A foggy compo system
The cost of the FSCS levy to life and pensions advisers rose by £85 million in 2015/16. Had this been from a starting point of several hundred million pounds the increase would have been significant. When you consider that the starting point for this increase was a 2014/15 levy of £34.5 million, the increase is staggering.
In the context of an increasing and unpredictable levy it is not surprising that the FCA is reviewing how the FSCS is funded. The possibility of risk-based levies, amended funding classes and better use of credit facilities are amongst the recommendations made.
It is important that the FSCS funding model functions properly, but there are other issues related to compensation that also need to be addressed.
If we were creating a wish list when it came to sorting out compensation, what issues would you put on it?
Top of the list for many would be the way the FSCS levy creates a position whereby firms that haven’t advised on failed investments, or permitted them in SIPPs, are paying a levy to compensate for the actions of those who have provided this advice or permitted the investments. Linked closely is the issue of phoenixing firms.
Lack of consistency in how the FSCS treats advised and non-advised individuals in relation to unregulated investments is also seen as a problem that must be addressed. Compensation is not paid directly in relation to unregulated investments, but in relation to the advice to invest. This leaves investors in failed unregulated investments in a position where those who were advised can claim compensation, whereas those who were not advised cannot – even though they hold the same unregulated investment.
Questions have also been raised about the adequacy of ongoing and run-off PI cover when it comes to advice on non-standard investments. In some cases compensation claims will fall on the FSCS, and so the funding cost will fall on other advisers, because the original advice was excluded from cover. Strengthening the requirements relating to cover in relation to some investments may not solve the problem. Insurers are still going to refuse to cover some risks, but perhaps linking the introduction of a risk-based levy to investments excluded from PI cover may help.
Moving on from the funding of FSCS compensation, issues continue to exist in relation to the payment of compensation, particularly where this is linked to investments in a pension scheme.
Most people assume that if compensation is paid in relation to an investment held in a pension scheme, for example a SIPP, it would work on the logical basis that:
- The compensation would be paid back to the SIPP.
- The compensation payable would be for the amount of assessed compensation, not adjusted for tax.
As with many other compensation-related matters it is not that simple. The issue on this occasion is not with the FCA, but with how HMRC interprets the rights to compensation.
In the vast majority of cases where compensation is payable in relation to SIPPs, the right to compensation is viewed as being held by the member personally. This means compensation is payable to the individual rather than to their pension scheme.
If the individual wants compensation to be paid into the pension scheme it typically has to be treated as a tax-relievable contribution. This creates serious problems for individuals with enhanced or fixed protection – the protection is lost. It can also be problematic if the compensation is for an amount greater than the member’s earnings or if it creates issues with the annual allowance.
This creates an anomaly where, if compensation is payable of, say, £40,000 and the individual retains it, £40,000 has indirectly been transferred out of their pension scheme without being taxed. If compensation is instead directed into the SIPP then, because it is treated as a tax-relievable contribution, the taxman very kindly pays a tax relief top-up. In this example, a generous £10,000 bonus!
The Financial Ombudsman Service has recognised and attempted to solve this SIPP anomaly. Unfortunately with perverse results. The FOS is directing, where compensation is retained outside the scheme, that it must be reduced by an amount equivalent to the tax that would have been paid on it at withdrawal. So an individual in the example above might be paid £34,000 in spite of an entitlement to compensation of £40,000. Similarly, if compensation is directed into the pension scheme the FOS is directing that the firm responsible for paying the compensation only needs to fund the net amount, here of £32,000. It is accepted that the state will fund the £8,000 tax.
All of this clearly needs sorting out. Advisers aren’t happy at the funding of FSCS compensation. Taxpayers would be equally unhappy if they knew they were funding a big chunk of directly paid compensation.
Francis Bacon once said “Imagination was given to man to compensate him for what he is not; a sense of humour to console him for what he is”.
I’m fairly certain that Francis Bacon was not thinking about the FSCS when he wrote this. However, I am sure many are struggling to maintain their sense of humour in light of ever-increasing levies. Equally, I’m sure we all hope that whoever is now tasked with solving the compensation dilemma has more imagination than the last culprit!