undischarged
bankrupt. If individuals do not comply with the terms of the bankruptcy order it may remain in place until the official receiver or insolvency practitioner is
satisfied that their requirements have been met.
During the period of bankruptcy, the individual’s possessions are, in effect,
surrendered to an official receiver, who can dispose of them and use the money
raised to pay off the creditors. The only exceptions are clothing, household
items and work‑related items.
Although bankruptcy cancels most kinds of debt and allows people to make a
fresh financial start, it comes at a price: it normally makes it more difficult to
obtain credit in the future and it can affect employment prospects. Bankrupts
are unable to borrow, other than nominal amounts, during the period that the
order is in force. An undischarged bankrupt will be unable to open a current
account, but may be able to open a basic bank account.
Even after the end of the period, the person must, by law, disclose the existence
of a previous bankruptcy when applying for a mortgage. This may mean that
it will be more difficult for them to obtain a loan or that they may be charged
a higher rate of interest to cover the greater perceived risk.
16.11.2 explain Individual voluntary arrangements
An individual voluntary arrangement (IVA) is an alternative to bankruptcy,
under which the debtor arranges with the creditors to reschedule the repayment
of the debts over a specified period. An IVA can be set up only if creditors
who represent at least 75 per cent of the debt agree to the arrangement. The
scheme must be supervised by an insolvency practitioner.
In recent years, a large market has arisen for firms that assist individuals with
significant personal debts to enter into IVAs. In most cases they are able to
arrange for interest to be frozen, for a reduction in the amount of the debt,
and for legal protection from creditors if the terms of the IVA are met. The
firms are generally able to persuade lenders to write off part of the debt in
exchange for a reasonable guarantee of receiving repayment of the remainder.
In many cases this is better for the lender than simply writing off the debt or
selling it to a debt recovery firm.
An individual with an IVA will find it difficult to obtain credit while the IVA is
in place, and creditworthiness is likely to be impaired even after the end of
the arrangement.
16.11.3 explain Company voluntary arrangements
The company equivalent of an IVA is the company voluntary arrangement
(CVA). Under the terms of the Insolvency Act 1986, a company that is in
temporary financial difficulties (but which its directors believe to have a viable
long‑term future) can make a binding agreement with its creditors – including
HM Revenue & Customs – about how its debt and liabilities will be dealt with.
In this way, the directors retain control of the company and it can continue
to trade. A CVA can be proposed by the directors of the company, or by a
liquidator if one has been appointed, but not by the creditors. However, many
creditors may feel that it will be to their advantage for the company not to go nto administration. As with IVAs, creditors representing 75 per cent of the
company’s debt must agree to the CVA being set up.
16.12 explain Scams
As mentioned in Topic 10, an adviser’s role in relation to scams is to be aware
of such schemes and to advise a customer to be mindful of the potential risk.
The FCA operates ScamSmart, a website designed to help consumers protect
themselves against pension and investment scams. In addition to providing
information on how to spot a scam, the website informs consumers how to
avoid them.
If a consumer is unsure as to whether a pension or investment opportunity is
a scam or not, they can complete a short questionnaire on the website. The
questionnaire asks them about the type of opportunity they are considering,
how they found out about it and whether the promoter mentions money from
their pension pot. On submitting their answers, the FCA will then confirm
whether or not the opportunity is regulated or not and whether or not they
suspect it is a scam. The consumer can then check if the promoter is in the list
of firms to avoid.
Consumers can also report a scam or an unauthorised firm via the website.In the past, where a victim of a scam had been deemed to have been negligent
by their bank or pension provider, perhaps because they had been tricked into
providing their personal details by what appeared to be a genuine employee
and then had their money taken from them, or because they transferred their
pension into what they believed was an FCA‑regulated pension fund, it was
very unlikely they would see their money again.
However, the Financial Ombudsman has recently raised the bar on what it views
as negligence to counteract increasingly sophisticated banking scams. This
means it will be harder for banks and building societies to reject complaints
and may mean refunds for many who have lost money in the past. Now, if a scam victim has been tricked into handing over details that enabled
someone else to take money from their account, the financial institution needs
to be able to demonstrate that the victim was ‘grossly negligent’ in doing
so in order to refuse a refund. This is a much higher standard than simply
being careless or negligent. If they cannot prove this, then the victim must be
refunded with interest.
For pension transfers, The Pensions Ombudsman is now likely to side with the
victim if the firm that transferred the pension did not have sufficient warnings
and checks in place to protect the member from such scams.
1) Jagdeep is a partner in Pascoe & Partners. In the event that
the business becomes insolvent, her liability is limited to the
amount she has invested in the partnership, together with any
personal guarantees she has given. True or false?
1) False. There is no information here to suggest that the partnership is a
limited liability partnership (LLP) so Jagdeep has unlimited personal
liability.
2) Jagdeep is also a shareholder in Allenton Engineering Ltd. If
the company were to become insolvent, what personal liability
would she have for its debts?
2) None. As a limited company, Allenton Engineering Ltd is a separate legal
entity and shareholders would not be liable for its debts.
3) For a contract to be valid, there must be consideration. What
does this mean?
a) There must be payment or a promise to provide payment.
b) Both parties to the contract must be aged 18 or over.
c) Both parties must be open and honest in their dealings
with each other.
d) There is a right to cancel the contract.
3) a) There must be payment or a promise to provide payment. In a contract,
one party provides goods or services, the other makes payment or a
promise to pay.
4) Rebecca owns a small paddock that she no longer needs for
her horses. The neighbouring farmer has offered to buy it and
they shook hands on the sale over a drink at the pub. Later,
the farmer changed his mind and tried to withdraw from the
purchase. Rebecca argued that their agreement in the pub
constituted a contract and he must honour it. Was she right?
4) No. Contracts for sale of land must always be in writing and the transfer
effected by deed.
5) Which is true of independent financial advisers in terms of
agency law?
a) They act on behalf of a network.
b) They act on their own account.
c) They act as agents of their client.
d) They act as agents of their company.
5) c) They act as agents of their client.
6) Why do mortgage lenders insist that joint mortgages are always
written on a joint and several liability basis?
6) Mortgage lenders usually insist that joint mortgages are written on a joint
and several liability basis because this means that all parties are equally
responsible for carrying out the full terms of the agreement. Therefore,
whether a jointly owned property is held as joint tenants or tenants in
common, each owner is responsible for the mortgage, so if one person
cannot make their payment, it is the responsibility of the other(s) to make
up the shortfall.
7) Which of the following statements about the requirements for
a valid will is correct?
a) An executor cannot be a beneficiary.
b) There must be a minimum of one witness.
c) A witness cannot inherit.
c) A witness cannot inherit.
8) Harry has died without leaving a will. His estate will be
distributed by:
a) an administrator.
b) a solicitor.
c) an executor.
d) an official receiver.
8) a) An administrator. (An executor distributes the estate of a person who
has made a valid will.)
9) What role does the Court of Protection play in relation to
enduring powers of attorney?
a) Enduring powers of attorney must be registered upon
execution with the Court of Protection.
b) Any action taken by attorneys must be agreed by the Court
of Protection.
c) The Court of Protection retains a list of all those qualified
to act as attorneys.
d) Enduring powers of attorney can only be revoked with the
consent of the Court of Protection.
9) d) Enduring powers of attorney can only be revoked with the consent of
the Court of Protection. They must be registered with the Office of the
Public Guardian.
10) One of the financial restrictions placed on undischarged
bankrupts is that:
a) they are only able to borrow nominal amounts of money.
b) they are unable to buy goods, except for their own
consumption.
c) they are unable to contribute to protection policies.
d) they are only able to work on an employed basis.
10) a) They are only able to borrow nominal amounts of money.
In terms of legislation, PREVENTION OR CURE?
(Exam question)
Although governments try to foresee problems and to
introduce legislation as a means of ‘prevention rather than
cure’, most regulatory legislation in the past has been reactive
rather than proactive, ie it has been passed in response to
problems, rather than designed to foresee and prevent them.
Legislation has often resulted from:
Particular scandals or crises – for example, the events
leading up to the credit crisis from 2007. This showed the
need for more diligent financial regulation of banks and for
tighter rules on lending activities.
An increase in consumers’ financial awareness and a
demand for a more customer‑focused business approach –
demands for a ‘one‑stop shop’ approach to financial
services sales were instrumental in the deregulation of
banks and building societies.
The need to respond to changes in lifestyle – more
relaxed attitudes to marriage and divorce have led to a
strengthening of the rights of divorcees to share in former
spouses’ pension benefits; the introduction of marriage for
same‑sex couples and civil partnerships has extended the
scope of some tax benefits and other financial and state
benefits.
Developments in business methods – technological
advance in particular has transformed business processes
at every level of the sector; for instance, many customers
of banks and building societies now carry out many of their
transactions electronically and rarely visit a branch office.
Innovation in product design – rapid expansion has
been seen in the ranges of certain products, particularly
in mortgage business and, more recently, in the pensions
arena in response to freedoms introduced in 2015. This
has made it more important than ever that a consumer
should be provided with sufficient clear information about
the features and benefits of the products they are buying.
The increasing number and complexity of financial
products has made it necessary to provide customers with
more information and advice.
Introduction to the FCAs aims and activities
Many people believe that, as commercial organisations have grown through
mergers and acquisitions, they have become more remote from their customers
and more concerned with their own financial results than with customer
satisfaction. This belief is reflected in the emergence of government‑sponsored
organisations, such as the Competition and Markets Authority (CMA), consumer
bodies such as Which?, and websites such as Money Saving Expert.
One of the primary objectives pursued by most modern governments is an
economic and legal environment in which a balance is established between the
need for businesses to make a profit and the rights of customers to receive a
fair deal. This has led to the regulation, to some degree, of most industries in
the UK. At the same time, the government recognises the right of companies
to make a profit and does not want rules and regulations to become a burden
that prevents this. Indeed, the government recognises that it is essential that
companies be permitted to make a reasonable profit; it would otherwise be
impossible to attract the investment that sustains the industries on which the
UK economy depends.
These twin objectives of a free market for business enterprise and the protection
of the consumer are among the principles on which the European Union is
based, and are promoted largely through European legislation – most of which
impacts, either directly or indirectly, on the UK. Despite Brexit, the force of
European law can be seen in most recent major developments in the regulation
of UK financial institutions.
Because the financial services industry deals with money – vital both to
individuals and to the national economy – it has become one of the most
regulated sectors of all. In the context of financial services, key aims of
regulation include:
ensuring that those businesses operating in the industry are authorised
to do so and conduct their business in a manner that ensures the fair
treatment of their customers;
ensuring that businesses have the necessary financial arrangements in
place to minimise the risk of loss to their customers;
establishing and understanding accountability at a senior level within
financial service organisations;
ensuring that individuals carrying out defined regulated activities have the
competence and capability to do so;
the ongoing development of the skills and knowledge of individuals
working in the industry;
ongoing supervision to ensure that regulatory requirements are adhered to
and to try to prevent problems;
actions to be taken when problems arise.
17.2 How did regulation change after the financial crisis?
The financial crisis of 2007‑09 was essentially caused by a failure of prudential
regulation. A number of firms were found to have inadequate management
systems and financial safeguards. Events leading up to and after the crisis led
to concerns about the effectiveness of the industry’s regulator, the Financial
Services Authority (FSA), and its ability to prevent and then deal with a similar
situation in the future.
In the years following the financial crisis there have been a number of issues
related to the conduct of firms in the financial services sector, including the
mis‑selling of payment protection, the Libor rate‑fixing scandal and the sale of
interest rate hedging products to corporates.
These concerns resulted in the Financial Services Act 2012, which modified the
Financial Services and Markets Act 2000 to enable changes to the regulatory
system to be made under existing legislation. The Act saw the creation of a
number of new regulatory bodies and the abolition of the FSA, with many of
its powers handed to the Bank of England. Most of these changes came into
effect on 1 April 2013.
In 2016, the Bank of England and Financial Services Act 2016 made further
changes to the regulatory architecture by strengthening the governance
and accountability of the Bank, ending the subsidiary status of the PRA and
establishing a new Prudential Regulation Committee (PRC), which makes the
PRA’s most important micro-prudential decisions. These changes also include
allowing the National Audit Office to undertake value-for-money reviews of
the Bank for the first time.
The Bank of England is responsible for protecting and enhancing monetary
and financial stability, aiming to maintain economic stability. The Bank
has a central role in the regulation of financial services in the UK. It was
also responsible for payment systems, settlement systems and clearing oversight, but from April 2015 these responsibilities passed to the Payment
Systems Regulator.
The Financial Policy Committee (FPC) is a committee of the Bank of
England. The FPC looks at the economy in broad terms to identify and
address risks that may threaten the stability of the whole (or large parts of
the) economy. The FPC has no direct regulatory responsibility for particular
sectors of the financial services industry, but has various powers to take
action where it sees threats to economic stability.
The Prudential Regulation Authority (PRA) has sole responsibility for
the day‑to‑day prudential (financial) supervision of banks and other
financial institutions. The PRA sits within the Bank of England, although
it is operationally independent. The PRA authorises large, systemically
important providers of financial services such as banks, insurance
companies and building societies. The powers of the PRA are exercised by the Prudential Regulation
Committee (PRC) which is also within the Bank of England. The PRA’s primary
objective is to promote the safety and soundness of the firms it regulates.
It has further objectives to secure an appropriate degree of protection for
insurance policyholders and to facilitate effective competition.
The Financial Conduct Authority (FCA) has responsibility for the conduct
of all retail and wholesale financial firms. The FCA also undertakes
prudential supervision of firms that are not regulated by the PRA. The FCA
is a quasi‑government department with statutory powers given to it under The powers of the PRA are exercised by the Prudential Regulation
Committee (PRC) which is also within the Bank of England. The PRA’s primary
objective is to promote the safety and soundness of the firms it regulates.
It has further objectives to secure an appropriate degree of protection for
insurance policyholders and to facilitate effective competition.
The Financial Conduct Authority (FCA) has responsibility for the conduct
of all retail and wholesale financial firms. The FCA also undertakes
prudential supervision of firms that are not regulated by the PRA. The FCA
is a quasi‑government department with statutory powers given to it under The powers of the PRA are exercised by the Prudential Regulation
Committee (PRC) which is also within the Bank of England. The PRA’s primary
objective is to promote the safety and soundness of the firms it regulates.
It has further objectives to secure an appropriate degree of protection for
insurance policyholders and to facilitate effective competition.
The Financial Conduct Authority (FCA) has responsibility for the conduct
of all retail and wholesale financial firms. The FCA also undertakes
prudential supervision of firms that are not regulated by the PRA. The FCA
is a quasi‑government department with statutory powers given to it under The powers of the PRA are exercised by the Prudential Regulation
Committee (PRC) which is also within the Bank of England. The PRA’s primary
objective is to promote the safety and soundness of the firms it regulates.
It has further objectives to secure an appropriate degree of protection for
insurance policyholders and to facilitate effective competition.
The Financial Conduct Authority (FCA) has responsibility for the conduct
of all retail and wholesale financial firms. The FCA also undertakes
prudential supervision of firms that are not regulated by the PRA. The FCA
is a quasi‑government department with statutory powers given to it under
the Banking Act 1987, the Financial Services and Markets Act 2000, and the
Financial Services Act 2012 (the Act that created the FCA).
Key terms
CONDUCT REGULATION
Regulation requiring firms that provide products and services to
consumers to ensure that those products and services meet the consumer’s
needs, and to act appropriately and to deal fairly with consumers.
PRUDENTIAL REGULATION
Regulation aimed at ensuring that a business is established and run on a
sound financial basis. This aims to limit the risk of that business failing
and, if a failure does occur, to limit any adverse impact on consumers
and the wider economy.
SYSTEMICALLY IMPORTANT PROVIDERS
Providers whose failure would have a significant adverse impact on the
national or global financial system. Generally these would be providers
with a large customer base.
17.3 What is the FCA’s role?
The FCA is an independent financial regulator that reports to the Treasury and
Parliament. The FCA and PRA oversee the regulation of the financial services
industry in the UK. As noted above, the FCA is responsible for conduct
regulation of all firms, and also for the prudential regulation of firms that are
not considered to be systemically important. Thus some firms are regulated
solely by the FCA, in relation to both prudential and conduct matters, while
others are regulated by the PRA in respect of prudential matters and the FCA
in respect of conduct.
The FCA’s strategic objective is to make sure relevant markets function well so
that consumers get a fair deal
In seeking to promote competition, the FCA uses its powers to ensure that:
there are no undue barriers to entry – in other words, to ensure that the
required regulatory standards are not set so high that new providers are
unable to enter the market;
consumers are empowered to engage in such a way as to drive competition –
for instance, by being able to switch providers easily if a product they hold
becomes uncompetitive; no single firm or small group of firms dominates the market; and
firms focus on consumers’ genuine needs and ensure that recommendations
made are suitable.
WORKING TOGETHER: THE FCA AND PRA
(Exam question)
The FCA works closely with the PRA to exchange information
that is relevant to each regulator’s objectives, but acts as a
separate entity when engaging with firms. A memorandum of
understanding sets out two key principles for co‑operation
between the two regulators, which are that:
each regulator’s supervisory judgements will be based on
all relevant information; and
supervisory activity will not usually be conducted jointly.
One example where the co‑operation between the FCA and the
PRA is particularly important is in the supervision of insurers
with with‑profits business, because the returns from such
investments are not well defined and impact on, or depend
on, prudential as well as performance criteria.
As part of its continuous assessment of an insurer’s financial
soundness, the PRA ensures that any discretionary benefit
allocations (such as discretionary bonuses) are compatible
with the firm’s continued safety and soundness.
The FCA monitors whether the proposed allocations are
consistent with the insurer’s previous communications
to policyholders; that conduct in communicating and
administering such payments is in line with the FCA’s conduct
rules; and that the insurer’s overriding obligation to fair
treatment of customers (see section 17.8.1) is maintained.
Can you recall what is meant by ‘with‑profits business’, referred to
in the information panel on PRA and FCA co‑operation?
1) With‑profits business relates to certain life policies issued by life
assurance companies. In addition to the sum assured under the policy, the
policyholder receives a share of the profits of the life company, payable
either during the term (reversionary bonuses) or at maturity or on death
of the life assured (terminal bonuses).
A major clearing bank has its headquarters in London but operates
in many other countries. It is regulated by:
a) the PRA.
b) the PRA and the FPC.
c) the FCA.
d) the PRA and the FCA.
2) d) A financial provider of this nature would be regarded as systemically
important. It would be regulated by the PRA in relation to its prudential
status and the FCA in relation to its conduct of business.
17.4 What powers does the FCA have?
The FCA has powers to enforce the prohibitions in the Competition Act 1998
on anti‑competitive behaviour in relation to the provision of financial services.
It also has powers under the Enterprise Act 2002 to carry out market studies
and make market investigation referrals to the CMA relating to market studies.
The competition powers held by the FCA in respect of financial services are
the same as those held by the CMA, so the FCA and the CMA are concurrent
regulators.
The FCA has product intervention powers, which means that it is able to act
quickly to ban or impose restrictions on financial products if it thinks that
they are not in the best interests of consumers because of their complexity
or suitability. It can disclose details of warning notices issued in relation to
disciplinary action. It can take formal action in response to misleading financial
promotions and publicise the fact that it has done so.
In discharging its powers, the FCA adopts a “proportionate” approach, focusing
its resources on those areas of the industry and firms that pose the greatest
risk to its objectives.
The PRA and the FCA are jointly responsible for the Financial Services
Compensation Scheme (FSCS), and the FCA is responsible for the Financial
Ombudsman Service (FOS).
COMPETITION AND MARKETS AUTHORITY. (CMA) (Exam question)
Like the FCA, the CMA aims to promote competition for the
benefit of consumers. It is responsible for investigating mergers
that could restrict competition, carrying out investigations into
markets where competition may not be working effectively
and enforcing consumer protection legislation. It has powers
to impose financial penalties and, in the case of cartels, is able
to bring criminal proceedings.
17.5 What is in the FCA Handbook?
The FCA Handbook details the FCA’s requirements of firms that operate in the
financial services industry and consists mainly of rules and guidance:
Rules – most of the rules in the Handbook create binding obligations
on authorised firms. If a firm contravenes a rule, it may be subject to
enforcement action and, in certain circumstances, to an action for damages.
Guidance – the purpose of guidance is to explain the rules and to indicate
ways of complying with them. The guidance is not binding, however, and a
firm cannot be subject to disciplinary action simply because it has ignored
the guidance; compliance with the rules is the key consideration, and firms
have discretion as to how they achieve this.
The FCA Handbook also contains evidential provisions. These are rules that
are not binding in their own right but relate to a binding rule. Compliance
with an evidential provision may be relied on (when it says so) as ‘tending to establish compliance’ with the rule to which it relates. Non-compliance with
an evidential provision may be relied on (again, when it says so) as ‘tending to
establish contravention’ of the rule to which it relates. Evidential provisions
are used, for example in the Code of Market Conduct, which specifies:
descriptions of behaviour that we consider amounts to markets abuse; and
factors that we will take into account when determining whether or not
behaviour amounts to market abuse.
In this text, we cover the areas of the FCA Handbook of greatest interest to
financial advisers and mortgage advisers, to enable advisers to carry out their
activities in an efficient, safe and well‑regulated manner.
Where are the high standards for the FCA applied?
17.5.2 explain Prudential standards
For those firms regulated solely by the FCA, prudential standards are detailed
in the prudential sourcebooks. They deal with the financial soundness and
management of firms, and cover issues such as the valuation of a firm’s assets
and liabilities, its reserves, and financial reporting. The PRA establishes and
monitors prudential requirements for dual‑regulated firms; we look at the role
of the PRA in more detail in Topic 19.
17.5.3 explain Business standards
Business standards are described in the following sourcebooks:
Conduct of Business sourcebooks comprising the:
— Conduct of Business Sourcebook (COBS), which sets general conduct
standards;
— Banking: Conduct of Business sourcebook (BCOBS);
— Insurance: Conduct of Business sourcebook (ICOBS);
— Mortgages and Home Finance: Conduct of Business sourcebook (MCOB).
These individual sourcebooks set out the standards that apply to the
marketing and sale of financial services products. We look at them in
greater detail in Topic 21.
Market Conduct sourcebook – this concerns investment markets and is
therefore primarily of interest to investment firms. It covers such issues as
insider dealing.
Client Assets sourcebook – contains the requirements relating to holding
client assets and safe custody of client assets.
17.5.4 Regulatory processes of the FCA
This section of the Handbook covers regulatory processes, including rules
and guidance for firms wishing to seek authorisation. It also includes the
Supervision manual, which sets out the way that the FCA regulates and
monitors the compliance of authorised firms.
17.5.5 Redress/specialist sourcebooks
17.5.5 Redress/specialist sourcebooks for the FCA
The two remaining sections of the Handbook cover:
redress – including regulatory standards for dealing with complaints and
the provision of compensation; and
specialist sourcebooks – including arrangements for credit unions,
professional firms such as solicitors and accountants, collective investments (COLL), consumer credit (CONC), investment funds, recognised investment
exchanges and regulated covered bonds.
CHECK YOUR UNDERSTANDING 3
Getting to grips with the different sections of the FCA Handbook
can be a challenge! To check your understanding of what you have
read so far, in which sections of the FCA Handbook would you look
for information on each of the following?
a) Training and competence requirements.
b) Rules surrounding the sale of mortgages.
c) General rules about conduct of business.
d) Rules relating to consumer credit.
e) Rules relating to compensation and complaints.
3) a) High‑Level Standards.
b) Business standards – specifically, the Mortgages and Home Finance:
Conduct of Business Sourcebook (MCOB).
c) Business standards – specifically, Conduct of Business Sourcebook
(COBS).
d) Specialist sourcebooks – specifically, the Consumer Credit sourcebook
(CONC).
e) Redress.
17.6 What are the Principles for Businesses?
The FCA’s regulatory regime is based on a set of 12 ‘Principles for Businesses’
(including the addition of the Consumer Duty), from which all of the more
precise rules and regulations follow. They apply to the behaviour of firms and
of the individuals who carry out the firm’s activities. The Principles, which
are set out in the PRIN subsection of the High‑Level Standards in the FCA
Handbook, are shown in Figure 17.5.
3
Key terms
SENIOR MANAGEMENT FUNCTIONS
Key individuals within a firm who perform significant roles. Individuals
must be pre‑approved by the FCA/PRA before they are appointed.
CERTIFICATION FUNCTIONS
Individuals who must be certified as fit and proper to carry out their
role. Also known as significant harm functions, this includes mortgage
and investment advisers.
firm must conduct its business with integrity
1. Integrity
A firm must conduct its business with due skill, care and diligence
2. Skill, care and diligence
A firm must take reasonable care to organise and control its affairs responsibly and effectively,
with adequate risk management systems
3. Management and control
A firm must maintain adequate fi nancial resources
4. Financial prudence
A firm must observe proper standards of market conduct
5. Market conduct
A firm must pay due regard to the interests of its customers, and treat them fairly
6. Customers’ interests
A firm must pay due regard to the information needs of its clients and communicate information
to them in a way that is clear, fair and not misleading
7. Communications with clients
A firm must manage confl icts of interest fairly, both between itself and its customers and between
one customer and another
8. Conflicts of interest
A firm must take reasonable care to ensure the suitability of its advice and discretionary decisions
for any customer who is entitled to rely on its judgement
9. Customers: relationships of trust
A firm must arrange adequate protection for clients’ assets when it is responsible for them
10. Clients’ assets
A firm must deal with its regulators in an open and co-operative way, and must disclose anything
of which the FCA or PRA would reasonably expect notice
11. Relations with regulators
A firm must act to deliver good outcomes for retail customers
12. Consumer Duty
There is a set of conduct rules that apply to all individuals working in the
financial services industry, except for those in certain ‘ancillary’ roles.
There is also a set of senior management conduct rules for those who carry
out a senior management function.
We look at the Senior Managers and Certification Regime and the codes of
conduct in more detail in Topic 18.
17.6.1what is Consumer Duty in terms of the FCA?
To further protect consumers from bad conduct, the FCA has implemented
the new Consumer Duty. The rules and guidance come into force on a phased
basis:
For new and existing products or services that are open to sale or renewal,
Consumer Duty is effective on 31 July 2023.
For closed products or services, Consumer Duty is effective on 31 July
2024.
The Consumer Duty goes beyond the existing framework relating to the fair
treatment of customers and adds Principle 12 to the Principles for Businesses:
“A firm must act to deliver good outcomes for retail customers”.
The Duty applies to products and services offered to retail customers and
applies to firms forming part of the distribution chain, whether there is a
direct relationship with the buyer or not. It does not apply to institutional
investors, professional clients or eligible counterparties.
Principles 6 (Customers’ interests) and 7 (Communication with clients) do not
apply where the Consumer Duty Principle 12 applies. However, the FCA has
retained Handbook and non‑Handbook material linked to Principles 6 and 7
as it continues to apply to firms and business activities outside the scope of
the Duty and may help firms in considering their obligations where the Duty
does apply.
Principle 12 is intended to improve consumer protection by ensuring that
firms place customer interests at the heart of everything they do. The FCA
has identified four outcomes for the key elements of the firm–consumer
relationship:
products and services;
price and value;
consumer understanding;
consumer support.
In addition, three cross-cutting rules require firms to:
act in good faith;
avoid causing foreseeable harm; and
enable and support retail customers to pursue their financial objectives.
17.6.2 what is Fair treatment of customers in terms of the FCA?
In order to ensure that regulatory principles are translated into a practical,
properly controlled regulatory regime, the FCA has established a very large body
of rules, many of which are found in the sourcebooks listed in section 17.7.
The establishment of rules and regulations can, however, have serious
drawbacks. People and organisations may make it their aim to comply with
the letter of the law rather than to operate according to its spirit. There is also
the danger firms might be able to hide behind the rules, using loopholes or
technicalities to their own advantage.
The former regulator, the FSA, was aware of these potential drawbacks, so it
introduced an initiative known as treating customers fairly (TCF), which the
FCA has continued to pursue. Among the FCA’s Principles, Principle 6 states
that “a firm must pay due regard to the interests of consumers and treat them
fairly”. The FCA expects that all firms must be able to show consistently that
the fair treatment of consumers is at the heart of their business, as spotlighted
by the new Principle 12.
17.6.3 What does fairness mean in practice?
The FCA does not provide a definition of ‘fair’; its view is that fairness is
a concept that is “flexible and dynamic”, which can “vary with particular
circumstances”. Firms must decide for themselves what fair treatment means
within the context of their own business. What is clear is that the FCA intends
fair treatment to apply at every stage throughout the life cycle of financial
products, such as:
product design;
sales and marketing;
advice and selling;
administration; and
post‑sales activities, including claims handling and dealing with complaints.
The FCA provides some guidance on the types of behaviour it wishes to see
and suggests a number of areas that a firm should consider. These include:
considering specific target markets when developing products;
ensuring that communications are clear and do not mislead;
honouring promises and commitments that it has made;
identifying and eradicating root causes of complaints.
Responsibility for the fair treatment of consumers lies with a firm’s senior
management, which is required to ensure that fair treatment is “built
consistently into the operating model and culture of all aspects of the business”.
17.6.4 explain Clarity in sales
Firms are expected to be clear about the services they offer and about the true
cost to the customer. Information must be provided to customers in a way
that is clear, fair and not misleading. Firms should always consider the ways
that the customer will assess their product against others in the market, and
ensure that a fair comparison can be made. This means not only that product
literature should be clear and appropriate to the target customer group’s
expected financial sophistication, but also that the advice given should be of
a sufficiently high quality to reduce the risk of mis‑selling.
What are the FCAs six outcomes?
FAIR TREATMENT OF CUSTOMERS
Due regard for the fair treatment of customers must apply
at every stage of a product’s life cycle.
Information provided to customers must be clear, fair and
not misleading.
Firms should honour promises and commitments they
make.
Root causes of complaints should be analysed and
eradicated.
Senior managers are responsible for ensuring that fair
treatment of customers is built into the operations and
culture of the firm.
Firms should seek to achieve the six outcomes for customers,
as set out by the FCA.
Firms must demonstrate to the FCA (eg through use of MI)
that they are consistently treating customers fairly.
17.7 The prevention of financial crime
The FCA has an operational objective to enhance the integrity of the financial
system and is therefore committed to reducing financial crime of all kinds, in
particular:
market abuse, which is separated into two aspects:
— insider dealing, where a person who has information not available to
other investors (eg a director with knowledge of a takeover bid) makes
use of that information for personal gain;
— market manipulation, where a person knowingly gives out false or
misleading information (for instance about a company’s financial
circumstances) in order to influence the price of a share for personal gain;
money laundering, which is dealt with in Topic 23.
What is WHISTLEBLOWING?
(Exam question)
Firms should have whistleblowing procedures in place to enable
employees to report serious inappropriate circumstances or
behaviour within the firm, which they believe are not being
addressed. Workers who wish to report their knowledge or
suspicions regarding, for example, a failure by the firm to
comply with legislation, have a right to protection under the
Public Interest Disclosure Act 1998. The firm’s procedures
should assist staff and not hinder them in the whistleblowing
process.
1) The main driver for changes to the regulatory structure governing
financial services that were introduced in 2013 was:
a) the collapse of Barings Bank.
b) the weaknesses exposed by the 2007–09 financial crisis
and a number of mis‑selling scandals.
c) the deregulation of banks and building societies.
d) the need to respond to changes in lifestyle.
1) b) The weaknesses exposed by the 2007–09 financial crisis and a number
of major mis‑selling scandals drove the changes to regulatory bodies
in 2013.
2) The FCA’s role is to identify and address risks that may threaten
the stability of the economy as a whole. True or false?
2) False. This is the key role of the FPC, the Financial Policy Committee.
3) The FCA is the conduct regulator for all firms within the
financial services industry and the prudential regulator for
firms that are not considered systemically important. Explain
what is meant by:
a) conduct regulation.
b) prudential regulation.
c) systemically important.
3) a) Conduct regulation requires firms to ensure that products and services
they supply to consumers meet the consumers’ needs, and to act
appropriately and deal fairly with consumers.
b) Prudential regulation aims to ensure that businesses are established
and run on a sound financial basis, to limit the risk of a business failing
and to minimise the impact on consumers and the wider economy if a
business does fail.
c) ‘Systemically important’ refers to financial institutions that play a key
role in the national and global economy. If they were to fail, it would
have a significant adverse impact on the national or global financial
system.
4) Name the three operational objectives of the FCA.
4) i) Protecting consumers from bad conduct by securing an appropriate
degree of protection; ii) Protecting financial markets, by protecting and
enhancing the integrity of the UK financial system; iii) Promoting effective
competition by promoting effective competition in the interests of
consumers.
5) What is the difference between ‘rules’ and ‘guidance’ in the
FCA Handbook?
5) Rules impose binding obligations and firms can face sanctions for not
complying with them. Guidance explains the rules and indicates ways in
which firms can comply but is not binding and firms are not required to
follow it.
6) Name four powers that the FCA can exercise in its regulation
of business conduct.
6) Competition powers; product intervention powers; power of disclosure;
power to take formal action against misleading financial promotions.
7) Which one of the following is not one of the FCA ‘Principles for
Businesses’ with which a firm must comply?
A firm must:
a) communicate with customers in a clear manner.
b) conduct its business with integrity.
c) maintain an independent compliance function.
d) observe proper standards of market conduct.
7) c) The FCA principles do not specifically require a firm to maintain an
independent compliance function.
8) The FCA Handbook contains a section on redress. This section
of the Handbook is primarily concerned with:
a) sales policy.
b) recruitment standards.
c) maintaining and developing skills and knowledge.
d) complaints and compensation.
8) d) The redress sourcebook is concerned with complaints and
compensation.
9) Which of the following is the phrase used by the FCA to
summarise its requirements for effective communication
designed to ensure the fair treatment of customers?
Information must be:
a) accurate, up to date and detailed.
b) clear, fair and not misleading.
c) brief, clear and accurate.
d) concise, written in plain English and truthful.
9) b) Information must be clear, fair and not misleading.
10) Under the Consumer Duty, what are the four outcomes for the
key elements of the firm–consumer relationship?
10) The FCA’s four outcomes for the key elements of the firm–consumer
relationship are:
products and services;
price and value;
consumer understanding;
consumer support.
18.1 What are regulated activities and investments in firms and individuals?
Any financial services business that carries out a regulated activity in the UK
must be authorised, unless they are exempt. Firms have to apply to the FCA
(or, if dual regulated, to the PRA) for authorisation.
The FCA describes two categories of regulated investment:
securities (such as shares, debentures and gilts); and
contractually based investments (including life policies, personal pensions,
options and futures).
What is THE GENERAL PROHIBITION?
(Exam question)
Section 19 of the Financial Services and Markets Act 2000
(FSMA) states that a person (which includes a corporate body)
must not carry on a regulated activity or purport to do so
unless they are an authorised or exempt person. This is known
as the general prohibition.
Carrying on a regulated activity in breach of the general
prohibition is a criminal offence under the FSMA.
Explain REGULATED ACTIVITIES: LEGAL BASIS
(Exam question)
The activities for which firms must be authorised were first
listed in the Financial Services and Markets Act 2000 (Regulated
Activities) Order 2001, often referred to as the Regulated
Activities Order (RAO).
The section of the FSMA 2000 under which permission may
be granted to a firm to carry out regulated activities is Part
4A – so this form of permission is often known as Part 4A
permission. Permission is granted in the form of a list of
regulated activities that the firm is allowed to carry out; it
also shows the regulated investments with which the firm is
allowed to deal.
The range of regulated activities covered by FSMA 2000
changes periodically as new activities fall under FCA and/or
PRA regulation.
Detailed guidance on the scope of regulated activities,
investments and exemptions is contained in FCA Perimeter
Guidance manual (PERG): www.handbook.fca.org.uk/
handbook/PERG/2/?view=chapter.
18.2 What is the Senior Managers and Certification Regime (SM&CR)?
In addition to regulating the activities of firms, the FCA also regulates the appointment
and activities of individuals within the firm. The rules relating to this aspect of its
work are set out in the High Level Standards section of the FCA Handbook.
Two particular issues the regulators had to address in the aftermath of the 2007–09
financial crisis were criticism of its approved persons regime and difficulties in
identifying which individual or individuals are responsible for a business’s failings.
In response, the FCA and PRA introduced a Senior Managers and Certification
Regime (SM&CR) for banks, building societies and credit unions. This framework establishes an individual accountability framework and regulates individual conduct
and standards in the financial services industry. The FCA extended the SM&CR
regime to FCA solo‑regulated financial services firms. This excludes appointed
representatives who continue to be subject to the approved persons regime.
Explain APPOINTED REPRESENTATIVES (ARS)
(Exam question)
An appointed representative (AR) is a firm or person who runs
regulated activities and acts as an agent for a firm, which is
known as the AR’s ‘principal’.
The principal firm is the regulated entity, not the AR, and the
principal takes full responsibility for ensuring that the AR
complies with FCA rules.
18.2.1 what is The SM&CR framework?
There are three tiers under the SM&CR:
Core – firms in this tier have to comply with the baseline requirements
outlined in the rest of this section.
Enhanced – only the firms representing the greatest risk to consumers
or markets are classed as enhanced firms. These firms have additional
requirements.
Limited scope – this applies to firms that are already exempt under
the approved persons regime. They are exempt from some baseline
requirements and generally have fewer senior management functions.
The core regime applies to the majority of these firms, and consists of three
key elements:
The Senior Managers Regime.
Certification Regime.
Code of Conduct.
18.2.2 What is the Senior Managers Regime (SMR)?
The SMR focuses on individuals in key roles in relevant firms. The FCA has
a number of designated senior management functions for core SM&CR firms
(see Table 18.1). These are the functions the regulator feels pose the greatest
risk to either customers or market integrity if the person conducting them is
not fit to do so. There is also a range of prescribed responsibilities that must
be allocated among the senior management of a business.
Where an individual applies for a senior management role or moves to a different
senior manager role that is materially different from their current one, they
must be pre‑approved by the regulator. Their application must be accompanied
by a “statement of responsibilities”, detailing the aspects of the business for
which they will take responsibility. The regulator can then compare the personal
capabilities of the individual with the nature of the role they will be performing.
Once an individual is appointed, firms must have robust procedures to equip
the senior manager to carry out their role effectively. Firms are also required to
ensure the ongoing fitness and propriety of their senior managers.
Enhanced firms have two additional requirements in which they must:
maintain a “responsibilities map”, which details the way responsibilities
are allocated between the senior management should problems arise, the
“responsibilities map” enables the regulator to more easily identify which
person is responsible.
ensure that each activity, business area and management function is
allocated a senior manager with overall responsibility.
There is a statutory duty for senior managers to take “reasonable steps” to prevent
regulatory breaches in their area of responsibility. If a breach occurs, then, in order
to take action against an individual, the regulator must be able to prove that the
senior manager failed to take reasonable steps to prevent the breach occurring.
The penalties for senior managers are wide and potentially severe. The FCA is
empowered to instigate criminal proceedings against a senior manager whose
action or inaction has led their business to fail, through “reckless misconduct”.
If an individual is found guilty, the maximum punishment is a prison sentence
of up to seven years and/or an unlimited fine.
TABLE 18.1 FCA‑DESIGNATED SENIOR MANAGEM
18.2.3 What is the Certification Regime (CR)?
The regulator recognises that the actions of those in more junior roles, below
senior management level, could still cause major damage to a business and its
customers. The FCA therefore defines a number of “certified” functions. A certified
function is one involving aspects of the firm’s business where there is a potential
risk of significant harm to the firm or its customers.
Individuals in certified functions are subject to the Certification Regime (CR): they
are not required to secure direct approval from the FCA but the firm, in effect,
certifies their fitness and propriety to carry out the role. Each firm must take
reasonable care to ensure that no employee carries out a role for which certification
is required until they have been assessed as “fit and proper”. Their continued
fitness and propriety must be assessed on an ongoing basis, at least annually.
The FCA certification regime applies to the following functions:
Significant management function.
Proprietary traders.
CASS operational oversight functions.
Functions subject to qualification requirements, eg mortgage advisers, retail
investment advisers and pension transfer specialists.
Client dealing function, eg financial advisers and investment managers.
Anyone supervising or managing a certified function who is not themselves
a senior manager.
Material risk takers.
Those with responsibility for algorithmic trading.
A designated senior manager must be responsible for each firm’s certification
regime.
18.2.4 What is the Code of Conduct?
Under SM&CR, the regulator has the power to make rules of conduct that apply
to senior managers, certified persons and other employees. Conduct rules
set expectations about standards of behaviour for those employed in firms
covered by the Senior Managers Regime, other than ancillary staff (ie those
performing a role that is not specific to financial services, such as security
staff, IT support, etc).
The tier one individual conduct rules are:
CR1 – you must act with integrity.
CR2 – you must act with due skill, care and diligence. CR3 – you must be open and co‑operative with the FCA, PRA and other regulators.
CR4 – you must pay due regard to the interests of customers and treat
them fairly.
CR5 – you must observe proper standards of market conduct.
The tier two conduct rules for senior managers are as follows:
SM1 – you must take reasonable steps to ensure that the business of the
firm for which you are responsible is controlled effectively.
SM2 – you must take reasonable steps to ensure that the business of the
firm for which you are responsible complies with the relevant requirements
and standards of the regulatory system.
SM3 – you must take reasonable steps to ensure that any delegation of
your responsibilities is to an appropriate person and that you oversee the
discharge of the delegated responsibility effectively.
SM4 – you must disclose appropriately any information of which the FCA
or PRA would reasonably expect notice.
Firms must:
make individuals who are subject to the rules aware that this is the case,
and provide training on how the rules apply to them;
take effective action where staff fall below required standards.
18.2.4.1 Reporting
The FCA requires firms to report to it within seven days if they take disciplinary
action against a senior manager as a result of a breach of one or more rules of
conduct. For all other staff, an annual report suffices. The FCA itself may take
disciplinary action against an individual found to be in breach of the conduct
rules; however, it is only likely to do so in extremely serious cases.
18.2.5 What are the rules on fitness and propriety?
An individual subject to the SM&CR must be deemed “fit and proper” to carry
out such a role. The FCA sets out the following criteria.
Honesty, integrity and reputation – these can be judged from a number
of factors, including:
— criminal record;
— disciplinary proceedings;
— known contravention of FCA (or other) regulations or involvement with
companies that have contravened regulations; — complaints received, particularly about regulated activities;
— insolvency, or management of companies that have become insolvent;
— dismissal from a position of trust or disqualification as a director.
Competence or capability – in terms of meeting the FCA’s training and
competence requirements (these are discussed in section 18.8).
Financial soundness – as indicated by:
— current financial position;
— previous bankruptcy or an adverse credit rating.
In addition to the requirements detailed above, the FCA requires that, when
assessing whether a person is fit and proper to perform a senior management
function, particular consideration must be given to whether that individual:
has obtained a relevant qualification;
has undergone or is undergoing training;
possesses a relevant degree of competence;
has the personal characteristics required by the FCA.
Despite the FCA’s emphasis on fitness and propriety there is a risk that an
individual with a poor conduct/disciplinary record could gain continued
employment in the financial services industry by moving from firm to firm if
each new employer remained unaware of past issues. To counter the risk, the
FCA requires that before an individual can be appointed to a senior manager role:
they must be verified as being “fit and proper” to exercise their duties;
the prospective employer carries out checks in respect of any criminal
record and a credit check;
references are provided from the individual’s current and former employers
covering the last six years. The reference should include details of any
disciplinary action taken against the individual over the last six years due
to breaches of the conduct rules and any findings that the person was not
fit and proper. Any other information relevant to assessing whether they
are fit and proper covering the previous six years should also be provided.
Prior to being appointed to a certificated function an individual must also be
verified as fit and proper, have their last six years’ references checked, and
have a certificate for their function. There is, however, no requirement for a
criminal record check.
What is the FINANCIAL SERVICES REGISTER?
What is the FCA DIRECTORY?
(Exam question)
The Financial Services Register is a public record of firms,
individuals and other bodies that are, or have been, regulated
by the PRA and/or FCA.
Under SM&CR, the FCA publishes and maintains a directory
of certified and assessed persons on the Financial Services
Register so consumers and professionals can check the details
of key individuals working in financial services. Firms are
responsible for submitting and maintaining a person’s data
using the FCA’s Connect system. You can find out more at the
following link: www.fca.org.uk/firms/directory-persons.
18.3 What are the responsibilities of senior managers?
Senior managers must take responsibility for a firm’s compliance with FCA
regulations and produce relevant management information (MI). This is to
demonstrate that their advisers give quality advice and treat customers fairly,
and there are three particular ways in which they are required to achieve this.
They must ensure that:
the firm embodies a compliance culture, with senior managers using MI
to drive forward the firm’s fair treatment of customers and the quality of
their advice process;
all staff have clearly defined responsibilities and are monitored appropriately;
monitoring and compliance procedures are regularly reviewed and updated.
18.3.1 what are Systems business?
A firm must implement systems and controls that are “appropriate to its
business”, and it must be able to demonstrate that such systems and controls are
appropriate. Systems and controls must be clearly documented and regularly
reviewed. They will relate to a wide range of the firm’s activities, including:
the establishment of clear chains of responsibility, delegation and reporting;
compliance;
assessment and reporting of risk;
reporting of other management information;
competence and honesty of staff, particularly those who are subject to the
SM&CR, with senior management applying the ‘competent employee’ rule,
ie employees must have the necessary skills to carry out the job for which
they are employed;
a strategy for controlling business risks and for recovering from serious
problems such as fire or computer failure;
adequate and readily accessible records (with backup) of systems and
controls must be securely kept;
an audit of the systems and controls must be made independently of the
persons who normally operate them.
18.4 What is the FCA’s approach to supervising firms?
The FCA seeks to ensure that firms are complying with regulatory requirements
through a programme of supervision, based on eight principles (see Figure
18.3).
FIGURE 18.3 EIGHT FCA PRINCIPLES FOR SUPERVISION
Source: FCA (2022)
Being forward-looking and pre-emptive – addressing poor conduct to
avoid risk and serious harm
Focusing on FCA strategy and fi rms’ business models
– identifying emerging
risks and ensuring the FCA’s supervisory activity mitigates these risks
Focusing on firms’ culture and governance
– examining a firm’s purpose and
the effectiveness of governance strategies used to identify and mitigate risks
Emphasis on individual accountability
Taking a proportionate and risk-based approach, ie targeting fi rms that
could cause the most harm or have the most signifi cant misconduct
Encouraging two-way communication
– engaging with consumers,
industry and fi rms, and being transparent about FCA priorities and work
Ensuring messages provided are co-ordinated and consistent, working
closely with other regulatory bodies
Fixing systemic harm, preventing it from occurring again and ensuring
consumers are compensated
18.4.1 How does the FCA prioritise its supervisory activity?
We saw in Topic 17 that the FCA adopts a “proportionate” approach to
supervision, focusing its resources on those areas of the industry and firms
that pose the greatest risk to its objectives. Firms are categorised according to
their potential impact on the FCA’s objectives. The category in which the FCA
places a firm determines the style of supervision carried out (see Figure 18.4).
The FCA’s system of categorising firms uses a combination of factors with
reference to the number of customers a firm has and the likely impact of a
firm’s failure on the financial services sector and the economy as a whole.
‘Fixed portfolio’ firms are a relatively small number of firms that, based on
size, customer numbers and market presence require the highest level of
supervisory attention.
The vast majority of firms present a lower level of risk and are classed as
‘flexible portfolio’ firms. These firms are supervised through a mixture of
targeted supervisory work depending on the markets they operate in and
programmes of communication and education.
Figure 18.4 summarises the categories and levels of supervision.
Why is regulatory attention focused on fixed portfolio firms?
2) Fixed portfolio firms are those that have the greatest impact on consumers
and the financial services marketplace, therefore the FCA directs most of
its resources to supervising these firms.
18.5 explain the FCA supervision model
The FCA’s supervision model is based on the three pillars, as illustrated in
Figure 18.5). These pillars draw on the FCA’s ongoing analysis of each industry
sector and the risks that sector poses to the FCA’s objectives.
FIGURE 18.5 FCA SUPERVISION MODEL: THREE PILLARS
Source: FCA (2022)
As well as focusing regulatory resources on those businesses posing the
greatest risk to its objectives, the FCA focuses its supervision on the areas
that have the greatest impact on consumers and market integrity. It examines
different parts of a business’s operations, and will be in direct contact with
a number of people within the business in order to understand how it is run.
Areas of particular interest include the following:
Business model and strategy – the FCA is aware that business strategy can
drive behaviours that lead to poor customer outcomes. It seeks to ensure
that a business has assessed and mitigated any risks to customers arising
from its strategy, as part of its objective to ensure customers get products
and services that meet their needs from providers they trust.
Culture – culture underpins everything a business does and an appropriate
culture will ensure the fair treatment of customers. The FCA will want to
understand:
— the way business is conducted;
3
Pillar 1
Proactive firm or
group supervision
Pre-emptive
identification of harm
through review and
assessment of firms
and portfolios: this
includes business
model analysis and
reviewing the drivers
of culture
Pillar 2
Event‑driven,
reactive supervision
Dealing with issues
that are emerging or
have happened to
prevent harm growing
Pillar 3
Issues and products
Wider diagnostic or
remedy work where
there is actual or
potential harm across
a number of firms
As well as focusing regulatory resources on those businesses posing the
greatest risk to its objectives, the FCA focuses its supervision on the areas
that have the greatest impact on consumers and market integrity. It examines different parts of a business’s operations, and will be in direct contact with a number of people within the business in order to understand how it is run.
Areas of particular interest include the following:
Business model and strategy – the FCA is aware that business strategy can
drive behaviours that lead to poor customer outcomes. It seeks to ensure
that a business has assessed and mitigated any risks to customers arising from its strategy, as part of its objective to ensure customers get products
and services that meet their needs from providers they trust.
Culture – culture underpins everything a business does and an appropriate
culture will ensure the fair treatment of customers. The FCA will want to
understand:
— the way business is conducted;
— expectations of staff; and
— attitude to customers.
Frontline business processes – this involves understanding the extent to
which business processes are designed to give customers what they need
and meet their expectations.
Systems and controls – this aspect of supervision focuses on the extent to
which culture is reinforced by effective systems and controls designed to
identify and deal with risks in areas such as conduct and financial crime.
Governance – the FCA expects senior management and the board within
a firm to understand and be able to explain the conduct risks in their
strategies. It pays particular attention to the way the governance of a
business implements consumer‑ and market‑focused strategies.
18.6 explain Training and competence in the FCA
The FCA aims to be proactive rather than reactive, preventing problems
from arising rather than simply dealing with them when they do. Ensuring
high levels of knowledge and ability among financial services staff is key to
achieving this objective. Consequently, the FCA places high importance on
training and competence.
The FCA’s Training and Competence (TC) sourcebook requires firms to make
certain commitments regarding the competence of anyone within the remit of
the SM&CR. It is particularly prescriptive in relation to three types of employee:
financial advisers and those who deal in, or manage, investments;
supervisors of those advisers, dealers or fund managers;
supervisors who oversee certain ‘back‑office’ administrative functions,
particularly within a product provider (eg supervisors of the underwriting
or claims functions in a life assurance company).
At the start of 2011, the TC sourcebook was moved into the High Level
Standards part of the Handbook to reflect its increased importance.
TC rules cover the following areas. Note that they do not apply to firms
transacting wholesale business with non‑retail clients.
18.6.1 Training in firms
Firms must, at appropriate intervals, determine each employee’s training
needs and organise training that is appropriate and timely. The success of the
training in achieving its objectives must be evaluated.
18.6.2 Assessing initial competence of investment advisors
Investment advisers must not be allowed to commence activities until the
employer is satisfied that an adviser has:
achieved an adequate level of knowledge and skill to operate under
supervision; and
passed the regulatory module of an appropriate qualification for investment
advisers at RQF Level 4 (such as the Financial Services Regulation and Ethics
unit as part of the Diploma for Financial Advisers).
Individuals must work under close (direct) supervision until they have been
assessed as competent to work under indirect supervision. Individuals must
not be assessed as competent until they have:
passed all modules of an appropriate examination (such as the Advanced
Financial Advice unit as part of the Diploma for Financial Advisers); and
demonstrated a consistent ability to act competently under minimum
supervision.
Supervisors should have coaching and assessment skills as well as technical
knowledge.
For investment advisers, the regulatory module of an appropriate qualification
must be achieved prior to commencing the activity and the remaining modules
must be achieved within 48 months of commencing the activity.
There are different examination standards for those in different roles: mortgage
advisers must achieve an appropriate qualification in mortgages at RQF Level
3, such as the Certificate in Mortgage Advice and Practice (CeMAP®). There are
no formal requirements for those working as overseers.
18.6.3 Appropriate examinations for investment advisors
The role of investment adviser comes within the remit of the SM&CR, and
investment advisers are required to pass an appropriate examination as
demonstration of their competence.
18.6.4 Maintaining competence in firms
As well as ensuring that employees become competent, firms must have definite
arrangements in place for ensuring that they maintain that competence. A
review must take place on a regular and frequent basis to assess the employee’s
competence, and appropriate action must be taken to ensure that they remain
competent for their role. Matters that must be taken into account include:
technical knowledge and its application;
skills and expertise;
changes in the market and to products, legislation and regulation.
A retail investment adviser who has been assessed as competent must complete
a minimum of 35 hours of appropriate continuing professional development
(CPD) in each 12‑month period; 21 hours of that CPD must be ‘structured CPD’.
Examples of structured CPD include attending courses, seminars, lectures,
conferences, workshops or e‑learning activities which entail a contribution
of 30 minutes or more.
Unstructured CPD includes conducting research as part of the adviser’s
role, reading industry or other relevant material, and participating in
coaching or mentoring sessions.
Under the terms of the Insurance Distribution Directive, which took effect
from 1 October 2018 (see section 24.4), advisers selling protection policies (if
they are not subject to the FCA Training and Competence Regime) are required
to undertake a minimum of 15 hours’ CPD each year. Advisers must obtain a Statement of Professional Standing (SPS) each year
from an FCA accredited body.
To receive an SPS, an adviser must meet the professional standards of the
professional body and declare that they adhere to its code of ethics. They
must also confirm that they hold the required qualifications to give retail
investment advice.
RECORD‑KEEPING in firms
(Exam questions)
Firms must maintain records showing how and when employees’
competence is being assessed. All records relating to the training
and competence of individual employees must be retained for
specific minimum periods of time after the person ceases to
carry out the activity or leaves the company. The time limits are:
at least three years for individuals carrying out non‑MiFID
business;
at least five years for individuals carrying out MiFID business;
indefinitely for individuals carrying out pensions transfer
business.
Typical records might include some, or all, of the examples
shown in Figure 18.6.
18.7 What enforcement action can the FCA take?
The FCA takes action when it considers that particular aspects of a firm’s
business model or culture (such as products, training, recruitment procedures
or remuneration policies) are likely to harm consumers. It places emphasis on
securing redress for consumers who have suffered harm.
The circumstances that may lead to an investigation cover a wide range of
situations including, for example, suspicion that an authorised person is:
contravening regulations;
providing false information;
falsifying documents;
acting outside the scope of their Part 4A permission;
participating in money laundering;
allowing persons who are not approved or certified to carry out functions
within the remit of the SM&CR;
falsely claiming to be authorised;
undertaking insider dealing or market manipulation.
The person appointed to carry out the investigation on the FCA’s behalf has
the power to demand that:
the person being investigated or anyone connected with them answer
questions and provide information;
any person (whether or not they are being investigated or are connected
with the person under investigation) provide documents and, in the case of
a specific investigation, answer questions or provide information.
If the FCA is satisfied that it has discovered a contravention of its rules, there
are a number of steps that it can take, depending on its view of the nature and/
or the severity of the contravention. Some of these are described in Figure 18.7.
FIGURE 18.7 FCA ENFORCEMENT POWERS
This may involve removal of one of the fi rm’s permitted regulated activities or a narrowing of the
description of a particular activity.
Variation of a fi rm’s permissions
The FCA might withdraw or suspend a person’s approval or certifi cation to carry out some or all of
their role.
Withdrawal of approval
If a person has benefi ted from a contravention of a regulation, the FCA can ask the court for an order
requiring that person to forfeit to the FCA any profi t made from the activity.
Restitution
The FCA can announce that it has begun disciplinary action against a fi rm, although it must consult the
recipient of the warning notice before making such an announcement.
Disclosure
If a person has contravened a regulation, the FCA can apply for an injunction to prevent that person from
benefi ting from the action, for instance by selling assets that they have misappropriated.
Injunction
• If it can be shown that losses have been made by identifi able customers as a result of the
contravention of a rule, the FCA may be able to obtain a court order requiring such losses to be made
good.
• However, there may be more appropriate ways for that customer to pursue such claims, such as through
the Financial Ombudsman Service or the Financial Services Compensation Scheme (see Topic 25).
Redress
If an approved person or an authorised fi rm is judged to be guilty of misconduct, the FCA has a range of
options regarding the sanctions it might apply. These are to:
• issue a ‘warning notice’;
• publish a statement of misconduct;
• impose a fi nancial penalty.
Disciplinary action
• This is an intensive supervisory regime designed to deal with issues in fi rms that are considered to
have serious governance failings.
• The FCA can enforce a range of actions, which include requiring the fi rm’s board to commit to specifi c
remedial action, the progress on which will then be reviewed.
• As an alternative, the FCA can impose binding requirements on a fi rm in respect of certain actions it
must take.
Before taking action against a dual‑regulated firm, the FCA will consult with
the PRA. If the decision is relevant to both regulators, they will decide whether
it is best to pursue a joint investigation or for one of them to act alone, keeping
the other informed of developments and findings.
Please see 18.7
Please see 18.7
Please see check your understanding 3 of 18
1) What is Part 4A permission?
1) Permission under Part 4A of the Financial Services and Markets Act 2000
to carry out specified regulated activities.
2) One of the reasons why direct investment in shares is
considered higher risk is because it is not classified as a
regulated investment. True or false?
2) False. Investment in shares is a regulated investment.
3) When assessing whether a person is fit and proper to perform a
senior management function, the FCA requires that particular
attention be given to certain factors. Which of the following is
not a factor that the FCA requires to be considered?
a) Whether the person has obtained a relevant qualification.
b) Whether the person has undergone or is undergoing
training.
c) Whether the person possesses a relevant degree of
competence.
d) Whether the person has worked in the financial services
industry for at least five years.
3) d) There is no need to pay attention to how long someone has worked in
the industry; an individual may have worked in the industry for many
years but have a poor track record, while an individual who is new to
the industry may have good credentials.
4) Which one of the following job applicants is least likely to meet
the FCA ‘fit and proper’ requirements?
a) George, who has recently been made redundant from a
firm of independent financial advisers.
b) Irene, who currently has an authorised overdraft limit of
£2,000.
c) Francois, whose father’s house was taken into possession
by the lender three years ago.
d) Yvette, who has missed her last two mortgage repayments
following a divorce.
4) d) Yvette. The ‘fit and proper’ requirements include a check of financial
soundness, and missing mortgage repayments would have adversely
affected Yvette’s credit rating.
5) What was the main reason behind the introduction of the
Senior Managers and Certification Regime in 2016?
5) The regime was introduced in order to clarify responsibilities within a
firm, thus making it easier to hold individuals to account for a particular
failing. Prior to its introduction, the FCA and PRA had found it difficult to
determine individual responsibility when seeking to take action against
firms in the financial services industry.
6) An employee is being reviewed to ensure they are maintaining
their competence, as required by the TC sourcebook. What
three areas will the review focus on?
6) The employee’s:
technical knowledge and application;
skills and expertise;
understanding of changes in the market and to products, legislation
and regulation.
7) What is a ‘fixed portfolio’ firm?
7) A ‘fixed portfolio’ firm is one that has a large number of customers and
the potential to have a major impact on the market; it receives the highest
level of supervision, involving continuous assessment and a designated
individual supervisor.
8) If the FCA discovers a contravention of its rules, one of the
steps it may take is to vary a firm’s permissions. This means
that:
a) the firm may no longer be able to carry out one or more of
its regulated activities.
b) the firm will be required to sell assets to provide restitution.
c) the firm will need to seek authorisation from a different
regulator.
d) the firm will be required to submit each sale to the FCA for
approval.
8) a) The firm may no longer be able to carry out one or more of its regulated
activities.
9) In relation to the FCA’s enforcement powers, what is the
difference between ‘restitution’ and ‘redress’?
9) Restitution refers to the FCA’s power, with a court order, to require a
person or firm to forfeit any profit made as a result of contravening an
FCA rule. Redress applies to a situation in which an identifiable customer
has made a loss as a result of a contravention of an FCA rule; the FCA, with
a court order, can require that the loss be made good.
10) What are the three pillars of the FCA’s supervision model?
10)
Pillar 1: proactive firm or group supervision.
Pillar 2: event-driven, reactive supervision.
Pillar 3: issues and products.
19.1 What is prudential management?
A vital element of the work of the industry regulators is to ensure that firms
have adequate risk management systems in place, particularly in relation
to financial risks. This is referred to as prudential management. The majority of the prudential rules are the remit of the PRA; it is responsible
for the prudential regulation of all deposit-takers, insurers and significant
investment firms. The FCA is responsible for the prudential regulation of firms
for which it is the sole regulator, typically smaller businesses.
The FCA’s general approach to prudential supervision is to manage failure when
it happens, rather than focusing valuable resources on reducing its probability.
Remember that, in respect of prudential regulation, the FCA regulates smaller
firms. Therefore the FCA’s approach has to be seen in context, that the failure
of a smaller firm would generally not present a risk to the integrity of the
whole financial system. There are exceptions, and where failure of a particular
firm is likely to have a wider impact, the FCA will focus on reducing the impact
on customers and the integrity of the financial system.
19.1.1hwat is International prudential regulation?
It is important to understand that the UK’s regulators do not operate in
isolation; their work is driven by regulatory requirements at an international
level. Trade is conducted on a worldwide basis, and the economies of many
different countries are highly interconnected: problems in one economy or
with a single large financial services provider can cause problems across the
world. Such problems were seen following the collapse of Lehman Brothers in the United States in 2008, an event widely believed to have triggered the
ensuing financial crisis. The Basel Committee on Banking Supervision sets
standards for the prudential regulation of banks globally. The EU sets out
detailed requirements for banks, building societies and investment firms
within the member states. We will look at standards set by the Basel Committee
in section 19.5 and the EU requirements in section 19.6
WHAT IS THE BASEL COMMITTEE ON BANKING
SUPERVISION?
The Basel Committee is a multinational body acting under
the auspices of the Bank for International Settlements, and
is based in Basel, Switzerland. Its role is to strengthen the
regulation, supervision and activities of banks to enhance
financial stability; many of the people who work for it are
on secondment from central banks and national regulatory
bodies. It first established an international framework for
deposit-takers (ie principally banks) in 1988. This framework,
which – among other things – set out minimum capital
requirements for banks, was known as the Basel Accord. It
was superseded by the expanded Basel II, itself superseded by
Basel III in 2010.
19.2 What is capital adequacy?
One of the key areas of prudential control for financial institutions relates to
their capital adequacy. There are different rules for deposit-takers (such as
banks and building societies), investment firms and life assurance companies.
Regulations about capital adequacy broadly state that, should a business run
into difficulties, the business must have sufficient capital to make it very
unlikely that deposits will be placed at risk. Capital in this context is often
referred to as the own funds of a business, ie those obtained from shareholders
and related sources, as distinct from funds deposited by customers. The
business aims to make a profit for its shareholders, and it is the shareholders
who are expected to bear the risks in pursuit of the financial reward. Thus
although a bank’s lending is generally financed by deposits, any losses made
(for instance if a loan is written off because the borrower does not repay
it) should be borne by shareholders rather than by depositors. Minimum
requirements for capital adequacy are set to protect a bank’s depositors so
that they do not lose money.
The minimum capital that a business must hold is expressed in the form of a
solvency ratio: that is, capital as a proportion of the value of the bank’s assets
(ie mainly its loans). The solvency ratio takes account of the fact that some assets represent more of a risk to the bank than others, because the level
of capital that must be held reflects the perceived risk level of the different
assets.
19.3 What is liquidity?
Liquidity can be defined as the ease and speed with which an asset can be
converted into cash – and thus into real goods and services – without significant
loss of capital value. It must not be confused with solvency, or with capital
adequacy, which are different issues. In relation to banks, the definition of
liquidity is a measure of a bank’s ability to acquire funds immediately at a
reasonable price in order to meet demand for cash outflows.
The regulators define liquidity risk as the risk that a firm, though solvent,
does not have sufficient financial resources available to enable it to meet its
obligations as they fall due. Problems could, for example, arise when a bank
that has committed a large volume of its assets to long-term mortgage advances
is faced with an unexpectedly high number of its savings account holders
wanting to withdraw funds; the bank may have the assets to enable the
withdrawals but the mortgage loans are too illiquid. In assessing liquidity risks
that they may face, banks need to consider the timing of both their assets and
their liabilities, and endeavour to match them as far as possible.
A firm’s assets can provide liquidity in three
main ways: by being sold for cash, by reaching
their maturity date, and by providing security
for borrowing. Asset concentrations, where
a large number of receipts from assets are
likely to occur around the same time, should
be avoided. Similarly, banks try to avoid liability concentrations, where a single factor or a single decision could result
in a sudden significant claim. A wide spread of maturity dates is one obvious
way to achieve this.
LIQUIDITY RISK explain in terms of northern Rock
The situation of the UK bank Northern Rock in 2007 illustrates
liquidity problems that can arise.
The bank had a business plan that involved borrowing money
short term on the money markets on a regular basis to fund
a proportion of its (much longer-term) mortgage lending. The
success of the plan depended on the continuing availability of
short-term interbank lending. When this dried up as a result of
escalating economic problems in the USA, the bank’s liquidity
quickly disappeared. It was forced to approach the Bank of
England for assistance.
At that point, a different aspect of liquidity risk appeared.
When concerns about the stability of the bank became widely
known, large numbers of depositors sought to withdraw their
savings (a so-called ‘run on the bank’). Banks do not retain all
the funds deposited with them in a readily accessible form –
as we have already learned, most of their deposits are lent
to customers who wish to borrow. Only a small proportion
is kept in cash or assets convertible into cash. If a run on the
bank occurs, its liquidity can quickly be used up. In the case
of Northern Rock, the government stepped in to guarantee
deposits, which halted the bank run.
It’s quite a while since you studied the role of the Bank of England
in the UK financial system. Can you recall its key functions and
explain the main reason why Northern Rock approached the Bank
for assistance?
1) The main functions of the Bank of England are:
issuer of banknotes;
banker to the government;
banker to other banks;
adviser to the government;
manager of the UK’s gold and foreign currency reserves;
lender of last resort.
The main reason why Northern Rock approached the Bank for assistance
was because of the Bank’s role as lender of last resort; Northern Rock
could not obtain the funds it urgently needed on the interbank market so
it had to ask for emergency funding from the Bank.
19.4 What is operational risk? In terms of prudential risk
The way in which a business is run and managed is another area in which
prudential risk can arise. Operational risk is the risk of loss as a result of failed
or inadequate internal processes, people and systems (eg staff fraud, or a
computer failure), or as a result of external events, such as a natural disaster. 9
Capital requirements for operational risk were included for the first time
in Basel II (see section 19.5.1). The basic approach to calculating the capital
required is to multiply the institution’s gross annual income (averaged over
the past three years) by 0.15. Insurance held against the events happening
cannot be offset against this. For large institutions with different business
lines, a more sophisticated system (called the standardised approach) can be
applied, using different multiplying factors for each line.
19.5.2 explain Basel III
Even before Basel II had been fully implemented, the events of the 2007–09
financial crisis highlighted the need for additional regulation. Basel III was
agreed by members of the Basel Committee in 2010–11 and implementation
was phased in up to 31 March 2019.
Basel III covers two main areas:
regulatory capital;
asset and liability management.
Regulatory capital
Basel III requires banks to reach a minimum solvency ratio of 10.5 per cent.
Regulatory capital is the amount of capital that a bank is required to hold in
order to meet regulatory requirements. There are precise definitions as to what
can be counted as regulatory capital and there are two broad classes of capital:
Tier 1 capital, which includes share capital and disclosed reserves (ie
profits retained in the business rather than being paid as dividends);
Tier 2 capital, which is known as supplementary capital.
The value of a bank’s assets is adjusted to take account of the risk that those
assets present. So, for example, loans to governments (such as a bank holding
UK government gilts) have a risk weighting of zero as they are considered to
be very secure; personal loans, conversely, are unsecured lending so carry
a risk weighting of 100 per cent. A general theme is that the higher the risk
presented by the business a bank is carrying out, the higher the level of capital
it is required to hold. In practice, institutions normally keep more than the
minimum solvency ratio required by Basel III.
Basel III also introduced a minimum leverage ratio, which is a bank’s Tier 1
capital divided by its average total consolidated assets. Banks are expected to
maintain a leverage ratio in excess of 3 per cent.
Asset and liability management
Basel III introduced two new ratios that banks must comply with in respect of
asset and liability management:
liquidity coverage ratio (LCR);
net stable funding ratio (NSFR).
The LCR requires that high-quality liquid assets available to the bank exceed
the net cash outflows expected over the next 30 days. In assessing a bank’s
ability to meet the LCR, different weightings are attached to different types
of asset according to their liquidity. The LCR was phased in between January
2015 and January 2019.
While the LCR is aimed at ensuring a bank’s short-term liquidity, the NSFR aims
to protect its longer-term position. The NSFR requires that long-term financial
resources exceed long-term commitments; long term in this context is taken as
being more than one year. NSFR requirements had to be met from 2018.
19.6 What is the Capital Requirements Directive?
In the EU the requirements of Basel I, II and III are implemented by the Capital
Requirements Directives (CRDs). CRD IV, which implements Basel III, came
into effect on 1 January 2014, with the capital requirements being phased
in over a number of years. The CRDs establish a supervisory framework that
aims to minimise the effects of a firm failing. They do this by ensuring that
firms hold sufficient financial resources to cover the risks that their business
activities present.
CRD IV builds on existing rules and introduces new prudential requirements.
Notably, the quality of capital that firms are required to hold has been improved
and new capital buffers have been introduced for some firms. CRD IV applies
to banks, building societies and investment firms.
CRD V came into effect on 28 December 2020 and introduced new rules
governing the remuneration of staff, including the basis for identifying so-
called ‘material risk takers’ – staff who are subject to the strictest remuneration
rules. The reforms to the rules governing remuneration in CRD V include
changes to deferral periods for performance-related pay and proportionality
thresholds above which the requirements apply. As CRD V came into effect
just before the end of the Brexit transition period, under the terms of the UK’s
Withdrawal Agreement with the EU the UK was required to ‘onshore’ the CRD
V rules.
19.6.1 explain Total loss‑absorbing capacity (TLAC)
There are additional capital requirements for banks deemed systemically
important or too big to fail. The Financial Stability Board (FSB), an international
organisation consisting of national regulators and central banks, issued a
minimum total loss-absorbing capacity (TLAC) standard on 9 November 2015 for
30 banks identified as global systemically important banks (G-Sibs) that the Basel
Committee on Banking Supervision (BCBS) deems at risk from being too big to fail.
The TLAC requirements aim to bolster G-Sibs’ capital and leverage ratios, ensuring
these banks are equipped to continue critical functions without threatening
financial market stability or requiring further taxpayer support. The minimum
TLAC requirement is in addition to minimum regulatory capital requirements, but
qualifying capital may count towards both requirements, subject to conditions.
Since 1 January 2022, the minimum TLAC requirement for G-Sibs has been at
least 18 per cent of the resolution group’s risk-weighted assets (RWAs).
19.7 explain What is Solvency II?
The failure of an insurance company presents a number of risks for consumers
and, as with the banks, there are rules relating to the amount of capital a
business must hold to mitigate the risk of insolvency. In the EU, a Directive
that focused on the capital adequacy of insurers was introduced in the early
1970s; this is now referred to as Solvency I. A new Directive, Solvency II,
came into effect on 1 January 2016. At an international level, the European
Insurance and Occupational Pensions Authority (EIOPA) is responsible for its
implementation. Within EU member states, national supervisory authorities
will implement the requirements of the Directive.
The main aims of Solvency II are to:
reduce the risk of an insurance company being unable to meet its claims;
reduce losses suffered by policyholders should an insurer be unable to
meet all claims in full;
establish a system of information disclosure that makes regulators aware
of potential problems at an early stage;
promote confidence in the financial stability of the insurance sector.
Solvency II aims to harmonise regulation of the EU insurance industry and is
primarily focused on the amount of capital an insurer must hold to reduce the
risk of insolvency. It is based on three main ‘pillars’ (see Figure 19.3).
Pillar 1
Capital requirements
and the valuation of
assets
Pillar two
Governance and
risk-management
requirements
Pillar 3
Disclosure and
transparency rules
The capital requirement is expressed in terms of a solvency capital requirement
(SCR) which comprises a basic SCR, plus an allowance for operational risk, less
an amount for adjustments. Insurers are required to complete and submit an
Own Risk & Solvency Assessment (ORSA). The PRA has made changes to its
Handbook to reflect the new requirements.
The regime applies to almost all EU insurance firms; some insurance firms are
not subject to Solvency II requirements, depending on the amount of premiums
they write, the value of technical provision or the type of business written.
The UK government retained all core aspects of Solvency II in UK law following
Brexit; however, it has since indicated plans to reform Solvency II.
19.8 What are the FCA/PRA prudential standards?
The FCA and PRA are responsible for establishing rules that translate EU
legislation into practical standards that apply to regulated financial services
providers. The FCA Handbook’s ‘Prudential Standards’ section details
prudential requirements. This section is made up of several subsections that
detail requirements for different types of firm. The FCA has implemented a
new prudential regime for investment firms, including the development of the
Prudential Sourcebook for Investment Firms (MIFIDPRU).
Explain INVESTMENT FIRMS PRUDENTIAL REGIME (IFPR)
(Exam question)
Most larger firms are now subject to the FCA’s Investment
Firms Prudential Regime (IFPR), whose rules can be found in
the MIFIDPRU sourcebook. IFPR reflects the FCA’s approach to
capital requirements following Brexit. The regime came into
force on 1 January 2022.
MIFIDPRU contains rules on own funds, concentration risk,
basic liquid assets requirements, governance and risk
management, and disclosure and reporting. The sourcebook
also covers firms acting as clearing members and indirect
clearing firms.
Further details can be found here: www.handbook.fca.org.uk/
handbook/MIFIDPRU/
1) Who is responsible for the prudential regulation of
deposit-takers and insurers?
a) Financial Conduct Authority (FCA).
b) Prudential Regulation Authority (PRA).
c) Monetary Policy Committee (MPC).
d) Financial Policy Committee (FPC).
1) b) Prudential Regulation Authority.
2) Why does the FCA concentrate on managing the failure of an
individual firm if it happens rather than proactively seeking to
prevent its failure in the first place?
2) The FCA is the prudential supervisor for smaller firms that, in general, would
not present a risk to the wider financial system if a particular one were
to fail. Therefore, the regulator concentrates its resources on managing a
firm’s failure in an orderly way to mitigate the impact on its customers.
3) Capital adequacy requirements are based on the principle that
in the event of a firm making a loss:
a) it can approach the Bank of England for additional funds.
b) its depositors, not its shareholders, should bear the loss.
c) the Basel Committee will determine whether the firm has
sufficient capital to continue trading.
d) its shareholders, not its depositors, should bear the loss.
3) d) Capital adequacy requirements are based on the principle that
shareholders, not depositors, should bear any loss.
4) What is a bank’s solvency ratio?
4) Capital as a percentage of the risk‑adjusted value of assets.
5) How did Basel II seek to ensure that capital adequacy
requirements more accurately reflected the risks represented
by a firm’s assets?
5) Under Basel II, instead of simply calculating their capital requirement
as a percentage of the total value of their assets, firms were required to
categorise each asset according to the risk it represented and hold more
capital in relation to the riskier assets.
6) Under Basel III, banks must work towards a minimum solvency
ratio of what level?
a) 10.5 per cent.
b) 8 per cent.
c) 5 per cent.
d) 4 per cent.
6) a) 10.5 per cent.
7) Basel III introduced new measures with regard to a bank’s capital
and asset liability management. Which of these measures is
aimed at protecting the long-term financial stability of a bank?
a) The liquidity coverage ratio.
b) The net stable funding ratio.
c) The Tier 1 capital measure.
d) The Tier 2 capital measure.
7) b) The net stable funding ratio.
8) What are the key aims of Solvency II?
8) To reduce the risk of an insurance company being unable to meet its claims;
to reduce losses suffered by policyholders should an insurer be unable to
meet all claims in full; to establish a system of information disclosure that
makes regulators aware of potential problems at an early stage; and to
promote confidence in the financial stability of the insurance sector.
9) Which of the following sections of the FCA Handbook contains
details of the prudential requirements applying to MiFID
investment firms?
a) BIPRU.
b) IFPRU.
c) MIPRU.
d) MIFIDPRU.
9) d) MIFIDPRU details the prudential requirements for MiFID investment
firms.
20.1 What are the Conduct of Business sourcebooks?
Regulations relating to the way in which advisers interact with clients are
set out in the Business Standards section of the FCA Handbook. Within this
section, there are a number of sourcebooks detailing the rules governing
advice in specific areas. Figure 20.1 summarises the sourcebooks we will be
considering. The remainder of this topic addresses the provisions of COBS,
with Topic 21 considering BCOBS, MCOB and ICOBS.
BCOBS
Banking: Conduct of
Business Sourcebook
Rules governing deposit-
takers, eg banks and
building societies
MCOB
Mortgages and Home
Finance: Conduct of
Business Sourcebook
Rules governing the
provision of advice
relating to mortgages and
home fi nance, including
equity release
ICOBS
Insurance: Conduct of
Business Sourcebook
Rules governing the
provision of advice on
general insurance and
protection products
The FCA Handbook also contains a conduct of business sourcebook for claims
management companies called CMCOB.
20.2 What are the types of client?
COBS sets out three types of client:
eligible counterparties;
professional clients;
retail clients.
Different rules apply to dealings with each of these client groups.
20.2.1 Eligible counterparties (conduct of business requirement)
This category includes governments, central banks and financial institutions
– the latter including firms such as banks, insurance companies, investment
firms and collective investment funds. The eligible counterparty definition
only applies to eligible counterparty business, which would include situations
such as straightforward execution of transactions received or the purchase of
shares, by a firm, for onward sale to the firm’s clients. Due to the assumed
level of knowledge and experience, clients in this category receive the lowest
level of investor protection.
20.2.2 Professional clients. In terms of conduct of business requirements
This category includes all the bodies that would otherwise be eligible
counterparties, except for the fact that they require a higher level of service
than would apply to ‘eligible counterparty business’ – for example, they require
advice, in addition to execution of transactions.
It also includes other types of large client, particularly institutional investors
whose main activity is investing in financial instruments. When dealing with
professional clients, advisers can assume an adequate level of experience and
knowledge and an ability to accept financial risks.
Clients can either be considered as professional clients on a de facto basis (ie
they qualify by meeting various tests) or they opt to be treated as professional
clients, in which case they are referred to as ‘elective professional clients’.
20.2.3 explain Retail clients in terms of conduct of business requirements
This category provides the highest level of investor protection and comprises
customers who do not fall into either of the previous two categories – especially
customers who might be described as ‘the person in the street’ and who cannot
be expected to have anything more than a basic general understanding of
financial services.
It is expected that most financial services customers will fall into this category.
Increasing knowledge and experience ➡️ retail clients, professional clients, eligible counter parties ⬅️ increasing investor protection
20.3 What are the different categories of adviser?
Advisers are grouped into one of two categories: independent advisers and
restricted advisers.
In order to inform a client that it provides independent advice, a firm must
assess a sufficient range of relevant products available on the market that
must:
be sufficiently diverse with regard to their type and issuers, or product
providers, to ensure that the client’s investment objectives can be suitably
met; and
not be limited to relevant products issued or provided by the firm itself or
by entities having close links with the firm, or other entities with which the
firm has such close legal or economic relationships, including contractual
relationships, as to present a risk of impairing the independent basis of the
advice given.
Source: FCA (no date)
Any firm or adviser that does not meet the requirements to be ‘independent’
will, by default, be providing advice that is ‘restricted’. This is designed
to reflect the idea of genuinely independent advice being free from any
restrictions that could impact on the ability to recommend whatever is best
for the customer. The restrictions may relate either to the range of product
providers that an adviser can recommend, or the range of individual products.
20.3.1 explain Independent advice
Independent advisers offer advice on a wide range of financial products and
providers. An advice firm can call itself independent even if it only offers
advice on a certain area.
For example, a firm could call itself independent while only offering advice
on pensions. The firm would have to be able to advise on all pension product
types and “would need to consider a sufficient range of pension products
which were sufficiently diverse, in terms of their type and provider, to suitably
meet the client’s objectives”.
The FCA Glossary defines a ‘personal recommendation’ as advice on
investments, advice on conversion or transfer of pension benefits, or on a
home finance transaction that is presented as suitable for the person for whom
it is made, or is based on consideration of the circumstances of that person.
The use of panels
The rules do not prohibit, or even restrict,
the use of panels by firms wishing to operate
as ‘independent’, but any panel should be
sufficiently broad in its composition to enable
the firm to make personal recommendations
based on an assessment of a sufficient range of
diverse and relevant products on the market.
Any panel should be reviewed regularly and
updated as necessary. The use of a panel must
not materially disadvantage any client.
The firm must recognise that there may be clients for whom the panel does
not work. It should therefore be possible for ‘off‑panel’ advice to be available
where a different product or product provider would provide a more suitable
outcome for that client.
The role of specialists
The rules relating to independent advice apply both at the level of the firm
and of the personal recommendation. Every adviser working in a firm that
describes its advice as independent needs to ensure that each personal
recommendation meets the definition of independence.
This does not, however, prohibit firms from having advisers that specialise in
certain areas, for example, investments, pension transfers or long‑term care.
DETERMINING WHICH REGULATORY RULES APPLY in terms of conduct of business requirements
(Exam question)
Firms that advise retail clients on any retail investment products
are subject to the FCA rules that apply to those operating in
a particular area of financial services. For instance, a firm
that only advised on mortgages would fall under the FCA’s
COBS and MCOB rules. If the firm decided to start advising on
protection products that could be used in conjunction with
mortgages, they would also be subject to ICOBS rules, and
their sales processes would need to be amended.
EXAMPLE: SPECIALISTS PROVIDING INDEPENDENT ADVICE.
(Exam question)
A firm providing independent advice has three advisers, each
with their own specialist area. The IHT specialist has a client
for whom a personal pension might be appropriate. They
consult the pension expert to seek their advice and guidance.
The personal recommendation provided to the client by the
IHT expert would meet the independence rule provided that
the recommendation of the pension expert would also meet
the independence rule, as defined in section 20.3.
20.3.2 Restricted advice
Restricted advice could be summarised as anything that is not independent
advice or basic advice. Restricted advisers generally focus on a limited
selection of products or providers.
PENSION AND INVESTMENT SCAMS
(Exam question)
The subject of pension and investment scams is detailed in
section 10. One of the ways an individual can seek to protect
themselves against a possible scam is to seek qualified
financial advice from a financial adviser, whether independent
or restricted. An accomplished financial adviser would be able
to identify the warning signs of a scam and advise accordingly.
20.4 What is execution‑only business?
The FCA expects that the majority of retail customers will receive qualified
investment advice, involving a recommendation based on analysis of their
needs and circumstances. There are situations where a customer may feel
equipped to make their own investment decisions and proceed without advice –
to proceed on an execution‑only basis. Execution‑only involves the customer
telling the firm what they wish to do and the firm executing their wishes; no
advice is given.
The FCA defines execution‑only business as “a transaction executed by a firm
upon the specific instruction of a client where the firm does not give advice on
investments relating to the merits of the transaction and in relation to which
the rules on the assessment of appropriateness do not apply”.
This can be contrasted with:
qualified investment advice – where an adviser makes a recommendation
based on a full analysis of a customer’s needs and circumstances; and
simplified advice – where a streamlined or automated process is used to
gather the personal and financial information on which advice is given.
Where investment business is undertaken on an execution‑only basis, the
customer instructs the adviser to effect
a specific transaction on their behalf,
detailing in full the nature of the product
required.
For an execution‑only transaction, the
adviser’s duty of care to fully explain
the nature of the transaction and risks
involved does not apply. The customer is
entirely responsible for their own choice.
It is expected that only a small proportion
of any adviser’s cases would be on an execution‑only basis.
A different situation arises where an adviser provides advice to a client, but
the client wishes to carry out a transaction that contravenes the advice given
(sometimes referred to as an ‘insistent’ customer). In this situation, the adviser
should require the client to sign to confirm that they are acting against the
advice provided.
THE NEED FOR CLEAR AND CREDIBLE EVIDENCE in terms of execution only business.
(Exam question)
The Financial Ombudsman Service (FOS) has highlighted
that complaints relating to execution‑only business often
result from the customer believing they had received advice
and not realising they have taken out an investment on an
execution‑only basis. The FOS has indicated that it expects
firms to be able to provide ‘clear and credible’ evidence that
a transaction was conducted on an execution‑only basis. This
would involve obtaining a signed statement from the customer
confirming that:
they are aware that business is being transacted on an
execution‑only basis;
they have not asked for or received advice;
the decision to take out the investment is theirs alone;
the adviser (and/or the firm they represent) takes no
responsibility for the suitability of the investment.
20.5 What are the rules relating to financial promotions?
A financial promotion is defined in COBS as an “invitation or inducement to
engage in investment activity”. This includes:
advertisements in all forms of media;
telephone calls;
marketing during personal visits to clients;
presentations to groups.
Financial promotions can be ‘communicated’ only if they have been prepared,
or approved, by an authorised person.
There is a distinction between:
real‑time financial promotions (non‑written financial promotions), such
as personal visits and telephone conversations; and
non‑real‑time financial promotions (written financial promotions), such
as newspaper advertisements and those on internet sites.
The overall principle is that financial promotions to retail clients and
professional clients must give a clear and adequate description of the product or service and be clear, fair and not misleading. In the case of retail clients,
this means specifically that information supplied must:
be accurate, including the requirement not to emphasise potential benefits
without giving a fair and prominent indication of the risks;
be understandable by an ‘average’ member of the group it is aimed at;
not disguise or obscure important
terms or warnings;
contain the name of the conduct
regulator (the FCA) in the case of
direct offer advertisements.
Figure 20.3 sets out the rules relating to financial promotions.
Comparisons
• Comparisons with other products must be meaningful, and presented in a fair and balanced way.
• Markets in Financial Instruments Directive (MiFID) firms are subject to additional requirements to detail
the source of information and the assumptions made in the comparison.
Past performance
• Past performance information must not be the most prominent part of a promotion.
• It must be made clear that it refers to the past, and it must contain a warning that past performance is
not necessarily a reliable indicator of future results.
• Past performance data must be based on at least five years (or the period since the investment
commenced, if less, but must not relate to a period of less than one year).
Unsolicited promotion (cold call)
• Permitted only in relation to certain investments, including packaged products,such as life assurance
policies and unit trusts. Not permitted in relation to higher-volatility funds (which use gearing) or
life policies with links to such funds, due to the increased investment risk involved. Cold calls are not
permitted in relation to mortgage contracts.
• Unsolicited telephone calls or visits must only be made at‘an appropriate time of the day’. Within the
industry,this is generally taken to mean between 9am and 9pm Monday to Saturday.
• The caller must check that the recipient is happy to proceed with the call.
• The caller must also give a contact point to any client with whom they arrange an appointment.
ADVERTISING STANDARDS AUTHORITY in terms of rules relating to financial promotions.
(Exam question)
In addition to abiding by the rules laid down in industry‑specific
regulations, advertisements for financial services and financial
products (whether delivered via print, broadcast media, eg TV
and radio, or non‑broadcast media, eg online) must meet the
standards laid down by the Advertising Standards Authority
(ASA).
All advertisements should be:
legal, ie containing nothing that breaks the law, or incites
anyone to do so, and omitting nothing that the law requires;
decent, ie containing nothing that is likely to cause serious
or widespread offence, judged by current prevailing
standards of decency;
honest, ie not exploiting the credulity, lack of knowledge
or inexperience of consumers;
truthful, ie not misleading by inaccuracy, ambiguity,
exaggeration, omission or any other means.
In relation to ‘decency’, particular care should be taken with
sensitive issues such as race, religion, sex or disability.
The ASA can take action against individuals and organisations
whose advertising contravenes its rules, from requiring an
advertisement to be amended or withdrawn, to taking legal
action.
20.6 What are the rules relating to adviser charges?
Traditionally many investment advisers charged for their services, in full or
in part, through the receipt of a commission payment from the providers of
products they recommended. This led to concerns that advice could be ‘skewed’
in favour of providers or products that offered the highest commission rates.
Since 1 January 2013, a firm advising on investment business must only be
remunerated for its services by adviser charges; it is no longer allowed to receive
commission from the product providers for the products it recommends.
Furthermore, it must not accept any other commissions or benefit of any kind
from any other party, even if it intends to refund the payment or pass some or
all of the benefits to the client.
The charging structure should be based on the service provided, rather
than the product/provider recommended.
Charges should be explained as part of the initial disclosures to a customer.
Any continuing charges can only be made where the customer has agreed
to these and where the service for which these charges are levied is actually
provided.
The firm can determine its charging structure for its services. This can be a
standard charging structure that applies to all clients, based on an hourly rate,
or can be based on a percentage of the amount being invested, but the firm
must pay due regard to the client’s best interests.
The charging structure must be clear, fair and not misleading and not conceal
in any way the amount or purpose of any of its adviser charges from the client.
For example, a firm cannot make arrangements for amounts in excess of its
adviser charge to be deducted from a client’s investment, even if it is with the
intention of making a cash refund of some or all of it to the client at a later
date.
The firm must ensure that the charging structure it discloses to its client at
the outset reflects as closely as possible the total charges that are to be paid.
If the firm’s charging structure is based on hourly rates, it must state whether
the rates are ‘indicative’ or actual and provide an approximate indication of
the number of hours that the provision of each service is likely to require.
A firm cannot use an adviser charging structure that entails payments by the
client over a period of time unless the service being provided is ongoing and
this is disclosed to the client at the outset. The client must be provided with
a right to cancel the service, without penalty and without having to give a
reason. The FCA is eager to ensure that any ongoing service that is charged for
is actually delivered by the adviser.
The firm must provide details of its charges during the initial disclosures and,
once the final charges are known, it may include the information about total
adviser charges in a suitability report.
20.7 What information must be provided at the outset?
Before any business is discussed, the adviser must disclose to the client
certain information about themselves, the services they provide and the costs
of those services. The information which must be provided and confirmed in
writing includes the following:
Contact information – the name and address of the firm and contact details
necessary to enable a client to communicate effectively with the firm.
Communication – the methods of communication used between the firm
and the client.
Authorisation – a statement of the fact that the firm is authorised and the
name of the regulator that has authorised it (the FCA if in the UK; otherwise,
the name of the competent authority that has authorised the firm – ie in
relation to MiFID business).
Advice type – whether the advice being provided is independent or
restricted, and if restricted, the nature of the restriction. If a firm offers
both, it must clearly explain the different nature of the independent advice
and restricted advice services.
Investment management – if the firm manages investments on behalf of a
client, the method and frequency of investment evaluation, details of any
delegation of the discretionary management of all or part of the client’s
portfolio, and the types of designated investments that may be included in
the client’s portfolio.
Client money or investments – if the firm holds designated investments or
client money for a retail client, that that money may be held by a third party
on behalf of the firm, responsibility of the firm for any acts or omissions
of that third party, and the consequences of the insolvency of that third
party.
Charging structure/method – this may be in the form of a list of the
advisory services offered with the associated indicative charges which will
be used for calculating the charge for each service.
Charges payable – the total adviser charge payable by a client in cash
terms (or equivalent). If payments are to be made over a period of time, the
firm must include the amount and frequency of each payment due, and the
implications for the client if a retail investment product is cancelled before
the adviser charge is paid. Details of complaints procedures, including FOS and FSCS – the firm
must make available to a client who has used or intends to use their services
details of their complaints procedures and explain the protections offered
by the Financial Services Compensation Scheme (FSCS) and the Financial
Ombudsman Service (FOS). We cover both of these in Topic 25.
Clients must be notified in good time of any material change to the services
the firm is providing to that client. For existing clients, the firm need not
treat each of several transactions as separate, but does need to ensure that
the client has received all relevant information in respect of a subsequent
transaction, such as details of product charges that differ from those disclosed
for a previous transaction.
20.8 When is a written client agreement required?
If a firm carries out designated investment business, other than advising
on packaged investment products, the firm must enter into a written basic
agreement with the client, setting out the essential rights and obligations of
the firm and the client.
Designated investment business is dealing in investment assets directly on
behalf of a client, as opposed to selling packaged investment products. It
often involves making investment decisions on behalf of the client, exercising discretion as to investment choice and switching from one to another without
having to gain the client’s individual agreement for every separate transaction.
The types of product involved
may include equities, options
and futures contracts. A client
agreement is not usually required
for packaged investments, such as
life assurance policies and personal
pensions, although these may
well be used as part of the whole
arrangement alongside the higher‑risk instruments. In addition to providing
the client with information about the firm and its services (as listed in section
20.7), the client must be given, in the form of a client agreement, the terms
upon which the adviser is to operate in respect of the client’s investments.
This will include investment range and limits.
20.9 What are the suitability requirements?
An adviser, whether independent or restricted, will make a personal
recommendation. They must not make a personal recommendation unless
they are satisfied that the recommendation is suitable. This means the adviser
must have fully ascertained the client’s personal and financial circumstances
relevant to the services that the adviser has agreed to provide.
20.9.1 Establishing the client’s circumstances
As we saw in Topic 14, the start point is to complete a confidential client
information questionnaire or ‘factfind’, which will capture a range of
information. That information must be retained for a specified period of time,
depending on the nature of the product recommended. In practice, advisers
retain information in all cases for as long as they believe they might be required
to justify the advice and recommendations given. Retaining the information
will help the firm to deal with complaints, provide an audit trail for advice and
provide evidence of compliance with regulatory requirements.
Once the factfind is completed, the adviser can formulate their
recommendations. To ensure that recommendations are suitable, the
adviser needs to consider a number of factors, such as ensuring that the
recommendation:
meets current and likely future needs;
is affordable, both initially and on an ongoing basis;
is consistent with the customer’s risk profile;
is flexible, to take account of future changes.
20.9.2 Risks in product proposed
The suitability rules specifically require advisers to take all reasonable steps
to ensure that the client understands the nature of any risks implicit in the
product proposed. Examples of risks that might need to be discussed include:
whether or not the customer’s capital will be returned in full;
the extent to which income levels from an investment may vary or the
circumstances in which no income may be paid at all;
the factors on which a customer’s income from a pension product will
depend;
any factors that might affect a customer’s ability to make a claim on a
protection product;
whether or not the level of life cover is sustainable for the duration of the
term without an increase in premiums.
The nature and extent of the discussion will depend on the client’s experience
and knowledge of the type of product under consideration. In assessing the
suitability of any recommendations, the adviser must be sure to first establish
the client’s attitude to and ability to tolerate risk.
20.9.3 Suitability reports
Advisers must recommend the product or service that is most suitable for
the client, based on the information supplied by the client and on anything
else about the client of which the adviser should reasonably be aware. The
recommendation must be solely in the best interests of the client and no
account should ever be taken of the remuneration that may be payable to the
adviser.
A suitability report explains why the particular product recommended is
suitable for the client based on:
their particular personal and financial circumstances;
their needs and priorities as identified through the fact‑finding process;
and
their attitude to risk (both in general terms and in relation to the specific
recommendations made).
Figure 20.5 shows the products for which a suitability report is required. Note
that the FCA does not require a suitability report to be provided in respect of
mortgage advice, although many lenders will prepare one.
The report should also identify any potential disadvantages of the transaction
for the client, such as any ‘lock‑in’ period during which an investment cannot
be encashed. It should be clear, concise and written in plain English, in line
with the general FCA requirement for communications to be clear, fair and not
misleading.
Suitability requirement is required for life policys, unit trusts, OEICs, pension policies, pension transfers and opt outs, ect
TIMESCALES FOR ISSUING SUITABILITY REPORTS
(Exam question)
When providing investment advice to a retail client and in
the case of life policies, a firm must, before the transaction is
concluded, provide the client with a suitability report.
In the case of telephone selling, if, prior to the conclusion of
the contract, the information is provided orally or in a durable
medium other than paper, the suitability report for a life
policy must be provided immediately after the conclusion of
the life policy. For a personal pension or stakeholder pension, where
cancellation rights apply, the report must be sent no later than
the fourteenth day after the contract is concluded.
In any other case, the report should be provided when or as
soon as possible after the transaction is effected or executed.
Explain the content of a Product disclosure document
CONTENT OF A KEY FEATURES DOCUMENT
A key features document must include:
a brief description of the product’s aims;
a brief description of how the product works;
the key terms of the contract, including any consequences
of failing to maintain the commitment or investment;
the material risks involved;
the arrangements for handling complaints about the product;
that compensation is available from the FSCS;
that a right to cancel or withdraw exists (or does not exist),
and if it does, its duration, the conditions for exercising it,
any amount the client might have to pay, and where the notice
must be sent.
20.10.1 What are key information documents?
Since 1 January 2018 a key information document (KID) must be provided if a
customer is buying a packaged retail and insurance‑based investment product
(PRIIP). A PRIIP is defined as an investment where the amount repayable to
the retail investor is subject to risk and fluctuation as a result of exposure to
reference values or the performance of assets not directly held by the client;
or an insurance-based product that is exposed to market fluctuations.
A PRIIPs KID is a short pre-sale disclosure document to give retail investors
the necessary information to make an informed investment. It must include
specific key information on an investment product in a prescribed way and in
a standard format, so that retail investors can assess and compare products.
The key information to be disclosed in the PRIIPs KID includes:
the nature and features of the product, including whether it is possible to
lose capital;
the costs and risk profile of the product;
relevant performance information.
PRIIPs regulation aims to improve the transparency and comparability
of investment products across the EU through KIDs. The purpose of the
requirements is to ensure that:
there is consistency between the information that different providers make
available to their customers;
the information provided covers certain key relevant areas;
the information is presented in an easy‑to‑understand manner;
it is easier for investment customers to make meaningful comparisons
between providers.
The KID must be no longer than three sides of A4 and the language used
must be plain, concise and easy to understand. It must contain certain key
information about the investment including:
product name;
name of the provider;
main features;
any possible risks;
any return that could be gained by investing;
costs and charges;
details of the complaints procedure.
Key investor information document (KIID)
An investor who is subscribing to a UCITS must be provided with a key investor
information document (KIID). The purpose of the KIID is to summarise the key
features and risks of the UCITS to provide investors with sufficient information
to make an informed investment decision. The KIID is a two‑page document
that describes key fund information in concise and plain language.
The KIID is split into the following five sections:
objectives and investment policy;
risk and reward profile;
charges;
past performance;
practical information.
The KIID contains a synthetic risk and reward indicator (SRRI) – a numerical
scale from one to seven (low risk to high risk–reward potential), based on
the volatility of a UCITS’s past performance. The SRRI is intended to allow
investors to easily compare investment products (Matheson, 2017).
KIIDs and KIDs provide important information about the fund, including its
charges, risk rating and investment profile. The key difference is that PRIIPs
KIDs show forward-looking performance scenarios, while UCITS KIIDs show
actual historical performance data.
20.11 Cooling off, cancellation rights and reflective periods
When a client buys a regulated packaged or insurance product, they have the
right to change their mind and withdraw from the contract within a specified
period, known as the cooling‑off period. The provider is required to send the
client a statutory cancellation notice, which explains the process.
The time period is usually either 14 or 30 days depending on the product type:
For life and pensions policies, and contracts of insurance that are, or have
elements of, a pure protection contract or payment protection, the period
is 30 days.
For investments or deposits and other insurances, the period is 14 days.
Binding mortgage offers trigger a seven‑day reflection period. During this
time the offer is binding on the lender, but the consumer can accept or reject
the offer at any time.
20
The cooling‑off period runs from the date when the contract begins or from
the date on which the client receives contractual terms if this is later. The
client can withdraw from the contract without penalty at any time during the
cooling‑off period, without any commitment or loss, by signing and returning
the cancellation notice to the product provider.
Generally, the client will receive a full refund of any premiums paid if they cancel
the contract during this period and this must be provided within 30 days of receipt
of the cancellation notice. The exception to this is if the client invests in a lump‑sum
unit‑linked investment (such as a unit trust, OEIC or investment bond), the money
has been invested and the value of the investment has fallen. Under these
circumstances, the client is entitled to a refund of the reduced investment; no
charges can be taken but an adjustment can be made to reflect the fall in value of
the investment. The aim is to prevent people cancelling due to falls in the market.
This risk should be explained to the client before they enter into the contract.
At the time the product purchase is made, the adviser must also explain
whether the client is liable to pay
any outstanding adviser charges if
they decide not to proceed with the
product and send back the signed
cancellation notice.
It is important that a firm can evidence
that a cancellation notice is issued to
a customer since, if they fail to do so, the customer can choose to cancel at any
time and will not be liable for any loss (including a fall in investment value).
RECORD‑KEEPING
(Exam question)
The maintenance of clear and readily accessible records
is vital at all stages of the relationship between financial
services professionals, their clients and the FCA, from details
of advertisements to information collected in factfinds, to
the reasons for advice given and beyond. Record‑keeping
requirements for the different stages can be found at
appropriate points within the Conduct of Business Sourcebook,
with details of what must be kept and the minimum period
for which it must be retained. The minimum retention period
varies according to the type(s) of product recommended.
Records can be kept in any appropriate format, which includes
computer storage, although the rules say that records stored
on a computer must be “capable of being reproduced on paper
in English”. Firms are expected to take reasonable steps to
protect their records from destruction, unauthorised access and
alteration.. In addition to the record‑keeping requirements that firms must
observe to comply with COBS, there are rules relating to the
prevention of money laundering and to the Data Protection
Act 2018 (and UK General Data Protection Regulation). We will
look at these in Topics 23 and 24 respectively.
RECORD‑KEEPING
(Exam question)
The maintenance of clear and readily accessible records
is vital at all stages of the relationship between financial
services professionals, their clients and the FCA, from details
of advertisements to information collected in factfinds, to
the reasons for advice given and beyond. Record‑keeping
requirements for the different stages can be found at
appropriate points within the Conduct of Business Sourcebook,
with details of what must be kept and the minimum period
for which it must be retained. The minimum retention period
varies according to the type(s) of product recommended.
Records can be kept in any appropriate format, which includes
computer storage, although the rules say that records stored
on a computer must be “capable of being reproduced on paper
in English”. Firms are expected to take reasonable steps to
protect their records from destruction, unauthorised access and
alteration.. In addition to the record‑keeping requirements that firms must
observe to comply with COBS, there are rules relating to the
prevention of money laundering and to the Data Protection
Act 2018 (and UK General Data Protection Regulation). We will
look at these in Topics 23 and 24 respectively.
1) Which of the three categories of investor identified in COBS is
provided with the highest level of regulatory protection?
1) The law of agency. When carrying out designated investment business,
the adviser acts as the agent of the client.
2) If a client intends to purchase an investment product on an
‘execution‑only’ basis, then:
a) no recommendation is provided.
b) no charges will be payable.
c) they can only use an independent adviser.
d) they will have to complete all the paperwork themselves.
A/ No recommendations is provided
3) A restricted adviser is one who:
a) can only make recommendations based on the products of
a single provider.
b) has not passed all of the relevant exams to enable them to
give independent advice.
c) generally focuses on a limited selection of products or
providers.
d) can only give basic advice on stakeholder products.
3) c) A restricted adviser generally focuses on a limited selection of products
or providers.
4) A firm is keen to develop its mortgage business and has
acquired a list of potential new customers from a marketing
company. It plans to call the listed individuals in the evenings
and at weekends. In what respects would this plan breach
COBS rules on financial promotions?
4) As the individuals are not existing customers, contacting them by
telephone would constitute cold calling, which is not permitted in relation
to mortgage contracts. Additionally, cold calls may only be made at an
‘appropriate time of day’ – evenings (to 9.00pm) and Saturdays would be
permissible but not Sundays.
5) Which of the following reflects the FCA’s rules on adviser
charging?
a) Advisers may minimise the upfront cost of their services to
clients by charging in instalments over a number of years.
b) Advisers’ charges must be based on hourly fees.
c) Advisers have discretion to determine their charging structures but they must pay due regard to the best interests of the client. d) It is accepted that it is not possible to provide an estimate in advance of chargeable hours because of the potential complexity of some transactions. When an adviser transacts
5) c) Advisers have discretion to determine their charging structures but
they must pay due regard to the best interests of the client.
6) When an adviser transacts designated investment business for
a client, the basis or amount of the charges would normally be
disclosed in which document?
a) The key features document.
b) The statutory cancellation notice.
c) The suitability report.
d) The client agreement letter.
6) d) The client agreement letter.
7) An adviser must issue a key features or key information
document and illustration prior to a sale being concluded for
all of the following products, except:
a) gilt‑edged securities.
b) life assurance.
c) stakeholder pensions.
d) unit trusts.
7) a) Gilt‑edged securities. Key features or key information documents must
only be provided in relation to packaged products, and gilt‑edged
securities are a direct investment rather than a packaged product.
8) How long is the cooling‑off period for pension policies?
a) 30 days from the date when the contract begins or from
the date on which the client receives contractual terms, if
this is later.
b) 14 days from the date when the contract begins or from
the date on which the client receives contractual terms if
this is later.
c) 14 days from the date when the cancellation notice is
issued.
d) 30 days from the date when the cancellation notice is issued.
8) a) 30 days from the date when the contract begins or from the date on
which the client receives contractual terms, if this is later.
9) An adviser would not be required to prepare a suitability report
in respect of a recommendation for a:
a) personal pension.
b) life insurance product.
c) mortgage.
d) unit trust.
9) c) Suitability reports are not required for mortgages, although many
lenders do issue them
10) Jane has cancelled an investment bond within the cancellation
period but received less back than she invested. Why is this?
a) A withdrawal charge has been applied to her plan.
b) She invested a lump sum into a unit‑linked plan.
c) A surrender charge has been applied to her plan.
d) She invested into a regular premium unit‑linked plan
10) b) She invested a lump sum into a unit‑linked plan. The value of the
investment fell between the date of her original investment and her
cancelling the bond.
21.1 How is the provision of mortgage advice regulated?
The FCA’s rules on mortgage advice are detailed in the Mortgages and Home
Finance: Conduct of Business (MCOB) sourcebook. The rules cover lending,
administration, advice and the arranging of loans. Banks, building societies,
specialist lenders and mortgage intermediaries must be authorised to carry
out these activities.
In terms of training and competence requirements, every seller must hold a
relevant mortgage qualification (such as CeMAP®). Mortgage advisers, arrangers
and lenders fall within the remit of the Financial Ombudsman Service and the
Financial Services Compensation Scheme.
When the FCA’s predecessor, the FSA, began regulating mortgage advice in 2004,
its rules covered loans taken out by individuals or trustees that were subject to
a first charge on the borrower’s property. This included not only mortgages but
also other loans where the security was a first charge on residential property.
As a consequence of the way the provisions of the EU Mortgage Credit Directive
were implemented in the UK, the scope of MCOB was extended in March 2016
to cover second charge loans.
A regulated mortgage, subject to MCOB is defined as a contract that satisfies
the following conditions:
the lender provides credit to an individual or trustees (the borrower);
the contract provides for the obligation of the borrower to repay to be
secured on land; and
at least 40 per cent of that land is used or intended to be used, as or in
connection with a dwelling.
As the UK left the European Union on 1 January 2021, the meaning of ‘land’
has now been modified as follows:
For regulated mortgage contracts entered into before the UK left the EU,
‘land’ refers to:
— land in the United Kingdom; or
— if the contract was entered into on or after 21 March 2016, land in the
UK or within the European Economic Area (EEA) at the time the contract
was entered into.
For regulated mortgage contracts entered into from 1 January 2021, ‘land’
refers to:
— land in the United Kingdom only.
This means that the regime covers home improvement loans, debt consolidation
loans and equity release schemes such as lifetime mortgages and home
reversion schemes.
The Mortgage Credit Directive (MCD) introduced a new category of consumer
buy to let (CBTL). Advising on, arranging, lending and administering CBTL
mortgages is subject to a legal framework detailed in the MCD Order 2015,
rather than the MCOB rules.
The FCA is responsible for regulating, supervising and, if necessary, taking
action against firms engaged in CBTL activity. Whilst the MCOB rules do not
apply in full, the government has prescribed rules in respect of the sale,
underwriting and administration of CBTL mortgages. The rules include
requirements in respect of:
pre‑contract disclosure;
assessing creditworthiness;
arrears management.
APPLICATION OF MCOB
MCOB applies to:
first‑charge loans secured on residential property;
second‑charge loans secured on residential property.
21.1.1 What is ‘consumer buy to let’?
To understand what is meant by ‘consumer buy to let’, it is helpful to compare
it to ‘business buy to let’, which is not regulated. Business BTL activity is
carried out by professional landlords who, typically, have one or more BTL
properties that they run as a business to generate profit. A consumer BTL
mortgage is defined as one where the mortgage has not been entered into
wholly or predominantly for the purpose of a business carried out by the
borrower.
The regulation of consumer BTL
mortgages is aimed at providing
protection for those who have
taken out a BTL mortgage more
as a result of circumstances than
from a particular desire to operate
a BTL business.
Such scenarios could include a
person who needs to relocate for their job but is unable to sell their property,
or someone who has inherited a property that they have opted to rent out
because it proves difficult to sell. In such circumstances it would be reasonable
to assume that the individual would not have the same experience or expertise
as a person who owns a portfolio of BTL properties; hence the additional
protections provided by the conduct standards applying to CBTL mortgages.
Lenders can use their own procedures to establish whether a borrower is a
business and therefore not subject to the conduct standards applying to CBTL
mortgages; they can also rely on the customer completing a declaration to
confirm they are a business borrower.
If a mortgage is taken out to support the purchase of a property that is to be
let out to a close relative then, unless the mortgage meets the criteria to be
classed as a business buy to let, the mortgage is regulated under the MCOB
rules, rather than the CBTL regime. MCOB defines a close relative as being a
spouse, civil partner, parent, brother, sister or grandparent of borrower.
21.2 What are the key elements of MCOB?
A summary of the provisions of MCOB is provided here.
MCOB 1: Application and purpose
Explains the scope of the rules, ie to whom they apply and for what types of
mortgage.
MCOB 2: Conduct of business standards: general
Includes:
the use of correct terminology (‘early repayment charge’ and ‘higher
lending charge’);
the requirement for communications with customers to be ‘clear, fair and
not misleading’;
rules about the payment of fees/commission and the accessibility of
records for inspection by the FCA.
MCOB 2A: Mortgage Credit Directive:
Includes rules on a range of matters that apply to a lender classed as a Mortgage
Credit Directive mortgage lender, including:
remuneration;
the tying of products (making a mortgage conditional on the purchase of
other products);
foreign currency loans; and
early repayments.
MCOB 3A: Financial promotions and communications with
customers
Distinguishes between ‘real‑time’ promotions (by personal visit or telephone
call) and ‘non‑real‑time’ (by letter, email, or adverts in newspapers and
magazines, or on television, radio or the internet).
Unsolicited real‑time promotions are not permitted.
Non‑real‑time promotions must include the name and contact details of the
firm. They must be clear, fair and not misleading. If comparisons are used,
they must be with products that meet the same needs. They must state that
“your home may be repossessed if you do not keep up repayments on your
mortgage”. Records of non‑real‑time promotions must be retained for one
year after their last use.
MCOB 3B: MCD general information
Specifies the requirements relating to information that must be provided to
customers, for lenders who make mortgage advances regulated under the
Mortgage Credit Directive.
MCOB 4 and 4A: Advising and selling standards
It must be clear whether advice is based on the products of the whole market,
a limited number of home finance providers, or a single lender.
Independent advisers are not required to be able to access all products
from all providers: they can source products from a panel of lenders as
long as the panel is representative of the market.
Any mortgage recommended must be suitable for the customer and
appropriate to their needs and circumstances; records to demonstrate this
must be kept for three years. However, there is no requirement to issue a
suitability report to the client.
Special requirements apply if the mortgage will be used to consolidate
existing debts.
On first making contact with a customer, certain information must be disclosed
prominently and clearly to the customer. An initial disclosure document
(IDD) can be given to detail the required information, but this is not a formal
requirement as long as the required information is clearly communicated. The
customer must be provided with the following information:
name and contact details;
whose mortgages are offered;
details of any limitations in service;
details of any fee payable for the mortgage advice;
the firm’s FCA registration details;
how to complain; and
details of the compensation scheme.
MCOB 5 and 5A: Pre‑application disclosure
Details the information that must be provided at the point at which a personal
recommendation is made and before an application is submitted to the lender.
This must include:
the annual percentage rate of charge (APRC), which shows th the amount by which the instalment would increase for each 1 per cent rise
in interest rates.
The required information must be provided via a European Standardised
Information Sheet (ESIS). The contents of the ESIS are set out in the rules, and
variations from the prescribed format are not permitted.
MCOB 6 and 6A: Disclosure at the offer stage
If a mortgage offer is made, the lender must provide a detailed offer document.
This is based on the information given at pre‑application stage, subject to any
changes between application and offer illustration. The offer is binding on the
lender but can be made conditional on the confirmation of certain details. The
offer must also:
state how long the offer will remain valid;
point out that there will be no right of withdrawal after the mortgage has
been completed; and
include or be accompanied by a tariff of charges.
The borrower must be granted a period of reflection of at least seven days to
consider whether to accept the offer or not.
MCOB 7 and 7A: Disclosure at start of contract and after sale
Before the first mortgage payment is made, the lender must confirm:
details of amounts, dates and methods of payment;
details of any related products such as insurance;
(for interest‑only mortgages) the responsibility of the borrower to ensure
that a repayment vehicle is in place; and
what the customer should do if they fall into arrears.
Annual statements must be issued, showing:
the amount owed and remaining term;
what type of mortgage it is;
for interest‑only mortgages, a reminder to check the performance of the
repayment vehicle;
interest, fees or other payments made since the last statement;
any changes to the charges tariff since the last statement.
If the mortgage is arranged on an interest‑only basis, then the lender must
contact the borrower at least once during the term to confirm that a credible
repayment vehicle remains in place interest rate
with any fees added;
the amount of the monthly instalment
If a change is to be made to the monthly payment, the customer must be
informed of the new amount, revised interest rate and date of the change.
MCOB 8 and 9: Equity release – advising and selling standards, and
product disclosure
Details the FCA’s requirements in respect of lifetime mortgages and home
reversion schemes. Special rules apply to equity release in relation to advising
and selling standards, and to product disclosure. The FCA Training and
Competence rules require that anyone giving advice on equity release must
hold a specialist qualification in this area of business.
MCOB 10: Annual percentage rate (APR)
Describes how to calculate APR (see section 22.1.1).
MCOB 10A: Annual percentage rate of charge
Describes how to calculate APRC (see section 22.1.1).
MCOB 11 and 11A: Responsible lending
Lenders must put in place a written responsible lending policy, and must be
able to show that they have taken into consideration a customer’s ability to
pay when offering a mortgage.
MCOB 12: Charges
Excessive charges are not permitted. Early repayment charges must be a
reasonable approximation of the costs incurred by the lender if the borrower
repays the full amount early. Similarly, arrears charges must be a reasonable
approximation of the cost of additional administration as the result of a
borrower being in arrears.
MCOB 13: Arrears and repossessions
Firms must deal fairly with customers who have mortgage arrears or mortgage
shortfall debt. This includes:
trying to reach an agreement on how to repay the arrears, taking into
account the borrower’s circumstances;
liaising with third‑party sources of advice;
not putting unreasonable pressure on customers in arrears;
repossessing a property only when all other reasonable measures have failed;
only applying arrears charges that are a reasonable reflection of the costs
of the work involved in dealing with the arrears.
Records must be kept of all dealings with borrowers in arrears.
Customers in arrears must be given the following information within 15
working days of the lender becoming aware of arrears:
the MoneyHelper information sheet ‘Problems paying your mortgage’;
the missed payments and the total of arrears including any charges incurred;
the outstanding debt;
any further charges that may be incurred unless arrears are cleared.
21.3 Providing mortgage advice to clients
The MCOB rules specify that one of two different levels of service can be
provided:
advice;
execution only.
There is no scope to offer an information‑only service, whereby the borrower
selects their own mortgage based on information provided.
The execution‑only service can only be provided in a limited range of situations
defined in the MCOB rules, ie for transactions involving business borrowers,
high‑net‑worth individuals and mortgage professionals. Evidence that the
individual falls into one of these categories must be retained. In the case of
joint applications where only one party is a mortgage professional, advice has
to be given to the non‑professional. Should a customer opt for execution only,
then the lender is required to make customers aware of the consequences of
proceeding on an execution‑only basis.
A mortgage adviser must take reasonable care to:
establish (from the prospective borrower) all information that is likely to
be relevant;
ensure that the advice they give is suitable given the customer’s
circumstances and needs.
Three steps to mortgage suitability
Assess whether
a mortgage is, in
itself, a suitable
product for the
client
➡️
Assess what type
of mortgage
is suitable, eg
repayment,
interest-only,
interest scheme,
additional features
➡️
Select best
mortgage and
mortgage
provider to meet
client’s needs and
circumstances
If it is established that a mortgage is suitable, then the next stage is to
recommend a suitable mortgage contract. The following questions must be
considered:
Which mortgage type is most suitable? Repayment, interest-only or a
combination of the two?
Which interest rate option is most suitable? Fixed, variable, capped, etc?
Over how long a term should the mortgage run?
What are the costs involved? Are they affordable?
There is no requirement under MCOB to issue a suitability report although
many lenders will do so.
21.3.1 Assessing affordability and verifying income
Mortgage lenders must verify income for every mortgage application, and
verification must be provided from a source independent of the borrower.
A lender must be able to demonstrate that the mortgage it is proposing is
affordable, taking into account specific categories of expenditure (committed
expenditure and basic essential expenditure). In assessing long‑term
affordability, lenders can take into account positive expected changes, if they
have evidence to support such changes.
In respect of interest‑only mortgages, the lender must be satisfied that there
is a clear and credible alternative source of capital repayment in place; if not,
affordability must be assessed on a repayment basis.
Lenders must take reasonable steps to ensure that the mortgage proposed is
affordable not just at the time the application is assessed but on an ongoing
basis. This is achieved by means of a stress test, which involves checking that
an applicant will be able to afford the payments if interest rates should rise.
21.4 What are the Insurance: Conduct of Business rules?
Firms and individuals working in the areas of general insurance, protection,
critical illness, long‑term care and income protection insurance have to be
authorised through the same processes of permission and approval as those
that apply to the rest of the industry.
Rules applicable to intermediaries who sell, administer or advise on general
insurance are contained in the Insurance: Conduct of Business Sourcebook
(ICOBS). The ICOBS rules are split into eight sections, which are summarised
here.
ICOBS 1: Application
Explains that the rules cover firms that deal with retail and commercial
customers for the sale of non‑investment insurance products. The activities
regulated by these rules include:
insurance distribution activities;
effecting and carrying out contracts of insurance;
managing the underwriting capacity of a Lloyds syndicate as a managing
agent at Lloyds;
communicating or approving a financial promotion.
ICOBS 2: General matters
Covers categorisation of clients:
policyholders (anyone who, upon the occurrence of the contingency insured
against, is entitled to make a claim);
customers (anyone who makes arrangements preparatory to concluding a
contract of insurance, ie a prospective policyholder).
Customers are further categorised as:
consumers (natural persons for purposes outside his or her profession);
commercial customers (anyone who is not a consumer).
ICOBS 2 also covers:
communications (which must be clear, fair and not misleading);
inducements (managing conflicts of interest fairly, and not soliciting
or accepting inducements that would conflict with a firm’s duties to its
customers);
record‑keeping; and
‘exclusion of liability’ (a firm must not seek to exclude or restrict liability
unless it is reasonable to do so).
ICOBS 3: Distance communications
Covers rules that ensure compliance with distance marketing disclosure rules,
which include the following:
A firm must provide a consumer with distance marketing information
before the conclusion of a distance consumer contract.
The identity of the firm and the purpose of the call must be made explicitly
clear at the beginning of any telephone communications.
Contractual obligations must be communicated to a consumer during the
pre‑contractual phase, and these obligations must comply with the law
presumed to apply to a distance contract.
Terms and conditions must be communicated to a consumer in writing
before the conclusion of a distance contract.
The consumer is entitled to receive a copy of the contractual terms and
conditions in hard copy on request.
ICOBS 3 also covers e‑commerce activities and states that a firm must make
the following information easily, directly and permanently accessible:
name and address;
details of the firm (including email address) that allow it to be contacted in
a direct and effective manner;
status disclosure statement, and confirmation that it is on the FCA Financial
Services Register, including its FCA register number.
Other rules include that any:
prices advertised must be clear and unambiguous, and the firm must
indicate whether the price includes relevant taxes; and
unsolicited commercial communication sent by email must be clearly
identifiable as such as soon as it is received.
ICOBS 4: Information about the firm, its services and remuneration
States that a firm must provide a customer with at least the following
information before the conclusion of an initial contract of insurance and, if
necessary, on its amendment or renewal:
its identity, address and whether it is an insurance intermediary or an
insurance undertaking;
whether it provides a personal recommendation about the insurance
products offered;
the procedures for making complaints to the firm and the FOS or, if the FOS
does not apply, information about the out‑of‑court complaint and redress
procedures available for the settlement of disputes.
An insurance intermediary must also provide the customer with the following
information:
the fact that it is included in the FCA Register and the means for verifying
this;
whether it has a direct or indirect holding representing 10 per cent or more
of the voting rights or capital in a given insurance undertaking (that is not
a pure reinsurer);
whether a given insurance undertaking (that is not a pure reinsurer) or its
parent undertaking has a direct or indirect holding representing 10 per
cent or more of the voting rights or capital in the firm; and
whether it is representing the customer or is acting for and on behalf of
the insurer.
Where an insurance intermediary proposes or advises on a contract of
insurance then before the conclusion of the initial contract, the intermediary
must provide information on whether the firm:
gives a personal recommendation on the basis of a fair and personal
analysis; or
is under a contractual obligation to conduct insurance distribution
exclusively with one or more insurance undertakings; or
neither of the above apply.
In which case it must provide its customer with the name of those insurance
undertakings with which the insurance intermediary may, and does, conduct
business.
Where a firm has given the above information, before the conclusion of an
initial contract of insurance with a consumer, a firm must also state whether
it is giving:
a personal recommendation, but not on the basis of a fair and personal
analysis;
other advice on the basis of a fair analysis of the market;
other advice not on the basis of a fair analysis of the market; or
just information.
A firm must provide details to a customer of any remuneration, including fees,
commission and economic benefits of any kind given in connection with the
contract in good time before the conclusion of the initial contract of insurance,
amendment or renewal. The firm must inform its customer of the amount of
any fee, where payable.
An insurance intermediary must, on a commercial customer’s request,
promptly disclose the commission that it or any associate may receive in
connection with a policy.
ICOBS 5: Identifying client needs and advising
States that:
a firm should take reasonable steps to ensure that a customer only buys a
policy from which they are eligible to claim benefits;
if a firm finds that parts of the cover do not apply, they should inform the
customer so that they can make an informed choice;
a firm should explain the duty not to misrepresent information, what
this includes, and the consequences of deliberate, reckless or careless
misrepresentation;
prior to the conclusion of a contract a firm must specify, on the basis of
information obtained from the customer, their needs;
a statement of demands and needs must be communicated in writing to the
customer in a clear and accurate manner, comprehensible to the customer;
the firm must take reasonable steps to ensure the suitability of its advice
to any customer who is entitled to rely upon its judgement, taking account
of level of cover and cost, relevant exclusions, excesses, limitations and
conditions – it must inform the customer of any demands and needs not
met.
ICOBS 6: Product information and 6A: Product specific rules
An insurer is responsible for producing, and an insurance intermediary for
providing to a customer, the product information required by ICOBS 6.
ICOBS 6 states that a firm must take reasonable steps to ensure a customer
is given appropriate information about a policy so that they can make an
informed choice about the arrangements proposed.
The information given will vary according to matters such as:
knowledge, experience and ability of a typical customer for the policy;
policy terms, benefits, exclusions, limitations, conditions and duration;
the policy’s complexity;
whether the policy is purchased in connection with other products and
services;
distance communication information requirements; and
whether the same information has been provided to the customer previously.
When dealing with a consumer, a firm must provide an Insurance Product
Information Document (IPID) in a durable medium. The IPID is drawn up by the
manufacturer of the policy.
A firm should provide evidence of cover promptly after the inception of a
policy.
Information disclosed ‘pre‑contract’ includes the arrangements for handling
complaints and the right to cancel.
Before a pure protection contract is concluded, a firm must provide the
customer with information, including:
the name of the insurance undertaking and its legal form;
address of its head office;
the definition of each benefit and option;
contract term;
the means of terminating the contract;
means of payment and duration of premiums;
tax arrangement for benefits under the policy;
cancellation information;
arrangements for handling complaints.
6A: Product-specific rules
Applies to firms that sell guaranteed asset protection (GAP) contracts to
customers in connection with the sale of a vehicle.
A GAP contract is insurance covering a policyholder in the event of total loss
to a vehicle, and it is the difference between:
the amount claimed under the policyholder’s vehicle policy in respect of
the loss; and
an amount calculated in accordance with the GAP contract.
ICOBS 7: Cancellation
States that a consumer has the right to cancel without penalty, and without
giving a reason, within:
30 days for a contract of insurance which is, or has elements of, pure
protection (eg critical illness) or payment protection;
14 days for any other contract of insurance or distance contract (such as
home insurance).
Firms are free to offer more generous cancellation terms than this, provided
they are favourable to the consumer.
The right to cancel does not apply to the following:
travel policies of less than one month;
policies the performance of which has been fully completed;
pure protection policies of six months or less, which are not distance
contracts;
pure protection policies effected by trustees of an occupational pension
scheme, or employers (or partners) for the benefit of employees (or
partners);
general insurance (which is not a distance contract or payment protection
contract) sold by an intermediary who is an unauthorised person; and
a connected contract which is not a distance contract.
On receipt of the cancellation notice, the insurance company must return all
premiums paid within 30 days, and the contract is terminated.
ICOBS 8: Claims handling
If claims are handled by an intermediary, the insurance company must ensure
that the rules are complied with, ensuring no conflict of interest. Claims must
be handled promptly and fairly, and the firm must provide reasonable guidance
to help the policyholder make a claim. The firm must not unreasonably reject
a claim.
Rejection of a claim is considered unreasonable if it is for:
non‑disclosure of a material fact which the policyholder could not
reasonably have expected to have disclosed;
non‑negligent misrepresentation of a material fact;
breach of a condition of the contract unless the circumstances of the claim
are connected to the breach.
21.5 What are the Banking: Conduct of Business rules?
The Banking: Conduct of Business Sourcebook (BCOBS) applies to firms
accepting deposits from UK banking customers in the UK, for example by
providing savings and current accounts.
BCOBS complements the Payment Services Regulations, which prescribe the
way that payments are to be undertaken within the European Economic Area
(EEA). The BCOBS rules are designed in such a way as not to overlap with the
provisions of the Payment Services Regulations. Those areas of the Payment
Services Regulations not covered by BCOBS are addressed by the Standards of
Lending Practice (see section 21.7), overseen by the Lending Code Standards
Board.
BCOBS has eight chapters, which are summarised here.
BCOBS 1: Application
BCOBS applies to firms that accept deposits from banking customers, if such
activities are carried on from an establishment maintained by the firm in the
UK, and activities connected with accepting such deposits.
BCOBS 2: Communications with banking customers and financial
promotions
Requires a firm to pay regard to the information needs of banking customers
when communicating with, or making a financial promotion to them, and to
communicate information in a way that is clear, fair and not misleading.
BCOBS 2A: Restriction on marketing or providing an optional
product for which a fee is payable
Details the rules applying to marketing or providing an optional product
(linked to a current account or savings account) for which a fee is payable.
BCOBS 3: Distance communications and e‑commerce
Applies to a firm that carries on any distance marketing activity from an
establishment in the UK, with or for a consumer in the UK.
BCOBS 4: Information to be communicated to banking customers
and statements of account
Details how a firm must provide or make available to banking customers
appropriate information about a retail banking service and any deposit made
in relation to that retail banking service.
BCOBS 5: Post‑sale requirements
A firm must provide a service in relation to a retail banking service that is
prompt, efficient and fair to a banking customer and which has regard to any
communications or financial promotion made by the firm to the banking customer
from time to time. This includes dealing with customers in financial difficulty,
those that wish to move bank accounts, and lost and dormant accounts.
BCOBS 6: Cancellation
Sets out a customer’s rights to cancel in various circumstances, and when
there are no rights to cancellation.
BCOBS 7: Information about current account services
Requires a firm to publish information about its provision of personal current
accounts and business accounts.
BCOBS 8: Tools for personal current account customers
Requires a firm to make available a cost calculator tool and an overdraft
eligibility tool either online or via an app and to provide alerts to personal
current account customers about their personal current account usage.
21.5 What are the Banking: Conduct of Business rules?
The Banking: Conduct of Business Sourcebook (BCOBS) applies to firms
accepting deposits from UK banking customers in the UK, for example by
providing savings and current accounts.
BCOBS complements the Payment Services Regulations, which prescribe the
way that payments are to be undertaken within the European Economic Area
(EEA). The BCOBS rules are designed in such a way as not to overlap with the
provisions of the Payment Services Regulations. Those areas of the Payment
Services Regulations not covered by BCOBS are addressed by the Standards of
Lending Practice (see section 21.7), overseen by the Lending Code Standards
Board.
BCOBS has eight chapters, which are summarised here.
BCOBS 1: Application
BCOBS applies to firms that accept deposits from banking customers, if such
activities are carried on from an establishment maintained by the firm in the
UK, and activities connected with accepting such deposits.
BCOBS 2: Communications with banking customers and financial
promotions
Requires a firm to pay regard to the information needs of banking customers
when communicating with, or making a financial promotion to them, and to
communicate information in a way that is clear, fair and not misleading.
BCOBS 2A: Restriction on marketing or providing an optional
product for which a fee is payable
Details the rules applying to marketing or providing an optional product
(linked to a current account or savings account) for which a fee is payable.
BCOBS 3: Distance communications and e‑commerce
Applies to a firm that carries on any distance marketing activity from an
establishment in the UK, with or for a consumer in the UK.
BCOBS 4: Information to be communicated to banking customers
and statements of account
Details how a firm must provide or make available to banking customers
appropriate information about a retail banking service and any deposit made
in relation to that retail banking service.
BCOBS 5: Post‑sale requirements
A firm must provide a service in relation to a retail banking service that is
prompt, efficient and fair to a banking customer and which has regard to any
communications or financial promotion made by the firm to the banking customer
from time to time. This includes dealing with customers in financial difficulty,
those that wish to move bank accounts, and lost and dormant accounts.
BCOBS 6: Cancellation
Sets out a customer’s rights to cancel in various circumstances, and when
there are no rights to cancellation.
BCOBS 7: Information about current account services
Requires a firm to publish information about its provision of personal current
accounts and business accounts.
BCOBS 8: Tools for personal current account customers
Requires a firm to make available a cost calculator tool and an overdraft
eligibility tool either online or via an app and to provide alerts to personal
current account customers about their personal current account usage.
21.6 What are the Payment Services Regulations?
The Payment Services Regulations (PSRs) cover most payment services,
including the provision and operation of ‘payment accounts’. Payment accounts
are accounts on which payment transactions may be made and where access
to funds is not restricted (a fixed‑term deposit is an example of a restricted
account). The regulations extend from the information that is to be provided
before a payment is made to the remedial action a firm must take if a payment
goes wrong.
PSRs apply to banks, building societies, e money issuers, non bank merchants, money remitters, non bank credit card issuers.
The PSRs introduced a new class of regulated firms known as payment
institutions (PIs). These are businesses authorised to process payments by
card, credit transfer or direct debit, to issue or acquire payment instruments
and to remit money. If not exempt, a PI must either be authorised or registered
by the regulator. Authorised PIs are subject to prudential requirements.
Conduct of business requirements apply to all payment service providers,
including banks, building societies, e‑money issuers and PIs.
21.6 What are the Payment Services Regulations?
The Payment Services Regulations (PSRs) cover most payment services,
including the provision and operation of ‘payment accounts’. Payment accounts
are accounts on which payment transactions may be made and where access
to funds is not restricted (a fixed‑term deposit is an example of a restricted
account). The regulations extend from the information that is to be provided
before a payment is made to the remedial action a firm must take if a payment
goes wrong.
PSRs apply to banks, building societies, e money issuers, non bank merchants, money remitters, non bank credit card issuers.
The PSRs introduced a new class of regulated firms known as payment
institutions (PIs). These are businesses authorised to process payments by
card, credit transfer or direct debit, to issue or acquire payment instruments
and to remit money. If not exempt, a PI must either be authorised or registered
by the regulator. Authorised PIs are subject to prudential requirements.
Conduct of business requirements apply to all payment service providers,
including banks, building societies, e‑money issuers and PIs.
21.6.1 Payment Services Directive (PSD2)
PSD2 came into effect on 13 January 2018 and is a significant evolution of
existing regulation for the payments industry. It aims to increase competition
in the payments industry, brings into scope new types of payment services,
enhance customer protection and security, and extend the reach of the Directive.
Even though the UK left the EU, PSD2 continues to apply to financial service
providers in the UK.
The key changes introduced by PSD2 can be grouped into four main themes:
market efficiency and integration; consumer protection; competition and
choice; and security.
PSD2 increases consumers’ rights in a number of ways. For example:
Payments sent or received where one of the payment service providers (PSPs)
is located outside the EEA are covered, as are payments in non‑EEA currencies.
The amount a payer can be obliged to pay in an unauthorised payment
scenario has reduced from €150 to €50, except in cases of fraud or gross
negligence by the payer.
PSD2 bans surcharging for the use of payment instruments covered by
the Interchange Fee Regulation and payment services covered by the SEPA
Regulation.
PSPs must put in place dispute resolution procedures and are required to respond
to payment complaints within 15 business days of receipt. In exceptional
circumstances, a holding reply can be provided, explaining the reasons for the
delay, with the final response being received within 35 business days.
To facilitate competition, banks must give third‑party providers access to
their account in order to carry out the transactions. There are two key types of organisation involved in providing the services, often referred to collectively
as third‑party providers or TPPs:
An account information service provider (AISP) is defined in PSD2 Article
(16) as an “online service to provide consolidated information on one or
more payment accounts held by the payment service user”.
Payment Initiation Service Providers (PISPs) are service providers that carry
out transactions for the account holder, which could include person to
person (P2P) transfers – an online technology that allows customers to
transfer funds from their bank account or credit card to another person’s
account via a mobile device using the internet – and general bill payments.
In addition, PSD2 introduces another new definition: “account servicing
payment service provider” (AS PSP) to distinguish the provider where the
customer’s payment account is held. The PSD2 text makes it clear that
customers have a right to use PIS and AIS where the payment account is
accessible online and where they have given their explicit consent.
There are further technical standards relating to strong customer authentication,
and common and secure communication.
21.6.2 Payment Systems Regulator
The Payment Systems Regulator (PSR) is a subsidiary of the Financial Conduct
Authority (FCA). It oversees all domestic payment systems that are brought
into the regulator’s scope by HM Treasury. The PSR has authority:
over requirements regarding system rules; and
to give directions to participants in designated payment systems.
It has further specific powers to:
require access to designated payment systems for a payment services provider;
vary agreements relating to designated payment systems (including fees
and charges); and
require owners of payment systems to dispose of their interests in them,
subject to the satisfaction of certain preconditions and subject to HM
Treasury approval.
21.7 The Standards of Lending Practice
Lending is not covered by BCOBS
. Although the FCA’s CONC sourcebook
applies, there is also a degree of self‑regulation by the industry in this area.
The Lending Standards Board (LSB) publishes standards to which firms that
are registered with the LSB must adhere.
The Standards of Lending Practice for personal customers set out a number of
principles, covering six main areas:
financial promotions and communications;
product sale;
account management and servicing;
money management;
financial difficulty;
customer vulnerability.
The key requirements are shown in Figure 21.4.
A separate set of Standards apply to business customers.
The Standards of Lending Practice also have a section on governance and
oversight, which sets out the framework that registered firms should have in
place to ensure effective implementation of the standards.
FIGURE 21.3 PRODUCTS COVERED BY THE STANDARDS OF LENDING
PRACTICE
Unsecure loans, credit card and charge cards and current account overdrafts.
Registered firms must at all times comply with the Consumer Credit Act 1974,
the Consumer Credit (EU Directive) Regulations 2010, the FCA’s Consumer
Credit Sourcebook (CONC), the Equality Act 2010 and other relevant legislation.
Compliance is monitored and enforced by the Lending Standards Board.
FIGURE 21.4 KEY REQUIREMENTS OFTHE STANDARDS OF LENDING
PRACTICE
Financial promotions and communications
Must be clear, fair and not misleading.
Product sales
Customers will only be provided with a product that is affordable and meets their needs.
Account maintenance and servicing
Customer requests will be dealt with in a timely, secure and accurate manner. Information provided will
be clear and detail any action required by the customer.
Money management
Customers will be helped to manage their finances through proactive and reactive measures designed
to identify signs of financial stress and help avoid financial difficulties.
Financial difficulty
Customers in financial difficulty will receive appropriate support and fair treatment.
Customer vulnerability
Firms are expected to provide inclusive products and services that take account of the broad range
of customers and are flexible enough to meet the needs of customers who are classed as vulnerable.
Firms are expected to have a formal strategy for dealing with vulnerable customers.
Governance and oversight
Firms are expected to put in place policies and procedures that ensure customers receive a fair
outcome when taking out a consumer credit product and throughout all their dealings with the firm.
21.8 What are the other categories of advice?
We looked earlier in this topic and in the previous topic at the principles and
regulations governing the provision of advice on regulated products such as mortgages and insurance contracts. There are a number of other categories of
advice that apply in certain limited circumstances:
basic advice;
generic advice;
focused advice;
simplified advice;
robo advice.
Following the Financial Advice Market Review (FAMR) in 2016, which
was launched by HM Treasury and the FCA to explore ways in which the
government, the industry and regulators could stimulate the development of
a market delivering affordable and accessible financial advice and guidance to
consumers, the FCA published guidance to help firms to provide ‘streamlined
advice’.
Streamlined advice is defined as “a personal recommendation which is limited
to one or more of a client’s specific needs and does not involve analysis
of the client’s circumstances that are not directly relevant to those needs”
(FCA, 2016). The FCA has produced guidance on streamlined advice services,
which it notes might include robo advice services (see section 21.8.3) or more
traditional face-to-face or telephone-based models.
WHEN IS BASIC ADVICE APPROPRIATE?
Basic advice is appropriate for clients who:
have their priority needs met (ie they do not need to reduce
existing debt, have adequate access to liquid cash, and have
their core protection needs met);
have some disposable income or capital that they wish to
invest;
do not want a holistic assessment of their financial situation,
just advice on a specific investment need.
STAKEHOLDER PRODUCTS in terms of basic advice, pensions and trust funds
We looked at stakeholder pensions and the reasons for
their introduction in Topic 10. When first introduced in
2001, stakeholder pensions were a popular option, and this
encouraged the government to extend the range of savings and
investments products. As with the stakeholder pension, the
idea was that customers who might be deterred from making
appropriate savings provision through a lack of confidence,
lack of understanding or concerns about risk and cost would be
attracted by a simple, low‑risk product with transparent charges.
A suite of products was introduced, covering short‑ and
medium‑term investment needs, along with the stakeholder
pension and a Child Trust Fund. Charges were capped: the
maximum permitted annual charge for the investment products
is now 1.5 per cent for the first ten years of the life of a product
and 1 per cent thereafter. For stakeholder pensions arranged
prior to 6 April 2005, charges are capped at 1 per cent throughout.
As stakeholder products were designed to be simple, the
expectation was that they would be straightforward to sell and
regulation could therefore be less complex. The ‘basic advice’
process was less costly for providers to deliver and it was hoped
that that would encourage take‑up
21.8.2 Generic, focused and simplified advice
Generic:
• Advice or information that does not relate to a particular product or investment and does
not meet the characteristics of regulated advice
• For example,‘for most people it is sensible to have adequate financial protection in place’
Focused:
• Where, at the request of the customer, advice and recommendations relate to specific
needs or investments
• Also referred to as limited advice
Simplified
• Advice that is limited, by the firm providing it, to one or more of a customer’s needs
• Does not involve analysis of the customer’s circumstances that are not directly relevant to
those needs
• This type of advice may be provided face to face, over the phone or online
21.8.3 Robo advice
Robo‑advisers are a class of financial adviser that provide financial advice or
portfolio management online with minimal human intervention. They provide
digital financial advice based on mathematical rules or algorithms. This
innovation is intended to provide a low‑cost alternative to face‑to‑face advice
and go some way to address the advice gap left by the cost of the traditional
advice model. The Treasury and FCA have been monitoring the development
of this approach and in April 2017 published guidelines, making it clear that
any funds offered to investors by robo‑advisers offering ‘streamlined advice’
are to be suitable for customers’ risk tolerance and investment objectives.
The guidelines advise companies on the information they need to collect
about investors, and warn on the importance of forming “clearly worded” risk
questionnaires that do not assume “a high level of financial capability”. The FCA
has suggested that robo‑advice companies could use consumer testing and web
analytics to monitor how long customers spend on each page of their websites.
1) A mortgage arranged for which of the following mortgagors
would not be a regulated mortgage?
a) Terry and Angel, who are joint borrowers buying their first
home.
b) Laszlo and Yuri, who are creating a mortgage in their
capacity as trustees.
c) John, who is a sole borrower, trading up to a bigger
property.
d) Décor Plus, which is a public limited company.
1) d) The mortgage arranged for Décor Plus would not be a regulated
mortgage.
2) Which of the following methods of obtaining new business is
not permitted for a regulated mortgage?
a) Cold calling.
b) Mortgage introducers.
c) Radio advertising.
d) TV advertising.
2) a) Cold calling, because it is an unsolicited real‑time promotion.
3) Maurice wants to use the equity in his property by arranging a
lifetime mortgage. He wants exactly the same product that his
brother has and does not want to waste time considering other
options. Why would it not normally be possible for Maurice
to proceed on an execution‑only basis, even though he knows
exactly what he wants?
3) Execution‑only transactions are permitted only for business borrowers,
high‑net‑worth individuals and mortgage professionals. Even if Maurice
were a high‑net‑worth client, it would not be possible to carry out the
transaction on an execution‑only basis because it is not possible to opt out
of advice for an equity release scheme such as a lifetime mortgage.
4) Which of the following statements is untrue in relation to
the offer document that is produced following a mortgage
application?
a) It must contain details of the monthly payments.
b) It must state how long the offer is valid for.
c) It must explain how the customer can withdraw from the
contract once the mortgage is completed.
d) It must be accompanied by an up‑to‑date tariff of charges.
4) c) This statement is untrue because it is not possible for a customer to
withdraw from the contract once the mortgage is completed.
5) When assessing affordability for a mortgage application, which
of the following is regarded as committed expenditure?
a) Repayments on a personal loan.
b) Council tax.
c) Water bills.
d) Costs of travel to work.
5) a) Repayments on a personal loan. The others are examples of basic
essential expenditure.
6) To ensure that there is no danger of misrepresenting the
policy benefits, an adviser must always allow the customer
to make their purchasing decision on the basis of information
published by the product provider. True or false?
6) False. ICOBS 6 requires firms to ensure customers are given appropriate
information about a policy; what is appropriate may vary depending on
the customer’s knowledge, experience and ability, and the complexity of
the product.
7) Eva has just taken out an income protection policy. If she
changes her mind and decides she no longer wants this policy,
what cancellation rights does she have?
7) Eva may cancel her policy within 30 days as it is a protection policy.
8) The Standards of Lending Practice are an example of
self‑regulation. True or false?
True
9) A customer who wishes to buy a stakeholder pension product
may receive:
a) focused advice.
b) generic advice.
c) information only.
d) basic advice.
9) d) Basic advice may be provided for stakeholder products.
10) What is the key difference between focused advice and
simplified advice?
10) Focused advice is provided when the customer has set parameters for the
areas they wish to discuss. Simplified advice is provided when the adviser
sets out specific areas of a customer’s needs for which they are providing
advice.
22.1 What are the Consumer Credit Acts?
The Consumer Credit Act 2006 covers the regulation of certain loans to
individuals, small partnerships and unincorporated bodies (but not companies)
– referred to as ‘consumer credit’. The Act sets out standards by which lenders
must conduct their business. It builds on the Consumer Credit Act 1974, with
the objective of increasing protection and meeting the needs of the modern
marketplace, while retaining many of the basic provisions of the 1974 Act.
Regulatory powers for consumer credit activities and firms involved in
consumer credit were transferred to the FCA in April 2014. The regulations for
firms are contained in the CONC sourcebook, which incorporates and builds
on the Consumer Credit Acts.
CONC contains FCA rules regarding the marketing, selling, disclosure,
customer information, debt handling and administration of consumer credit,
together with basic principles relating to firms’ conduct and the fair treatment
of customers.
Regulated mortgages, including all loans secured on an individual’s main
residence, are specifically exempt from the provisions of the Consumer Credit
Act and are regulated under the Mortgages and Home Finance: Conduct of
Business rules (MCOB).
22.1.1what are the Main provisions of the credit consumer act?
The main provisions of the Consumer Credit Act 2006 and those retained from
the 1974 Act are as follows:
There is generally no limit to the amount of a loan covered by the Act.
Loans over £25,000 to a small business for business purposes are exempt
from the regulations.
High‑net‑worth borrowers can opt to be exempt from the Act, but it must
be at their request rather than the lender’s requirement.
Borrowers protected by the Act include an ‘ordinary’ borrower or a
partnership with three or fewer members. Although sole traders and
unincorporated associations are covered under the Act, other businesses
are outside the legislation.
Complaints relating to credit arrangements regulated through the Act can
be taken to the Financial Ombudsman Service (FOS).
There are provisions to increase the fair treatment of borrowers.
Borrowers must be given a copy of the credit agreement in writing.
Borrowers are given a cooling‑off period of 14 days from the latter of the
contract starting or receipt of a copy of the agreement to change their
mind. If the borrower exercises this option, they must repay any money
received and any interest accrued to that point. The contract for goods
linked to the borrowing is not cancelled, so the borrower must find another
way to pay for them.
The lender must send the cooling‑off notice with a copy of the credit
agreement.
Certain agreements do not benefit from the right to cancel using the
cooling‑off period. Examples include bank overdrafts, small loans of £50 or
less (unless they are hire purchase or conditional sale agreements), small
loans of £35 or less completed away from the lender’s premises and loans
to pay death duties.
The annual percentage rate (APR) for the loan must be calculated using a
set formula, which includes all relevant costs of setting up the loan. The
APR must be shown in any advertisements or agreements.
What is THE IMPORTANCE OF APR?
Exam question
One of the 1974 Act’s most significant innovations was a system
for comparing the price of lending. This is the APR, which
must be quoted for all regulated loans. The APR represents a
measure of the total cost of borrowing and its aim is to allow a
fair comparison, between different lenders, of the overall cost
of borrowing.
The calculation of the APR is specified under the terms of the
Consumer Credit Act 1974 and it takes account of two main
factors:
the interest rate – whether it is charged on a daily, monthly
or annual basis; and
the additional costs and fees charged when arranging the
loan, such as an application fee.
The result is that the APR is higher than the interest rate being
charged on the loan
What is ANNUAL PERCENTAGE RATE OF CHARGE (APRC)?
Under the provisions of the EU Mortgage Credit Directive, a
new annual percentage rate of charge (APRC) was introduced
from 21 March 2016. The APRC is similar to the APR and applies
to first‑ and second‑charge mortgage lending. APR applies to
personal loans, credit cards and hire purchase agreements.
22.1.2 what is The Consumer Credit Directive?
The Consumer Credit Directive (CCD) was implemented by six sets of
regulations (some of which have since been repealed as part of the changes in
the regulation of consumer credit). The implementing regulations apply to all
consumer credit agreements regulated under the Consumer Credit Acts (CCAs),
other than agreements secured on land, although there are modifications for
certain types of agreement.
The key changes brought about by the EU Credit Directive are as follows:
A representative example must be included as part of any advertisement
that shows an interest rate or a figure relating to the cost of credit. This
example must include a ‘representative’ APR.
Creditors must assess a borrower’s creditworthiness before granting credit
or significantly increasing the amount of credit.
‘Adequate explanations’ must be provided in respect of a proposed credit
agreement, to enable the borrower to assess whether the agreement meets
their needs.
Certain information must be provided to a borrower before they enter
into a credit agreement, and there are standards for the way in which
that information must be provided. Pre‑contractual information must be
given in good time before the borrower enters into the agreement, and the
information must be clear and easily legible.
The borrower has the right to withdraw from a credit agreement within
a period of 14 days (the cooling-off period) from the conclusion of the
agreement, or from the point the borrower receives the agreement, if this
is later.
The borrower must be notified, in writing, of changes to the interest rate
under the agreement, before the change takes effect.
The borrower is able to seek redress from the creditor in certain
circumstances if they are unable to obtain satisfaction from the supplier
of the goods or services. This applies in cases where the CCAs would not normally provide for such redress, and where the value of goods or services
is more than £30,000 and the credit does not exceed £60,260.
The borrower can terminate an open‑ended agreement at any time, subject
to giving one month’s notice. The creditor must give two months’ notice of
termination of credit and must give justified reasons for termination.
The borrower must be informed if the debt is to be sold to a third party.
Credit intermediaries must disclose the extent to which they are acting
independently or work exclusively with one or more creditors. Any fee
payable to the intermediary must be disclosed up front.
Where an application for credit is declined based on information supplied
by a credit reference agency, the creditor must notify the borrower and
provide contact details of the credit reference agency.
22.2 what is FCA consumer credit regulation and authorisation?
The FCA has applied certain aspects of its regulatory approach to consumer
credit. While the general scope of CCA provisions remains unchanged, some
aspects of the FCA’s approach are more rigorous.
Consumer credit firms must be authorised by the FCA.
The FCA maintains a register of firms that have been granted a consumer
credit licence.
FCA conduct rules apply, such as the high‑level Principles for Businesses –
for example, financial promotions must be clear, fair and not misleading.
The FCA expects firms that offer consumer credit to demonstrate how they
ensure the fair treatment of their customers.
The FCA has greater supervisory powers than the OFT had. The FCA uses its
senior managers and certification regime for individuals performing roles
that require FCA approval or certification.
The FCA also has much greater powers than the OFT had with regard to
investigation, enforcement and redress. It has dedicated supervision and
enforcement teams to tackle poor practice in the industry.
Please explain HIGH‑COST, SHORT‑TERM CREDIT
(Exam question)
One area on which the FCA has focused is the high‑cost,
short‑term lending market, such as ‘payday’ lenders. Such
lenders provide loans on what is intended to be a very short‑term
basis: for example to cover a shortfall in funds between one
payday and the next. Prior to the FCA’s intervention, interest
rates on these types of loan were very high; borrowers who
were unable to repay the loan in full at the original due date
and had to ‘roll over’ the loan for an extended period found
themselves having to repay far more than they had originally
borrowed.
Following a review of this sector of the market, the FCA
introduced a cap on high‑cost, short‑term credit. Interest
and fees charged must not exceed 0.8 per cent per day of
the amount borrowed, default fees cannot exceed £15, and
borrowers must never be required to repay more than 100 per
cent of the amount borrowed by way of fees and charges.
22.2.1 what is the FCA authorisation full and limited permissions ? And examples of full
The FCA’s authorisation structure for consumer credit activities comprises full
and limited permission tiers.
Activity requiring full permission: credit broking, P2P lending, debt collecting, credit information services
The limited permission tier covers ‘lower‑risk’ activities. It is aimed at
businesses outside financial services that are caught by the consumer credit
legislation and regulations. Firms carrying out lower‑risk activities cannot
apply for full FCA authorisation and are required to supply less information to
the FCA in comparison with firms that require full authorisation.
22.2.2 Consumer Credit sourcebook (CONC)
The FCA has not made substantial changes to the provisions of the CCAs, which
continue to provide the main framework for UK consumer credit regulation.
The relevant details are contained within the Consumer Credit sourcebook
(CONC), which was introduced in April 2014. A summary of the provisions of
CONC is provided here.
CONC 1: Application and purpose and guidance on financial
difficulties
Explains the purpose of CONC as a specialist sourcebook for credit‑related
regulated activities, and reminds firms that the Principles for Businesses
apply. There is also guidance on the FCA’s indicators that a customer is in
financial difficulty.
CONC 2: Conduct of business standards – general
In respect of their credit‑related activities, all providers are expected to
treat customers fairly and not mislead them. Examples of activities that may
contravene these rules are:
targeting customers with offers of credit that are unsuitable for them;
high‑pressure selling, aggressive or oppressive behaviour or coercion;
not allowing sufficient and reasonable time to make repayments;
taking steps to repossess a customer’s home other than as a last resort.
CONC 3: Financial promotions and communications with
customers
Much of the earlier legislation relating to the provision of quotations and
advertisements was repealed and included in this section of CONC.
This section details what is considered to be a ‘communication’ with a
customer in relation to a credit agreement, and advises that communications
should be fair and not misleading. Providers must ensure they use plain and
understandable language, specify who is making the offer of credit and only
make credit available based upon the consumer’s financial circumstances.
CONC also introduces new rules relating to risk warnings for high‑cost,
short‑term credit, such as that offered by payday lenders. Any such lending
must carry the message: “Warning: Late repayment can cause you serious
money problems. For help, go to moneyhelper.org” (FCA, 2021).
CONC 4: Pre‑contractual requirements
Deals with the content of quotations for credit and the relevant ‘health warnings’
that must be included. This is particularly significant when the customer’s
home is to be used as security. In such circumstances the lender must include
the statement: “Your home is at risk if you do not keep up repayments on a
mortgage or other loan secured on it” (FCA, 2014).
CONC 4 also details the information a lender must provide about interest
rates, charges and costs should the borrower be unable to pay.
CONC 5: Responsible lending
Details what a provider must do before making credit available in order to
ensure that the customer can afford to maintain payments in respect of
their borrowing. Creditworthiness must be confirmed based on information
obtained from the prospective borrower and from a credit reference agency.
The rationale behind this explicit requirement is that there was concern
that some lenders of short‑term funds (such as payday lenders) were not
undertaking adequate checks.
CONC 5A: Cost cap for high‑cost, short‑term credit
Details the maximum charges that can be applied for high‑cost, short‑term
credit (such as that provided by payday lenders). Broadly speaking, the
payment of any charge, when combined with other charges applied under the
terms of the agreement, cannot exceed an amount more than that borrowed.
CONC 5B: Cost cap for high‑cost, short‑term credit
This imposes a total credit cap of 100 per cent on rent-to-own agreements,
meaning firms cannot charge more than the cost of the product. Firms must
also benchmark their base prices (including delivery and installation) against
the prices charged by three mainstream retailers on the high street.
CONC 5C: Overdraft pricing
This requires firms to implement and maintain overdraft charging structures
that are simple, transparent and capable of easy comparison. It forbids firms
from obliging a customer to pay a rate of interest for an unarranged overdraft
that exceeds the rate of interest for an arranged overdraft.
CONC 5D: Overdraft repeat use
Firms must monitor customers’ patterns of overdraft use, identify patterns of
repeat use and take appropriate steps with the aim of changing such patterns
of use.
CONC 6: Post‑contractual requirements
Covers the checks a lender must undertake if they significantly increase the
lending to a customer under a regulated agreement, eg increasing an overdraft
or the credit limit on a credit card. Creditworthiness must be assessed if there
is a significant increase in lending.
This section also details the action a lender must take if a customer exceeds
their overdraft limit, which is to contact the customer in writing without delay.
CONC 7: Arrears, default and recovery (including repossessions)
CONC 7 states that providers must have appropriate policies and procedures
for dealing with customers whose accounts fall into arrears, and must treat
such customers fairly and reasonably. This includes being aware of customers
who are considered vulnerable, for example, customers with mental health
difficulties.
Another aspect of this regulation is that it covers debt collection and debt
administration activities, and the organisations that undertake such work.
This area of consumer credit was previously unregulated.
CONC 8: Debt advice
Debt advice can be undertaken by third‑party debt counsellors and other
organisations that provide information. Failure to pay proper regard to the
different debt‑solution options available to consumers, or to the differences
in enforcement actions and procedures available, is likely to contravene the
Principles for Businesses. Examples include recommending a debt solution that
is unaffordable to the consumer, or discouraging a consumer from seeking an
alternative source of debt counselling.
CONC 9 used to set out requirements for credit rating agencies but has now
been deleted.
CONC 10: Prudential rules for debt management firms
Details the rules for debt management firms (those that manage repayments to
creditors on the behalf of an individual) and small, not‑for‑profit debt advice
bodies to ensure that the relevant financial and management resources are in
place.
CONC 11: Cancellation
Covers the cancellation rights of peer‑to‑peer lenders and those providers that
make services available over the internet.
CONC 12–15 and Appendix 1
Deal with some of the less common areas of consumer credit. Appendix 1
contains the rules relating to the total charge for credit, what it applies to and
how it is calculated.
1) Which of the following is exempt from the Consumer Credit
Acts?
a) A credit card account with a limit of £5,000.
b) A further advance for house repairs of £15,000.
c) A loan for £20,000 secured on property for car purchase.
d) An unsecured personal loan of £10,000.
1) b) A further advance for house repairs of £15,000. Regulated mortgages,
including further advances for any purpose, are exempt from the CCAs.
Rather, these loans would be regulated under MCOB.
1) Which of the following is exempt from the Consumer Credit
Acts?
a) A credit card account with a limit of £5,000.
b) A further advance for house repairs of £15,000.
c) A loan for £20,000 secured on property for car purchase.
d) An unsecured personal loan of £10,000.
1) b) A further advance for house repairs of £15,000. Regulated mortgages,
including further advances for any purpose, are exempt from the CCAs.
Rather, these loans would be regulated under MCOB.
2) How does providing an APR in relation to consumer credit help
consumers?
2) It allows consumers to compare products more accurately, as the APR
includes not only the interest rate but also any fees and charges that apply
to the product.
2) How does providing an APR in relation to consumer credit help
consumers?
2) It allows consumers to compare products more accurately, as the APR
includes not only the interest rate but also any fees and charges that apply
to the product.
3) Businesses are not protected by the provisions of the Consumer
Credit Acts. True or false?
3) False. Partnerships with three partners or fewer and sole traders are
covered by the CCAs, as well as ‘ordinary’ borrowers and unincorporated
associations.
4) How long is the cooling‑off period for a customer once they
have signed a consumer credit agreement?
4) Fourteen days from the conclusion of the agreement, or from the point the
consumer receives the agreement if this is later.
4) How long is the cooling‑off period for a customer once they
have signed a consumer credit agreement?
4) Fourteen days from the conclusion of the agreement, or from the point the
consumer receives the agreement if this is later.
5) If a lender rejects an application on the basis of information
from a credit reference agency, what must the lender do?
a) Ensure the applicant is not made aware of the reason for the
rejection to protect the confidential nature of the lender’s
relationship with the credit reference agency.
b) Only advise the applicant of the reason for rejecting their
application.
c) Advise the applicant of the reason for rejecting their
application and provide details of the credit reference
agency used.
d) Advise the applicant of the reason for rejecting their
application and provide details of a debt counselling
service.
5) c) The lender must advise the applicant of the reason for rejecting their
application and provide details of the credit reference agency used.
5) If a lender rejects an application on the basis of information
from a credit reference agency, what must the lender do?
a) Ensure the applicant is not made aware of the reason for the
rejection to protect the confidential nature of the lender’s
relationship with the credit reference agency.
b) Only advise the applicant of the reason for rejecting their
application.
c) Advise the applicant of the reason for rejecting their
application and provide details of the credit reference
agency used.
d) Advise the applicant of the reason for rejecting their
application and provide details of a debt counselling
service.
5) c) The lender must advise the applicant of the reason for rejecting their
application and provide details of the credit reference agency used.
6) A charity that provides debt counselling services must have
full permission from the FCA. True or false?
6) False. Full permission is required for debt counselling services that are
carried out on a commercial basis.
7) What is the maximum that a borrower can be required to repay
to a high‑cost, short‑term lender in fees and charges?
7) One hundred per cent of the original amount borrowed.
8) Interest rates provided in an advertisement for consumer
credit must include what?
8) A representative example that includes a representative APR.
9) Providers of consumer credit must check that the applicant
can afford the repayments and must check the applicant’s
status with a credit reference agency. True or false?
9) True. These provisions are included under CONC 5: Responsible lending.
10) Which previously unregulated area of consumer credit now
falls under the provisions of CONC 7?
10) Debt collection and debt administration.
23.1 What is money laundering?
Money laundering involves filtering the proceeds of any kind of criminal
activity (including terrorism) through a series of accounts or other financial
products in order to make such funds appear legitimate or to make their
origins difficult to trace. It will generally not be easy to spot someone who
is trying to launder money; criminals carrying out money laundering will use
sophisticated techniques. Examples of where the financial services industry
has been used in an attempt to launder money include:
opening an account with a small initial deposit and then adding large sums
in cash;
making an investment into a collective investment which is then encashed
within a short period of time;
arranging a mortgage or loan that is then quickly paid off using cash.
A significant proportion of transactions that are identified as suspicious
take place in banks and reports of suspicious transactions also come in from
building societies, finance companies, credit card providers, money service
businesses such as bureaux de change, accountants, tax advisers, solicitors
and estate agents, among others.
Financial services firms have a legal duty to take steps to mitigate the risk of
money laundering; in the UK, the key legislation is the Proceeds of Crime Act
2002, the Terrorism Act 2000 and the EU’s Money Laundering Directives.
What is THE NATIONAL CRIME AGENCY?
(Exam Question)
The National Crime Agency (NCA) works to combat serious
and organised crime. Although it is a UK body, it works in
partnership with law enforcement agencies internationally; the
nature of serious and organised crime makes such cross‑border
co‑operation essential. Its National Economic Crime Centre is
responsible for tackling money laundering, fraud, bribery and
corruption, and counterfeiting of currency.
Explain the three PRINCIPAL MONEY LAUNDERING OFFENCES
Concealing criminal property
• Criminal property is
property that a person
knows, or suspects, to
be the proceeds of any
criminal activity
• It is a criminal offence
to conceal, disguise,
convert or transfer
criminal property
Arranging
knows, or suspects, to
be the proceeds of any
criminal activity
• It is a criminal offence
to conceal, disguise,
convert or transfer
criminal property
Arranging occurs when a
person becomes involved
in a process that they
know or suspect will
enable someone else to
acquire,retain, use or
control criminal property
(where that other person
also knew or suspected
that the property derived
from criminal activity
Acquiring, using or processing
It is a criminal offence for
a person to acquire, use
or possess any property
when that person knows
or suspects that the
property is the proceeds
of criminal activity
23.2.1 Failure to disclose 23.2.2 Tipping off. Explain In terms of money laundering
All suspicions of money laundering must be reported to the authorities.
The Proceeds of Crime Act 2002 introduced the requirement for a person to
disclose information about money laundering if they have reasonable grounds
for knowing or suspecting that someone is engaged in money laundering.
It is also an offence to disclose to (ie tip off) a person who is suspected of
money laundering that an investigation is being, or may be, carried out.
23.3 How does the Terrorism Act 2000 relate to money
laundering?
The Terrorism Act 2000 defines ‘terrorism’ as the use or threat of serious
violence against a person or serious damage to property or electronic systems,
with the purpose of influencing a government, intimidating the public or
advancing a political, religious or ideological cause.
The Act specifically mentions as an offence “the retention or control of
terrorist property, by concealment, removal from the jurisdiction, transfer to
nominees or in any other way” – in other words, money laundering.
‘Terrorist property’ is defined as:
money or other property that is likely to be used for terrorism purposes;
proceeds of the commission of acts of terrorism;
proceeds of acts carried out for the purposes of terrorism.
23.4 What are the Money Laundering Regulations and Third Money Laundering
The key EU legislation relating to money laundering is the Money Laundering
Regulations, which implement the EU’s Money Laundering Directives.
Directive
The EU’s Third Money Laundering Directive (2005) repealed and consolidated
two earlier directives. The Directive defines money laundering in some detail.
It comprises “the following conduct when committed intentionally:
the conversion or transfer of property, knowing that such property is
derived from criminal activity or from an act of participation in such
activity, for the purpose of concealing or disguising the illicit origin of the
property or of assisting any person who is involved in the commission of
such activity to evade the legal consequences of his action;
the concealment or disguise of the true nature, source, location, disposition,
movement, rights with respect to or ownership of property, knowing
that such property is derived from criminal activity or from an act of
participation in such activity;
the acquisition, possession or use of property, knowing, at the time of
receipt, that such property was derived from criminal activity or from an
act of participation in such activity;
participation in, association to commit, attempts to commit and aiding,
abetting, facilitating and counselling the commission of any of the actions
mentioned in the foregoing paragraphs”.
Three more important definitions are included, in order to clarify this definition
of money laundering:
property is assets of every kind, tangible or intangible, movable or
immovable, as well as legal documents giving title to such assets;
criminal activity is a crime as specified in the Vienna Convention (the
United Nations Convention Against Illicit Traffic in Narcotic Drugs) and any
other criminal activity designated as such by each member state;
criminal property is defined as property that consists, directly or indirectly,
wholly or in part, of a benefit from criminal conduct, where the alleged
offender knows or suspects that it constitutes a benefit.
The Directive specifies that money laundering that takes place within the EU
will be treated under EU money laundering rules, even if the activities that
generated the property to be laundered took place in a non‑EU country.
23.4.2what is the Fourth Money Laundering Directive?
In response to recommendations made by the Financial Action Task Force
(FATF), the European Commission adopted a fourth Money Laundering Directive
on 26 June 2015. The provisions of the directive were implemented in the UK
in June 2017 and the Money Laundering Regulations and the Proceeds of Crime
Act were updated. The aim was to strengthen the anti‑money‑laundering (AML)
regime.
Key elements of the Money Laundering Regulations 2017 include:
a requirement to adopt a risk‑based approach to the implementation of
AML measures such as customer due diligence (ie to understand the nature
of the threats faced and devote most resources to the areas of greatest
risk). A relevant person must produce a written AML risk report and
translate its findings into written policies to be approved by the firm’s
senior management;
a widened definition of ‘politically exposed persons’, including those
holding prominent positions in their home country. Politically exposed
people are those individuals who, because of their position, are considered
to be more vulnerable to corruption;
the introduction of a new criminal offence. An individual found guilty of
recklessly making a statement in the context of money laundering that is
false or misleading may face a fine and/or a maximum two‑year jail sentence.
The fourth Money Laundering Directive also:
includes ‘tax crimes’ within EU legislation for the first time;
strengthens co‑operation between member states;
increases transparency around the beneficial ownership of legal entities –
each member state must maintain a central register of the beneficial owners
of legal entities (beneficial owners are those who own or control 25 per
cent of a legal entity).
In the UK, legislation requiring businesses to maintain a register of individuals
having significant control came into effect in April 2016. This had to be
strengthened as it only applied to companies, not to other legal entities such
as trusts and therefore did not fully meet the requirements of the Fourth
Money Laundering Directive.
The Money Laundering and Transfer of Funds (Information) (Amendment) (EU
Exit) Regulations 2018, published on 13 November 2018, ensures that the UK’s
anti‑money‑laundering regime and counter‑terrorism financing legislation
continues to work effectively even though the UK withdrew from the EU.
23.4.3 what is the Fifth Money Laundering Directive?
The Fifth Money Laundering Directive came into force in the UK on 10 January
2020. The scope of the new directive was broadened to include additional
entities, such as virtual currency providers, art traders for transactions of
€10,000 or more and estate agents acting as intermediaries for properties let
at €10,000 per month.
It also introduced changes regarding electronic money, including:
A new maximum monthly payment transaction limit of €150 for non-
reloadable payment instruments, and where the maximum amount stored
electronically exceeds €150, they are now subject to customer due diligence
(CDD) measures. The threshold has been reduced from €250 to €150.
Remote payment transactions that exceed €50 are subjected to customer
due diligence measures. The threshold has been reduced from €100 to €50.
The directive also introduced changes to customer due diligence and beneficial
ownership registers, such as:
The identification and verification of customers must be based on
documents, data or information from a reliable and independent source,
which should also include electronic identification means that have been
approved by national authorities.
Any member of the public has the right to access beneficial ownership
information held in the register for corporate and other legal entities.
Access is no longer limited to persons who can demonstrate legitimate
interests.
Implementing requirements to harmonise the enhanced due diligence
(EDD) measures for entities across member states to apply to business
relationships with high risk third countries (Deloitte, 2018).
The Sixth Money Laundering Directive was implemented in the EU in June
2021. Any UK regulated business in the financial sector operating in the EU
must therefore comply with these new regulations.
What is the FINANCIAL ACTION TASK FORCE?
Exam question
The Financial Action Task Force (FATF) is an inter‑governmental
organisation established in 1989 to co‑ordinate the
international fight against money laundering. In 2001, the
remit of the FATF was expanded to include terrorist financing.
It is a policy‑making body: it does not become involved in law
enforcement (that is the responsibility of local authorities in
individual countries, such as the National Crime Agency in
the UK). In addition to member nation states, the European
Commission and the Gulf Co‑operation Council also belong to
the FATF.
The work of the FATF falls into three main areas:
setting appropriate standards for national
anti‑money‑laundering programmes, detailed in a list of 40
recommendations incorporating minimum standards for
the measures that countries should have in place within
their own criminal justice and regulatory systems;
evaluating the extent to which individual countries have
implemented these standards;
identifying trends in money‑laundering methods.
The FATF also maintains a list of “non‑cooperative countries
and territories”, which it considers do not have adequate
anti‑money‑laundering measures.
23.5 Customer due diligence
One of the most important elements in the financial service industry’s
action against money laundering is the process of confirming the identity of
customers, referred to as ‘customer due diligence’ or CDD. CDD is required in
relation to transactions that are seen as higher risk. Figure 23.2 summarises
the circumstances in which evidence of identity is required.
CIRCUMSTANCES REQUIRING IDENTIFICATION PROCEDURES
TO BE CARRIED OUT
New business relationship:When entering into a new business relationship (particularly when opening a new account, or
selling a new investment or policy).
Occasional transactions exceeding 1500
When the value of an ‘occasional’ transaction exceeds €15,000, whether as a single
transaction or as a series of linked transactions. Note that for a business trading in goods and
services the threshold is €10,000.
Life assurance policy: When the value of annual premiums exceeds €1,000, or €2,500 for single premiums.
Suspicion: of money laundering
Doubts: Where there are doubts about proof of identity that has previously been obtained.
Change of circumstances
If a client is introduced to the firm by a financial intermediary or another
authorised firm, it is permissible for the firm to rely on identification carried out
by the intermediary or other firm. This is important to, for instance, financial
advisers and mortgage advisers. Under the terms of the Money Laundering
Regulations 2017, an intermediary must provide the customer with the due
diligence information it has obtained.
The definition of what constitutes satisfactory evidence of identity is rather
vague – evidence should be reasonably capable of establishing that the applicant
is the person they claim to be, to the satisfaction of the person who obtains the
evidence. Acceptable forms of identification are shown in Figure 23.3.
Utility bill, passport, entry of electronic role, driving licence and national identity card.
23.5.1 what is the Preventing financial exclusion?
Some people’s personal circumstances are such that they are unable to provide
any of the documents included in Figure 23.3. For instance, a person who
has never travelled abroad, does not drive a car and is not responsible for
household bills may well be unable to produce a passport, driving licence
or utility bill bearing their name. Nevertheless, it is important that people in
these situations are not denied access to appropriate financial services. In
such circumstances, the FCA considers that a firm may accept, as evidence of
the customer’s identification, a letter or statement from a person in a position
of responsibility (such as a solicitor, doctor or minister of religion) who knows
the client.
RECORD‑KEEPING REQUIREMENTS
For money laundering
Exam question
Institutions must keep appropriate records in respect of
customer due diligence for use as evidence in any investigation
into money laundering. This means that:
evidence of identification must be retained until at least
five years after the relationship with the customer has
ended;
supporting evidence of transactions (in the form of
originals or copies admissible in court proceedings) must
be retained until at least five years after the transaction
was executed.
Remember also that there are record‑keeping requirements
that relate to COBS (see Topic 21), and we will look in Topic 24
at the requirements in relation to GDPR.
23.5.2 Credit reference agencies in relation to anti money laundering
Anti‑money‑laundering checks are often carried out by credit reference
agencies on behalf of financial institutions. While the search leaves an
anti‑money‑laundering ID footprint, this will not show up in a credit search,
nor will it affect an individual’s ability to obtain credit.
23.6 What is the role of the FCA? I’m reference to money laundering
The FCA has an operational objective to ensure the integrity of financial
markets. To help achieve this, the FCA requires that all authorised firms must
have systems and controls in place which mitigate the risk that the firms may
be used to commit financial crime, including money laundering.
The FCA details its requirements in the Senior Management Systems and
Controls (SYSC) section of the Handbook and requires that all authorised firms:
establish accountabilities, procedures and systems to minimise the risk of
money laundering;
give responsibility for anti‑money‑laundering systems and controls to a
senior manager;
appoint a money laundering reporting officer (MLRO) (see section 23.6.1);
have a documented risk policy related to money laundering;
give regular training to staff about what is expected of them under the
money‑laundering rules, including the consequences for the firm and for
themselves if they fail to comply;
educate their staff about potential problems;
take reasonable steps to ensure that procedures are up to date and reflect
any findings contained in periodic reports on money‑laundering matters
issued by the government, by the Financial Action Task Force (FATF) and
the FCA’s own guidance on financial crime;
requisition a report at least once in each calendar year from the MLRO;
take appropriate action to strengthen its procedures and controls to remedy
any deficiencies identified by the report.
The FCA expects that firms have procedures in place to ensure that individuals
working within the firm:
report suspicious circumstances by completing ‘suspicious activity reports’
(SARs);
refrain from alerting persons being investigated.
The FCA has the power to take enforcement action against firms and to impose
sanctions on them for non‑compliance with Money Laundering Regulations.
When assessing a firm’s compliance with its money‑laundering requirements,
the FCA will take into account the extent to which the firm has followed the:
Joint Money Laundering Steering Group’s guidance notes for the financial
sector – these describe the steps that firms should take to verify the identity
of their customers and to confirm the source of their customers’ funds;
publications of the FATF – these highlight any known developments in
money laundering and any deficiencies in the money‑laundering rules of
other jurisdictions;
FCA’s own guidance on financial exclusion – see section 23.5.1.
JOINT MONEY LAUNDERING STEERING GROUP
Exam question
The Joint Money Laundering Steering Group is made up of the
leading UK trade associations in the financial services industry.
Its aim is to promote good practice in countering money
laundering and to give practical assistance in interpreting the
UK money‑laundering regulations. This is primarily achieved
by the publication of guidance notes.
23.6.1 What is the role of the MLRO?
Each firm must appoint a money laundering reporting officer (MLRO) with
responsibility for co‑ordinating all the firm’s AML activities. The MLRO must
be a person of ‘appropriate seniority’.
All members of staff must make a report to the MLRO if they know or suspect
that a client is engaged in money laundering. The MLRO will then determine
whether to report this to the National Crime Agency, using known information
about the financial circumstances of the client and the nature of the business
being transacted. Such reports are known as ‘suspicious activity reports’ (SARs).
At least once in each calendar year senior management of the firm must
requisition a report from the MLRO. This report must:
assess the firm’s compliance with the Joint Money Laundering Steering
Group guidance notes;
indicate how Financial Action Task Force findings have been used during
the year;
provide information about reports of suspected money‑laundering
incidents submitted by staff during the year.
A firm’s senior management must consider this report and must take any
action necessary to solve any problems identified.
23.6.2 What training is required?
Training should be given on a regular basis throughout the time that an
individual handles transactions that could facilitate money laundering.
PENALTIES FOR MONEY‑LAUNDERING OFFENCES
Exam question
The FCA can discipline firms and individuals for breaches of
money‑laundering rules, as described in section 23.6. It also
has the power to prosecute anyone who breaks the Money
Laundering Regulations established under UK law to give
effect to the EU Money Laundering Directives.
Anyone convicted under the Proceeds of Crime Act 2002 of
concealing, arranging or acquiring (see section 23.2) could be
sentenced to up to 14 years’ imprisonment or an unlimited
fine, or both. The offence of failing to disclose or of tipping
off carries a prison sentence of up to five years or an unlimited
fine, or both.
A partner or director who fails to comply with money laundering
regulations can be fined, receive up to two years in prison (or
both) or be subject to appropriate civil penalties.
23.7 what is The Bribery Act 2010?
The Bribery Act 2010, which came into effect in July 2011, created an offence
of offering, promising or giving “financial or other advantage” to another
where the advantage is intended to bring about improper performance by
another person of a relevant function or activity, or to reward such improper
performance. An offence is also deemed to have been committed if the person offering,
promising or giving the advantage knows (or simply believes) that acceptance
of the advantage itself constitutes improper performance.
The offence applies to
bribery relating to any
function of a public nature,
connected with a business,
performed in the course of
a person’s employment or
performed on behalf of a
company or other body.
The function or activity may
be carried out either in the
UK or abroad, and need have
no connection with the UK.
The Act also makes it an
offence to request, agree to receive, or accept “financial or other advantage”,
where the person requesting the ‘bribe’ performs their function or activity
improperly (or intends to) as a result of the ‘reward’ requested or received.
The maximum penalty in the UK for an individual convicted of a bribery
offence is an unlimited fine and imprisonment for up to ten years.
1) If a staff member of a financial services organisation were to
be accused of ‘arranging’ under the Proceeds of Crime Act
2002, it could mean that they:
a) had knowingly become involved in the process of converting
criminal property.
b) personally owned the proceeds of criminal activity.
c) had unwittingly failed to report a potentially suspicious
transaction.
d) had personally used the proceeds of criminal activity.
1) a) It could mean that they had knowingly become involved in the process
of converting criminal property.
2) Transferring criminally obtained money through different
accounts is an offence only if the funds derive from drug
dealing or terrorist activity. True or false?
2) False. Transferring, disguising, concealing or converting criminal property
is an offence, no matter what form of criminal activity the funds derive
from.
3) The FATF’s role is to establish a broad policy framework at
an international level for the prevention of money laundering.
True or false?
True
4) In order to be required to report a transaction to the money
laundering reporting officer, a member of staff first needs to:
a) be certain that the person is involved in money laundering.
b) advise the person that they may be investigated.
c) review the circumstances of the case with other experienced
staff members.
d) have reasonable grounds for believing that a person is
involved in money laundering.
4) d) A member of staff who has reasonable grounds for believing that a
person is involved in money laundering is obliged to report the suspect
transactions.
5) A bank cashier notices that a customer is paying an unusually
large sum of money into their account in cash. The cashier advises
the customer that they regard the transaction as suspicious
and calls a supervisor to discuss the matter further with the
customer. What offence has the cashier potentially committed?
a) Data protection breach.
b) Tipping off.
c) Failure to disclose.
d) Arranging.
5) b) By alerting the customer to the fact that they were suspicious about the
unusual transaction, the cashier potentially committed the offence of
‘tipping off’.
6) When accepting an investment into a savings account at what
transaction value will it become necessary to obtain evidence
of the customer’s identity?
a) €15,000.
b) €10,000.
c) £10,000.
d) £15,000.
6) a) The threshold is €15,000, meaning that customer due diligence will be
carried out in a greater number of situations.
7) The EU Fourth Money Laundering Directive contains a provision
requiring member states to maintain a register of the beneficial
owners of legal entities. A beneficial owner is one who controls
what percentage of a legal entity?
7) 25 per cent.
8) A new client has invested £12,000 in the forms of stocks and
shares in an ISA product offered by Forward Bank. The bank
did not carry out any client identification procedures. This is
most likely to have been because:
a) investments into ISAs are exempt from money‑laundering
identification requirements.
b) the client is only temporarily resident in the UK.
c) investment amounts of less than £15,000 are exempt from
money‑laundering identification requirements.
d) the client was introduced by an intermediary who obtained
the necessary evidence.
8) d) Identification procedures must always be carried out for new clients,
so the most likely reason why Forward Bank did not carry them out
in this case is that the procedures were carried out instead by an
intermediary.
9) If a money laundering reporting officer (MLRO) suspects a case
of attempted money laundering, to whom must this be reported?
9) The National Crime Agency.
10) A firm’s senior management is required to request a report
from the money laundering reporting officer at least once a
year. What action should they take on receiving the report?
a) Forward it to the FCA.
b) Include the total number of SARs in the firm’s annual report
and accounts.
c) Review and if necessary improve the firm’s processes and
training.
d) Retain the report indefinitely.
10) c) The firm should review and if necessary improve the firm’s processes
and training in the light of the report.
24.1 What are the rules relating to data protection?
Interacting with a financial services institution inevitably involves the
customer providing personal information; in Topic 23, for example, we looked
at the process of customer due diligence, which requires the customer to
prove their identity in order to complete a transaction. If such information is
not handled appropriately and stored securely, then not only does the firm
breach the customer’s right to privacy, it also exposes the customer to the risk
of becoming a victim of crime as a result of identity theft. Until May 2018, the EU data protection legislation was the Data Protection
Directive of 1995. The primary UK legislation in relation to data protection
was the Data Protection Act 1998.
To update the EU legislation, particularly in relation to online activity and the
rise of social media, a General Data Protection Regulation came into force in
May 2016 and each EU member state was required to adopt its provisions by
25 May 2018. The primary UK legislation became the Data Protection Act 2018.
If relation to personal data explain IDENTITY THEFT
Exam question
Personal data is valuable to fraudsters. Details such as an
individual’s name, address and date of birth – sometimes
pieced together and supplemented from a number of sources –
can be used to open bank accounts, take out credit cards, order
goods, take over the victim’s original accounts or apply for key
documents such as a passport or driving licence. The latter
items can then be used to facilitate further criminal activity.
The prevention of fraud arising from identity theft falls within
the remit of the FCA, as part of its objectives to reduce financial
crime and enhance consumer protection.
24.1.1 explain The General Data Protection Regulation
On 25 May 2018, the General Data Protection Regulation (GDPR) came into
effect in the UK. It applies to ‘personal data’, which is information relating
to an individual who can be identified (for example, by name, identification
number, location data or online identifier). This reflects changes in technology
and the way information is collected.
The GDPR applies to both automated personal data and to manual records
containing personal data. The provisions of the GDPR were retained in UK Law
as ‘UK GDPR’ at the end of the Brexit transition period.
24.1.2 What are the data protection principles?
The basis of the UK GDPR is a set of six data protection principles, which all
relate to the processing of personal data. The data must be:
1) Processed lawfully, fairly and in a transparent manner in relation to
individuals.
2) Collected for specified, explicit and legitimate purposes and not further
processed in a manner that is incompatible with those purposes; further
processing for archiving purposes in the public interest, scientific or
historical research purposes or statistical purposes shall not be considered
to be incompatible with the initial purposes.
3) Adequate, relevant and limited to what is necessary in relation to the
purposes for which they are processed.
4) Kept accurate and up to date. Every reasonable step must be taken to ensure
that personal data that are inaccurate, having regard to the purposes for
which they are processed, are erased or rectified without delay.
5) Kept in a form which permits identification of data subjects for no longer
than is necessary for the purposes for which the personal data are processed,
although archiving is allowed in certain circumstances.
6) Processed in a manner that ensures appropriate security of the personal
data, including protection against unauthorised or unlawful processing and
against accidental loss, destruction or damage, using appropriate technical
or organisational measures.
24.1.3 explain the UK GDPR requirements
Some of the relevant definitions are as follows:
Data subject – an individual (a natural person) whose personal data is processed.
Personal data – information that can directly or indirectly identify a natural
person. This information can be in any format.
Special categories of personal data – this data is more sensitive and so
needs more protection. Generally (although there are exceptions) such data
can only be processed if the individual has given explicit consent. Sensitive
data includes information about an individual’s:
— race;
— religious beliefs;
— political persuasion;
— trade union membership;
— sexual orientation;
— health;
— biometric data;
— genetic data.
Processing – this has a very broad meaning, covering all aspects of owning
data, including:
— obtaining the data in the first place;
— recording of the data;
— organisation or alteration of the data;
— disclosure of the data, by whatever means;
— erasure or destruction of the data.
Data controller – this is the ‘legal’ person who determines the purposes
for which data are processed and the way in which this is done. The data controller is normally an organisation/employer, such as a company,
partnership or sole trader. They have prime responsibility for ensuring the
data protection requirements are adhered to.
Data processor – this is a person who processes personal data on behalf of
the data controller.
An organisation must have a lawful basis for processing data. At least one of
the following must apply when processing personal data.
1) Consent – clear consent has been given by the individual to process their
personal data for a specific purpose.
2) Contract – the processing is necessary for a contract between the organisation
and the individual, or because the individual has asked for certain steps to
be taken before entering into a contract.
3) Legal obligation – the processing is necessary for the organisation to
comply with the law.
4) Vital interests – the processing is necessary to protect someone’s life.
5) Public task – the processing is necessary for the organisation to act in the
public interest.
6) Legitimate interests – the processing is necessary for the organisation’s
legitimate interests or the legitimate interests of a third party, unless there
is a good reason to protect the individual’s personal data which overrides
those legitimate interests.
A data subject has a number of rights, including the right to:
access personal data through subject access requests (under UK GDPR, no
charge can generally be made for this);
correct inaccurate personal data;
have personal data erased, in certain cases;
object;
move personal data from one service provider to another.
In order to demonstrate compliance with the UK GDPR, an organisation must:
establish a governance structure with roles and responsibilities;
keep a detailed record of all data processing operations;
document data protection policies and procedures;
carry out data protection impact assessments for high-risk processing
operations. The UK GDPR contains rules on the transfer of personal data to receivers located
outside the UK that are separate controllers or processors. These rules apply
to all transfers, no matter the size of transfer or how often they are carried
out. Only the controller or processor who initiates and agrees to the transfer
is responsible for complying with the UK GDPR rules on restricted transfers.
A restricted transfer can be made if the receiver is located in a third country
or territory, is an international organisation, or is in a particular sector in a
country or territory covered by UK ‘adequacy regulations’.
24.1.4 How is the UK GDPR enforced?
Serve information notices
Requiring organisations to provide the Information Commissioner’s Office with specified
information within a certain time period
Serve assesment notices
To conduct compulsory audits to assess whether organisations’ processing of personal data
follows good practice.
Issue undertakings
Committing an organisation to a particular course of action in order to improve its compliance.
Issue monetary policy penalty notices
Notification that the organisation is to be subject to a financial penalty as a result of a serious
breach of the UK GDPR
Serve enforcement notices and stop now notices
Requiring organisations to take (or refrain from taking) specified steps in order to ensure they
comply with the law
Those who commit criminal offences under the UK GDPR.
Conduct Consensual assesment
To check organisations are complying.
Issue a ban
A temporary or permanent ban on data protection can be imposed
CRIMINAL OFFENCES UNDER THE UK GDPR
Exam question
The following are criminal offences.
For a data controller to fail to comply with an information
or enforcement notice.
Failure to make a proper notification to the Information
Commissioner. ‘Notification’ is the way in which a data
controller effectively registers with the Information
Commissioner’s Office by acknowledging that personal
data are being held and by specifying the purpose(s) for
which the data are being held.
Processing of data without authorisation from the
Commissioner.
Intentionally or recklessly re-identifying individuals
from data that is pseudonymised – it can no longer be
attributed to a specific person without the use of additional
information, which is kept separately – or anonymised – it
does not relate to a natural person or has been processed
so the data subject cannot be identified (ICO, no date).
The maximum penalty is the higher of £17.5m or 4 per cent
of an organisation’s total annual worldwide turnover in the
previous financial year.
24.2 What is the role of the Pensions Regulator?
The regulation of work-based (ie occupational) pension schemes remains
separate from the regulation of other financial services – separate even from
the regulation of private pension arrangements such as personal pensions and
stakeholder pensions. Nevertheless, financial advisers should have a good
knowledge of matters relating to work-based schemes, in order, for instance, to
be able to advise individuals who are members of such schemes or employers
who may be considering establishing a scheme.
The Pensions Regulator (TPR) is responsible for the regulation of work-based
pension schemes (as well as some personal pension schemes), and it aims to:
ensure employers enrol their staff onto a work-based pension scheme
(known as ‘automatic enrolment’);
protect the benefits of a work-based pension scheme, as well as people’s
savings;
protect the benefits of personal pension schemes where there is a direct
pay arrangement;
promote good administration of work-based schemes, as well as people’s
savings;
reduce the risk of situations arising that might lead to claims for
compensation from the Pension Protection Fund (see section 24.3);
maximise employer compliance with duties and safeguards under the
Pensions Act 2008;
minimise any adverse impact on the sustainable growth of an employer
(TPR, 2022).
The Pensions Regulator aims to identify and prevent potential problems rather
than to deal with problems that have arisen, and takes a risk-based approach
to its work. It assesses the risks that might prevent it from meeting its statutory
and operational objectives,
such as inadequate funding,
inaccurate record-keeping,
lack of knowledge or
understanding on the part of
the trustees, or even
dishonesty or fraud. The
regulator considers the
combined effect of:
the likelihood of the event occurring; and
the impact of the event on the scheme and its members.
Schemes that are judged to have a higher risk profile will be more closely
monitored than those that represent a lower risk.
To protect the security of members’ benefits, the TPR has a range of powers,
and these fall broadly into the three categories shown in Figure 24.2.
The Pensions Act 2004 requires the Pensions Regulator to issue voluntary codes
of practice on a range of subjects. The codes provide practical guidelines for
trustees, employers, administrators and others on complying with pensions
legislation, and set out the expected standards of conduct.
The TPR supervises pension schemes through engagement with trustees,
managers and sponsoring employers of pension schemes. The TPR has
worked with the FCA to develop a joint strategy for regulating the pensions
and retirement income sector and works with other bodies including the
Department for Work and Pensions, Pension Protection Fund and the Money
and Pensions Service.
The Act also introduced requirements for trustees to have a sufficient
knowledge and understanding of pension and trust law, and of scheme
funding and investment. Trustees must also be familiar with the trust deed
and other important documents such as the scheme rules and the statement
of investment principles.
What are the powers of the pension regulator?
Investigating schemes:
• Identifying and
investigating risks
• Requiring all schemes to
make regular returns to
the regulator
• Requiring trustees or
scheme managers to give
notification of any changes
to important information,
such as the types of benefit
being provided by the
scheme
• Requiring that the
regulator be informed
quickly if the scheme
discovers that it cannot
meet the funding
requirements,so that
remedial action can be
taken at an early stag
Putting things right:
• Requiring specific action
to be taken to improve
matters within a certain
time
• Recovering unpaid
contributions from an
employer who does not
pay them to the scheme
within the required period
(by the 19th day of the
month following that in
which they were deducted
from the member’s salary)
• Disqualifying trustees who
are not considered fit and
proper persons
• Imposing fines or
prosecuting offences in the
criminal courts
Acting against avoidance:
• Preventing employers from
deliberately avoiding their
pensions obligations and
so leaving the Pension
Protection Fund to cover
their pension liabilities
• Issuing:
– contribution notices,
requiring the employer
to make good the
amount of the debt
either to the scheme
or to the Pension
Protection Fund; or
– financial support
directions, which require
financial support to
be put in place for an
underfunded scheme
24.3 What is the Pension Protection Fund?
The Pensions Act 2004 established the Pension Protection Fund (PPF) to protect
members of private sector defined-benefit pension schemes in the event that a
firm becomes insolvent with insufficient funds to maintain full benefits for all
its scheme members. The PPF is also responsible for the Fraud Compensation
Fund, which provides compensation to occupational pension schemes that
suffer a loss as a result of dishonesty.
The role of the PPF has been brought into focus as a growing number of
occupational pension schemes have encountered financial problems.
The PPF provides varying levels of compensation, depending on the
circumstances of the member. There are only limited circumstances where
the compensation paid is 100 per cent of the benefits being drawn or to which
the member would have been entitled had the scheme remained solvent.
The PPF funds the compensation payments it makes in several ways:
It imposes a levy on defined-benefit schemes (there are exceptions for
some schemes in certain circumstances).
It takes on the assets of schemes that are transferred to the fund.
It seeks recovery of assets from insolvent employers.
It seeks to grow its funds through investment.
24.4 EU Directives affecting regulation of the financial services sector and electronic money regulations
In Topic 2 we explored the role of the EU in financial services and the differences
between directives and regulations. In Topic 19 we looked at the provisions of
the Capital Requirements Directive and Solvency II. In this section we are going
to look at some other examples of how EU legislation affects the provision of
financial services and advice.
24.4.1 Electronic Money Regulations 2011
The second Electronic Money
Directive (2EMD) was implemented
in the UK on 30 April 2011, in
the form of the Electronic Money
Regulations 2011.
The issuance of e-money has
been regulated since 2002; the
Electronic Money Regulations 2011
introduced new requirements for
all electronic money issuers (EMIs),
and new authorisation/registration
and prudential standards for electronic money institutions.
As part of Brexit, the UK government retained the Payment Services Regulations
2017 and the Electronic Money Regulations 2011 on UK statute books. This
was achieved through the Electronic Money, Payment Services and Payment
Systems (Amendment and Transitional Provisions) (EU Exit) Regulations 2018.
24.4.2 Markets in Financial Instruments Directive (MiFID)
The Markets in Financial Instruments Directive (MiFID) applies to firms that
provide services to clients in relation to tradeable financial instruments, which
include shares, bonds, units in a collective investment, and derivatives. Life
assurance, pensions and mortgages are outside the scope of MiFID.
In the UK, MiFID became effective from November 2007. It is a key element of
the EU Financial Services Action Plan and aims to harmonise the regulation of
investment services across the EU. MiFID has the main objectives of increasing
both competition and consumer protection by setting requirements in three
main areas:
conduct of business;
organisation;
market transparency.
MiFID distinguishes between core and non-core activities: core activities are
“investment services and activities” and non-core activities are “ancillary
services”. Where a firm performs both core and non-core activities, MiFID
applies to both aspects of its activities. A firm that only performs non-core
activities is not subject to MiFID.
MiFID includes the principle of an EU ‘passport’, meaning that a firm subject
to MiFID has the right to operate throughout the EEA on the basis of a single
authorisation in its home state. The aim of the directive is to make cross-border
activity easier to conduct by imposing a single set of rules across the EEA.
The FCA, as the body responsible for the securities industry in the UK, has
written MiFID into its Handbook. Firms affected include securities and futures
firms, banks conducting securities business, recognised investment exchanges
and alternative trading systems. The types of investment activity covered by
MiFID are summarised in Figure 24.3.
Given that MiFID does not apply where a business only carries out ‘non-core
activities’, UK firms are exempt from MiFID if they do not hold client money
and do not advise on or arrange complex investments such as derivatives.
However, any firm making use of the exemption in respect of ‘non-core’
activities will not be able to engage in cross-border business on the basis of
home state authorisation.
MiFID II
The European Commission launched proposals for reform in 2010. These were
intended to improve the functioning of financial markets in light of what was
learned from the financial crisis, improve investor protection and tackle some
of the issues that were missed in the original MiFID.
MiFID II represents a comprehensive set of reforms covering eight main
areas (see Figure 24.4). The legislation was published in June 2014 and has
applied within EU member states since 3 January 2018. The onshore UK
MiFID framework commenced at the end of the Brexit transition period on 31
December 2020.
24.4.3 Undertakings for Collective
Investment in Transferable
Securities and the Alternative Investment Fund Managers
Directive.
Two EU directives regulate investment funds and their managers – the
Undertakings for Collective Investment in Transferable Securities (UCITS)
Directive (2009) and the Alternative Investment Fund Managers Directive
(AIFMD). The UK government retained both directives in UK law after Brexit.
The UCITS Directive applies to regulated investment funds that can be sold to
the general public throughout the EU. It aims to provide a common framework
of investor protection and product control.
The Directive lays down the principle of mutual recognition of authorisation
that facilitates free circulation within the EU of the units of funds it covers.
The funds must comply with various requirements, which include having an
adequate spread of risk among their underlying investments and a high degree
of liquidity to enable investors to redeem their units on demand. Since July
2011, management companies established in any EU state have been able to
operate UCITS funds established in another state. The UCITS V Directive was implemented in the UK from March 2016 and aims
to increase standards of investor protection and customer confidence.
Since Brexit, UCITS authorised by the FCA are referred to as ‘UK UCITS’ but
have lost their passporting right to market under a streamlined process in EU
member states. UK UCITS wishing to market into the EU will be designated
as Alternative Investment Funds (AIF) and therefore must comply with the
marketing rules in the member state where the investor is located. Some
member states do not permit the marketing of non-EU funds to retail investors.
The AIFMD applies to the managers of AIFs that are typically sold to professional
investors (eg hedge funds and private equity funds) and those funds that invest
in assets which are ineligible for UCITS (eg real estate). The AIFMD provides
a passporting framework for managing and marketing funds across the EU,
enabling cross-border activities to be carried out. Some AIFs are sold to retail
investors but cannot be marketed cross-border to a retail investor using the
marketing passport. Instead, the local marketing rules in the member state
where the investor is located apply.
The AIFMD entered into force on 22 July 2011. The UK government retained the
AIFMD in UK law after Brexit. As is the case with UCITS, AIF that are domiciled
in the UK lost their passporting right to market under a streamlined process
in EU member states
24.4.5 what is General insurance? In terms of life insurance
In 1988, the Second Non-Life Council Directive laid down rules for cross-frontier
non-life insurance that balance the needs of freedom of service and consumer
protection. This allowed companies to supply insurance in another member
state without having to establish a branch or subsidiary in the other state.
The Third Non-Life Council Directive, issued in 1992, completed the process
and now any insurance company whose head office is in one of the member
states can establish branches, and carry on non-life insurance business, in
any other state. That activity will be under the supervision of the competent
authorities of the member state in which the insurance company’s head office
is situated.
Authorisation to carry out insurance business under the terms of this directive
is granted for a particular class of insurance (or even, sometimes, for some of
the risks relating to a particular class). General insurance risks are classified
into a large number of categories or classes; companies can, of course, be
authorised for more than one class.
Directive on Insurance Mediation
As well as ensuring that insurance companies can operate throughout the EU,
the EU also wants to ensure that retail markets in insurance are accessible
and secure. To this end, a Directive on Insurance Mediation (IMD) came into
force in January 2003, the purpose of which is to establish the freedom for
insurance intermediaries to provide services in all states throughout the EU.
A key aim of the IMD has been to regulate the sales standards of insurance
brokers and intermediaries.
Insurance mediation is defined in the Directive as “the activities of introducing,
proposing or carrying out other work preparatory to the conclusion of
contracts of insurance, or of concluding such contracts, or of assisting in the
administration and performance of such contracts, in particular in the event
of a claim”. When an employee of the insurance company, or someone acting
under the responsibility of the insurance company (a tied agent), carries out
such activities, they are not included in the definition of insurance mediation.
The Directive has established a system of registration for all independent
insurance (and reinsurance) intermediaries. They must be registered with a
competent authority in their home state: independent financial advisers based
in the UK who are selling life assurance or general insurance must be registered
with the FCA.
Registration is subject to strict requirements regarding professionalism and
competence: intermediaries must have the necessary general, commercial and
professional knowledge and skills. Exactly what this means depends on the
relevant national authority.Insurance intermediaries are also required to be “of good repute”. Again,
local interpretations of this may vary, but minimum requirements are that an
intermediary must not have been:
convicted of a serious criminal offence relating to crimes against property
or other financial crimes;
declared bankrupt.
The latest Directive requires that insurance intermediaries should hold
professional indemnity insurance of at least a minimum threshold per case
and a minimum in total per annum, or an amount equivalent to a percentage
of annual income to a maximum limit – whichever is higher.
Rules are also included to protect clients’ funds, including the requirement to keep
client money in strictly segregated accounts. This is backed up by a requirement
for intermediaries to have financial capacity of an amount equal to a percentage
of premiums received per annum, subject to a minimum amount.
The regulations specify in some detail what information an intermediary must
give to a customer. In relation to the intermediary, the following information
must be supplied:
name and address;
details of registration and means of verifying the registration;
whether the intermediary has any holding of more than 10 per cent of the
voting rights or capital of an insurance company;
conversely, whether any insurance company has a holding of more than 10
per cent of the voting rights or capital of the intermediary;
details of internal complaints procedures and of external arbitrators (eg
ombudsman bureaux) to which the customer could complain;
whether the intermediary is independent or tied to one or more insurance
companies.
In relation to the advice offered and products recommended:
independent intermediaries must base their advice on analysis of a
sufficiently large number of contracts available on the market to enable
them to recommend, in accordance with professional criteria, a product
that is adequate to meet the customer’s needs;
the intermediary must give the customer (based on the information
supplied by the customer) an assessment of their needs and a summary
of the underlying reasons for the recommendation of a particular product.
This requirement is satisfied in the UK by the use of a confidential client
questionnaire, or factfind, to obtain the necessary information, and by the
issue of a suitability letter to justify the specific recommendation.
All information provided by an intermediary to a customer must be set out in
a clear and accurate manner, and must be comprehensible to the customer.
Insurance Distribution Directive
The existing IMD was replaced with effect from 1 October 2018 under the terms
of the Insurance Distribution Directive (IDD). The aim is to address issues of
inconsistency with regard to the way the IMD was adopted across member states
and provide better consumer protection and greater legal clarity and certainty.
IDD continues to apply in the UK.
24.5 What is the role of oversight groups?
In addition to the regulation of the financial services sector set out in EU
Directives and carried out by bodies such as the FCA, there are also a number
of other ways in which the activities of financial services institutions are
kept under review. It is important to ensure that the investments of both
shareholders and customers are being handled safely and honestly and that
the institution is abiding by all the applicable laws and regulations, in the best
interests of all its stakeholders. This oversight of an institution’s business can
be carried out by different individuals and groups, such as auditors, trustees
or compliance officers.
24.5.1 Auditors
External auditors
External auditors are concerned particularly with published financial
statements and accounts. They are independent of the business whose
accounts are being audited; they are normally firms of accountants, and it is
their responsibility to provide reasonable assurance that published financial
reports are free from material misstatement and are compiled in accordance
with legislation and with appropriate accounting standards. They must
conform to the professional standards of the Auditing Practices Board and the
Accounting Standards Committee.
External auditors may also be members of professional bodies, such as the
Institute of Chartered Accountants in England and Wales (ICAEW) or the
Association of Chartered Certified Accountants. Both bodies publish ethical
codes that their members are expected to adhere to.
Internal auditors
Internal auditors may be in-house members of staff, or the process may be
outsourced. Their basic task is to:
review how an organisation is managing its risks;
ascertain whether appropriate controls have been established; and
evaluate and suggest improvements to control and governance processes.
They check that operations are being conducted effectively and economically in
line with the organisation’s policies, and that records and reports are accurate
and reliable. It is not the responsibility of internal auditors to put controls and
systems in place; that remains the responsibility of management. The role of
the internal audit is to inform management decisions by identifying problems
and recommending possible solutions.
Internal auditors may be members of a professional body, such as the Chartered
Institute of Internal Auditors.
24.5.2 Trustees
A trustee is a person (or in some cases an organisation) whose responsibility
is to ensure that any property held in trust is dealt with in accordance with
the trust deed for the benefit of the trust’s beneficiaries. Examples of trusts
can be found throughout the financial services industry. For instance, unit
trusts are investment schemes set up under a trust deed and the trustees are
the legal owners of the trust’s assets on behalf of the unit-holders. Similarly,
most occupational pension schemes are set up under trust: this is important
for the security of members’ benefits because it enables the pension assets to
be kept separate from the employer’s business assets. The rights and duties
of pension scheme trustees are set out in the Pensions Acts of 1995 and 2004.
Trustees are subject to statutory requirements in respect of the way they
carry out their duties. The key legislation is the Trustee Act 1925 and the
Trustee Investment Act 2000. The former is concerned with the general duties
of trustees, the latter with the way in which trustees deal with the investment
of trust assets.
24.5.3 explain Compliance officers
Firms that are authorised by the Financial Conduct Authority (FCA) or the
Prudential Regulation Authority (PRA) are required to appoint a compliance
officer to have oversight of the firm’s compliance function, in other words to
ensure compliance with all relevant legislation and regulations. Firms are also
required to appoint a money laundering reporting officer (MLRO). Both roles
are senior management functions under the Senior Managers and Certification
Regime (SM&CR). Responsibilities of a compliance officer will include:
production and publication of a compliance manual;
maintenance of compliance records such as complaints register and
promotions records;
responding to and corresponding with the FCA on compliance matters;
ensuring that staff meet FCA requirements as regards recruitment, training,
supervision and selling practices.
Compliance officers may be members of a professional body, such as the
Association of Professional Compliance Consultants.
Explain CODES OF CONDUCT for professional bodies.
Exam question
Many professional bodies and trade associations have
codes of conduct to which their members must adhere. For
example, we saw in 18.6.4 that in order to receive a Statement
of Professional Standing (SPS), an adviser must meet the
professional standards of their professional body and declare
that they adhere to its code of ethics.
Other examples of codes of conduct include:
The Advertising Standards Authority (described in 20.5);
The Standards of Lending Practice (described in 21.7).
1) What is the difference between a data controller and a data
processor?
1) A data controller is legally accountable for the purposes for which data is
processed and the way such processing is carried out. A data controller
is a ‘legal person’ but not necessarily a ‘natural person’, ie it might be an
organisation rather than an individual.
2) What does UK GDPR define as ‘sensitive data’?
2) Sensitive data includes information about an individual’s:
race;
religious beliefs;
political persuasion;
trade union membership;
sexual orientation;
health;
biometric data;
genetic data.
2) What does UK GDPR define as ‘sensitive data’?
2) Sensitive data includes information about an individual’s:
race;
religious beliefs;
political persuasion;
trade union membership;
sexual orientation;
health;
biometric data;
genetic data.
3) Which of the following is not one of the UK GDPR principles?
a) Data must be adequate (but not excessive) and relevant to
the purpose for which it is processed.
b) Data controllers must take appropriate technical and
organisational measures to keep data secure from
accidental or deliberate misuse, damage or destruction.
c) Data must not be kept for longer than five years from the
point at which it is gathered.
d) Data must be kept accurate and up to date.
3) c) This statement is incorrect. The principle actually states that data must
not be kept for longer than is necessary. In a financial services context,
this will be determined by the record‑keeping requirements relating to
specific products or to money‑laundering rules.
4) What is the penalty for committing a criminal offence in
relation to UK GDPR?
4) The maximum penalty for a criminal offence in relation to UK GDPR is the
higher of £17.5m or 4 per cent of the organisation’s worldwide turnover
of the previous financial year.
4) The maximum penalty for a criminal offence in relation to UK GDPR is the
higher of £17.5m or 4 per cent of the organisation’s worldwide turnover
of the previous financial year.
5) The Pensions Regulator is responsible for the regulation of
occupational pension schemes only. True or false?
5) False. The Pensions Regulator is responsible for occupational pension
schemes and for personal pension schemes where the employer has a
direct pay arrangement.
5) The Pensions Regulator is responsible for the regulation of
occupational pension schemes only. True or false?
5) False. The Pensions Regulator is responsible for occupational pension
schemes and for personal pension schemes where the employer has a
direct pay arrangement.
6) What is the role of the Pension Protection Fund?
6) The Pension Protection Fund provides compensation payments to
members of defined‑benefit pension schemes if a firm becomes insolvent
with insufficient funds to maintain full benefits for scheme members.
7) Which of the following products is UK not subject to MiFID?
a) Units in a collective investment.
b) Shares.
c) Life assurance.
d) Bonds.
7) c) Life assurance is not subject to MiFID.
8) What investment activities are subject to MiFID?
8) Receipt and transmission of orders from investors, execution of those
orders on behalf of customers, investment advice, discretionary portfolio
management (on a client‑by‑client basis, in accordance with mandates given
by investors), and underwriting the issue of specified financial instruments.
9) A general insurer with a head office in one of the member states
may set up branches in other member states; these branches
will be regulated by the national regulator of the state in which
the head office is situated. True or false?
True
10) With which regulator must UK-based IFAs who sell life assurance
or general insurance be registered?
a) The FCA.
b) The PRA.
c) The CMA.
d) The IDD
10) a) The FCA. Note that d) the IDD is the abbreviation for the Directive that
governs insurance distribution, not for a regulatory body.
25.1 explain Consumer rights legislation in brief
KEY CONSUMER RIGHTS
Consumers have the right to buy products and services with
confidence and have rights when things go wrong. In particular,
they have the right to:
clear and honest information before they buy;
get what they pay for;
be supplied with goods that are fit for purpose and services
that are performed with reasonable care and skill;
have any faults corrected free of charge, or get a refund/
replacement.
25.1 explain Consumer rights legislation in brief
KEY CONSUMER RIGHTS
Consumers have the right to buy products and services with
confidence and have rights when things go wrong. In particular,
they have the right to:
clear and honest information before they buy;
get what they pay for;
be supplied with goods that are fit for purpose and services
that are performed with reasonable care and skill;
have any faults corrected free of charge, or get a refund/
replacement.
25.1.1 What is the Consumer Rights Act 2015?
For many years consumer law in the UK was governed by the Supply of
Goods and Services Act 1982 and the Unfair Terms in Consumer Contracts
Regulations 1999 (UTCCRs). From 1 October 2015, the Consumer Rights Act
2015 (CRA) took effect, replacing and revoking the UTCCRs. The CRA applies
to consumer contracts entered into from 1 October 2015 onwards and gives
consumers enhanced and easier‑to‑understand rights that change the rules
applying when things go wrong in relation to goods and services.
The CRA covers:
what to do when goods are faulty;
what should happen when digital content is faulty (the first time that digital
content has been covered in consumer rights legislation);
how services should match up to what has been agreed, and what should
happen when they do not;
what should happen when goods and services are not provided with
reasonable care and skill;
unfair terms in contracts;
greater flexibility for organisations such as the FCA or Trading Standards
to respond to breaches of consumer law.
The Consumer Rights Act 2015 is the first piece of consumer rights legislation
to detail what should happen if a service is not provided in the manner agreed
or with reasonable care and skill. Essentially, the business that provided the
service must align it with what was agreed or, if this is not realistic, provide
a refund.
25.1.1 What is the Consumer Rights Act 2015?
For many years consumer law in the UK was governed by the Supply of
Goods and Services Act 1982 and the Unfair Terms in Consumer Contracts
Regulations 1999 (UTCCRs). From 1 October 2015, the Consumer Rights Act
2015 (CRA) took effect, replacing and revoking the UTCCRs. The CRA applies
to consumer contracts entered into from 1 October 2015 onwards and gives
consumers enhanced and easier‑to‑understand rights that change the rules
applying when things go wrong in relation to goods and services.
The CRA covers:
what to do when goods are faulty;
what should happen when digital content is faulty (the first time that digital
content has been covered in consumer rights legislation);
how services should match up to what has been agreed, and what should
happen when they do not;
what should happen when goods and services are not provided with
reasonable care and skill;
unfair terms in contracts;
greater flexibility for organisations such as the FCA or Trading Standards
to respond to breaches of consumer law.
The Consumer Rights Act 2015 is the first piece of consumer rights legislation
to detail what should happen if a service is not provided in the manner agreed
or with reasonable care and skill. Essentially, the business that provided the
service must align it with what was agreed or, if this is not realistic, provide
a refund.
25.1.2 explain Alternative dispute resolution
An aim of the Consumer Rights Act 2015 is to reduce the incidence of
disagreements between businesses and consumers and to reduce the number
of such disputes ending in court action. It is also hoped that the speed with
which disputes are resolved will be improved and the associated costs reduced.
In pursuit of these goals, the application of alternative dispute resolution (ADR)
has been broadened and is now open to all business. ADR aims to help when a
dispute with a consumer cannot be settled directly. The business involved in
the dispute will engage the services of a certified alternative dispute resolution
provider and must find out whether or not the consumer is willing to use the
service.
25.1.3 Unfair contract terms
The UTCCRs were revoked by the CRA, which reforms and consolidates the
previous regime.
The legislation in respect of unfair contract terms applies to consumer
contracts between a business and a consumer, and to any notice that relates
to the rights and obligations between a business and a consumer or purports
to exclude or limit a business’s liability to a consumer.
The main areas covered by the legislation are as follows.
Fairness
All terms in regulated contracts should be fair, with a contract or notice
being deemed to be unfair if it causes a significant imbalance in respect
of the rights and obligations of the various parties to the contract to the
detriment of the consumer.
All terms should adhere to the requirement of good faith.
Any unfair term or notice will not be binding on the consumer unless they
choose to be bound by it. Where an element of the contract is deemed to
be unfair then the rest of the contract can continue to take effect, as long
as this is practicable.
Terms that may be deemed unfair include:
— disproportionately high charges where the consumer decides not to
proceed with services that have yet to be supplied;
— terms allowing the business to determine the characteristics or subject
matter after the consumer is bound;
— terms allowing the business to determine the price after the consumer
is bound.
Transparency
The written terms of a contract should be transparent and expressed in
clear, easily understood language. If there is any doubt about the meaning
of a written term, the interpretation most favourable to the consumer will
be adopted.
Good faith
A term that causes a significant imbalance between the rights and obligations
of the various parties to the contract to the detriment of the consumer will
be deemed to be in breach of good faith.
Explain UNFAIR CONTRACT TERMS AND THE FCA
Exam question
The FCA can challenge unfair terms in financial services
consumer contracts. Specifically, it can:
request that a firm amend or remove an unfair contract
term from its future consumer contracts; and
prevent a firm from imposing the term against existing
customers by appealing to a court for an injunction.
The FCA’s Unfair Contract Terms and Consumer Notices
Regulatory Guide (UNFCOG), which is part of the FCA’s
handbook, contains information on how the FCA exercises its
powers.
The FCA has also set out the following five key messages for
firms to focus on:
“Firms should take into account consumers’ legitimate
interests in relation to contracts.
Fairness is not contrary to the prudent management of the
business, but part of it.
Focusing on narrow technical arguments to justify a contract
term that, in fact, may be unfair, risks future challenge.
Schedule 2 to the CRA and the UTCCRs each contain an
indicative and non-exhaustive list of types of terms that
may be regarded as unfair. The fact that a term does not
resemble any of the indicatively unfair terms listed in
Schedule 2 may not in itself, remove the risk of unfairness.
Firms need to assess whether a term is fair under the CRA/
UTCCRs as a whole and in the context of the particular
product or service.
Firms should take into account developments in legislation
and relevant case law concerning the fairness and
transparency of terms in consumer contracts.”
25.2 How are customers protected within the financial
services sector?
Many financial services products are, by nature, technical and not easy for
the average customer to understand; there is a reliance on the provider and
the adviser to give the customer full, accurate information that is easy to
understand. It is easy to see that providing a customer with a financial product
that does not meet their needs has considerably more serious implications
than providing them with, say, an unsuitable lawnmower. These are among
the reasons why the sector is so tightly regulated.
One of the FCA’s operational objectives (see Topic 17) is to protect consumers
of financial services and products from bad conduct. A step towards achieving
this is to make it easier for customers to know how to complain when they feel
that they have been badly treated by a financial institution or by an individual
working in the industry. Customers who are not satisfied with a firm’s
response to their complaint can refer the matter to a dedicated independent
ombudsman bureau. In some circumstances, customers who have lost money
can receive compensation. We look at these options in further detail here.
It is important to note that consumers are expected to take some responsibility
for the purchasing decisions they make – there can never be 100 per cent
protection from the impact of making poor decisions. For instance, the FCA:
makes it clear that it cannot protect investors from falls in stock market values
(although it will attempt to educate consumers about the risks involved); and
sets limits on the amounts of compensation the Financial Services
Compensation Scheme can offer.
25.2.1 The role of government departments in consumer rights compensation
The activities of various government departments affect firms within the
financial services industry and the process of advising clients:
HM Treasury – the government’s economic and finance ministry, maintaining
control over public spending, setting the direction of economic policy
and working to achieve strong and sustainable economic growth. It is the
department responsible for the regulation of financial services under the
direct authority of the Chancellor of the Exchequer. The Chancellor is also
responsible for the Budget.
HM Revenue and Customs (HMRC) – the UK’s tax, payments and customs
authority. It collects the money that pays for the UK’s public services and helps
families and individuals with targeted financial support. The self‑employed
and those who have further income tax to pay on their savings, capital gains
or who have inheritance tax liabilities have direct contact with HMRC via the
self‑assessment system. Pension providers also have dealings with them, as
they need to reclaim tax taken at source from personal pension contributions.
The Department for Work and Pensions – responsible for welfare, pensions
and child maintenance policy. It administers the state pension and a range
of working age, disability and ill‑health benefits. It also provides a useful
website outlining the benefits payable and how they can be claimed: www.
gov.uk/browse/benefits.
National Crime Agency (NCA) – the role of the NCA is to protect the public by
disrupting and bringing to justice those serious and organised criminals who
present the highest risk to the UK. As we learned in Topic 23, it tackles money
laundering, fraud, bribery and corruption, and counterfeiting of currency.
25.2.2 The role of guidance services in cons
Earlier in this section we highlighted that consumer bodies have a role to
play in consumer protection. Some of these are industry‑specific, such as the
Money and Pensions Service (previously the Single Financial Guidance Body),
whereas others have a broader remit such as Which? and Citizens Advice. We
will consider each of these bodies in more detail, starting with the Money and
Pensions Service
25.2.3 The Money and Pensions Service
The Money and Pensions Service (MaPS), previously the Single Financial
Guidance Body, brought three providers of government guidance together
into one organisation:
the Money Advice Service;
The Pensions Advisory Service; and
Pension Wise.
MaPS is an arm’s-length body sponsored by the Department for Work and
Pensions, with funding through levies on the financial services industry and
pension schemes.
Its mission is to help individuals to manage their personal finances as well
as their circumstances allow. Its aim is to deliver a more streamlined service
than the three previous providers by offering people easier access to the
information and guidance they need to help them make effective financial
decisions throughout their lives. The consumer-facing brand of MaPS is
MoneyHelper.
MaPS (2019) has five core functions:
Pensions guidance: provision of information for the public about workplace
and personal pensions.
Debt advice: providing people in England with information and advice on
debt.
Money guidance: provision of information to enhance people’s
understanding and knowledge of financial matters and day‑to‑day money
management skills.
Consumer protection: working with the government and the FCA to protect
consumers.
Strategy: working with all bodies involved in financial capability to drive
significant, co-ordinated change over the longer term.
25.2.4 Which?
Which? has, for more than 60 years, championed the causes of consumers in
a wide range of areas, including financial services. It campaigns to protect
consumers’ rights, reviews products and services, and offers independent
advice on a variety of subjects.
Which? has campaigned on many occasions for fairer treatment for financial
services customers, to the extent that it is now involved with the regulator
in many consultations and is seen as a stakeholder on issues relating to the
industry.
Which?, along with other consumer bodies including Citizens Advice, are
designated to make ‘super‑complaints’ related to the financial services sector
directly to the FCA.
In many cases, the individual consumer may not be aware of a problem because
they are not able to see the ‘bigger picture’ and so are unlikely to challenge
the provider. The role of Which? is to identify such issues and take action on
behalf of the consumer.
25.2.5 Citizens Advice
Like Which?, Citizens Advice has ‘super‑complaint’ status. It provides free,
confidential and independent advice to help people overcome their problems.
It is a voice for clients and consumers on the issues that matter to them.
It values diversity, champions equality and challenges discrimination for
everyone. Help is available online, via telephone and face‑to‑face.
25.3.2 Key requirements
The FCA places a significant emphasis on the fair treatment of customers,
and the rules and guidance on complaint handling aim to ensure that
complainants are dealt with promptly and fairly. Firms must have appropriate
and effective complaints‑handling procedures and make consumers aware
of these procedures – this is normally done through the client agreement or
initial disclosure document.
When a complaint is received, a firm must take the steps summarised in Figure
Payment services providers must give a full response to a complaint within
15 days. This can be extended to 35 days in exceptional circumstances, with a
holding letter sent in the interim.
Firms are also required to:
report to the FCA on their complaints‑handling on a six‑monthly basis;
investigate the root cause of complaints and take action to prevent the
recurrence of similar issues in future.
The FCA requires financial services firms to appoint an individual at the
firm, or in the same group as the firm, to be responsible for oversight of the
firm’s compliance with the complaints rules. The individual appointed must
be carrying out a governing function. Firms are not required to notify the
individual’s name to the FCA or FOS but are expected to do so promptly on
request.
25.3.3 Complaints resolved quickly
Firms are able to adopt a less formal approach to resolving a complaint where
the complaint can be resolved by close of business on the third working day
following receipt. This may apply to relatively minor service issues such as
rudeness by a staff member or the misspelling of a name or address on a
communication. More significant matters, such as an allegation of poor advice
or mis‑selling, would generally take longer to investigate.
Where a complaint can be resolved quickly in this way, there is no need for
the firm to provide a final response letter. However, the firm must provide a
summary resolution communication to the complainant. Situations might arise
in which the firm believes the matter has been resolved, but the customer does
not agree; the summary resolution communication will explain that, should
the complainant remain dissatisfied, they can still refer the matter to the FOS.
The format of the summary resolution communication is prescribed in DISP.
25.3.4 Root cause analysis
As well as dealing with individual complaints in a prompt, fair and consistent
manner, firms are expected to put in place appropriate management controls
and take reasonable steps to ensure that they identify and remedy any
recurring or systemic problems, for example by investigating the root causes
of complaints to identify any weaknesses in their procedures. In this way, they
should be able to improve their service to customers.
RECORD‑KEEPING of complaints
Exam question
Firms have to keep records of all complaints. Records have to
be retained for at least three years from the date a complaint
is received.
Where the complaint relates to collective portfolio management
services for a UCITS scheme, the minimum period for which
records must be retained is five years. Where the complaint
relates to MiFID business, records should generally be kept
for a minimum of five years and a maximum of seven years
(although there are exceptions).
25.3.5 Reporting
On a six‑monthly basis, firms are required to report to the FCA the following
information:
total number of complaints received;
total number of complaints closed:
— within four weeks or less of receipt;
— within more than four weeks and up to eight weeks of receipt; and
— more than eight weeks after receipt;
total number of complaints:
— upheld in the reporting period; and
— outstanding at the beginning of the reporting period;
total amount of redress paid in respect of complaints during the reporting
period; and
the root causes of complaints and corrective action taken to prevent
recurrence.
There are simplified reporting requirements where a firm receives fewer than
500 complaints in a six‑month period.
Publication of complaints information
In the interests of transparency, firms are required to publish complaints
information if they receive 500 or more complaints over a six‑month period.
Both the FCA and FOS publish complaints data.
Explain SUPER‑COMPLAINTS
Exam question
The Financial Services and Markets Act 2000 (FSMA)
gives designated consumer bodies the right to make a
‘super‑complaint’ to the FCA where they consider that there
are features of a financial services market in the UK that are or
may be significantly damaging the interests of consumers. The
FCA super‑complaints regime for financial services markets
is distinct from the cross‑sectoral super‑complaints regime
provided for in the Enterprise Act 2002.
Under the Financial Services Act 2012, designated consumer
bodies, regulated persons and the FOS can make a
super‑complaint to the FCA.
The FCA is required to respond to a super‑complaint within 90
days, setting out how it proposes to deal with the complaint
and any possible actions. The FCA’s response might, for
example:
announce plans to consult on an issue;
set out a timetable for regulatory action which would allow
the FOS to consider whether or not to place a hold or stay
on complaints;
explain how the FCA is already taking action to address an
issue; or
explain why it is not taking any action.
It can also carry out wider enquiries – such as internal research
or public requests for information – with a view to testing the
evidence. It can carry out a review of the relevant regulated
firms.
25.4 What is the role of the Financial Ombudsman
Service?
A customer who is dissatisfied with the actions of a firm must first complain to
the firm itself, as explained in section 25.3. If the customer is still not satisfied
once the firm’s internal complaints processes have been completed, they can
take their complaint to the Financial Ombudsman Service (FOS). Certain types
of pension and aspects of pension arrangements are dealt with by the Pensions
Ombudsman (see section 25.5).
The FOS attempts to resolve complaints at the earliest possible stage and
by whatever means appear to be most appropriate, including mediation or
investigation. The process for investigation is outlined in Figure 25.4.
The FOS will determine a complaint by reference to what is, in its opinion, fair
and reasonable in all the circumstances of the case, taking into account: the relevant:
— law and regulations;
— regulators’ rules, guidance and standards;
— codes of practice; and
where appropriate, what they consider to have been good industry practice
at the relevant time.
25.4.1 What are the time limits?
Complaints to the FOS must be made within six months of receiving a final
response, six years of the event that gives rise to the complaint, or within
three years of the time when the complainant should have become aware that
they had cause for complaint, whichever is the later.
If a firm receives a complaint which is outside the time limits for referral to
the FOS, it may reject the complaint without considering the merits. In a ‘final
response’, the firm must explain
to the complainant that the
complaint is ‘time barred’, and
indicate that the Ombudsman
may waive the time limits in
exceptional circumstances.
In addition, the FOS will not
usually consider any complaint
that is the subject of a court case.
25.4.2 What are the compensation limits?
Limits on the maximum compensation the FOS can award for complaints about
acts or omissions by firms (plus interest and the complainant’s reasonable
costs) are set. Different limits apply depending on when the act or omission
occurred and when a case is brought to the FOS.
Awards are binding on the firm but not on the complainant, who is free to
pursue the matter further in the courts if they wish. The award is not intended
to punish the firm, but to restore the complainant to the financial position in
which they would have been had the event complained about not taken place.
25.5 What is the role of the Pensions Ombudsman Service?
The Pensions Ombudsman Service (POS) deals with complaints and disputes
relating to the running of personal and occupational pension schemes, and
also with complaints about the Pension Protection Fund (PPF). Complaints
relate to cases of maladministration, and complainants need to show that this
has led to injustice (financial loss, distress, delay or inconvenience). Disputes
are disagreements about facts or about law.
The service does not deal with complaints about the sales and marketing of
pension schemes – these are the province of the FOS (see section 25.4) – or
with complaints about state pensions.
Complaints and disputes can be made by a wide range of people: individuals,
managers, trustees or employers. They are commonly made by:
members or ex‑members of schemes;
spouses of members or ex‑members of schemes;
widows or dependants of members who have died;
solicitors or others representing the interests of such people.
Complaints or disputes should first be addressed to the pension scheme’s
managers or trustees. If this does not result in agreement, the next step is to
contact the POS.
Complaints and disputes must be communicated to the service in writing
within three years of the event being complained about. Any time spent trying
to resolve the matter using the scheme’s internal complaints procedures is
normally excluded from this time period.
A team of assessors and adjudicators review and seek to resolve cases; final,
binding decisions are taken by the individual Ombudsmen, who are appointed
by the Secretary of State for Work and Pensions.
An Ombudsman’s decision is binding on all parties and can be enforced in the
courts.
See also section 24.2 on the role of The Pensions Regulator and section 24.3
on the PPF.
25.6 The Financial Services
Compensation Scheme
The Financial Services Compensation Scheme (FSCS) provides compensation
for customers who have lost money through the insolvency of an authorised
firm. The PRA and the FCA are jointly responsible for the rule‑making and
oversight of the FSCS and undertake regular reviews of the compensation
framework. The FSCS’s costs are made up of management expenses and compensation
payments. The scheme is funded by levies on firms authorised by the FCA
and the PRA. Levies are split into five broad classes corresponding to the
sub‑schemes outlined below, and contributions are based on the class and
specific activities each firm undertakes.
To qualify for compensation, a claimant must be eligible under rules outlined
in the FCA Handbook. The main points are as follows:
Compensation can only be paid when an authorised firm is in default.
Claims cannot be made against the FSCS for other losses, ie losses due to
negligence, poor advice or a fall in stock market values.
Compensation can only be paid for financial loss and there are limits to the
amounts of compensation payable.
The FSCS was set up mainly to assist private individuals, although smaller
businesses are also covered. Larger businesses are generally excluded,
although there are some exceptions for deposit and insurance claims.
The FSCS does not cover firms based in the Channel Islands or the Isle of
Man.
DEPOSITS
Exam question
This sub‑scheme covers claims made against failed
deposit‑taking firms, for example banks, building societies and
credit unions. The FSCS is triggered when a firm authorised
to accept deposits by the PRA goes out of business, eg if the
firm goes into administration or liquidation, and is unable to
repay its depositors. The FSCS can also be involved if the PRA
considers that an authorised firm is unable, or likely to be
unable, to repay its depositors.
Maximum claim
Generally 100 per cent of £85,000 per person per firm, although
there is cover of up to £1m for temporarily high deposit balances.
The £1m limit applies to balances that are held for less than six
months and provides additional protection where a person’s
savings are temporarily boosted by certain life events such as: sale of a house;
divorce settlement;
taking pension benefits;
receipt of inheritance;
redundancy payment;
criminal injuries compensation.
To claim under the higher £1m limit, a person would have to
provide proof that the money was only held temporarily as a
result of a relevant life event.
DEBT MANAGEMENT
Exam question
Customers with money held by debt management firms may
be covered in relation to client money they held with a failed
debt management firm of up to £85,000.
INVESTMENTS
Exam question
The FSCS is triggered when a firm authorised to advise on or
arrange investments goes out of business, and is considered
by FSCS to be unable, or likely to be unable, to pay claims
made against it. This will generally be because the firm has
stopped trading and has insufficient assets to meet claims, or
is insolvent.
Maximum claim
100 per cent of £85,000 per person per firm.
INSURANCE COMPANIES
Exam question
This sub‑scheme covers claims for compensation that arise
following the failure of an authorised insurer (life and general).
Maximum claim
For all long‑term insurance and for certain types of general
insurance, compensation is 100 per cent of the value of
the policy with no upper limit. (Policies with 100 per cent
protection include long‑term and general insurance that
provide benefits on death/disability only.)
Where a long‑term policy includes a savings as well as a
protection element, the protection element has 100 per
cent protection.
Annuities that are being used to provide an income also
receive 100 per cent protection.
If the insurance is compulsory (such as employers’ liability
cover or motor insurance), the figure is 100 per cent of the
whole amount.
For other types of insurance the compensation limit is 90
per cent of the claim with no upper limit.
INSURANCE BROKERS
Exam question
The FSCS will safeguard policyholders if an authorised firm is
unable, or likely to be unable, to pay claims against it, eg if it
has been placed in provisional liquidation or administration.
Maximum claim
Compensation is 90 per cent with no upper limit.
1) In situations where alternative dispute resolution is being
used, which of the following options allows for appeal through
the courts?
a) Arbitration.
b) Mediation.
c) Adjudication.
d) Conciliation.
1) c) Adjudication. Note that option d) conciliation is not one of the options
available under alternative dispute resolution.
2) In summary, in what circumstances is a contract or notice
deemed to be unfair?
2) A contract or notice is deemed to be unfair if it causes a significant
imbalance in the rights and obligations of the various parties to the
contract to the detriment of the consumer.
3) Which of the following would not be classed as an eligible
complainant according to the FCA’s definition?
a) A private individual.
b) A business with an annual turnover below £6.5m and fewer
than 50 employees, or an annual balance sheet below £5m.
c) A charity with an annual income of less than £6.5m when
the complaint is made.
d) Trustee of a trust that has a net asset value of less than
£6.5m when the complaint is made.
3) d) The net asset value must be less than £5m, not £6.5m.
4) Which of the following is a step that must be carried out when
a firm receives a complaint, if it cannot be resolved within
three working days?
a) Call the complainant to discuss the matter.
b) Advise the customer that they can refer the matter to the
FSCS.
c) Refer the complaint to an individual in an FCA governing
function.
d) Ensure the complaint is investigated by a person of sufficient
competence, who, where possible, is not someone directly
involved in the matter under complaint.
4) d) A firm must ensure the complaint is investigated by a person of
sufficient competence, who, where possible, is not someone directly
involved in the matter under complaint.
5) Within what period of time does the FCA expect firms to resolve
the majority of complaints?
5) Eight weeks.
6) Once a firm has completed its procedures for resolving a
complaint, it must always issue the complainant with a final
response letter. True or false?
6) False. For complaints that are resolved by close of business on the third
working day following receipt, the firm must provide a summary resolution
communication to the complainant, advising them of their right to refer
the matter to the FOS should they remain dissatisfied with the firm’s
response.
7) For how long must records of complaints involving MiFID
business be retained by the firm?
a) One year.
b) Three years.
c) Five years.
d) Indefinitely.
7) c) Five years.
8) Within what time limits must a complaint be made to the
Financial Ombudsman Service?
8) Complaints to the FOS must be made within six months of receiving a final
response, six years of the event that gives rise to the complaint, or within
three years of the time when the complainant should have become aware
that they had cause for complaint, whichever is the later.
9) Which organisation is responsible for dealing with complaints
relating to the sale of pension products?
a) The Financial Ombudsman Service.
b) The Pensions Ombudsman Service.
c) The Money and Pensions Service.
d) The Financial Services Compensation Scheme.
9) a) The Financial Ombudsman Services. The Pensions Ombudsman Service
only deals with complaints relating to the running (ie administration) of
personal and occupational pension schemes. The Money and Pensions
Service does not get involved in pension complaints. The Financial
Services Compensation Scheme deals with compensation for customers
who have lost money through the insolvency of an authorised firm.
9) Which organisation is responsible for dealing with complaints
relating to the sale of pension products?
a) The Financial Ombudsman Service.
b) The Pensions Ombudsman Service.
c) The Money and Pensions Service.
d) The Financial Services Compensation Scheme.
9) a) The Financial Ombudsman Services. The Pensions Ombudsman Service
only deals with complaints relating to the running (ie administration) of
personal and occupational pension schemes. The Money and Pensions
Service does not get involved in pension complaints. The Financial
Services Compensation Scheme deals with compensation for customers
who have lost money through the insolvency of an authorised firm.
10) What is the maximum permissible compensation payable by
the FSCS for a term assurance policy that provides £100,000
cover over a 20‑year term?
10) One hundred per cent of the value of the policy with no upper limit
