In the regulatory world, last week was all about the long-awaited publication of the technical standards for the EU Sustainable Finance Disclosure Regulation (SFDR). In all the excitement, another piece of regulation, which came out just a day earlier, went practically unnoticed. That was the revised technical standards for the key information document (KID) of packaged retail investment and insurance-based products (PRIIPs).
For those of us who are “cult” followers of PRIIPs, this was even more hotly anticipated than SFDR. Those that are not cult followers of PRIIPS might be wondering why. The reason is simple: the regulation is fundamental to the way that we communicate with clients. It will change everything we have grown accustomed to seeing in a UCITS fund’s key investor information document (KIID).
The added bonus is that PRIIPs has been one of the most controversial and contested legislative files in EU history. There are always surprises and, sometimes, even drama in the process.
So what is in the latest episode in the PRIIPs saga?
“Previously in PRIIPs…”
To re-cap what happened in the previous episodes, PRIIPs came into effect in 2018. Quickly afterwards however, it became obvious that there were major issues on three key areas:
- Performance is shown as scenarios, i.e. forecasts of returns that someone may expect to get in the future. These are based on past returns, but past returns are not shown at all.
- Costs are counter-intuitively presented as a “reduction-in-yield” (RIY), i.e. return that is lost (because there are ongoing charges and other costs) instead of what the costs have actually been.
- One component of costs (implicit transaction costs, relating to dealing in the underlying assets of the fund) is estimated using a methodology called “slippage” which contains market noise and, depending on how the market has behaved, can result in misleading and confusing cost numbers (including negative cost numbers) which cannot be explained.
The more fundamental problem, as we wrote last year, is that PRIIPs covers a very diverse set of products that work in very different ways.
There are structured products designed to deliver an outcome based on what happens to something else, e.g. an index rising above a certain level. There are insurance products that involve a future guarantee and may involve biometric elements, e.g. cover in case of death. And there are (non-structured) investment funds that have an investment objective but do not guarantee any outcome.
Regulators have been striving to apply the same rules to everything. This drive for full comparability has sometimes come at the cost of meaningfulness. Policymakers have refused to amend the overarching framework (Level 1 regulation) to allow for a more tailored approach. As a result, finding a solution has been placed solely at the hands of the European Supervisory Authorities (ESAs) who, by design, can only tweak the technical details (through Level 2 regulation).
After multiple efforts over the last two years, the ESAs finally submitted the technical rules to the European Commission last week.
These rules had actually been drafted and rejected by the same ESAs in July 2020 and after months of eerie silence, the Commission sent back not one but two letters in quick succession. The first one in December 2020 asked for a resolution of the problem, effectively saying that the Commission would take over if the lack of progress were to continue. The second one in January 2021 outlined a number of actions the Commission would commit to (after completing another study by the end of 2021) if the ESAs would be forthcoming with the rules. These actions included a broader review of the PRIIPs regulation, alignment of disclosures between PRIIPs and other regulation, and consideration of digital delivery of key information.
The ESAs promptly approved the exact same rules they had rejected last summer but were explicit that they did so based on the Commission’s promises in the January letter.
The solution for performance
The answer to the KID question “What could I get in return?” will remain in the form of a table showing possible returns under four scenarios: favourable, moderate, unfavourable, and stress. But there is now going to be some divergence between structured and non-structured products.
The former will continue using the same methodology but firms will be able to make adjustments if they consider the results provide investors with “inappropriate expectations about the possible returns they may receive”.
Non-structured PRIIPs will calculate the product’s return on a rolling window basis within the past ten years. The lowest of these values will be the unfavourable scenario, the median the moderate and the highest the favourable. The length of this rolling window will be determined by the recommended holding period of the investment product as defined by the provider (usually five years). If there is not enough historical information for such a calculation, firms can use the reference benchmark as a proxy and if there is no reference benchmark, they can use a benchmark they consider to be appropriate and which is subject to the EU Benchmark Regulation. Notably, the stress scenario calculation will remain as it was.
The proverbial ‘cherry on the top’ is that non-structured PRIIPs will additionally include a link in the “Other relevant information” section, guiding investors to another website or document showing past performance. This will be in the form we know and love from UCITS disclosure: a bar chart with the discrete annual returns over the past ten years. The reason for not showing the actual chart in the performance section of the KID is that it would apparently contravene Level 1 regulation.
We can debate whether investors will ever open and read a KID, let alone another document within it (we believe they won’t). The fact is that the ESAs have managed to bring past performance back into the picture because they think it is “key information for retail investors” and they stated that they need it for ongoing work on closet indexing. To be fair, they are clear that this is the “second best” solution; the best one being reviewing the Level 1 rules. We agree.
The solution for cost presentation
Cost in PRIIPs is presented in two tables: one showing the impact of the total cost on returns over different holding periods and one listing all the different cost components. The total cost has been presented as an RIY and this RIY presentation remains in the revised rules. The ESAs acknowledged the concerns around it, including those by consumer associations that retail investors don’t understand it, but consider that “the key message for the retail investor is not which calculation method has been used, but that this is a summary figure that they can use to compare between different PRIIPs”.
Nevertheless, the ESAs have made some adjustments to it.
First, where the total cost is presented for a holding period of one year (which all PRIIPs products must do), the RIY figure will now assume a 0% return. For other holding periods (and the recommended holding period) RIY will assume the return of the moderate performance scenario. But still, this means that the one-year figure will be much more aligned to what investors see from distributors which is subject to different regulation (MiFID).
Second, where the individual cost components are listed, there will be additional explanation as to what those are. They will also be expressed as:
- For insurance-based products: RIY assuming moderate scenario return and recommended holding period
- For everything else that falls in the scope of MiFID: cost expressed as RIY in monetary terms assuming 0% return and one year holding period.
The solution for implicit transaction cost estimation
We have written quite extensively about transaction cost disclosure and the use of the slippage methodology in estimating implicit transaction costs. All the evidence so far suggests that slippage can contain market movement. Regulators have insisted that aggregating across many transactions will cancel this market movement out. Again, the evidence suggests that this does not happen even at a fund level, which becomes most apparent when funds report a negative transaction cost figure.
Despite evidence to the contrary, the ESAs maintain that “slippage is a more accurate representation than bid-ask spread”. But they still go on to introduce exemptions to the use of slippage. They will allow use of the spread approach for over-the-counter transactions and if the number and volume of transactions is so low that aggregation does not eliminate the effects of market movement. We note that no concrete definition is given as to how low “very low” actually is.
This is a considerable step forward and will improve transaction cost disclosure for many funds. But the slippage issue remains for other funds. According to the ESAs, the solution is to “floor” the total (sum of explicit and implicit) transaction costs at a minimum of (the always positive) explicit transaction costs.
This is baffling. A floor being proposed at all proves that something is wrong. Negative costs are a symptom but not the disease: they just indicate the flaw in the methodology which can also artificially inflate positive costs. So the problem with the floor is that it hides the issue under the carpet rather than treating it head on.
Another consequence of this floor concerns the anti-dilution benefit. Anti-dilution is a mechanism to manage transaction costs caused by people buying and selling fund units and it is expressed as a negative transaction cost because it is a benefit for the fund and the investors in it. The new PRIIPs rules say that this benefit will only be taken into account to the extent that it “does not take the total transaction costs below explicit transaction costs”. So if clients benefit from it, they will never know they do.
All in all, this floor will probably be anathema for all supporters of cost transparency.
Divergence hidden in plain sight
The most observant among the cult followers will have noticed that despite the relentless drive for having fully comparable information across the PRIIPs product universe, the new rules end up making some distinctions between different types of PRIIPs.
For performance, it is not just the link to past performance information that changes the balance. It is also the fact that the methodologies behind the performance scenarios will now differ between structured and non-structured products even if they are shown as a table in the same format.
For costs, there may be comparability on the aggregate cost figure, but the separate cost components will be shown on a different basis. Structured products will assume the return of the moderate scenario. Non-structured products will assume a 0% return and show the figure only as a monetary amount.
The question then is, why not go all the way and tailor disclosure according to product type? This is not without precedent. For example, UCITS makes this distinction and allows structured UCITS to show scenarios and non-structured products to show only past performance.
Running out of time again
The cult followers of PRIIPs will remember how little time was available for non-UCITS products to prepare before PRIIPs came into effect in 2018. Now that UCITS are due to roll into PRIIPs, we are in the same place.
To make matters (marginally) worse, the rules we saw last week are not final. If adopted by the Commission (and we expect they will be) they then need to be endorsed by the European Parliament and the Council of the European Union. Could there be surprises there? Unlikely, as it has become crystal clear that many want to see the back of PRIIPs. So we expect the rules to be rubberstamped soon (about a year later than expected) which leaves less than ten months to implement them.
The European asset management industry has already called for a delay in the implementation. Is time pressure really a problem? Yes. But not more so than the fact that the amendments solve some but not all problems. Or more accurately, they solve some problems in some but not all ways. So we still have a suboptimal key information document that we must show to retail investors.
Better Finance, the voice of European retail investors, and the Chartered Financial Analyst Institute (CFA) have sent a joint letter asking for the UCITS exemption to be extended until the Level 1 review has been completed. Unless this really happens, we will have to wait for at least another couple of years until the Commission delivers on its promises and reviews the entire framework which will (hopefully) result in better information for investors.
Another PRIIPs saga across the Channel
As part of last October’s Financial Services Bill, the UK government listed critical areas for the competitiveness of the financial services sector in a post-Brexit world. PRIIPs had the honour of being part of this list.
The three changes, which had already been presented in an HM Treasury policy statement last July to “avoid consumer harm”, included reviewing the scope, changing the presentation of performance information, and extending the exemption of UCITS from the PRIIPs rules until the end of 2026. The idea is that by that time, the government will have reviewed the disclosure framework for UK investment products and introduced a more appropriate domestic successor to the UCITS KIID.
One can only hope that this review will cover the contentious point of how to estimate implicit transaction costs as well.
In the interim, we have yet to see whether those EU UCITS still allowed to be sold in the UK will need to keep providing a UCITS KIID for the UK investors, while still having to produce the new PRIIPs KID for EU investors.
So long, UCITS KIID!
The latest episode in the PRIIPs series is an improvement but, yet again, not a permanent fix. As long as policymakers do not revisit the fundamental framework, the ESAs will remain constrained to the technical detail and not be able provide a definite solution.
It is not a secret that we have strong views on the matter of PRIIPs disclosure, expressed by our CEO and our Head of Public Policy. We have written multiple times about it and (obviously) still do. We have responded to consultations and attended roundtable discussions. And we will continue providing views and input when the opportunity arises again – as, undoubtedly, it will.
The driver behind our engagement is a conviction, in the face of evidence, that there is still so much to improve to help people understand what they can expect from an investment product. The driver behind initiatives like the Capital Markets Union is that EU citizens need to be encouraged to take money out of low (or zero) interest rate paying bank accounts and invest it. Presenting them with a document (and a faulty one at that) is going to do little, if anything, to support that cause.
The UCITS KIID will be missed by many, not because it was the perfect document but because its PRIIPs successor is so demonstrably and frustratingly imperfect.
