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Growing Pains: the many problems facing PRIIPs

Growing Pains: the many problems facing PRIIPs
  • United Kingdom
  • Financial services and markets regulation - Briefings and articles

29-10-2019

The Packaged Retail and Insurance-based Investment Products (PRIIPs) Key Information Document (or KID) has only been around since last year but, as a policy dossier, it is already over a decade old. Creaking under the weight of widespread criticism, the regime needs significant reworking before UCITS operators are forced to use it.1

The PRIIPs regime was announced as a European Commission policy intention back in April 2009. While its aims have been generally supported, the implementation has been arduous and the output almost universally criticised, including by national competent authorities.

We now have an uncomfortable position where firms are making statements that downplay or even contradict a regulatory-required disclosure because they are concerned about the risk of miss-selling. At the same time, it is difficult to argue at this stage that PRIIPs has improved the position, with respect to disclosure, of any of the types of products within its scope.

In this article, we look at the current state of play and towards the future of this troubled regime.

Overly ambitious

The PRIIPs Regulation aims to cut across various product areas that were previously subject to separate regimes, condensing, simplifying and unifying the disclosure. It is an ambitious aim, allowing consumers to compare structurally different products that have similar investment return profiles.

But, as is often the case, one size does not fit all, and this problem manifests itself in two quite different ways. The regime is simultaneously overly broad and too specific. Continuing the one-size-fits-all analogy, it is tight in some places and baggy in others.

The framework legislation (so-called Level 1 regulation) is broadly drafted. The drafting appears to follow a cast-the-net-widely-and-exclude approach as opposed to an approach comprehensively specifying what should be included. This makes the regime comprehensive, flexible and future-proof. The obvious disadvantage is that it leads to fundamental uncertainties as to which products are in scope, which geographies are in scope, and who is a manufacturer.

On the other hand, the legislation that specifies the form and content of the KID (Level 2), aims to be prescriptive in its application so that the resultant KIDs are prepared in a uniform way. In an effort to be universal, however, this approach fails to allow for the nuances of products that are fundamentally different. This has led to a catalogue of implementation problems from misleading performance presentations to flawed risk disclosures.

Sticking plasters

The European Supervisory Authorities (ESAs), the European Commission and the UK’s Financial Conduct Authority (FCA) have all intervened in some way to try to alleviate the issues firms have faced in implementing PRIIPs.

There have been numerous statements regarding scope. The FCA published a Policy Statement in May 2017 confirming the scope for ISAs, investment trust savings schemes, account services, debt securities, VCTs and Holloway sickness policies.2 The Commission also issued guidelines on the application of the regime in July 2017 which makes some useful clarifications (including territorial application, closed offers, and PRIIPs issued against no consideration).3 The ESAs and the Commission have also exchanged letters (in 2018 and 2019) regarding the application of the regime to bonds.4

In respect of the application of the Level 2 requirements, the ESAs published a 48-page Q&A covering a variety of topics.5 However, within a month of the PRIIPs KID coming into force, perhaps the most remarkable intervention was the FCA’s statement that it is “comfortable with [PRIIPs manufacturers] providing explanatory materials to put the [performance scenario] calculation in context and to set out their concerns for investors to consider”.6 In other words, the publication of ancillary documents that supplement (but may even contradict) the PRIIPs KID.

Although the interventions above are helpful, none are binding. Each is a sticking plaster, intended to provide some comfort, but belies the fact that the underlying regime needs major surgery. Such a degree of supervisory intervention should not be needed just to understand the fundamentals of a regime.

Listening mode

Both the FCA and the ESAs have been consulting with the industry.

In July 2018, the FCA published a Call for Input.7 This work highlighted issues around the uncertainty in applying the regime, particularly the potential for the summary risk indicators and performance scenarios to mislead consumers. In its February 2019 Feedback Statement, the FCAstated its concerns around some of these topics and said it would be working with the ESAs and the Commission to address them.8

In parallel, the ESAs launched a limited consultation into the PRIIPs KID in November 2018 and the outcomes of that consultation were also published in February 2019.9

This is not the full scale review of the PRIIPs regime that was envisaged to be undertaken by the Commission under the PRIIPs Regulation itself. That review was originally scheduled for December 2018 and has now been pushed back until December 2019.

That review by the Commission will of course be informed by work of the ESAs. It is a shame therefore that this consultation was extremely short dated, with firms having less than a month to respond in the busy lead up to Christmas (although, as discussed below, a further consultation is planned).

You may well ask: if the concerns regarding PRIIPs have been so thoroughly exposed, to the point that a national regulator is willing to state its concerns, why have these reviews not been more joined up and comprehensive? The answer is complicated, but essentially it is driven by UCITS funds.

UCITS fall within the PRIIPs definition, but they have the benefit of an exemption to allow them to continue to provide a UCITS KIID instead of the PRIIPs KID. That same exemption also applies to other non-UCITS products whose regulators have adopted the UCITS KIID (e.g. UK NURS).10

However, the exemption was time-limited, and it was due to expire on 31 December 2019. There was no equivalent cut-off that applied to the requirement to produce the UCITS KIID, meaning that without further legislative intervention, UCITS funds would have been subjected to both regimes from 1 January 2020.

It was in that climate that the Commission mandated the ESAs’ consultation. Therefore the ESAs had one eye on fixing known problems with PRIIPs and another on how to make PRIIPs work for UCITS.

A remedy for UCITS has since come in the form of a further period of exemption until 31 December 2021.

That amendment was tacked onto the Regulation on the cross-border distribution of collective investment schemes, which came into effect on 1 August 2019.11 A parallel piece of legislation to allow multi-option products (e.g. fund-linked insurance products) to rely on UCITS KIIDs for the disclosure of the underlying options is planned. But will these be more plasters?

Not so popular

The ESAs’ final report revealed that stakeholders did not on the whole support the amendments the ESAs suggested in their consultation, and it seems that stakeholders took the opportunity to comment on the regime more widely, not just on the narrow topics under review.

As a result, the ESAs concluded that they would not propose substantive amendments to the PRIIPs regime until later.

In the following paragraphs, we look at the points addressed by the ESAs’ consultation and final report in further detail, particularly the original suggestions and notable criticisms or weaknesses.

KIID vs KID

The ESAs’ consultation includes a high-level gap analysis between the existing UCITS KIID and PRIIPs KIDs requirements, considering which UCITS-specific disclosures should be ported over (with specific emphasis on the rules around the extent of passive versus active management), including those for specific types of UCITS structures.

The proposal was for these UCITS-specific content provisions to be included in the Level 2 Regulation, which, the ESAs conceded, might then also need to be read across to different types of PRIIPs for consistency.

Most respondents did not comment on these points. However, some respondents were concerned that a notable benefit of the PRIIPs regime might fall away – that the PRIIPs KID does not need to be provided to professional investors (whereas the UCITS KIID has to be provided to all investors).

Expectation management

The rest of the material points in the ESAs’ consultation concerned awkward or misleading disclosures.

Performance scenarios

The issue with performance scenarios (projected unfavourable, moderate and favourable scenarios) is that they have the

potential to be overly optimistic. They draw from five years’ historic returns and use past performance as a prediction of likely future performance. The ESAs previously tried to address this by including the fourth stress scenario (which is calculated on a different basis) featured in the present-day PRIIPs KID. However, the issues persisted.

The consultation included a number of options:

  • Use of past performance alongside simulated future performance. Although not perfect, past performance is at least a factual statement about the product. But responses appear to have been mixed. Past performance is favoured for products that actually have past performance (like funds), and indeed firms felt it should replace the existing simulated future performance presentation (rather than being alongside it). Past performance does, however, have the potential to suggest the fund will perform as well in the future. Certain products also do not have past performance (structured notes, contracts for difference, etc.) and would need to use a simulation which may give rise to data-sourcing issues. The ESAs will be considering this further in their upcoming work.
  • Amendments to narrative explanations to contextualise the performance presentation. In practice, firms are already doing this in external warnings and the ESAs decided to publish a supervisory statement (in relation to the existing rules already in force), including a new recommended piece of narrative to be included in the PRIIPs KID downplaying reliance on the performance scenarios.12
  • Changing the methodology for the future performance scenario so that it is based on a risk-free rate of return. This is unlikely to capture all factors that affect a product’s performance and stakeholders noted that it hides the risks posed by different asset classes.
  • Changing the nature of the existing performance scenarios so that only two scenarios are given (favourable and stress scenarios with a broader range of underlying outcomes). This means providing investors with less information about the product and there is a risk that investors see the two outcomes as the maximum and minimum.
  • Use more historical data (e.g. 10 years rather than five). However, this extended data set may still not cover periods of poor performance (meaning the projected performance continues to be over-optimistic) and many products would not have a sufficient past-performance history. This was also not favoured by stakeholders.

Products that can close early (auto-callable products)

Some products may automatically mature or close at different trigger points, depending on market conditions. That point may occur earlier than the recommended holding period. The performance scenarios presentation currently assumes that the product is held for the recommended holding period in all cases, which may mean displaying a post-cost return for years when the product would have already matured. The consultation proposed an alternative, based on likely holding periods in the various scenarios. For example, if the favourable scenario arises, the product may be called during year one, in which case there is no need to show the performance after costs for later years. Most respondents were in favour but a significant minority were not.

Summary risk indicator

The Summary Risk Indicator relies on formulas to determine the product’s market risk measure (MRM), which contributes to the overall risk rating. Different categories of PRIIP have different formulas. For “Category 2” PRIIPs (including most funds), the formula assumes a one-off investment, making it less suited to regular payment schemes. To allow these Category 2 PRIIPs to capture regular payments, the formula will need to be amended. The consultation made a proposal for a variation to the formula for this purpose.

The consultation also proposed a longer free-text narrative of 300 for explaining risks not otherwise captured by the summary risk indicator. This amendment was favoured by stakeholders.

Narratives for performance fees

This has been identified as an area where the prescribed text is fundamentally incompatible with some of the products in scope, since it assumes that performance fees are only triggered by a specified outperformance of a benchmark. Specifically this does not work where the trigger for the performance fee is not considered to be a benchmark or the trigger is not an index at all.

Therefore the language was proposed to be relaxed so that other triggering conditions can be specified. Flexibility was generally favoured by stakeholders although one noted that the actual language proposed by the ESAs may not address all scenarios.

Growth assumptions for reduction in yield calculations

The reduction in yield is based on each product’s moderate predicted performance scenario. An unfortunate implication is that a product that is predicted to perform less well will appear cheaper (e.g. if the moderate scenario shows a zero or even negative return). Instead, the ESAs proposed to use a fixed assumed 3% return for all PRIIPs instead of the moderate scenario. The predictable issue identified by stakeholders is that a 3% return would be generous to certain products (e.g. those with returns in line with money market rates).

Who makes the rules?

The consultation and final report indicated the various places that the PRIIPs Level 1 and Level 2 Regulations would need to be amended to implement the proposed changes. However, the ESAs also originally suggested that some of the fixes could be supplemented by Q&As (particularly if the changes to the legislation were kept light).

The ESAs are to be commended for thinking practically (it being far easier to pass minor changes to legislation), and it seems that the ESAs were making the best of a bad situation (now alleviated by the official extension to the UCITS exemption).

However, the tendency to rely on devices like Q&As is a problematic development that essentially allows quasi-laws to be written on the fly. We are seeing this happen in other policy areas. The Q&As are not consulted on, cannot be relied on legally and yet become de facto industry standards. More worrying, Q&As often contain content that is extremely difficult to reconcile with the source material, can contradict established practice in particular member states and can cause inconsistency with local requirements.

Ambiguous legislation needs to be fixed at source. We do not need any more plasters.

Time for a change

It is clear that stakeholders felt that the proposals did not get to the heart of the problems they faced. In the ESAs’ own words: “the amendments were considered to be of limited benefit and to not address the fundamental issues”.

This was perhaps the result of a residual dogmatic stance in the ESAs’ consultation concerning the need for a level playing field. However, there are signals that the ESAs will be increasingly willing to consider product-specific variations in the rules.

This is a positive development.

For PRIIPs to become a better regime, it needs to get more specific in its scope and more flexible in its delivery. That means that the drafting may need to become less idealistic. It may need to mirror the patchwork of regimes it sits on top of, and become less universal. Essentially, the one-size-fits-all approach needs to become a more tailored approach.

When it comes to narrative disclosure, rather than prescribing language, the rules could set out the policy aim and allow firms to come up with appropriate language. In many cases, firms will be able to explain risk with better language and in simpler terms than the prescribed language in the regulation.

Yes, that might mean that there are slight variations for different products. Yes, that might mean that rather than having a “Category 1”, there is just a subset of rules for “funds”, “insurance products”, and so on. Yes, it might theoretically risk a playing field with a few bumps in it. However, it would also mean that the output would make more sense when a product is viewed on its own, and would still be very largely comparable when put side by side.

Perhaps acknowledging this way of thinking, the ESAs next consultation (discussed below) is to include consideration of where it might be “appropriate to introduce some additional differentiation in how the rules apply to different types of products, while still adhering to the overarching aim of comparability…”

The “B” word

At the time of writing, it is a distinct possibility that the UK will leave the European Union without entering into a withdrawal agreement (and the transitional arrangements that would come with it). PRIIPs is one area where greater discretion for the FCA could usefully be employed to fix some of the issues with the PRIIPs regime (without slavishly following a single rulebook agenda). However, like all similar notions in this space, we will need to balance flexibility with reciprocity, as international firms want single standards that can be applied across territories. Additionally, there are matters of resource and priority. Those considerations are all well documented.

So, what next?

The ESAs are currently working towards a new RTS (a draft amended Level 2 Regulation). With that aim in mind, they published a new Consultation Paper on 16 October 2019.13 This consultation will be open until 13 January 2020.

Following this, the ESAs will be working with the Commission to test existing and proposed approaches with consumers, and intend to conclude their review “around the end of the first quarter 2020.”

The Consultation Paper covers old and new ground, including: performance scenarios, potential use of past performance, calculation and presentation of costs, changes to accommodate UCITS, the rules for multi-option PRIIPs and a lengthy proposal for the legislative changes that would be required.

The revised rules will come into force by the beginning of 2022, but it is possible that the changes will be brought into force earlier in 2021 (this is one of the points under consultation).

We eagerly await firms’ responses.

 


Article originally published in "Global Trustee and Fiduciary Services News & Views", Issue 52, 2019. Link here.

1 Packaged Retail and Insurance-based Investment Products.

2 PS17/6: FCA’s Disclosure Rules Following Application of PRIIPs Regulation: Feedback to CP16/18 and Final Rules, Financial Conduct Authority, 2 May 2017.

3 Guidelides on the Application of Regulation (EU) No 286/2014 of the European Parliament and of the Council on Key Information Documents for Packaged Retail and Insurance-Based Investment Products (PRIIPs) (2017/C 218/02).

4 Letter from the ESA Chairs to Olivier Guersent dated 19 July 2018, “Implications of the Uncertainty as to the Scope of the PRIIPs Regulation (1286/2014) and Request for Commission Guidance. Link Letter from Olivier Guersent to the ESA Chairs dated 14 May 2019, “Guidance on Bonds”.

5 Questions and answers (Q&A) on the PRIIPs KID, JC 2017 49, 20 November 2017.

6 Statement on Communications in Relation to PRIIPs, Financial Conduct Authority, 24 January 2019.

7 Call for Input: PRIIPs Regulation — Initial Experiences with the New Requirements, Financial Conduct Authority, July 2018.

8 FS19/1: PRIIPs Call for Input Feedback Statement, Financial Conduct Authority, February 2019.

9 Joint Consultation Paper Concerning Amendments to the PRIIPS KID, Joint Committee of the European Supervisory Authorities, JC 2018 60, 8 November 2018. Final Report Following Joint Consultation Paper concerning Amendments to the PRIIPs KID, Joint Committee of the European Supervisory Authorities, JC 2019 6.2, 8 February 2019.

10 Key Investor Information Document.

11 Article 17 of Regulation (EU) 2019/1156 of the European Parliament and of the Council of 20 June 2019 on Facilitating Cross-Border Distribution of Collective Investment Undertakings and Amending Regulations (EU) No 345/2013, (EU) No 346/2013 and (EU) No 1286/2014.

12 Joint ESA Supervisory Statement Concerning the Performance Scenarios in the PRIIPs KID, included as an Annex to the Final Report dated 8 February.

13 Joint Consultation Paper concerning amendments to the PRIIPs KID, Joint Committee of the European Supervisory Authorities, 16 October 2019.