Q&A: Why the problems with PRIIPs linger on
Q&A: Why the problems with PRIIPs linger on
Controversial rules that cover the promotion of investment funds in Europe have been in the news again.
The regulations for packaged retail investment and insurance-based products, known as PRIIPs, have been widely covered by the financial press for several years. This week saw yet another roadblock in amending the rules, which were introduced in 2018.
In this article, we answer seven questions around the PRIIP problem. We also explain why it is time to stop debating and take action, no matter how challenging this action may be. As we have seen from the process so far, quick fixes which try to cover the symptoms instead of treating the underlying illness will get us nowhere. And the only ones who are potentially disadvantaged by this are the investors, whom the PRIIPs rules are designed to protect in the first place.
What are PRIIPs?
“PRIIPs” covers practically all types of investment-based products. This includes open- and closed-ended investment funds, alternative investment funds (AIFs), insurance based investment products, annuities with fluctuating returns, derivatives, structured products etc. The aim is to have one common key information document (KID) which potential and existing investors can use to get all the main information around cost, risk and performance before they buy an investment product. Such a high disclosure standard has existed for several years for investment funds, and particularly for open-ended funds through the EU UCITS directive. The main objective of the PRIIPs regime has been to apply the same level of disclosure to all investment-based products (including those within an insurance or banking wrapper).
Why is this important?
The PRIIPs KID is the information which people must see before buying an investment product. Importantly, it is what regulators consider people must see at point of sale in order to make an informed investment decision. Anecdotal evidence, however, would suggest people spend on average only a couple of seconds viewing such documents. Be that as it may, the KID is supposed to convey everything that someone would need to know about their product: what it is, what are the costs, what are the risks and what they could get in return.
What is the problem?
The problem with the PRIIPs KID is the way it communicates performance and costs – arguably amongst the most important things an investor would need to know. In a nutshell, according to the PRIIPs rules:
- Performance is shown as a forecast of returns that someone may expect to get in the future. This is based on past returns but past returns are not shown at all.
- Costs are counterintuitively presented as a “reduction-in-yield”, 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 which contains market noise and, depending on how the market has behaved, can result in negative cost numbers (suggesting that dealing in the underlying asset actually made money, when, in fact, the market moved between the decision to deal and the actual deal). This is because that estimation methodology had originally been designed to measure “best execution”, i.e. how efficiently a transaction is carried out, rather than to express cost.
A lot of this relates to the design of the technical standards. For example, there are other ways to estimate implicit transaction costs that don’t produce negative numbers. But some of it relates to how the rules themselves have been drafted. For example, on performance disclosure, the PRIIP Regulation refers to “performance scenarios”, which is being deemed to exclude past performance.
What is the more fundamental problem?
The more fundamental problem, which is causing all the complications on cost and performance disclosure, is a drive, in the interests of comparability, to apply exactly the same requirements to all types of products, even though some of them work in very different ways. Hence, applying 100% the same type of disclosure doesn’t work across everything. For example, the reduction-in-yield is partly used in the insurance product market but it is a completely unknown concept in the UCITS market and is not aligned with MiFID II disclosures that investors will see on platforms or receive from advisers.
Performance scenarios work well for structured products which are all about possible outcomes depending on what may happen in a specific market (e.g. if the FTSE 100 index is higher in five years from now, the payoff is the initial invested amount plus half the increase). They do not work well for investment funds where markets and, thus returns, are completely unpredictable; which is also why presentation of past returns is always accompanied by the disclaimer that past performance is not a guide to future performance. So having scenarios makes sense for structured products but not for non-structured products, while having past performance makes sense for non-structured products but not for structured products. Incidentally, this is a distinction which the UCITS regulation has recognised and that is why it prescribes different type of performance disclosure for different types of UCITS.
Why is PRIIPs still in the news?
PRIIPs came into force for most types of investment products in January 2018. UCITS were exempt at the time, for a limited period, as the UCITS Directive already provided a corresponding information document (Key Investor Information Document – KIID) for investors. A review was built into the original legislation, which was due to be completed before the exemption expired. The first wave of PRIIPs KIDs brought all these issues into the spotlight resulting in very negative headlines and criticism from consumer groups and practitioners alike.
In light of this criticism, policymakers decided to take extra time to address all concerns, and so extended the UCITS exemption until the end of 2021. This was designed to ensure that by that time, as originally intended, the overarching regulatory framework (known as “Level 1”) would be reviewed. What actually happened since then is that policymakers took the stance that there should just be adjustments to the technical implementation of this framework (“Level 2”). The European Supervisory Authorities (ESAs) took on the task of making recommendations and have since carried out two consultations and hosted numerous roundtables with consumer groups and industry representatives.
Despite the ESAs’ best efforts, it has become apparent that constraining the solution to Level 2 fixes is not sufficient. The ESAs made proposals to which some members of the European Parliament have objected and the Commission rejected, amendments were proposed which then some ESA members could not support, multiple letters were sent etc. This has provided ample material to discuss but the actual issue at hand hasn’t moved forward one iota.
Why haven’t the issues been addressed?
There are ways to address the known issues around cost and performance disclosure and we have written on this subject arguing that what is needed is a review of the Level 1 framework and the principle that there should be 100% comparable information. The PRIIP regulation had provided for a Level 1 review to be completed by the end of 2019 but, for reasons that remain unclear, this never happened and it not expected any time soon.
The appeal of trying to resolve this within Level 2 is understandable. Changing anything at Level 1 is a complicated process which involves discussion and drafting of legislation between the European Commission, the European Parliament and the Council of the EU. This requires a lot of time and effort which is in addition to all the resources that all parties involved have already invested in this. The process for amending the technical standards at Level 2 is, in comparison, more straightforward. But by trying to avoid the “hard way” we may end up in a place where a much greater amount of effort is spent in trying the “easier way” with no beneficial result.
What happens next?
The latest episode in the PRIIPs series has been that the ESAs have written to the European Commission to inform them that they are “not in a position to formally submit” a final proposal. What happens next is anyone’s guess. It is worth noting that there is no other legislative file which has been so controversial among policymakers or where the process has been so full of surprises.
The lesson which, hopefully, we have learnt by now is how much time and effort by all involved can be put into something with no solution in sight. If the actual problems are not addressed by a proper review of the Level 1 regulation, which must be completed before the PRIIP rules start applying to UCITS, it is very likely we will continue with quick fixes which serve no one and certainly not investors. And this is what we shouldn’t forget in all this: the people who are potentially disadvantaged by misleading disclosures or are put off from investing due to an ever changing KID are the investors themselves.
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