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The subject of whether Independent Financial Advisers should outsource Discretionary Fund Management (DFM) services divides opinion. Some see it as an essential tool in providing a holistic service to clients, while others see it as an unnecessary and potentially costly fad. There is actually some truth in both arguments, and central to the effectiveness of DFM is the client and what service you intend to offer them. DFM services are not suitable for all clients or all advisers, and identifying for whom such a service will be beneficial is as important as the actual service itself.
This guide will explain what DFM is and the key considerations. Most importantly, it will help you to identify whether DFM can benefit your clients, and the steps that should be taken to put in place an effective DFM service.
ROLE OF DISCRETIONARY FUND MANAGEMENT
Firstly, we will briefly explain what Discretionary Fund Management is, and how it fits into the context of Independent Financial Advice. DFM involves delegating the day to day investment decisions to a professional investment manager, commonly referred to as a "Discretionary Manager". The Discretionary Manager will specialize in managing investment portfolios, and the expectation is that they will possess a higher level of knowledge and experience than a general financial adviser. The Discretionary Manager will take responsibility managing the client's portfolio, and does not need to obtain approval for the client for individual decisions. They will instead use their expertise to meet the client's objectives, which will be agreed at the outset.
While the adviser and client will maintain regular contact with the Discretionary Manager, for the arrangement to work effectively it is essential that the Discretionary Manager is given autonomy over day to day decision making. The adviser's role is still an important one, as the Manager will be working towards meeting whatever wants and needs the adviser has agreed with the client. It is also vital to stress that while the activity may be delegated, the adviser cannot delegate regulatory responsibility for meeting the client's requirements.
RULES AND REGULATION
While it cannot be credited with kickstarting the use of Discretionary Management by IFAs, the Retail Distribution Review (RDR) has brought the issue into sharp focus, particularly as we approach the RDR "deadline" (31st December 2012). A recent survey by wealth manager Heartwood found that over half the advisers polled were either using or set to use the services of a DFM, with RDR boosting the popularity of outsourcing solutions. One of the key changes brought by the RDR is that it will widen the range of products that an Independent Financial Adviser* must consider within client portfolios. The requirements to be considered "Independent" post RDR are complex, but in simple terms an adviser must consider all investment solutions that could be suitable for the client's situation. For many will require increased expertise and more robust processes for research and due diligence. As a result, increasing numbers of IFAs are looking towards Discretionary Fund Management to assist them with meeting their regulatory obligations.
*(Please note that throughout this article we have assumed that you will be operating as an Independent adviser following RDR)
Advisers need to be aware that failing to use Discretionary Managers correctly could result in them breaching regulatory rules, rather than assisting them. Recent guidance from the FSA on Investment Propositions (FG12/6) stated that firms would need to consider a wide range of investment solutions in the market before recommending a Discretionary investment service. This guidance from the regulator underlines the importance of robust due diligence before entering into a discretionary arrangement, and also highlights their concerns with clients potentially being "shoe-horned" into unsuitable arrangements. The FSA also expect any additional costs to the client to be justifiable, and for advisers and any support staff to be understand the investment service. In other words, DFM has to be right for the client, and the justification for this must be clearly documented. As stated in the previous section, the IFA remains responsible for the success or failure of the DFM service, so "getting it right" is critical.
We will explore these points in further detail later in the article, but we will first provide technical information regarding the taxation implications of DFM, and appropriate products that can be used in a DFM service.
The key taxation consideration with discretionary fund arrangements is that for each transaction within a Disretionary portfolio, a potential Capital Gains Tax (CGT) liability arises. Each sale is treated as a disposal for CGT purposes, and any gain on that sale is added to the total of the client's taxable gains in that tax year. Any losses on sales can be offset against gains, and any gains above the client's annual exemption (£10,600 for 2012/13) are taxed at either 18% or 28%, depending on the client's total taxable income.
When calculating any CGT liability, the acquisition cost is deducted from the sale price to arrive at the total gain (or loss) for that item. Gains for that tax year are totaled up, and any losses deducted. The Annual Exemption is then deducted from this figure to determine whether any CGT is due:
Mr X made gains in 2012/13 of £80,600 from disposals of assets in his portfolio.
The Annual Exempt Amount for individuals for 2012/13 is £10,600.
Mr X's gains are above this amount - so he deducts the Annual Exempt Amount from his gains.
He is liable to tax on £70,600 (£80,600 - £10,600).
Mr X is a higher rate tax payer so the Capital Gains Tax rate is 28 per cent.
He must pay Capital Gains Tax of £16,800 (£60,000 x 28%).
It is the responsibility of the adviser and the client to ensure that these gains are documented on the client's annual self-assessment. This means that the Discretionary manager will need to be familiar with the client's tax affairs to avoid creating unnecessary liabilities. The FSA have also made it clear that they expect taxation to be taken into account when assessing the suitability of any investment solutions
This again highlights the need for the adviser to identify the client's circumstances and goals to outset, and for there to be a clear definition of responsibilities between client, adviser and Discretionary Manager.
Another potential complication is that the European Court of Justice has recently recommended that all elements of discretionary management services should be subject to VAT, increasing the costs further by 20%. While the full implications of this recommendation are yet to be clear, this is something that all advisers will need to keep an eye on going forward.
APPROPRIATE TAX WRAPPERS - back up with calculations & examples?
As taxation is an important factor to consider, the choice of tax wrappers and platforms used to facilitate Discretionary Management is extremely important. We will provide an overview of the most common below. This is not an exhaustive list, but is intended to cover the most common wrappers available.
ISA - Individual Savings Accounts are available to all UK residents aged 18 and over (although cash-only ISAs are available to residents 16 and over). The ISA acts as a "wrapper", within which all gains are free from income and capital gains tax. As discetionary transactions can incur a CGT liability, ISAs are a potentially valuable tool to minimize tax liabilities.
The main drawback with ISAs is that annual contributions limits are relatively low (£11,280 for 2012/13), and it can take many years to build up the size of portfolio where Discretionary Management is likely to be most effective. Nevertheless, a fundamental part of sound financial advice is that clients should maximise their annual ISA contributions whenever possible.
SIPP - Another common tax wrapper for DFM is the SIPP (Self-Invested Personal Pension). SIPPs are a specific type of Personal Pension, and share the common characteristics as below:
Contributions - Contributions upto £50,000 per input period (tax year for most individuals) receive income tax relief. This is known as the "Annual Allowance" threshold.
Tax Relief - Contributions receive full tax relief upto the client's highest marginal rate. For example, a higher rate taxpayer will receive tax relief of 40% on all contributions paid into a Personal Pension.
Eligibility - Clients must be UK resident and under the age of 75 to set up a Personal Pension Plan and obtain tax relief on contributions.
Personal Pensions enable the client to make large contributions, which will grow in a tax-efficient environment. The major disadvantage is that under pension legilsation benefits cannot generally be accessed until age 55, and even at this point there are restrictions on how benefits can be taken. Typically a client will purchase an annuity (income for life) with their pension fund, or draw down funds from the scheme within government limits. While pension funds these days are used for an increasing variety of purposes, it is important to stress that for most clients the fundamental purpose is to provide for an income in retirement.
SIPPs differ from conventional Personal Pensions in that they allow a greater range of investments to be held, giving more freedom to make investment decisions. This flexibility lends itself to DFM services, as the specialist fund manager can utilise a wider choice of investment opportunities.
The downside is that charges on a SIPP are generally higher than a conventional Personal Pension. In other words, the extra flexibility often comes at a cost, that will be expected to be recouped in better performance.
It is important to establish whether the SIPP will allow DFM, and what the costs of this will be. These costs should be factored in when assessing whether DFM services are appropriate for the client.
OFFSHORE INVESTMENT BONDS
Investment Bonds are collective investments written under Life Insurance legislation. The rules may at first glance appear esoteric, but a good understanding is required to identify their potential use for Dicretionary Fund Manahement and financial planning in general. An in-depth analysis of Investment Bonds is beyond the scope of this article, but the essential points as relevant to DFM will be explained below.
The Life Insurance element is usually nominal, with the vast majority of the investment applied to the funds held within. The investment funds are subject to life company taxation on income and capital gains, with no further liability for the investor. Offshore bonds (typically based in tax havens such as the Isle of Man or Jersey) differ from conventional onshore bonds in that investment returns can are rolled-up without further tax, which enables investments to be switched without incurring a CGT liability. Tax is essentially deferred until enchashment.
This structure offers potential advantages for DFM, as switches can be made without CGT being an issue. Clients utislising a DFM service are likely to be higher rate tax payers due to the large sums typically involved, and it is possible to defer encashment to a point where they are no longer higher rate tax payers, reducing the overall tax payable.
Offshore Bonds do not have the small contribution limits of ISAs, and there is greater flexibility than a SIPP over how and when benefits can be taken. As a result, they are commonly used in Discretionary Fund Management. However, it is important to stress that they do not hold the same tax advantages. A common misconception is that Offshore Bonds are "tax-free", but the funds are taxed within the bond, and there may be a further tax liability at encashment. They are also considerably more complex, and must be used carefully to optimize tax efficiency.
Over recent years, "Platforms" are becoming an increasingly common tool in IFA services. Platforms are described by the FSA: 'Internet based services used by intermediaries (and sometimes clients) to view and administer investments. They tend to offer a range of tools which allow advisers to see and analyse a client's overall portfolio, and to choose products for them.As well as arranging transactions, platforms generally arrange custody for clients' assets'
"Wrap" is the term typically used to describe a type of platform that offers access to a wide range of investments, with an "unbundled" charging system where payments to fund managers and advisers are transparent. They also provide cash management facilities, and enable all investments to be held in one place, cutting down on paperwork and easing the administrative burden. Typically, fees can be paid to the DFM directly from the client's cash account held on the Wrap
In the context of DFM, there is a potential conflict as both the platform and DFM will require custody of the assets held, and this initially created barriers to the two services being used together. It is becoming more commonplace for DFMs and Wrap providers to work together, and there will often be a list of DFMs available via the Wrap.
An advantage of using DFM via a wrap is that the adviser can maintain sight and a level of control over the assets held, and it is also possible to select which part of the portfolio the DFM has access to. This can make it easier to view how the funds under discretionary management fit into the overall picture for the client. The transparent charging makes it easier for the client to see what their money is paying for, and it easier to check how their funds are performing.
The obvious disadvantage is that the wrap adds another layer of charging to the service. This again steers the service towards higher net worth clients, and emphasises the need to identify clients for whom discretionary management AND wrap administration are an essential requirement rather than an expensive luxury.
To illustrate with an example, a typical breakdown of charges using figures from a leading Wrap provider:
£300,000 of funds held on the platform
Platform administration charge of 0.5% of the fund per year
Discretionary Fund Manager charge of 1% of the fund per year
Adviser charge of 0.5% of the fund per year
Total Base Charge = 2%
Unless these additional charges result in benefit to the client (eg improved investment performance), the arrangement does not add value to the client's portfolio.
ADVANTAGES OF DFM
Advocates of DFM point to several benefits from IFAs in using this service.
Improved Investment Performance - although this cannot be guaranteed, the increased investment expertise and specialist knowledge of the discretionary manager should hopefully lead to overall greater investment returns
Frees up time and resource - a common complaint from IFAs is that they spread themselves too thin. The time and resource they would otherwise have spent on day to day montoring of investments can in theory be put to more effective use in other areas. The obvious example is that it allows the adviser to spend more time with the client, building relationships and looking at a holistic picture of their circumstances and objectives.
Speed - As the DFM is able to act without the client's consent, they can react more quickly to changing circumstances, and take advantage of new opportunities that arise.
Reduced Investment Risk - The DFM's greater knowledge and depth of research should enable the construction of a more diversified portfolio, which can reduce the impact of investment volatility.
DISADVANTAGES OF DFM
On the other side of the coin, critics of DFM cite a number of risks and drawbacks to using a DFM service
Fees and charges - Discretionary management services do not come cheaply, and it adds another layer of payments that the client must meet, either from their fund or their own pocket. In order for the service to be of value to the client, the DFM must recoup these additional charges through improved investment performance. Many argue that the actual benefit provided by DFMs is limited.
Impact on Adviser/Client Relationship - DFM involves a 3rd party taking day to day investment decisions on behalf of the client. For many clients, this raises the question of what the financial adviser is doing to justify THEIR fees. Unless the client sees the value of the adviser's role, this can have a negative effect on the client's relationship with the adviser.
Lack of Control - The DFM will have authority to make decisions without consulting the adviser. There is the risk that the DFM will not manage the investments in the way the adviser and client expected, especially if the original terms of the agreement and the client's objectives were vague. To combat against this, the adviser will need to oversee the activities of the DFM. The temptation could be for the adviser to spend valuable time watching what the DFM is doing, especially if the adviser does not have full confidence in the DFM.
Regulatory responsibility - As has been stressed previously, the adviser is still responsible for the overall service being provided to the client. A poor DFM not only reflects badly on the adviser; it can land the adviser in hot water with the FSA!
KEY COMPONENTS OF A DISCRETIONARY MANAGEMENT SERVICE
Thus far we have explained the role of the DFM, the relevant rules and regulation, and distribution channels for DFM services such as tax wrappers and platforms. We have also provided what are considered to be the most common advantages and disadvantages in a DFM service.
We will now focus on the steps that should be taken
Central to the service being provided is the client. Discretionary Fund Manahement services are unoikely to be of value to clients who do not need them, and instead cause problems. Also, the adviser runs the risk of falling foul of the regulator if clients are not provided with suitable solutions to their needs. The FSA identified that "shoe-horning" of unsuitable clients into DFM arrangements was s significant concern, and highlighted that
Size of Fund: As the Discretionary Manager will incur charges, it is unlikely to be suitable for clients with funds of less £100,000 to invest
Control: With a discretionary service decisions will be made without the client's approval
Involvement: How often does the client want to be involved day to day etc
Trust: Is the client willing to relinquish control to another professional. Inserts another individual into the client/adviser relationship
Objectives - What is the client looking to achieve with their investments? Clients with more conservative goals are less likely to be suitable for a DFM service.
Due Diligence - Before deciding which Discretionary Fund Manager to use, robust due diligence is essential. As well as sound business practice, the FSA will also expect to see evidence of thoroiugh analysis of the available options. This should include past performance (verified independently) along with the financial security of both the DFM and platform provider (if applicable).
Level of Discretion - Establish how much discretion the manager has to make individual decisions, and what controls are in place. A more flexible approach could lead to a more personal portfolio, but could also create additional risk.
Investment Vehicles - What range of investment vehicles does the manager use? Will they focus on mainly collective investments, or are they prepared to use direct equities, hedge funds and structured products to meet the client's objectives.
Client Meetings - What level of contact will there be between adviser, DFM and client? Are these meetings remote or face to face? Is there a facility for ad-hoc meetings as and when the client requires?
Goals - This includes establishing the client's Attitude to Risk, investment objectives and timescales. Clear instruction to the DFM is required to give the best chance of meeting the stated goals.
Reporting - How often will the DFM provide reports on the client's invesments.
Charges - Is there an annual fee, a transaction charge, or a combination of both?
Adviser Remuneration - Not only the level of remuneration, but how this is facilitated with the discretionary service?
Documentation - All steps in the
Review - Even if the above steps have been completed, there is no guarantee that the arrangement will be successful.
Exit - If the arrangement is not working, how easy is it to get out of?
Martin has accumulated significant wealth, in the form of a large pension fund and substantial other non-pension
assets. He has had a well paid job in the legal profession, and is about to retire. He is in good health, and requires a
significant but flexible income from his pension fund, which in this case is being provided via phased capped
Martin's adviser is concerned that whilst he feels he can put together a suitable holistic product solution, he lacks the
time and resources to run the investments and will therefore looks to outsource this using a SIPP. From the range of
options, the adviser feels that in this instance a Discretionary Fund Manager (DFM) would be most appropriate.
The solution looks like this:
SIPP Bank Account £ 4,000
DFM Portfolio £496,000
The DFM is instructed to construct a portfolio specific to Martin's attitude to risk and requirements over the coming
years. By appointing an expert full time fund manager in this way, he hopes that future market uncertainty can at least
be left in the hands of someone dedicated to the role, although he realises that it is impossible to totally eliminate
risk and that investments are not guaranteed.
He is happy that the portfolio can be managed in a way that allows decisions to be taken quickly by the fund manager,
without having to involve Martin or the adviser in each and every instance. Discretionary management means that
this can be done, since the DFM can alter the portfolio without lengthy processes to request the client's permission
each time, so long as it is within the terms of the agreement between Martin and the DFM.
Regular reviews are agreed, as it's essential that the adviser reviews Martin's attitude to risk and capacity for loss over
time, as well as anything else that may impact the on-going appropriateness of the advice. Martin's adviser feels he
can add value by being built in to the reporting process, whilst allowing him to concentrate on the overall strategy.
There is the potential to provide your clients with a service that adds value to your overall service, and provides a level of expertise above and beyond what you could otherwise provide. However, there is also the potential for it to be an expensive and unnecessary mistake, negatively impacting on the relationship with your clients.
Although the use of Discretionary Fund Management continues to divide opinion, it is clearly here to stay. In order to assess whether it will be of benefit to your clients, the first step is to identify what the needs of your clients are. Once this has been established, you will then to review the DFM services available, and assess whether these can satisfy the needs of your clients. Finally, the arrangement should be reviewed, refined and if necessary changed on a regular basis.