Cefap 2016-17 Online Full

Certificate in Financial
Administration and Planning

2016/17
Claire Bateson
Updated for 2016/17

by Carl Burlin
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© The London Institute of Banking & Finance 2016

Author information
Claire Bateson MBA BA (Hons) is a Fellow of The London Institute of Banking &
Finance and a chief examiner and moderator. Having worked in the financial services
industry for over 20 years, Claire now runs her own consultancy, Cobalt Advantage
Ltd, providing specialist training solutions and management development.
Carl Burlin BA Hons has worked in financial services for over 20 years. He started
his career as an adviser on protection, investments and retirement planning and
moved into training in 1994. Since 1994, he has specialised in the training of financial
advisers and sales managers, providing both technical and skills development.
Having worked for a large bancassurer until 2011, Carl is now a freelance training
consultant.
Carl has worked closely with The London Institute of Banking & Finance since 1997
and produced a number of study materials to support students across a range of
qualifications. He has achieved two Level 4 qualifications in financial services and
also holds CeMAP®.
Contents
1 Key influences in the UK financial services industry 1

1.1 Introduction 1
1.2 The functions of the financial services industry 1
1.3 Financial institutions 4
1.4 The role of government 12
1.5 The clearing process and settlement organisations 15
2 The Prudential Regulation Authority and the Financial
Conduct Authority 17
2.1 Introduction 17
2.2 Prudential Regulation Authority (PRA) 19
2.3 The Financial Conduct Authority 24
2.4 The prevention of financial crime 30
2.5 Discipline and enforcement 30
3 Conduct of business rules 35
3.1 Introduction 35
3.2 Conduct of Business Sourcebook 35
3.3 Regulation of mortgage business 37
3.4 Regulation of general insurance 41
3.5 Banking conduct of business 45
4 Complaints and compensation 49
4.1 Introduction 49
4.2 Regulatory requirements concerning complaints 49
4.3 Financial Ombudsman Service 53
4.4 Pensions Ombudsman 54
4.5 Financial Services Compensation Scheme 55
5 Other rules and regulations relevant to advising financial
services clients 59
© The London Institute of Banking & Finance 2016 v

5.1 Introduction 59
5.2 The Competition and Markets Authority 59
5.3 Consumer credit legislation 60
5.4 The regulation of occupational pensions 63
5.5 Unfair contract terms 67
5.6 Advertising Standards Authority 69
5.7 The Standards of Lending Practice 70
5.8 The Data Protection Act 1998 72
6 Clients’ needs and managing money 77
6.1 Introduction 77
6.2 Consumer goals, needs and objectives 78
6.3 Budgeting 81
6.4 Protection 81
6.5 Borrowing and debt 85
7 Customer needs for future income 89
7.1 Introduction 89
7.2 Risk 90
7.3 Saving and investment 95
7.4 Retirement planning 97
7.5 Estate planning 99
7.6 Tax planning 99
8 Overview of financial services products 101
8.1 Introduction 101
8.2 Savings and deposits 101
8.3 Financial protection 102
8.4 Lending products 104
8.5 Direct investments 108
8.6 Collective investments 110
8.7 Pension products 111
9 Economic factors 115
9.2 Inflation 115
9.3 Interest rates 118
vi © The London Institute of Banking & Finance 2016

9.4 Socio-economic factors 119
9.5 Key economic indicators 121
10 UK taxation and state benefits 127
10.2 Income tax 128
10.3 National Insurance 135
10.4 Capital gains tax 135
10.5 Inheritance tax 137
10.6 Other personal and business taxes 138
11 Principles of financial protection: Existing provision 141
11.2 Support for people on low incomes 142
11.3 Support for bringing up children 143
11.4 Support for people who are ill or disabled 145
11.5 Support for people in hospital or receiving residential /
nursing care 147
11.6 Support for people in retirement 148
11.7 Universal Credit 148
11.8 The benefit cap 149
11.9 Benefits and financial advice 150
12 Financial protection products 153
12.2 Life assurance protection 153
12.3 Ill-health and accident insurance 161
12.4 Protection needs for businesses 168
13 Investment products 169
13.2 Asset classes 169
13.3 Cash deposits 170
13.4 Individual savings accounts 174
13.5 Government securities 177
13.6 Local authority stocks 178
13.7 Permanent interest-bearing shares 178
© The London Institute of Banking & Finance 2016 vii

13.8 Corporate bonds 178
13.9 Eurobonds 179
13.10 Equities and other company finance 179
13.11 Property 183
14 Indirect investments and other investment types 187
14.2 Unit trusts 188
14.3 Open-ended investment companies (OEICs) 192
14.4 Investment trusts 194
14.5 Investment products based on life assurance 196
14.6 Investment bonds 198
14.7 Offshore life assurance company bonds 199
14.8 Other types of investment 200
15 Pensions 205
15.2 State pension provision 206
15.3 Occupational pensions 208
15.4 Non-occupational pension provision 213
15.5 Tax rules 215
15.6 Pension benefits 217
16 Mortgage loans and associated products 221
16.2 Interest-only mortgage repayment options 221
16.3 Mortgage interest options and other schemes 224
16.4 Methods of releasing equity 228
16.5 Shared-ownership mortgages 229
16.6 Related property insurance 230
17 Interacting ethically with clients 233
17.2 Regulatory requirements for financial advice 234
17.3 Regulatory requirements for ethical behaviour 235
17.4 Regulatory requirements for training and competence 240
17.5 Conduct of the client relationship 242
viii © The London Institute of Banking & Finance 2016

18 The sales process: Part 1 249
18.2 The sales process 250
18.3 Introductions and initial disclosure 251
18.4 Establish client needs 253
19 The sales process: Part 2 265
19.2 Collating and interpreting client information 265
19.3 Evaluating affordability and suitability 266
19.4 Matching appropriate solutions to customer needs 266
19.5 Presenting solutions 267
19.6 Ongoing review and relationship management 270
19.7 Telesales 271
19.8 The skills required 272
20 Key legal concepts 275
20.2 Legal persons 275
20.3 Ownership of assets 276
20.4 Law of contract 276
20.5 Power of attorney 277
20.6 Wills and intestacy 278
20.7 Insolvency and bankruptcy 280
UK taxation figures for the tax year 2016/17 283
Answers to review questions 293
© The London Institute of Banking & Finance 2016 ix

x © The London Institute of Banking & Finance 2016
Topic 1
Key influences in the UK financial
services industry
Learning objectives
The purpose of this topic is to enable you to understand the key influences in
the UK financial services industry. It sets the scene for the remainder of the
study text and, to help you keep up to date, it is an area in which you should
undertake your own reading.
After studying this topic you should be able to:
u explain the function of the financial services industry in the economy;
u classify the main institutions and markets;
u explain the role of the UK government and the European Union;
u explain the purpose and position of clearing and settlement organisations.
1.1 Introduction
This topic begins by providing a broad introduction to the functions of the financial
services industry and to the institutions that make up the industry.
The government has a huge impact on the financial services industry, one of the
reasons for this being the requirements of the European Union, of which the UK is
a member state. Regulation of the industry is considered in later topics.
In the final part of this topic you will consider the role of organisations that are
responsible for ensuring that money flows around the financial system. This flow
is known as ‘clearing’, and it is ‘settlement’ organisations that enable it to happen.
1.2 The functions of the financial services

industry
The existence of money is taken for granted in all advanced societies today −
so much so that most people are unaware of the enormous contribution that the
concept of money, and the industry that has developed to manage it, have made
to the development of our present way of life.
In earlier civilisations the process of bartering was adequate for exchanging goods
and services: a poultry farmer could exchange eggs or chickens for carrots and
cabbages grown by a gardener. In modern society people still produce goods or
© The London Institute of Banking & Finance 2016 1

1: Key influences in the UK financial services industry
provide services that they could, in theory, trade with others for the things they
need. The complexity of life, however, and the sheer size of some transactions
make it virtually impossible for people today to match what they have to offer
against what others can supply to them.
What is needed is a separate commodity that people will accept in exchange for
any product and that forms a common denominator against which the value of all
products can be measured. These two important functions (defined technically as
being a medium of exchange and a unit of account respectively) are carried
out by the commodity we call money. In order to be acceptable as a medium of
exchange, money must have certain properties. In particular it must be:
u sufficient in quantity;
u generally acceptable to all parties in all transactions;

u divisible into small units, so that transactions of all sizes can be carried out
precisely;
u portable.
Money also acts as a store of value. In other words, it can be saved because it
can be used to separate transactions in time: money received today as payment
for work done or for goods sold can be stored in the knowledge that it can be
exchanged for goods or services later when required. To fulfil this function, money
must retain its exchange value or purchasing power, and inflation (considered in
Topic 7) can, of course, adversely affect this function.
Notes and coins are legal tender, ie they have the backing of the government and
the central bank, but money comprises much more than cash. It includes amounts
held in current and deposit accounts, and other forms of investments.
The financial services industry exists largely to facilitate the use of money. It ‘oils
the wheels’ of commerce and government by channelling money from those who
have a surplus, and wish to lend it for a profit, to those who wish to borrow it, and
are willing to pay for the privilege (this is described in more detail in section 1.2.1).
Financial services organisations want to make a profit from providing this service
and, in the process of so doing, they provide the public with products and services
that offer, among other things, convenience (eg current accounts and payment
cards), means of achieving otherwise difficult objectives (eg loans and mortgages),
protection from risk (eg insurance) and peace of mind (eg provision for retirement).
1.2.1 Intermediation
In any economy there are surplus and deficit sectors. The surplus sector comprises
those individuals and organisations who are cash-rich − ie they own more liquid
funds than they currently wish to spend. They want to lend out their surplus funds
in exchange for a profit. The deficit sector comprises those who own less liquid
funds than they wish to spend; these are prepared to pay money (interest) to
anyone who will lend to them.
In this context, a financial intermediary is an organisation that borrows money
from the surplus sector of the economy and lends it to the deficit sector, paying
a lower rate of interest to the person with the surplus and charging a higher rate
of interest to the person with the deficit. Banks and building societies are the
best-known examples. An intermediary’s profit margin is the difference between
the two interest rates.
2 © The London Institute of Banking & Finance 2016

The functions of the financial services industry
But why do the surplus and deficit sectors need the services of a financial
intermediary? Why can they not just find each other and cut out the middleman’s
profit? Actually, there are some cases where this does happen and it is known as
disintermediation (the process by which lenders and borrowers interact directly
rather than through an intermediary). An example would be where friends lend
money to each other, rather than using a bank. There are, however, several reasons
why both individuals and companies need the services of intermediaries. The four
main reasons relate to the following factors.
u Geographic location: firstly, there is the physical problem that individual
lenders and borrowers would have to locate each other and would probably
be restricted to their own area or circle of contacts. A potential borrower in
Surrey is unlikely to be aware of a person in Edinburgh with money to lend, but
each may have easy access to a branch of a high-street bank.
u Aggregation: even if a potential borrower could locate a potential lender,
the latter might not have enough money available to satisfy the borrower’s
requirements. The majority of retail deposits are relatively small, averaging
under £1,000, while loans are typically larger, with many mortgages for £50,000
and above. Intermediaries can overcome this size mismatch by aggregating
(collecting together) small deposits.
u Maturity transformation: even supposing that a borrower could find a lender
who had the amount they wanted, there is a further problem. The borrower
may need the funds for a longer period of time than that for which the
lender is prepared to part with them. The majority of deposits are very short
term (eg instant access accounts), whereas most loans are required for longer
periods (personal loans are often for two or three years, while companies often
borrow for five or more years, and typical mortgages are for 20 or 25 years).
Intermediaries are able to overcome this maturity mismatch by offering a wide
range of deposit accounts to a wide range of depositors, thus helping to ensure
that not all of the depositors’ funds are withdrawn at the same time.
u Risk transformation: individual depositors are generally reluctant to lend all

their savings to another individual or company, principally because of the risk
of default or fraud. Intermediaries enable lenders to spread this risk over a wide
variety of borrowers so that, if a few fail to repay, the intermediary can absorb
the loss.
Some of these issues have been overcome by peer-to-peer lenders such as Zopa
and Funding Circle who base their services online. However, investors have no
protection from a compensation scheme, and if a borrower defaults then the
investor is liable to lose funds. Peer-to-peer lenders mitigate the risk to investors
by spreading funds between borrowers; however, this would not take into account
worsening economic conditions with large numbers of borrowers defaulting.
1.2.2 Risk management

Another form of intermediation is the mitigation of risk through insurance, which
has been defined as ‘a means of shifting the burden of risk by pooling to minimise
financial loss’. Individuals effectively get together to contribute to a fund from
which the losses of the few who suffer in certain specified circumstances are
covered. Without the services of a central organisation − the insurance company
− individuals would struggle to find a convenient way of sharing their risks in this
manner.

This means that individuals and businesses, in return for a payment, can protect
themselves against an unexpected loss. The insurance company employs actuaries
who work out the probability of the loss and the resulting financial impact, and
then are able to calculate premiums that ensure the likely number of possible
claims can be met and a profit made.
The insurance company may choose to insure some (but not all) of the risks that
they are exposed to with specialist reinsurers. The insurer can then recover a part
of the claims they pay out from the reinsurer. This reduces the risk of the failure
of the insurer in the event of a catastrophic event, such as a natural disaster, that
may produce a very high level of claims.
1.2.3 ‘Product sales’ intermediaries

There is a further type of intermediation, slightly different in nature from
those defined above. This is the intermediation that ‘oils the wheels’ of the
financial services industry itself by bringing together product providers (such
as banks, building societies and insurance companies) and potential customers
who wish to purchase the providers’ products and services. These intermediaries
include independent financial advisers, insurance brokers, mortgage advisers,
stockbrokers, many of whom work as relatively small businesses serving a
particular geographic area. More recently, large retail organisations such as
supermarkets have moved into providing financial services as intermediaries.
1.3 Financial institutions

This section briefly describes the main types of financial institution that make up
the financial services industry in the UK.
Prior to the 1980s there were more clearly defined boundaries between different
kinds of financial organisation: some were retail banks, some wholesale banks;
others were life assurance companies or general insurance companies, although a
few offered both types of insurance and were known as ‘composite’ insurers; yet
others were investment companies.
Today, many of the distinctions have become blurred, even disappearing
altogether. Increasing numbers of mergers and takeovers have taken place across
the boundaries, and now even the term ‘bancassurance’, which was coined to
describe banks that owned insurance companies (or vice versa), is inadequate
to describe the complex nature of modern financial management groups. For
example, one major UK ‘bank’ offers the following range of services:
u retail banking services;
u mortgage services through a subsidiary that is a former building society;

u payment card services, split into UK customers, international customers,
corporate chargecards and merchant services;
u wealth management services for high-net-worth individuals;
u financial asset management (fund management) for institutional customers;

Financial institutions
u investment banking, including financing, risk management and corporate

finance advice;
u insurance services, by acting as an independent intermediary in relation
to general insurance and as an appointed representative in relation to life
assurance, pensions and income protection.
1.3.1 The Bank of England

The Bank of England (often referred to simply as ‘the Bank’) was founded by a
group of wealthy London merchants in 1694 and later granted a Royal Charter by
William III. It developed a unique relationship with the Crown and Parliament, which
was formalised in 1946 when it was nationalised and became the UK’s central bank.
A central bank is an organisation that acts as banker to the government, supervises
the economy and regulates the supply of money. In the USA, for example, these
tasks are the responsibility of the US central bank, which is known as the Federal
Reserve. Within the eurozone of the European Union, the European Central Bank
(ECB) acts as the central bank for those states that have accepted monetary union.
The Bank of England plays a number of important roles within the UK economy. Its
main functions are as follows.
u Issuer of banknotes: the Bank of England is the central note-issuing authority
and is charged with the duty of ensuring that an adequate supply of notes is in
circulation.
u Banker to the government: the government’s own account is held at the
Bank of England. The Bank provides finance to cover any deficit by making an
automatic loan to the government. If there is a surplus, the Bank may lend it
out as part of its general debt management policy.
u Banker to the banks: all the major banks have accounts with the Bank of
England for depositing or obtaining cash, settling clearing (see section 1.5) and
other transactions. In this capacity the Bank can wield considerable influence
over rates of interest in various money markets, by changing the rate of interest
it charges to banks that borrow or the rate it gives to banks that deposit.
u Adviser to the government: the Bank of England, having built up a specialised
knowledge of the UK economy over many years, is able to advise the government
and help it to formulate its monetary policy. The Bank’s role in this regard was
significantly enhanced in May 1997, when full responsibility for setting interest
rates in the UK was given to the Bank’s Monetary Policy Committee (MPC).
This committee meets eight times per year and its mandate in setting the official
Bank interest rate − the ‘base rate’ − is to ensure that the government’s inflation
target is met. If the target is not met the chairman of the MPC must write to the
Chancellor of the Exchequer explaining why the target has not been achieved.
u Foreign exchange market: the Bank of England manages the UK’s official
reserves of gold and foreign currencies on behalf of the Treasury.
u Lender of last resort: the Bank of England traditionally makes funds available
when the banking system is short of liquidity, in order to maintain confidence
in the system. This function became very important in 2007−08 following a run
on Northern Rock and subsequent liquidity problems for a number of banks.
While the Bank of England performs this function it is not duty bound to do so.
The Bank of England was also formerly responsible for managing new issues
of gilt-edged securities. This function has now been transferred to the Debt

Management Office within the Treasury in order to avoid conflicts of interest

that might arise in relation to the Bank’s responsibility for setting interest rates.
Gilt-edged securities, also known as ‘gilts’, are loans to the government. There are
a wide variety of loans on different terms and for varying periods, including some
with no fixed redemption date. These securities are called ‘gilt-edged’ because the
government guarantees their income and redemption amounts (see section 13.5).
In addition to the functions described above, the Bank of England was previously
charged with responsibility for the supervision and regulation of those institutions
that make up the banking sector in the UK. This responsibility was transferred
to the Financial Services Authority (FSA) in 1998, but the FSA ceased to be in
April 2013, with regulatory functions being shared between the Financial Policy
Committee (FPC) (part of the Bank of England), the Prudential Regulation Authority
(PRA) (a subsidiary of the Bank of England) and the Financial Conduct Authority
(FCA) (accountable to Parliament).
1.3.2 Proprietary and mutual organisations

We have already mentioned that the boundaries between different types of financial
organisation have become blurred. One distinction that still exists, albeit to a
reduced extent, is the split between ‘proprietary’ and ‘mutual’ organisations.
u Proprietary organisations, which account for the great majority of the large
financial institutions, are public limited companies. They are owned by their
shareholders, who have the right to share in the distribution of the company’s
profits in the form of dividends and can contribute to decisions about how the
company is run by voting at shareholders’ meetings.
u Mutual organisations, in contrast, are not constituted as companies and
do not, therefore, have shareholders. The most common types of mutual
organisation are building societies and friendly societies, each of which is
mutual by definition, and life assurance companies, of which only a small
proportion are mutual.
A mutual organisation is, in effect, owned by its members, who can determine how
the organisation is managed through general meetings similar to those attended
by shareholders of a company. In the case of a building society, the members
comprise its depositors and borrowers; for a life company, they are the with-profit
policyholders.
Since the Building Societies Act 1986, a building society has been able to
demutualise − in other words, to convert to a bank (with its status changed to that
of a public limited company). Such a change requires the approval of its members
and this approval has in practice generally been readily given, in large part because
of the ‘windfall’ of free shares to which members have become entitled following
conversion to a company.
The possibility of a windfall on conversion led to a spate of ‘carpetbagging’ − the
practice of opening an account at a building society that it is believed will soon
convert, purely to obtain the subsequent allocation of shares. Societies considering
conversion have, in response, sought to protect the interests of their long-term
members by placing restrictions on the opening of new accounts.
In the past some mutual life assurance companies, including Norwich Union (now
Aviva) and Standard Life, have also elected to demutualise.

1.3.3 Credit unions

Another example of a mutual organisation is the credit union. Credit unions are
financial co-operatives run for the benefit of their members, who are all linked in
a particular way, for instance by living in the same area or belonging to the same
club, church or other association. A co-operative is an autonomous group of people
who have come together to meet common economic, cultural and social needs by
forming a jointly owned, democratic organisation.
In order to join a credit union, the member must meet the membership
requirements, pay any required entrance fee and buy at least one £1 share in the
union. All members are equal, regardless of the size of their shareholding or their
status, whether this is as a consumer, corporate body, association or partnership.
Traditionally, credit unions operated in the poorer sections of the community,

providing savings and reasonably priced short- and medium-term loans to their
members as an alternative to ‘loan sharks’ (unscrupulous and unregulated lenders).
In more recent years it has been recognised that credit unions have a strong
role to play in combating financial exclusion and delivering a range of financial
services and financial education to those outside the mainstream. It has also
been recognised that the image of credit unions needs to be improved in
order to encourage participation from a wider range of consumers. As a result,
the government has funded a number of initiatives to widen the scope of the
movement.
Credit unions are owned by the members and controlled through a voluntary board
of directors, all of whom are members of the union. The board members are elected
by the members at the annual general meeting (AGM). Although the directors
control the organisation, the day-to-day management is usually carried out by
employed staff. Credit unions undergo the same authorisation and regulation as
other lenders and their customers also have access to the same compensation
scheme (covered in Topic 4).
Credit unions offer simple savings and loan facilities to members. Savers invest
cash in units of £1, with each unit buying a share in the credit union. Each share
pays an annual dividend, typically 2−3 per cent. These savings create a pool of
money that can be lent to other members; the loans typically have an interest rate
of around 1 per cent of the reducing balance each month (with a legal maximum of
2 per cent of the reducing capital). Recent legislation has meant that credit unions
will be able to offer interest on deposits, and to charge a market rate for providing
ancillary services to members.
A unique feature of credit unions is that members’ savings and loan balances are
covered by life assurance. This means that any loan balance will be paid off on
death, and a lump sum equal to the savings held will also be paid, subject to
overall limits.
In order to compete in today’s financial services marketplace, many credit unions
offer additional services, often in conjunction with partners, including basic bank
accounts, insurance services and mortgages.
1.3.4 Retail and wholesale markets

The concepts of ‘retail’ and ‘wholesale’ are most obvious in the world of banking.
The main distinction between retail and wholesale transactions is one of size,
with wholesale transactions being generally much larger than retail ones. The

end-users of retail services are normally individuals and small businesses, whereas
wholesale services are provided to large companies, the government and other
financial institutions.
Retail banking is primarily concerned with the more common services provided
to consumers and corporate customers, such as deposits, loans and payment
systems. It is largely the province of high-street banks and building societies
that deliver their products through traditional branch networks, call centres or
the internet.
These institutions are, as described in section 1.2.1, acting as intermediaries

between people who wish to borrow money and people who have money that
they are prepared to deposit. The price of borrowing and the reward for investing
is, of course, interest. With the widespread replacement of cheques by credit and
debit cards, the traditional suppliers of retail banking are experiencing increasing
competition from major stores, such as Tesco and Sainsbury’s, which are offering
their own banking facilities, credit cards and other financial services.
Wholesale banking refers to the process of raising money through the wholesale
money markets in which financial institutions and other large companies buy and
sell financial assets. This is the method normally used by finance houses (which
provide specialised advice and funding to large corporate organisations), although
the main retail banks are also heavily involved in wholesale banking in order to
top up deposits from their branch networks, which enable them to offer more
lending facilities to customers. For example, if a bank has the opportunity to make
a substantial profitable loan but does not have adequate deposits, it can raise
the money very quickly on the interbank market. This is a very large market
encompassing over 400 banking institutions, which serves to recycle surplus cash
held by banks, either directly between banks or more usually through the services
of specialist money brokers. However, during the credit crisis of the late 2000s,
banks became increasingly reluctant to lend to one another, thus increasing the
seriousness of the problems experienced.
The rate of interest charged in the interbank market is the London interbank offered
rate (Libor). It acts as a reference rate for the majority of corporate lending, for
which the rate is quoted as ‘Libor plus a specified margin’. Libor rates are fixed
daily and vary in maturity from overnight through to one year.
The Wheatley report, undertaken in 2012, looked at the way in which Libor
was governed (previously an unregulated activity) following the Libor fixing
scandal. The report’s recommendations were accepted by the government to make
participation in setting Libor a regulated activity and to make manipulation of Libor
a criminal offence. The Financial Services Act 2012 (effective from April 2013)
brought these changes into effect. ICE Benchmark Administration Limited (IBA) was
established in July 2013 and the transfer of regulation by the IBA was completed
on 1 February 2014, following authorisation by the FCA (ICE, 2016).
Building societies are also permitted to raise funds on the wholesale markets: up
to 50 per cent of their liabilities (deposits from customers).
The distinction between ‘retail’ and ‘wholesale’ in financial services is much less
obvious than it used to be, with many institutions now operating in both areas. The
terms tend not to play a part in the day-to-day terminology in other financial areas

such as life assurance, pensions and unit trusts, but the concepts are present in
the background.
u Some organisations are clearly based at the wholesale end of the market, such
as life assurance companies and unit trust managers providing products to third
parties for onward sale.
u These third parties can be other organisations and individuals, such as

insurance brokers and financial advisers, who are purely retailers of the
products and services offered by the providers.
u Product providers that sell direct to the public or through their own dedicated
sales forces are, in effect, operating in both a wholesale and retail capacity.
1.3.4.1 The Financial Services (Banking Reform) Act 2013

In the wake of the global financial crisis that started in 2007, the Independent
Commission on Banking (ICB) was established in June 2010. Its purpose was to
consider structural and related non-structural reforms to the UK banking sector
to promote financial stability and competition. It should be remembered that the
context was that a number of big banks had run into significant financial difficulties
and depositors’ money placed at risk. The ICB’s final report (known as the Vickers
report after the chairman Sir John Vickers) was published 12 September 2011. Its
key recommendations were as follows:
u UK retail ring-fencing: proposals in this area were seen as particularly
significant, as a number of banks had seen their retail operations impacted
by the way in which other areas of their business had been conducted.
The ICB concluded that the best way to prevent another financial crisis was
to separate retail banking operations from investment / wholesale banking
functions, effectively creating a ring-fence around personal and SME deposits
and overdrafts.
u Capital: a key issue here was that banking operations were potentially under
threat where a bank failed to hold adequate capital to ‘ride out’ difficult
economic conditions. Under the recommendations, it was suggested that the
largest ring-fenced UK retail banks would be required to hold greater levels
of capital in reserve, so as to provide greater protection in the event of an
economic downturn.
u Bail-in and depositor preference: the report recommends that the UK
resolution authority should have a statutory power of bail-in (to recapitalise
banks in resolution) and that insured deposits should have preferred creditor
status. Bail-in refers to investors, creditors and unprotected depositors taking
the financial consequences of keeping a depositor solvent, for example by
losing some or all of their deposited funds. This can be contrasted to
‘bail out’ whereby the government, and therefore taxpayers, pay a bank’s debts.
u Competition: the ICB called for improved processes for customers to switch
accounts and greater transparency so that customers can compare prices.
The proposals may also create opportunities for non-UK banks to compete
in the British retail banking market and could inhibit UK investment banking
operations in competing globally.
u Structural reform: under ring-fencing, banks will be required to create
separate standalone subsidiaries with their own governance arrangements,
referred to as ‘ring fenced bodies’ (RFBs).

At around the same time as the ICB was carrying out its work, there had also
been many concerns about the rewards provided to many senior managers in the
banking industry and the conduct of some of those managers.
Following the ICB, the government established the legislative framework for
changes to the UK banking system to be put in place through the Financial
Services (Banking Reform) Act 2013 (the Act). The Act will bring about the reforms
suggested by the ICB and also by a separate Parliamentary Commission on banking
standards, which was concerned with standards of conduct. The purpose is to
improve the resilience (ability to deal with adverse economic conditions) and
resolvability (how financial problems within an area of a bank’s operations are
dealt with so as to minimise impact on other areas of operations). The Act impacts
all UK banks with retail deposits of £25bn or more.
The Bank of England, through the PRA, has responsibility to implement changes in
respect of the ring-fencing of UK banks’ retail operations, the objective being to
ensure the continuity of core services for the bank’s customers. Core services
are accepting deposits and making payments from an account, facilities for
withdrawing money and making payments from an account and the provision of
overdraft facilities.
The system of ring-fencing is to be implemented by 1 January 2019, and the Bank
of England will publish final rules, to enable banks to make the necessary changes,
ahead of this date.
The Bank of England continues to consult on changes in respect of the capital levels
that banks are required to hold. It is proposed that UK ring-fenced banks should
hold reserves of capital equal to at least 11 per cent of their risk weighted assets.
There are likely to be more stringent capital requirements for ‘globally significant’
banks.
In respect of the conduct and accountability of senior managers, a new Senior
Managers’ Regime was introduced in March 2016. The regime overhauls the
approved persons regime and applies to UK incorporated banks, building societies
and credit unions and to UK incorporated and PRA designated investment firms.
The intention is to extend the regime to all banks operating in the UK. The regime
sees an approval process for senior managers and a certification process for more
junior employees. There is also a new conduct regime. Perhaps most significantly,
a new criminal offence of ‘recklessly leading a bank into insolvency’ has been
introduced, with a maximum punishment of seven years’ imprisonment. The aim of
the Senior Managers’ Regime is to enhance conduct and improve levels of individual
accountability.
A similar regime has been introduced for senior managers in the insurance
industry.
The Senior Managers’ Regime is detailed in section 2.2.3.
1.3.5 The London Stock Exchange and AIM

The London Stock Exchange has been London’s market for stocks and shares for
hundreds of years. Government stock, share capital and loan capital, overseas
shares and options are all traded on this market.
There are two markets for shares: the main market (for which a full listing is
required) and the Alternative Investment Market (AIM).

Companies quoted on the London Stock Exchange main market must conform to
the stringent requirements of the listing rules laid down by the FCA, acting in its
capacity as the UK Listing Authority (UKLA). For a full listing (ie a listing on the main
market), a considerable amount of financial and other information is required to
be disclosed. In addition:
u the applicant company must have been trading for at least three years;
u at least 25 per cent of its issued share capital must be in the hands of the public.
The London Stock Exchange, like most stock markets, is both a primary
and secondary market. The primary market is where companies and financial
organisations can raise finance by selling securities to investors. They will either
be coming to the market for the first time, through the process of ‘going public’
or ‘flotation’, or issuing more shares to the market. The main advantages of listing
include greater ease with which shares can be bought or sold, and the greater ease
with which companies can raise additional funds. The secondary market − which
is much bigger in terms of the number of securities traded each day − is where
investors buy and sell existing securities.
The AIM was established in 1995 and is an additional, separate market on the
London Stock Exchange. It is mainly intended for new, small companies with the
potential for growth. Its purpose is to enable suitable companies to raise capital by
issuing shares and it allows those shares to be traded. In addition to the benefit of
access to public finance, companies will enjoy a wider public audience and enhance
their profiles by joining the AIM.
Rules for joining the AIM are fewer and less rigorous than those for joining the
official list (the main market), and were designed with smaller companies in mind.
1.3.5.1 Participants in the markets

Those that trade in financial markets include:
u governments, public institutions and corporations who raise money on the
markets and whose securities are traded;
u investment banks and other large organisations that facilitate the issue of new
securities;
u banks and other traders that issue, buy or sell shares or derivatives;
u investors who wish to invest their money − this includes individuals and
financial institutions, such as life insurance companies and pension funds.
1.3.5.2 Off-market trading

This is sometimes called ‘over-the-counter’ (OTC) trading. It is not very common
between individual private investors, but becoming more prolific between
institutions who trade large blocks of securities with little publicity about the price
paid or the company(ies) whose shares are being traded. This form of trading is
sometimes called ‘dark pools’.
1.3.6 The government bond market

The UK government borrows money by selling bonds, known as ‘gilts’. This money
is to fund the shortfall between government spending and tax revenues. The
majority of the spending is to fund the welfare state.

Gilts are sold at regular auctions held by the UK Debt Management Office (DMO)
on behalf of Her Majesty’s Treasury. The term gilt is short for ‘gilt-edged security’
and is a reference to their perceived safety as an investment. The government has
never failed to make a repayment on a gilt.
When a gilt is sold, the government guarantees to pay the holder a fixed interest
payment every six months until the maturity date, at which point the full value
of the bond is repaid. The majority of gilts are held by UK institutions, such as
pension funds, but a large proportion are also held by foreign governments and
investors.
See section 13.5 for further details.
1.4 The role of government

One of the primary objectives pursued by most modern governments is to engender
an economic and legal environment in which a balance is established between the
need for businesses to make a profit and the rights of consumers to receive a fair
deal. This has led to the regulation, to some degree, of most industries in the
UK but, at the same time, the government recognises the right of companies to
make money. Indeed, it recognises that it is essential that companies be permitted
to make a reasonable profit; it would otherwise be impossible to attract the
investment that sustains the industries on which the UK economy depends.
These twin objectives of a free market for business enterprise and the protection
of the consumer are among the principles on which the European Union is
based. It is not surprising to discover that these objectives have been promoted
largely through European legislation, most of which impacts, either directly or
indirectly, on the UK. The force of European law can be seen in most recent major
developments in the regulation of UK financial institutions.
The role of the government in the UK in this context is to provide a framework
of regulation that stipulates how the financial services sector should be operated.
However, the regulation of the financial services industry is, broadly speaking, a
five-tier process.
u First level: European legislation that impacts on the UK financial industry. The
two main types of European legislation are ‘regulations’ and ‘directives’ (see
section 1.4.1).
u Second level: Acts of Parliament that set out what can and cannot be done.
Whenever reference is made to Acts of Parliament, it should be borne in mind
that the effects of the laws are often achieved through subsidiary legislation −
known as statutory instruments − which are made pursuant to (in accordance
with) the Act. Examples of legislation that directly affect the industry are the
Financial Services and Markets Act (FSMA) 2000, the Banking Act 1987, the
Building Societies Act 1997 and the Financial Services Act 2012.
u Third level: the regulatory bodies that monitor the regulations and issue rules
about how the requirements of legislation are to be met in practice. The main
regulatory bodies are the Prudential Regulation Authority (PRA) and the Financial
Conduct Authority (FCA).
u Fourth level: the policies and practices of the financial institutions themselves
and the internal departments that ensure they operate legally and competently

The role of government
− eg the compliance department of a life assurance company that monitors the

operations of the organisation to ensure that they comply with regulations.
u Fifth level: the arbitration schemes to which consumers’ complaints can be
referred. For most cases this is the Financial Ombudsman Service (see Topic 4).
1.4.1 The influence of the European Union

Following the referendum in June 2016, the UK will exit the EU (Brexit). The details
of how and when this will happen are yet to be worked through, but regulatory
policy will remain unchanged in the short term. The UK has been a member of
the European Union since 1973, although it remains outside the eurozone, having
chosen not to adopt the euro when the single currency was introduced in 1999.
In spite of the UK retaining its own currency and control over its own monetary
policy, the financial services industry is hugely influenced by the European Union’s
policies and laws. Few people realise that large portions of the UK’s financial
regulatory regime for consumers and companies are determined by European
laws. This includes regulation relating to banking, investment, life assurance,
general insurance, operating as a financial adviser, compensation for losses, money
laundering, data protection and many other areas.
The European Parliament and the Council of Ministers share the power to adopt
European laws, often acting on suggestions from the European Commission. These
laws can take a number of forms, of which the two most common are regulations
and directives.
u Regulations have general application, are binding in their entirety and
directly applicable in all member states (unless particular states have specific
dispensation).
u Directives are binding as to the result to be achieved upon each member state
to which they are addressed. In other words, the objectives of the directive must
be achieved within a specified timescale (typically two years) but exactly how
they are achieved is left to national authorities in each state.
Many of the regulatory requirements that affect UK financial services organisations
can be seen to mirror closely the details found in related European directives.
1.4.2 The Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision is an international committee of
banking supervisory authorities established in 1974 that provides a forum for
cooperation on banking supervisory matters. The mandate of the Basel Committee
is to strengthen the regulation, supervision and practices of banks worldwide,
with the purpose of enhancing financial stability. One of the ways to do this is to
formulate supervisory standards and guidance.
1.4.2.1 Basel I
Referred to as the Basel Accord. In 1988, the Basel Accord published a set of
minimum capital requirements for banks. The rules were adopted by the G10
group of countries, including the UK.

1.4.2.2 Basel II
Basel II was published in 2004 and superseded the original Basel Accord. The
objective was to establish an international standard for banking regulators in terms
of how much capital a bank should hold to provide protection against financial and
operational risk. An area of focus was ensuring consistency in the regulations so
as to provide a level playing field for banks when competing with those who fall
under a different regulatory jurisdiction.
Basel II details risk and capital management requirements so that banks are
required to hold appropriate levels of capital, given the risk presented by their
lending and investments practices; as risk increases so do the associated capital
requirements.
Basel II consists of three ‘pillars’, as follows:
u Pillar 1 details capital requirements in respect of three aspects of a bank’s
operations:
− credit risk;
− operational risk; and
− market risk.
u Pillar 2 gives banking regulators more effective supervisory tools and enables
regulators to deal with the individual components of risk.
u Pillar 3 contains a set of disclosure requirements so that the capital adequacy
of an organisation can be properly assessed.
In relation to supervision and disclosure, Basel II introduced the requirement for
banks to carry out ‘stress tests’, the use of computer simulations to understand the
effect of certain events on the firm. Stress tests ascertain the extent to which the
firm will have sufficient capital if certain unexpected adverse economic conditions
prevail.
1.4.2.3 Basel III

Basel III was agreed by members of the Basel Committee in 2010−11, and is due
to be fully implemented by March 2019. Basel III covers two main areas, which are
regulatory capital, and asset and liability management.
Regulatory capital is the amount of capital that a bank is required to hold in order to
meet regulatory requirements. A general theme is that the higher the risk presented
by the business a bank is undertaking, the higher the level of capital it is required
to hold.
In respect of regulatory capital, Basel III requires banks to reach a minimum
solvency ratio of 7 per cent by 2019. The solvency ratio is defined as an institution’s
regulatory capital as a percentage of the risk-adjusted value of its assets. It
establishes a capital buffer so that the bank’s depositors are protected in the
event that those the bank has lent money to default on loan repayments.
Basel III introduced two new ratios that banks must comply with in respect of assets
and liabilities management, which are as follows:
u liquidity coverage ratio (LCR);
u net-stable funding ratio (NSFR).

The clearing process and settlement organisations
1.4.2.4 The Capital Requirements Directives

In the EU, the requirements of Basel I, II and III are implemented by the Capital
Requirements Directives. The latest iteration of the Capital Requirements Directive
is CRD IV, which came into effect on 1 January 2014, with the capital requirements
being phased in over a number of years to 2019. The CRDs establish a supervisory
framework, which aims to minimise the negative effects of a firm failing by ensuring
that firms hold sufficient financial resources to cover the risks that their business
activities present.
CRD IV builds on existing rules and introduces new prudential requirements.
Notably, the quality of capital that firms are required to hold has been improved,
and new capital buffers have been introduced for some firms.
CRD IV applies to banks, building societies and investment firms. The PRA has
amended its Handbook to take account of CRD IV.
1.5 The clearing process and settlement

organisations
The clearing process enables the transmission of money around the financial
system. ‘Money transmission’ is a term that covers a range of services, including
the provision of cash, cheque clearing, direct debits and standing orders, credit
and electronic transfers, and payment card services. Customers can access these
services via their branch, an ATM, over the telephone and via the internet.
‘Clearing’ in the banking context refers to the process, at the end of each business
day, of settling between banks the transfers of money outstanding as a result of
the use by customers of cheques, direct debits, debit cards and other means of
money transfer. At the end of any particular day, for instance, NatWest will need
to pay to Barclays a total sum in relation to cheques written by its customers and
banked by Barclays’ customers − and of course exactly the same will be true in
reverse. As a result, a net figure will be due from one of the banks to the other,
and this is settled through accounts that the banks hold at the Bank of England.
As a result of the development of more automated methods of funds transfer −
such as direct debits, payment cards and the use of smart technology − cheque
volumes are falling and are expected to continue to fall. Around 410m cheques
were issued in the UK during the 12 months to November 2015, a 12 per cent fall
on a year earlier (Payments UK, 2015).
By comparison, card payments reached 18bn during 2014 (Peachey, 2015).
Not all retail banks are clearing banks. Clearing banks are those that have
established their own clearing systems in conjunction with other clearing banks.
Banks, and some building societies, that require payment systems to be set up but
do not have their own clearing service, have to establish an agency arrangement
with one of the clearing banks.
The Bank of England acts as a settlement bank to the other banks for daily
reconciliation of the amount owed between banks for customer transactions.
The activity of the clearing services in the UK are co-ordinated by UK Payments
Administration Ltd, an association of major banks and building societies that acts

as the umbrella organisation for the UK payments industry. It manages the major
UK payment clearing systems through three operational clearing companies.
u Cheque and Credit Clearing Company, which oversees the clearing of
cheques and paper credits on a three-day processing cycle;
u Bankers’ Automated Clearing Services Ltd (BACS), which is responsible
for the bulk electronic clearing (eg direct debits) operated on their behalf by
VocaLink Ltd; and
u CHAPS (the Clearing House Automated Payment System), an electronic
same-day interbank transfer system for high-value wholesale payments.
Payment services in the UK are regulated by the Payment Systems Regulator, a
subsidiary of the FCA.
References
Payments UK (2015) Payment statistics November 2015 [pdf]. Available at: http://www.paymentsuk.
org.uk/sites/default/files/Monthly%20Payment%20Statistics%20Nov%202015.pdf
[Accessed: 17 May 2016].
Peachey, K. (2015) Cashless payments overtake the use of notes and coins. BBC [online], 21 May
2015. Available at: http://www.bbc.co.uk/news/business-32778196 [Accessed: 17 May 2016].
ICE (2016) [online]. Available at: https://www.intercontinentalexchange.com/about [Accessed: 9
June 2016].
Review questions
The following questions are designed to consolidate and enhance your
understanding of the material you have just studied.
Answers to the review questions are contained at the back of this study text.
1. What is the main purpose of the financial services industry?

2. Explain the term ‘financial intermediation’.
3. List the main types of financial institution in the UK.
4. What is the role of the Monetary Policy Committee?

5. What are the main features of a mutual organisation?
6. Which type of customers are credit unions aimed at?

7. What is the purpose of the London Stock Exchange?
8. How does the European Union influence the financial services industry in the
UK?
9. What is the difference between an EU regulation and a directive?
10. What is ‘clearing’?

Topic 2
The Prudential Regulation Authority
and the Financial Conduct Authority
Learning objectives
u explain the objectives and role of the PRA;
u explain the objectives and role of the FCA;
u summarise the approach to the prevention of financial crime;
u interpret the FCA’s approach to supervision within the financial services
industry.
2.1 Introduction
During the latter part of the twentieth century, strong views developed in Western
societies concerning the rights of the consumer. The context for this was that,
as commercial organisations have grown through mergers and acquisitions, they
have become more remote from their customers and more concerned with their
own business performance than with customer satisfaction. This is reflected in
the emergence of both government organisations, such as the Competition and
Markets Authority, and consumerist bodies, such as Which? and Money Saving
Expert.
Perhaps because it deals with money − a vital common denominator both in the
lives of individuals and in the national economy − the financial services industry
has become one of the most regulated business sectors of all. Since the mid 1980s
there has been a raft of legislation relating to the financial services sector and there
is no sign of a slowing down in the trend for greater regulation of the industry,
often because as one problem is dealt with, another issue emerges.
Although governments try to foresee problems and to introduce legislation as
a means of ‘prevention rather than cure’, it remains true that most regulatory
legislation in the past has been reactive rather than proactive − ie it has been
passed in response to problems, rather than designed to foresee and prevent
them.
Much of this topic describes the current regulatory structure in the UK, presided
over by the PRA and the FCA. These bodies took over from the previous regulator,
the Financial Services Authority (FSA) in April 2013. This new structure was
introduced following implementation of the Financial Services Act 2012, legislation
that was introduced following the failure of the previous regime in the period
leading up to the 2007 credit crisis. The PRA operates as a subsidiary of the Bank

2: The Prudential Regulation Authority and the Financial Conduct Authority
of England and has sole responsibility for the day-to-day prudential supervision
of banks and other financial institutions; prudential supervision is concerned with
the financial arrangements of a business, in particular, whether financial affairs are
arranged in such a way so as not to threaten the operation of the business. Within
the Bank of England, the Financial Policy Committee (FPC) looks at the economy in
broader terms to identify and address risks that may threaten economic stability.
The consumer protection aspects of the FSA’s former role were transferred to the
Financial Conduct Authority (FCA), which has responsibility for the conduct of all
retail and wholesale financial firms.
The FCA has responsibility for conduct regulation (ie the behaviour of firms and
individuals) for all firms, and prudential regulation for those firms not covered
by the PRA. This means there is some dual regulation by the FCA and PRA. The
following firms are PRA-authorised and so are ‘dual-regulated’ by the PRA for
prudential purposes and the FCA for conduct purposes:
u banks;
u building societies;
u credit unions;
u insurers (including friendly societies);
u Lloyd’s of London and Lloyd’s managing agents;
u certain systemically important investment firms designated by the PRA.
The FCA regulates all other firms, known as FCA-authorised firms or FCA-only firms
in respect of both conduct and prudential matters. The PRA and FCA are tasked
with co-operation and with co-ordinating their activities. The PRA has the power to
overrule or ‘veto’ decisions made by the FCA where it considers that action being
taken by the FCA threatens financial stability or is likely to cause the failure of a
PRA-authorised person in a way that could adversely affect financial stability.
Any financial services organisation conducting business in the UK must be
authorised by the PRA and/or FCA if it carries out ‘regulated activities’ in relation
to ‘regulated investments’. Both regulated activities and regulated investments
are detailed in the Financial Services and Markets Act 2000. Regulated activities,
for which firms must be authorised under the Regulated Activities Order (RAO),
include:
u accepting deposits;
u effecting and carrying out insurance contracts (including funeral plans);
u dealing in and arranging deals in investments;
u managing investments;
u establishing and operating collective investment schemes;
u establishing stakeholder pension schemes;
u advising on investments;
u mortgage lending and administration;
u advising on and arranging mortgages;
u advising on and arranging general insurance;

Prudential Regulation Authority (PRA)
u offering credit cards and personal loans;

u selling goods or services on credit;
u offering goods for hire; or
u providing debt counselling or debt adjusting services to consumers (FCA, 2013).
Permission is given in the form of a list of regulated activities that the firm is
allowed to undertake; it also shows the regulated investments with which the firm
is allowed to deal. The relevant provision of the Financial Services and Markets
2000 (FSMA) under which permission is granted is Part IV, and as a result this form
of permission is often referred to as ‘Part IV permission’.
The RAO also defines regulated investments. They include:
u deposits;
u electronic money (e-money);
u insurance contracts, including funeral plans;
u shares, company loan stocks and debentures, and warrants;
u gilt-edged stocks and local authority stocks;
u units in collective investment schemes;
u rights under stakeholder pension schemes;
u options and futures;
u mortgage contracts.
The FCA defines two key categories of regulated investment: securities (such as
shares, debentures and gilts) and contractually based investments (including life
policies, personal pensions, options and futures).
2.2 Prudential Regulation Authority (PRA)

The PRA is responsible for the prudential regulation of banks, building societies
and credit unions (known collectively as ‘deposit-takers’), insurers and major
investment firms. The PRA promotes the safety and soundness of these firms,
seeking to minimise the risk of such businesses failing, and limiting the adverse
effects that such a failure could have on the stability of the financial system. The
PRA also contributes to ensuring that insurance policy holders are appropriately
protected.
In the event that a firm should fail, or encounter problems that prevent it from
operating its business in a normal manner, the PRA’s intent is to avoid harm
resulting from disruption to the continuity of provision of financial services; for
example ensuring that depositors are able to continue to access their money
and operate their accounts. In promoting safety and soundness the PRA focuses
primarily on the harm that firms can cause to the stability of the financial system.
A large part of the PRA’s expectations reflects the statutory threshold conditions
that firms are legally required to meet. These conditions require firms to:
u have an appropriate amount and quality of capital and liquidity (the ability to
quickly convert assets into cash, if required);
u have appropriate resources to measure, monitor and manage risk;

u conduct their business prudently;

u be fit and proper;
u be capable of being supervised by the PRA.
There are three key areas of prudential control for financial institutions relating to
their capital adequacy, liquidity and solvency. In simple terms capital adequacy is a
bank’s own funds (from shareholders), not money deposited by investors. Liquidity
is the speed at which cash can be acquired (borrowed or through the sale of assets).
Solvency concerns the amount of a bank’s own funds (short-term assets) in relation
to its longer-term assets (such as loans to customers). There are different rules for
deposit-takers, for investment firms and for life assurance companies. We will look
at prudential regulation for deposit-takers in more detail.
2.2.1 Capital adequacy regulations and solvency ratios

Regulations about capital adequacy broadly state that deposit-taking institutions
must have sufficient capital to make it very unlikely that deposits will be placed at
risk. The meaning of ‘capital’ in this context is perhaps best illustrated by the fact
that it is also sometimes referred to as ‘own funds’, ie the bank’s own capital base,
obtained from shareholders and related sources, as distinct from funds deposited
by customers.
Although a bank’s lending is generally financed by deposits, any losses made (for
instance if a loan is written off because repayment cannot be obtained) should
be borne by shareholders rather than by depositors. Minimum requirements for
capital adequacy are set to protect a bank’s depositors so that they do not lose
money, whereas shareholders are expected to take risks.
These minimum capital requirements are specified in terms of a bank’s solvency
ratio, which means that the capital required is denominated as a proportion of
the bank’s assets (ie mainly its loans), with appropriate allowances made for the
perceived risk level of different assets.
The solvency ratio is defined as ‘own funds of the institution as a percentage of the
risk-adjusted value of its assets’. (This reflects the very reasonable principle that
any losses made on traditional banking business − such as debts written off when
borrowers default − should be carried by the institution’s shareholders and not
by the investors whose deposits provide the funds that the institution lends out.)
There are different rules applying to different types of financial business. As an
example, current regulations require credit institutions to keep a solvency ratio of
at least 8 per cent. This means that their own funds must amount to at least 8 per
cent of their risk-weighted assets. In practice, institutions normally keep more than
the required 8 per cent. The provisions set out by the Basel Committee on Banking
Supervision (see section 1.4.2) detail the rules for minimum capital requirements,
and the provisions of Basel III will see minimum capital requirements for banks
reduce to 7 per cent by 2019, but the method used to calculate the solvency ratio
is being made more exacting.
2.2.1.1 EU Solvency Directives

The failure of an insurance company presents a number of risks for consumers. In
the EU the Solvency Directives are the key legislation in respect of the prudential
supervision of insurance companies.

Solvency I was a minimum harmonisation directive introduced in the early 1970s,

which allowed for differences to emerge in the way that insurance regulation was
applied across Europe, leading to different regimes. It was primarily focused on the
capital adequacy of insurers and did not include requirements for risk management
and governance of firms.
The Solvency II directive aims to harmonise regulation of the EU insurance industry
and is primarily focused on the amount of capital that an insurer must hold to
reduce the risk of insolvency.
Solvency II has been adopted by all European Union (EU) member states, plus three
of the European Economic Area (EEA) countries. It aims to protect policyholders’
interests more effectively by making firm failure less likely, and by reducing the
probability of consumer loss or market disruption. Solvency II should also make it
easier for firms to do business across the EU.
The main aims of Solvency II are to:
u reduce the risk of an insurance company being unable to meet its claims;
u reduce losses suffered by policyholders should an insurer be unable to meet all
claims in full;
u establish a system of information disclosure that makes regulators aware of
potential problems at an early stage;
u promote confidence in the financial stability of the insurance sector.

Solvency II aims to achieve consistency across Europe and is based on three main
‘pillars’, which are as follows:
u Pillar 1: capital requirements and the valuation of assets.
u Pillar 2: governance and risk management requirements.
u Pillar 3: disclosure and transparency rules.

The capital requirement is expressed in terms of a solvency capital requirement
(SCR), which comprises a basic SCR, plus an allowance for operational risk, less an
amount for adjustments. Insurers will be required to complete and submit an own
risk and solvency assessment (ORSA).
The new regime will apply to almost all EU insurance firms. Some insurance firms
will be out of scope depending on the amount of premiums they write, the value
of technical provision, or the type of business written.
The requirements of the Solvency II Directive became effective for supervisors
and the European Insurance and Occupational Pensions Authority (EIOPA) from
1 January 2016.
The PRA has made changes to its Handbook to reflect the new requirements.
2.2.2 Liquidity
Liquidity can be defined as the ease and speed with which an asset can be converted
into cash − and thus into real goods and services − without significant loss of
capital value. It must not be confused with insolvency, or with capital adequacy,
which are different issues.

The question of liquidity was at the heart of the issues arising in the lead up to and
the aftermath of the credit crunch in the latter part of the 2000s. The UK’s central
bank, the Bank of England, has had to operate in its role as ‘lender of last resort’
to rescue banks whose liquidity was inadequate.
In relation to banks, the definition of liquidity is a measure of a bank’s ability
to acquire funds immediately at a reasonable price in order to meet demands
for cash outflows. Liquidity risk can be defined as the risk that a firm, though
solvent (in terms of the level of assets held), does not have sufficient financial
resources available to enable it to meet its obligations as they fall due. This could,
for example, happen when a large portion of a bank’s assets have been advanced
as long-term loans and they face a situation when an unexpectedly high number
of depositors are seeking to withdraw their savings.
In assessing the liquidity risks that they may face, banks need to consider the
timing of both their assets and their liabilities, and endeavour as far as possible to
match them.
u Asset liquidity: a firm’s assets can provide liquidity in three main ways: by
being sold for cash, by reaching their maturity date and by providing security
for borrowing. Asset concentrations, where a large number of receipts from
assets are likely to occur around the same time, should be avoided.
u Liability liquidity: similarly banks try to avoid liability concentrations, where
a single factor or a single decision could result in a sudden significant claim. A
wide spread of maturity dates is one obvious way to achieve this.
2.2.3 Arrangements, systems and controls for

senior managers
In seeking to take action against firms in the financial services industry, regulators
have often found it difficult to identify which individual or individuals are
responsible for a business’s failings. In response, the FCA / PRA introduced a
new Senior Managers’ Regime from March 2016.
At the outset the Senior Managers’ Regime applies to ‘relevant firms’:
u UK based banks, building societies and credit unions;
u PRA designated investment firms;
u the UK branches of overseas firms.
The Senior Managers’ Regime will be extended to all financial services firms in
2018.
Senior managers in relevant firms are personally accountable for aspects of the
business for which they have responsibility. The FCA / PRA define certain senior
management roles and also a range of prescribed responsibilities that must be
allocated between the senior management of a business. Where an individual
applies for a senior management role, their application must be accompanied by a
‘statement of responsibilities’, detailing the aspects of the business they will take
responsibility for. The regulator can then compare the personal capabilities of the
individual to the nature of the role they will be performing.
The FCA and PRA personally vet those who apply for a senior management role and
firms must take action to ensure the ongoing fitness and propriety of their senior
managers. Where a senior manager moves into their role or where the nature of

the role is subject to significant change, the firm must have robust procedures to
ensure a smooth transition so as to equip the senior manager to carry out their
role effectively.
Each firm must maintain a ‘responsibilities map’ which details the way
responsibilities are allocated between the senior management team. Should
problems arise, the responsibilities map enables the FCA / PRA to more easily
identify which person is responsible.
The penalties for senior managers are wide and the regime enables the FCA /
PRA to instigate criminal proceedings against a senior manager whose action or
inaction has led their business to fail. If found guilty, the maximum punishment is
a prison sentence of up to seven years and / or an unlimited fine.
The regulators recognise that the actions of those in more junior roles, below senior
management level, could still cause major damage to a business and its customers.
The FCA / PRA define a number of ‘significant-harm’ functions. Individuals in these
roles are subject to a certification regime and each relevant firm must assess the
fitness and propriety of those in such roles on an ongoing basis, at least annually.
All those working for a regulated firm are subject to a Code of Conduct, unless they
perform an ancillary role. Where an individual breaches one or more of the rules
contained in the Code, then the FCA / PRA can take enforcement action against
them personally.
For insurance companies, there is a similar regime for Senior Insurance Managers.
One significant difference is that there is no scope for criminal proceedings.
Firms should have whistleblowing procedures in place to enable employees to
report serious inappropriate circumstances or behaviours within the firm that they
believe are not being addressed. Workers who wish to report their knowledge or
suspicions regarding, for example, a failure by the firm to comply with legislation
have a right to protection under the Public Interest Disclosure Act 1998. The firm’s
procedures should assist staff and not hinder them in the whistleblowing process.
The role of oversight groups is important. It is appropriate that all aspects of the
activities of financial services institutions should be kept under review to ensure
that the investments of both shareholders and customers are being handled safely
and honestly and that the institution is abiding by all the applicable laws and
regulations, in the best interests of all its stakeholders. This oversight of an
institution’s business can be carried out by different individuals and groups, such
as auditors, trustees or compliance officers.
2.2.4 The PRA’s approach to regulation and supervision

Prior to the revised regulatory structure introduced from April 2013, the FSA
was the sole regulator of the UK financial services industry, responsible for both
conduct and prudential regulation. The FSA’s Handbook was inherited and updated
by the FCA and PRA; not an ideal situation given the different areas of regulation
that each body focuses on. The PRA has since designed its own handbook. The
regulatory regime of the PRA is based on eight fundamental rules, as follows.
A firm must:
u conduct its business with integrity;
u conduct its business with skill, care and diligence;

u act in a prudent manner;

u at all times, maintain adequate financial resources;
u have effective risk strategies and risk management systems;
u organise and control its affairs responsibly and effectively;

u deal with regulators in an open and cooperative way and disclose to
the PRA appropriately anything relating to the firm of which the PRA could
reasonably have expected notice of;
u prepare for resolution so, if the need arises, it can be resolved in an orderly
manner with a minimum disruption of critical services.
Regulation requires firms to meet detailed standards, including high level policies
and more detailed rules. Supervision of firms involves the PRA assessing the risks
that firms pose, in terms of likelihood of a risk event occurring and the impact if it
did, and taking action where necessary to reduce the risks presented.
The PRA’s supervisory approach has three characteristics:

u a judgement-based approach − to determine whether firms are safe and sound
and have the ability (and will continue to have the ability) to meet the threshold
conditions;
u a forward-looking approach − assessing current and future risks by
understanding the economic environment in which firms operate;
u a focused approach − looking at those issues and firms that pose the greatest
risk to the stability of the financial system and policy holders.
2.3 The Financial Conduct Authority

The FCA is an independent limited company with responsibility for regulating
the conduct of business of retail financial services firms and wholesale market
participants, such as investment exchanges and over-the-counter financial
markets. It will also have prudential responsibility for those smaller firms not
regulated by the PRA. The FCA has one strategic objective − to make relevant
markets work well. Delivery of the strategic objective will be through the following
three operational objectives:
u to facilitate efficiency and choice in the market for financial services;

u to secure an appropriate degree of protection for consumers;
u to protect and enhance the integrity of the UK financial system.

The FCA remit makes clear that it should take a key role in promoting competition
within markets, particularly in relation to pricing issues and fairness.
The Financial Services Act 2012 gave the new FCA powers as the ongoing legal
entity of the disbanded Financial Services Authority. The FCA is directly accountable
to HM Treasury and Parliament and has been given the statutory objective of
ensuring that ‘relevant markets work well’.

The Financial Conduct Authority
2.3.1 Integrity of markets

To deliver good market conduct the FCA looks at behaviour that damages trust in
the integrity of markets. Three priorities for this activity are:
u focus on wholesale conduct − to enhance trust and confidence in these markets,

which impact on the retail market when problems occur;
u trust in the integrity of markets − where poor behaviour leads to the detriment
of consumers, for example where charges and fees within wholesale markets
are passed down to retail consumers;
u preventing market abuse − by policing and tackling criminal and civil abuse.
2.3.2 Consumer protection

The FCA can achieve consumer protection in several ways:
u Product governance and intervention − lessons have been learned from

previous problems such as the mis-selling of payment protection insurance (PPI).
This means that the FCA will intervene earlier, acting on information gathered
(for example, from consumer organisations or whistleblowers). Enhanced
scrutiny of new products and the way they are sold before launch will help to
prevent problems occurring. The FCA has the power to ban products that pose
unacceptable risks to consumers, including securing refunds for customers.
u Financial promotions − the FCA has the power to ban misleading financial
promotions, which is intended to help raise standards for new products or new
delivery channels. Promotions that adversely affect the consumers’ ability to
make informed choices and secure the best deal can also be banned.
u Publicising enforcement action − the FCA is able publicly to announce that it

has begun disciplinary action against a firm or individual. Firms will understand
what behaviour is unacceptable and consumers will know what action is being
taken on their behalf.
2.3.3 Competition
In comparison with its predecessor, the FCA has greater powers and wider
responsibilities in respect of the promotion of effective competition. The FCA’s
statutory objective is to ensure that relevant markets function well, and one of its
three operational objectives is to promote effective competition. To understand
the role of the FCA in terms of competition, it is important to consider the broader
context of competition, and the promotion thereof, in the UK economy.
The FCA aims to promote competitive markets so as to enable consumers to have

access to a range of financial products on which they can make an informed
choice. From April 2015, the FCA was granted wider powers in order to open up
competition. These powers enable the FCA to enforce the prohibitions under the
Competition Act 1998 on anti-competitive behaviour in relation to the provision
of financial services. Under the Enterprise Act 2002, the FCA can also carry out
market studies and make market investigation references to the Competition and
Markets Authority (CMA) (see section 5.2).

In seeking to achieve its operational objective in respect of competition, the FCA

will want to promote:
u competitive markets where firms compete by offering better quality services
that meet defined consumer needs;
u the alignment of prices charged with costs of production and distribution;
u innovation and the development of new products.

The financial services competition powers held by the FCA are the same as those
of the CMA; thus, the FCA and the CMA are concurrent regulators.
2.3.4 Principles for Businesses

The FCA works on the assumption that it would be impossible to make a rule
to fit every possible situation. It therefore takes a principles-based approach that
stresses outcomes rather than means. It makes a general principle and seeks to
inculcate a general culture whereby institutions will seek to achieve the outcomes
but will make their own decisions on how best to do this. The principles referred
to are the FCA’s 11 Principles for Businesses, which are contained in the FCA
Handbook.
1. Integrity: a firm must conduct its business with integrity.

2. Skill, care and diligence: a firm must conduct its business with due skill, care
and diligence.
3. Management and control: a firm must take reasonable care to organise and
control its affairs responsibly and effectively, with adequate risk management
systems.
4. Financial prudence: a firm must maintain adequate financial resources.
5. Market conduct: a firm must observe proper standards of market conduct.

6. Customers’ interests: a firm must pay due regard to the interests of its
customers, and treat them fairly.
7. Communications with clients: a firm must pay due regard to the information
needs of its clients, and communicate information to them in a way that is clear,
fair and not misleading.
8. Conflicts of interest: a firm must manage conflicts of interest fairly, both

between itself and its customers and between one customer and another.
9. Customers’ relationship of trust: a firm must take reasonable care to ensure

the suitability of its advice and discretionary decisions for any customer who is
entitled to rely on its judgment.
10.Clients’ assets: a firm must arrange adequate protection for clients’ assets
when it is responsible for them.
11.Relations with regulators: a firm must deal with its regulators in an open
and co-operative way, and must disclose to the FCA anything relating to the
firm of which the FCA would reasonably expect notice.

2.3.5 Approved persons

The FCA has established a set of criteria for determining whether an individual
is a ‘fit and proper’ person to be approved to undertake a controlled function.
This refers to the need for individuals to be authorised under the terms of the
FSMA 2000 before they can undertake certain specified jobs or activities within the
financial services industry.
The criteria relate to a person’s:

u honesty, integrity and reputation, which can be judged from a number of
factors, including:
− criminal record;
− disciplinary proceedings;
− known contravention of FCA (or other) regulations or involvement with

companies that have contravened regulations;
− complaints received, particularly about regulated activities;
− insolvency, or management of companies that have become insolvent;

− dismissal from a position of trust or disqualification as a director;
u competence or capability, in terms of meeting the FCA’s training and

competence requirements;
u financial soundness, based on:
− current financial position;

− previous bankruptcy or an adverse credit rating.
There is a separate regime, the Senior Managers’ Regime, for those who hold
key roles in relevant firms, particularly banks and insurance companies (see
section 1.3.4.1 and section 2.2.3).
2.3.6 ‘Treating Customers Fairly’

In order to ensure that regulatory principles are translated into a practical, properly
controlled regulatory regime, the FCA has established a very large body of rules,
many of which are found in the sourcebooks listed in Topic 3.
The establishment of rules and regulations can, however, carry serious drawbacks.
People and organisations make it their aim to comply with the letter of the law,
rather than to operate according to its spirit. There is also the danger firms might
be able to ‘hide behind’ the rules, using loopholes or technicalities to their own
advantage.
The former regulator, the FSA, was aware of these potential drawbacks, so it
introduced an initiative known as Treating Customers Fairly (TCF) in 2006. The
FCA has continued to pursue this and now refers to Treating Customers Fairly as
the ‘fair treatment of customers’. Amongst the FCA’s Principles, Principle 6 states
that ‘a firm must pay due regard to the interests of consumers and treat them
fairly’. The FCA expect that all firms must be able to show consistently that the fair
treatment of consumers is at the heart of their business.

The FCA does not provide a definition of ‘fair’; its view is that fairness is a concept
that is ‘flexible and dynamic’, which can ‘vary with particular circumstances’. Firms
must decide for themselves what fair treatment means within the context of their
own business. What is clear is that the FCA intends fair treatment to apply at every
stage throughout the life cycle of financial products, such as:
u product design;
u sales and marketing;

u advice and selling;
u administration; and
u post-sale activities, including claims handling and dealing with complaints.
The FCA has given some guidance on the types of behaviour it wishes to see and
has suggested a number of areas that a firm should consider. These include:
u considering specific target markets when developing products;
u ensuring that communications are clear and do not mislead;

u honouring promises and commitments that it has made;
u identifying and eradicating root causes of complaints.
Responsibility for the fair treatment of consumers lies with a firm’s senior
management, which is required to ensure that fair treatment is ‘built consistently
into the operating model and culture of all aspects of the business’.
A key issue the FSA intended to address when it launched the original TCF initiative
was the extent to which customers are helped to understand the financial products
they are buying. Firms are expected to be clear about the services they offer and
about the true cost to the customer. Information must be provided to customers
in a way that is clear, fair and not misleading. Firms should always consider the
ways that the customer will assess their product against others in the market, and
ensure that a fair comparison can be made. This means not only that product
literature should be clear and appropriate to the customer’s expected financial
sophistication, but also that the advice given should be of a sufficiently high quality
to reduce the risk of mis-selling.
2.3.6.1 Fair treatment of customers − the outcomes.

The FCA defines six outcomes a firm should strive to achieve in order to ensure
the fair treatment of its consumers:
1. Consumers can be confident that the firms they are dealing with are committed
to fair treatment of customers.
2. Products are designed to meet the needs of properly identified customer
groups.
3. Consumers are provided with clear information at all stages, before, during and
after a sale.
4. Any advice given is suitable for the customer, taking account of their
circumstances.

5. Products perform as customers have been led to expect, and associated services
are of an acceptable standard.
6. There are no unreasonable barriers to switching product or provider, making a
claim, or complaining.
The FCA is clear that these outcomes are at the core of what it expects from firms.
Since 2009, firms have had to demonstrate to the regulator that they are
consistently treating their customers fairly. This can be done by using management
information that shows how they are delivering the six consumer outcomes or, in
areas of the business where outcomes are below standard, what action the firm is
taking to address the issues.
The concept of ‘conduct risk’ has developed from the TCF strategy and the FCA
places a lot of emphasis on the way firms in the financial services industry conduct
themselves. Firms will need to demonstrate how culture, retail strategies and
controls deliver fair treatment to their customers.
There is a strong focus on the culture and behaviours firms display − for example to
be less sales- and bonus-driven and deliver better customer service − and stronger
enforcement strategies when the rules are ignored.
2.3.7 The FCA’s approach to regulation and supervision

The FCA is the conduct supervisor for more than 70,000 firms and prudential
supervisor for many of those firms not supervised by the PRA. While all firms are
required to meet the regulations, supervisory work is focused on those firms whose
failure would have the greatest impact.
The FCA looks at bigger issues within individual firms and across the industry.
This industry-wide activity includes using market intelligence from firms, consumer
groups and competition regulators such as the Competition and Markets Authority
(CMA). The FCA studies markets where intelligence indicates that competition is
not functioning well.
Firms are categorised according to their potential impact. The categories are as
follows:
u Fixed portfolio firms − those with a large number of retail customers / large
level of client assets whose failure would pose a substantial risk. Such firms are
allocated a named FCA supervisor and supervised on a proactive basis.
u Flexible portfolio firms − these firms represent the vast majority and are
supervised by a mixture of thematic market work and programmes of
communication, engagement and education.
FCA supervision is based on ten principles, which are:
1. ensuring fair outcomes for consumers and markets;
2. being forward-looking and pre-emptive, identifying potential risks and acting
before they have a serious impact;
3. focusing on big issues and causes of problems, concentrating resources on
issues that pose the greatest threat to the objectives of the FCA;
4. taking a judgement based approach focused on achieving the right outcomes;

5. ensuring firms act in the right spirit, that they consider the impact their actions
have on consumers and markets, rather than simply following the letter of the
law;
6. examining business models and culture and the impact they have on consumer
and market outcomes;
7. an emphasis on individual accountability, ensuring senior management
understand they are responsible for their actions and that they will be held
to account when things go wrong;
8. acting in a robust manner when things go wrong;
9. communicating openly with (financial) industry, firms and consumers so as to
understand the issues they face;
10.having a joined up approach to ensure that messages are consistent (FCA,
2015).
2.4 The prevention of financial crime

The FCA is committed to reducing financial crime of all kinds, in particular:
u Market abuse − behaviour that distorts the price of securities. Market abuse
is separated (under EU Market Abuse Regulation) into three aspects:
− insider dealing, where a person who has information not available to other
investors (for example, a director with knowledge of a takeover bid) makes
use of that information for personal gain, whether directly or indirectly (via
another party);
− unlawful disclosure of inside information, where a person who has
information not available to other investors discloses that information for
reasons other than required for the normal performance of their role.
− market manipulation and attempted market manipulation, where a person
knowingly gives out false or misleading information (for instance about a
company’s financial circumstances) in order to influence the price of a share
for personal gain.
u Money laundering − there is appropriate legislation to which firms must
adhere, principally the Proceeds of Crime Act 2002, the Terrorism Act 2000
and the Money Laundering Regulations 2012. Firms are given the flexibility to
structure their controls and procedures to reflect the specific risks they face,
drawing guidance from the Joint Money Laundering Steering Group’s revised
guidance notes, an updated version of which was made available in 2010.
2.5 Discipline and enforcement

Unfortunately there will be occasions when the FCA needs to investigate situations
in which it believes the regulations have been broken and it may need to discipline
organisations or individuals.
The FCA is empowered to undertake general investigations into the business of
authorised persons by looking at the business as a whole or at particular aspects of

Discipline and enforcement
that business. The FCA is also empowered to undertake specific investigations

if it has particular suspicions about the activities or behaviour of an authorised
person. The circumstances under which this might occur cover a wide range of
situations including, for example, suspicion of an authorised person:
u contravening regulations;
u providing false information;
u falsifying documents;
u acting outside the scope of their Part IV permission;
u participating in money laundering;
u allowing persons who are not approved to carry out controlled functions;
u falsely claiming to be authorised;
u undertaking insider dealing or market manipulation.
The person who is appointed to carry out the investigation on the FCA’s behalf has
the power to:
u demand that the person being investigated or anyone connected with them:
− answer questions;
− provide information;
u demand that any person (whether or not they are being investigated or are
connected with the person under investigation) provide documents. In the case
of a specific investigation, any person can also be required to answer questions
or provide information.
If there are reasonable grounds for believing that someone has not complied with
the requirement to provide information or documents, the FCA can apply to a
Justice of the Peace for a search warrant to enter a property and seize documents
or take copies.
2.5.1 Enforcement powers

If the FCA is satisfied that it has discovered a contravention of its rules, it has
a number of steps that it can take, depending on its view of the nature and/or
severity of the contravention. Some of these steps are as follows.
u Variation of a firm’s permissions: this may involve removal of one of the
firm’s permitted regulated activities or a narrowing of the description of a
particular activity.
u Withdrawal of approval: the FCA might withdraw a person’s approval to carry
out some or all of the controlled functions that they currently carry out.
u Injunction: if a person has contravened a regulation, the FCA can apply for an
injunction to prevent that person from benefiting from the action, for instance
by selling assets that they have misappropriated.
u Restitution: similarly, if a person has benefited from a contravention of a
regulation, the FCA can ask the court for an order requiring that person to
forfeit to the FCA any profit made from the activity.

u Redress: if it can be shown that losses have been made by identifiable

customers as a result of the contravention of a rule, the FCA may be able
to obtain a court order requiring such losses to be made good. There may,
however, be other more appropriate ways for that customer to pursue such
claims, for instance through the Financial Ombudsman Service or the Financial
Services Compensation Scheme (see Topic 4).
u Disciplinary action: if an approved person or an authorised firm is judged to

be guilty of misconduct, the FCA has a range of options regarding the sanctions
it might apply. These are:
− to issue a private warning;

− to publish a statement of misconduct;
− to impose a financial penalty;
− to order compensation to be paid;

− to bring criminal prosecutions.
u Enhanced supervision: this power was introduced in 2014 to tackle situations

where serious failings are found in the way a firm is conducting business.
Although a new power, it was introduced to formalise the FCA’s approach in
such situations. This involves:
− a review of the supervisory approach (taken with the relevant firm);
− requiring the firm to make commitments with regard to future conduct;
− consideration of the use of other tools and powers.
Before taking action against a dual-regulated firm the FCA will consult with the
PRA. They will decide whether a joint approach or single approach will be the most
appropriate. If a single approach is taken then information will be shared as the
investigation continues.
References
FCA (no date) Business plan 2015/16 [online]. Available at: http://www.fca.org.uk/static/channel-page/
business-plan/business-plan-2015-16.html?utm_source=businessplan2015&utm_medium
=businessplan2015&utm_campaign=businessplan2015#c1 [Accessed: 18 May 2016].
FCA (2013) The FCA sets out in detail how it will regulate consumer credit, including
payday lending, when it takes over responsibility in April 2014 [online]. Available at:
http://www.fca.org.uk/news/firms/consumer-credit-detail [Accessed: 18 May 2016].
FCA (2015) The FCA’s approach to supervision for fixed portfolio firms [pdf]. Available
at: http://www.fca.org.uk/static/documents/corporate/supervision-guide-fixed.pdf [Accessed: 18
May 2016].

Review questions
Review questions
1. What are the three operational objectives of the FCA?
2. What is the main aim of the PRA?

3. How can the FCA achieve consumer protection?
4. Which of the FCA’s 11 Principles for Businesses directly affect relationships

with clients?
5. What are the criteria for an individual’s ‘fit and proper test’?
6. In respect of the fair treatment of customers, what does the FCA expect a
business to be able to demonstrate?
7. Explain the term ‘capital adequacy’.
8. List the types of financial crime.
9. What are the powers available to someone who has been appointed to
undertake an investigation on the FCA’s behalf?
10. List the main enforcement powers of the FCA.

Topic 3
Conduct of business rules
Learning objectives
u summarise the Conduct of Business Sourcebook (COBS);

u explain the regulatory rules for mortgage advice (MCOB);
u explain the regulatory rules for general insurance (ICOB);

u summarise the Banking Conduct of Business Sourcebook (BCOBS).
3.1 Introduction
This topic examines the FCA’s Conduct of Business Sourcebooks, which are
important in the context of advising clients and customers. We saw in Topic 2
that these Sourcebooks are part of the Handbook published by the regulators,
setting out the rules for financial service providers to follow.
The four Sourcebooks covered in this topic are the ones that are most relevant
in the retail financial services environment, and therefore applicable in the adviser
and planner roles. We will also overview the regulation of payment service providers
as this links to the Banking Conduct of Business Sourcebook (BCOBS).
The Sourcebooks can be examined in much more detail on the regulator’s website;
the information contained in this topic is a summary version to provide a general
introduction.
3.2 Conduct of Business Sourcebook

The Conduct of Business Sourcebook (COBS) is part of the FCA Handbook. It
sets out, in detail, the rules by which approved persons must operate when carrying
out their controlled functions.
In November 2007 a new Conduct of Business Sourcebook was introduced to give
firms increased flexibility to decide how best to achieve regulatory outcomes in a
way that is suitable for their particular businesses. It also placed stronger emphasis
on senior management responsibility because the FSA (at the time) considered that
senior managers are best placed to decide how to achieve the outcomes required.

3: Conduct of business rules
There are 22 chapters to this Sourcebook. The information presented here relates
primarily to retail markets and concerns the sales process covered in Topic 18 and
Topic 19. Students are only required to be able to summarise the following details:
u COBS 1: Application This explains, in general terms, which firms and activities
COBS applies to and the territorial scope of COBS.
u COBS 2: Conduct of business obligations This explains that a firm must
act honestly, fairly and professionally with the best interests of its client
in mind. Clients must be provided with information that is appropriate and
comprehensible about the firm and its services, products and investment
strategies, costs and associated charges. This rule covers payments of fees
and commissions and when they are appropriate.
u COBS 3: Client categorisation A firm must notify a new client of
its categorisation as a retail client, a professional client or an eligible
counterparty (such as investment firms, credit institutions, insurance
companies, undertakings for the collective investment of transferable securities,
pension funds and national governments).
u COBS 4: Communication with clients, including financial promotions
This stipulates that communications of whatever sort must be fair, clear and not
misleading. Information must be presented in such a way as to be understood
by the average reader. Firms must not cold-call unless there is an existing
relationship with the provider and other criteria about the product can be met.
u COBS 5: Distance communication This covers the time to be allowed to
consumers before they are bound by contracts (conducted over the phone
for example) and that any e-commerce activities will have information easily,
directly and permanently accessible.
u COBS 6: Information about the firm, its services and remuneration This
covers the costs to be paid by the retail client, and that firms must disclose
commissions to retail clients.
u COBS 7: Insurance mediation Clients taking life insurance must be provided
with specific information about that product. The firm must specify the demands
and needs of that client and, if they have given advice, supply the client with a
suitability report.
u COBS 8: Client agreements Firms must enter into a written basic agreement
with a retail client setting out the rights and obligations of both parties.
u COBS 9: Suitability (including basic advice) This deals with the need for
firms to ensure that any personal recommendations are suitable for the client.
This includes gathering sufficient information and using pre-scripted questions.
Suitability reports must be provided.
u COBS 10: Appropriateness (for non-advised services) Where a client does
not wish to take advice the firm must ask the client to provide information on
their knowledge and experience so it can determine whether the product or
service is appropriate. If the firm does not consider the product or service to be
appropriate then it must warn the client.
u COBS 11: Dealing and managing This includes requirements for firms that
execute orders on behalf of clients, receive and transmit client orders or manage
client investment portfolios.
u COBS 12: Investment research This sets out the rules for managing conflicts
of interest relating to the production and distribution of investment research.

Regulation of mortgage business
u COBS 13: Preparing product information This covers the requirements

to provide clients with information about product services in ‘Key Features’
documents or ‘Key Features’ illustrations.
u COBS 14: Providing information to clients This covers the rules on

information to be given to clients both before the conclusion of a sale and on
variation of an existing policy. This information must be in a durable medium
− eg paper-based. The information must outline the nature and risks of any
investments, taking into account whether the client is a retail or professional
client.
u COBS 15: Cancellation Firms must tell consumers about their right to cancel
life and pension policies, cash-deposit NISAs and certain non-life contracts. The
cancellation period is either 14 or 30 days depending on the type of product.
u COBS 16: Reporting information to clients This covers the need to supply
clients with reports on the services received, including any associated costs. It
includes regular statements for investments and deposits held.
u COBS 17: Claims handling for long-term care insurance This contains
rules on the information that must be provided to long-term care insurance
(LTCI) claimants and a rule on dealing with LTCI claims.
u COBS 18: Specialist regimes This contains provisions that modify COBS for
certain types of firm and activity, most of which are only relevant to non-retail
firms.
u COBS 19: Pensions supplementary provisions This chapter contains

additional rules and guidance specific to pensions business.
u COBS 20: With-profits This applies to firms that offer with-profits life policies.
It governs distribution of funds from the policies, charges and what needs to
be done should the firm stop offering this type of product.
u COBS 21: Permitted links for long-term insurance business This relates
to policies where the benefits are wholly or partly reliant on the value of, or the
income from, property.
u COBS 22: Restrictions on the distribution of certain regulatory

capital instruments This section details restrictions, limitations and relevant
exemptions in respect of distribution of certain specialised capital instruments.
3.3 Regulation of mortgage business

The FCA’s rules on mortgage loans relate to loans taken out by individuals or
trustees, which are subject to a first or second charge on the borrower’s property.
The property must be in the UK and it must be residential to the extent that
the borrower or their immediate family must occupy at least 40 per cent of the
property (with an exception for ‘consumer’ buy-to-let mortgages − see section
3.3.1). This covers home improvement loans, debt consolidation loans and equity
release schemes such as lifetime mortgages and home reversion schemes, and
also ‘consumer’ buy-to-let mortgages. The FCA’s rules in respect of mortgages are
detailed in its Mortgage Conduct of Business sourcebook (MCOB). The MCOB rules
were subject to some major changes in April 2014 to reflect new requirements in
respect of the FCA’s Mortgage Market Review.

MCOB rules cover various activities including lending, administration, advice and
the arranging of loans. Banks, building societies, specialist lenders and mortgage
intermediaries need authorisation.
Mortgage sales, including those in respect of most variations of existing mortgage
contracts, are generally conducted on an advised basis. Execution-only sales are
only allowed in a limited number of circumstances; for example where a customer
is classed as being a high-net-worth customer or a mortgage professional.
Non-advised sales, where the customer is given information on a range of options
and picks one, are no longer allowed except for the most basic contract variations.
Advice is required where the sale has been conducted on an interactive basis,
with interaction between the consumer and a representative of the lender. Where
advice is given, the adviser must ensure the recommended product is suitable for
the customer.
The assessment of suitability must be based not only on a consideration of which
mortgage best suits the client’s needs and circumstances, but also on the initial
and ongoing affordability of the scheme for that client. This includes assessing
the impact of any possible increase in interest rates on a variable-rate mortgage
and considering the effect of the mortgage term running beyond a customer’s
retirement age. Responsibility for confirming the initial and ongoing affordability
of a mortgage sits with the lender, even where the mortgage has been introduced
by a third party, such as an intermediary.
Assessing the suitability of a mortgage involves three stages, as follows:
u assessing whether a mortgage is, in itself, a suitable product for the client;
u assessing what type of mortgage is suitable, in terms of both the method of
repayment (whether a repayment / interest-only or part and part mortgage is
suitable), the interest scheme (variable, fixed, tracker rate etc) and additional
features − the rules regarding interest-only mortgages have been tightened up
and a lender may now only grant an interest-only mortgage where the borrower
has a credible means of repayment;
u selecting the best mortgage and mortgage provider to meet the client’s needs
and circumstances.
Mortgage advisers, arrangers and lenders come under the scope of the Financial
Ombudsman Service and the Financial Services Compensation Scheme.
The structure of the Mortgages and Home Finance: Conduct of Business (MCOB)
sourcebook is as follows.
u MCOB 1: Application and purpose − this explains the scope of the rules, ie
to whom they apply and to what types of mortgages.
u MCOB 2: Conduct of business standards: general − this includes: the use
of correct terminology (‘early repayment charge’ and ‘higher lending charge’);
the requirement for communications with customers to be ‘clear, fair and not
misleading’; rules about the payment of fees/commissions; and the accessibility
of records for inspection by the FCA.
u MCOB 3: Financial promotions − this distinguishes between ‘real-time’
promotions (by personal visit or telephone call) and non-real-time promotions
(by letter, email or advert in newspapers, magazines or on television, radio or
the internet). Unsolicited real-time promotions are not permitted. Customers
must not be contacted during ‘unsocial’ hours (these are generally accepted
as 9pm to 9am, and all day Sunday) with due account taken of religious
beliefs and work patterns. Non-real-time promotions must include the name

Regulation of mortgage business
and contact details of the firm. They must be clear, fair and not misleading, and
if comparisons are used they must be with products that meet the same needs.
They must state that ‘your home may be repossessed if you do not keep up
repayments on your mortgage’. Records of non-real-time promotions must be
retained for one year after their last use.
u MCOB 4: Advising and selling standards − this includes the information
that must be disclosed to the customer at the outset (the initial disclosures);
the content must include a clear explanation of whether advice is based on the
products of the whole market, a limited number of lenders or a single lender.
‘Independent’ advisers must be wholly or predominantly ‘whole of market’.
The nature of the way in which the firm is remunerated must also be made
clear, along with details of FCA regulation and coverage under the Financial
Services Compensation Scheme. Any mortgage recommended must be suitable
for the customer and appropriate to their needs and circumstances. Suitability
includes the requirement to ensure that the mortgage is affordable; records to
demonstrate this must be kept for three years. However, there is no regulatory
requirement to issue a suitability report to the client. Special requirements apply
if the mortgage will be used to consolidate existing debts.
u MCOB 5: Pre-application disclosure − this gives details of the mortgage

illustration that must be provided at the point at which a personal
recommendation is made and before an application is submitted to the
lender. This must include the annual percentage rate of charge (as specified
under the EU Mortgage Credit Directive), the amount of the monthly
instalment and the amount by which the instalment would increase for each
1 per cent rise in interest rates. The contents of an illustration are set out in the
rules, and variations from the prescribed format are not permitted.
u MCOB 6: Disclosure at the offer stage − if a mortgage offer is made, the

lender must provide a detailed offer document. Unless circumstances have
changed since the illustrations was issued, this is based on the information
given in the mortgage illustration. The offer document must also: state how
long the offer will remain valid; point out that there will be no right of withdrawal
after the mortgage has been completed; include or be accompanied by a tariff
of charges.
u MCOB 7: Disclosure at start of contract and after sale − after the first
mortgage payment is made, the lender must confirm: details of amounts, dates
and methods of payment; details of any related products such as insurance;
the responsibility of the borrower to ensure that (for interest-only mortgages)
a repayment vehicle is in place; what the customer should do if they fall into
arrears. Annual statements must be issued, showing: the amount owed and
remaining term; the type of mortgage, and for interest-only a reminder to check
the performance of the repayment vehicle; interest, fees or other payments
made since the last statement; and any changes to the charges tariff since the
last statement. If a change is to be made to the monthly payment, the customer
must be informed of the new amount, revised interest rate and date of the
change.
u MCOB 8 and 9: Equity release − equity release are products used by older
customers to raise money using the equity in their property (the difference
between the value of their property and the debts secured on it) to raise
finance. Special rules apply to equity release (home reversion plans and lifetime
mortgages) in relation to advising and selling standards, and to product
disclosure.

u MCOB 10: Annual percentage rate of charge − this describes how to

calculate APRC so that customers are able to compare interest rates from
different providers.
u MCOB 11: Responsible lending − lenders must put in place a written

‘responsible lending policy’, and must be able to show that they have taken
into consideration a customer’s ability to pay when offering a mortgage.
u MCOB 12: Charges − ‘excessive’ charges are not permitted. Early repayment
charges must be a reasonable approximation to the costs incurred by the lender
if a borrower repays the full amount early. Similarly, arrears charges must be a
reasonable approximation to the cost of additional administration as the result
of a borrower being in arrears.
u MCOB 13: Arrears and repossessions − firms must deal ‘fairly’ with
customers who have mortgage arrears or mortgage shortfall debts. This
includes: trying to reach an agreement on how to repay the arrears, taking
into account the borrower’s circumstances; liaising with third-party sources
of advice; not putting unreasonable pressure on customers in arrears;
repossessing a property only when all other reasonable measures have failed.
Records must be kept of all dealings with borrowers in arrears. Customers
in arrears must be given the following information within 15 working days
of becoming aware of arrears: the FCA information sheet on what do when
in arrears; the missed payments and the total of arrears including any charges
incurred; the outstanding debt; any further charges that may be incurred unless
arrears are cleared.
3.3.1 The Mortgage Credit Directive

The EU Mortgage Credit Directive (MCD) sets an EU-wide framework for the
regulation of secured credit (first and second charge loans) and ‘consumer’
buy-to-let activity and aims to:
u create an EU-wide mortgage credit market;

u ensure high levels of consumer protection.
Member states had until 21 March 2016 to implement the new requirements. The
system of regulation in respect of secured credit in the UK was already considered
robust and met many of the requirements of the MCD. Some changes have been
made to ensure full compliance with the MCD, as follows:
u The regulation of second charge lending was already within the remit of the FCA,
but the FCA has changed the nature of the regulation, moving its requirements
from the CONC (Consumer Credit) sourcebook to MCOB.
u Buy-to-let mortgages were regulated under CONC. Since 21 March 2016,
there has been a distinction between ‘consumer’ buy-to-let mortgages (now
regulated under MCOB) and ‘business’ buy-to-let mortgages (which are now
unregulated). Examples of consumer buy-to-let mortgages would be situations
where someone has inherited a property, or has moved house and is unable to
sell their previous property and so decides to raise a mortgage on the property
so they can then rent it out.
u In respect of second charge lenders, the switch from CONC to MCOB means
that their business processes have to become more robust, particularly with

Regulation of general insurance
regard to professional standards, assessing suitability, confirming affordability

and dealing with customers who are in arrears.
u There have been some changes to MCOB rules; the key changes are as follows:
− Requirements in respect of pre-application disclosure have changed with the

key features illustration being replaced by a European Standard Information
Sheet (ESIS), referred to as a mortgage illustration. Lenders have until
21 March 2019 to introduce the ESIS but unless using an ESIS before that
date, they must provide an updated key features illustration, a KFI plus, from
21 March 2016. The KFI plus contains additional information when compared
to the previous KFI.
− Lenders are required to provide a binding offer and allow prospective
borrowers a seven day ‘right of reflection’ to consider whether they wish
to proceed with the mortgage.
3.4 Regulation of general insurance

In January 2005 the EU Directive on Insurance Mediation was implemented,
designed to open and standardise the market for insurance intermediaries across
the European Union. This meant the regulation of product providers (insurance
companies) and intermediaries.
Firms and individuals working in the areas of general insurance, protection, critical
illness, long-term care and permanent health insurance have to be authorised
through the same processes of permission and approval as apply to the rest of
the industry.
Rules applicable to intermediaries who sell, administer or advise on general

insurance are contained in an FCA rulebook, Insurance Conduct of Business
Sourcebook (ICOBS). The ICOBS are split into eight sections, the contents of
which are summarised below.
3.4.1 ICOBS 1 Application of the rules

ICOBS 1 explains that the rules cover firms who deal with retail commercial
customers for the sale of non-investment insurance products. The activities
regulated by these rules include:
u insurance mediation;
u effecting and carrying out contracts of insurance;

u managing the underwriting capacity of a Lloyd’s syndicate as a managing agent;
u communicating or approving a financial promotion.

3.4.2 ICOBS 2 General rules

ICOBS 2 covers categorisation of clients, as follows:
u policyholders (anyone who, upon the occurrence of the contingency insured
against, is entitled to make a claim);
u customers (anyone who makes arrangements preparatory to concluding a
contract of insurance), further categorised as:
− consumers (natural persons for purposes outside his or her profession);

− commercial customers (anyone who is not a consumer).
It also covers: communications (which must be clear, fair and not misleading);
inducements (managing conflicts of interests fairly, and not soliciting or accepting
inducements that would conflict with a firm’s duties to its customers); record
keeping; and ‘exclusion of liability’ (a firm must not seek to exclude or restrict
liability unless it is reasonable to do so).
3.4.3 ICOBS 3 Distance communications

ICOBS 3 covers rules that ensure compliance with the EU Distance Marketing
Directive, which include the following.
u A firm must provide a consumer with distance marketing information before

the conclusion of a distance consumer contract.
u The identity of the firm and the purpose of the call must be made explicitly
clear at the beginning of any telephone communications.
u Contractual obligations must be communicated to a consumer during the
pre-contractual phase, and these obligations must comply with the law
presumed to apply to a distance contract.
u Terms and conditions must be communicated to a consumer in writing before
the conclusion of a distance contract.
u The consumer is entitled to receive a copy of the contractual terms and
conditions in hard copy on request.
ICOBS 3 also covers e-commerce activities and states that a firm must make the
following information easily, directly and permanently accessible.
u Name.
u Address.
u Details of the firm (including email address) which allow it to be contacted in a

direct and effective manner.
u A status disclosure statement, and confirmation that it is on the PRA/FCA
Register, including its PRA/FCA register number.
Other rules include: that any prices advertised must be clear and unambiguous,
and the firm must indicate whether the price includes relevant taxes; and that any
unsolicited commercial communication sent by email must be clearly identifiable
as such as soon as it is received by the recipient.

Regulation of general insurance
3.4.4 ICOBS 4 Information about the firm, its services

and remuneration
ICOBS 4 states that a firm must provide a consumer with at least the following
information.
u Name and address.
u The fact that it is on the PRA/FCA Register.
u Whether it has a direct or indirect holding representing more than 10 per cent
of the voting rights or capital in an insurance undertaking (ie that it is not a
pure reinsurer).
u Whether a pure reinsurer has more than a 10 per cent holding in the firm.
u The procedures for making complaints to the firm and the Financial
Ombudsman Service.
Prior to the conclusion of a contract, a firm must tell the consumer whether:
u it gives advice after a fair analysis of the market; or
u it is under a contractual obligation to conduct insurance mediation business
exclusively with one or more insurance undertakings; or
u neither of above apply.
A firm must provide details to a customer of any fees, other than premiums, that
are payable for insurance mediation activity before the fee is incurred. If an exact
fee cannot be given, it must disclose the basis for its calculation. An insurance
intermediary must, on a commercial customer’s request, promptly disclose the
commission that it or any associate may receive in connection with a policy. A
firm must use an initial disclosure document (IDD) or combined initial disclosure
document (CIDD) to disclose status, scope of service and fees.
3.4.5 ICOBS 5 Identifying client needs and advising

ICOBS 5 states that:
u a firm should take reasonable steps to ensure that a customer only buys a policy
for which he or she is eligible to claim benefits;
u if a firm finds that parts of the cover do not apply, they should inform the
customer so that they can make an informed choice;
u a firm should explain the duty to disclose all material facts, what this includes,
and the consequences of non-disclosure;
u prior to the conclusion of a contract a firm must specify, on the basis of
information provided by the customer, their needs and the reasons for the
advice being given on that policy;
u a statement of demands and needs must be communicated in writing to the
customer in a clear and accurate matter;
u the firm must take reasonable steps to ensure the suitability of its advice to any
customer who is entitled to rely upon its judgment, taking account of costs,
exclusions, excesses, limitations and other conditions.

3.4.6 ICOBS 6 Product information

ICOBS 6 states that a firm must take reasonable steps to ensure a customer is
given appropriate information about a policy so that he or she can make an
informed choice about the arrangements proposed. The information given will
vary according to matters such as:
u knowledge, experience and ability of the customer;
u policy terms, benefits, exclusions and limitations;
u the policy’s complexity;
u whether the policy is purchased in connection with other products and services;
u whether the same information has been provided to the customer previously.
A firm should provide evidence of cover promptly after the inception of a policy. If
the product is purchased in connection with any other product or service, the firm
must confirm the price of the policy separately from any other, and whether it is
compulsory.
It is the intermediary’s responsibility to provide this information, but insurance
companies must provide the intermediary with adequate information to be able
do this. If there is no intermediary, the insurance company must provide the
information.
Information disclosed ‘pre-contract’ includes the arrangements for handling
complaints and the right to cancel.
Before a pure protection contract is concluded, a firm must provide the customer
with:
u the name of the insurance undertaking and its legal form;
u address of their head office;
u the definition of each benefit and option;
u contract term;
u the means of terminating the contract;
u the means of payment and duration of premiums;
u tax arrangement for benefits under the policy;
u cancellation information;
u arrangements for handling complaints.
3.4.7 ICOBS 7 Cancellation

ICOBS 7 states that a consumer has the right to cancel without penalty, and without
giving a reason, within:
u 30 days for contracts of insurance which is, or has elements of, pure protection
(eg critical illness) or payment protection;
u 14 days for any other contract of insurance or distance contract.

Banking conduct of business
Firms are free to offer more generous cancellation terms than this, provided that
they are favourable to the consumer. The right to cancel does not apply to the
following:
u travel policies of less than one month;
u policies, the performance of which has been fully completed;
u pure protection policies of six months or less, which are not distance contracts;
u pure protection policies effected by trustees of an occupational pension scheme,
or employers (or partners) for the benefit of employees (or partners);
u general insurance (which is not a distance contract or payment protection
contract) sold by an intermediary who is an unauthorised person.
On receipt of the cancellation notice the insurance company must return all
premiums paid within 30 days, and the contract is terminated.
3.4.8 ICOBS 8 Claims handling

ICOBS 8 covers claims handling. If claims are handled by an intermediary, the
insurance company must ensure that the rules are complied with, ensuring no
conflict of interest. Claims must be handled promptly and fairly, and the firm must
provide reasonable guidance to help the policyholder make a claim. The firm must
not unreasonably reject a claim.
Rejection of a claim is considered unreasonable if it is:
u for non-disclosure of a material fact which the policyholder could not reasonably
have expected to have disclosed;
u for non-negligent misrepresentation of a material fact.
Breach of a condition of the contract unless the circumstances of the claim are
connected to the breach.
3.5 Banking conduct of business

The Banking Conduct of Business Sourcebook (BCOBS) and the Payment
Services Regulations (PSRs) (see section 3.5.1 ) came into effect from 1 November
2009.
BCOBS introduced principles-based regulation to the deposit-taking products and
services for consumers. The Payment Services Regulations implemented in the UK
the EU Payment Services Directive, which prescribes the way that payments are to
be undertaken within the European Economic Area (EEA). This regulation relates
directly to the retail banking sector and should improve protection for consumers.
Those areas not covered by BCOBS are addressed by the Standards of Lending
Practice (see section 5.7), overseen by the Lending Standards Board. The changes
were required for a number of reasons.
u With the FCA, as the ‘competent authority’ for the UK, taking responsibility for
the PSRs, it seemed common sense that it should also take responsibility for
customers’ core financial services relationships through BCOBS.
u No one organisation had clear accountability: by the FCA taking control it
increased the FCA’s regulatory effectiveness.

u The (then applicable) ‘Treating Customers Fairly’ (TCF) principle, now fair
treatment of customers, did not have an equivalent for day-to-day banking
operations, which increased the risk of potential customer detriment. The FCA,
however, has the ability to fine and suspend operations of providers if it sees
fit.
u UK branches of credit institutions authorised in other EEA states are now subject
to BCOBS rules, which afford better protection for customers.
u There was increased pressure from government and the public for more controls
over the financial services sector due to recent regulatory failures. It has been
necessary to bolster public confidence in the UK financial services industry and
further regulation may go some way to doing this.
There are six chapters to this Sourcebook.

BCOBS 1: Application The Sourcebook applies to a firm with respect to the activity
of accepting deposits from banking customers carried on from an establishment
maintained by it in the UK and activities connected with that activity.
BCOBS 2: Communications with banking customers and financial
promotions This chapter requires a firm to pay regard to the information needs
of banking customers when communicating with, or making a financial promotion
to them, and to communicate information in a way that is clear, fair and not
misleading.
BCOBS 2A: Optional additional products This chapter details the rules applying
to marketing or providing an optional product (linked to a current account or
savings account) for which a fee is payable.
BCOBS 3: Distance communications and e-commerce This chapter applies to

a firm that carries on any distance marketing activity from an establishment in the
UK, with or for a consumer in the UK or another European Economic Area state. It
contains many of the provisions of the Distance Marketing Directive.
BCOBS 4: Information to be communicated to banking customers and
statements of account This chapter contains details about how a firm must
provide or make available to banking customers appropriate information about
a retail banking service and any deposit made in relation to that retail banking
service.
BCOBS 5: Post-sale requirements A firm must provide a service in relation to a
retail banking service that is prompt, efficient and fair to a banking customer and
which has regard to any communications or financial promotion made by the firm
to the banking customer from time to time. This includes dealing with customers
in financial difficulty, those that wish to move bank accounts, and lost and dormant
accounts.
BCOBS 6: Cancellation This chapter sets out a customer’s rights to cancel in
various circumstances and when there are no rights to cancellation.
3.5.1 Payment Systems Regulator

The Payment Services Regulations (PSRs) cover most payment services, including
the provision and operation of ‘payment accounts’. Payment accounts cover
accounts on which payment transactions may be made and where access to funds
is not restricted, (for example a restricted account is a fixed-term deposit). The

Banking conduct of business
regulations extend from information to be provided before a payment is made to

the remedial action firms must take if a payment goes wrong.
The PSRs’ conduct of business provisions only apply to payment services made in
euros or sterling, so primarily to sterling and euro-denominated accounts.
The PSRs affect firms providing payment services and their customers. These firms
include:
u banks;
u building societies;
u e-money issuers;
u money remitters;
u non-bank payment card issuers; and
u non-bank merchant acquirers.
The PSRs introduced a new class of regulated firms known as payment institutions
(PIs), which must either be authorised or registered by the regulator. Authorised
PIs are to be subject to prudential requirements. Conduct of business requirements
apply to all payment service providers, including banks, building societies, e-money
issuers and the new PIs.
The government created the Payment Systems Regulator (PSR) as a competition-
focused regulator for payment systems. The PSR is a subsidiary of the Financial
Conduct Authority (FCA). Launched in 2015, the Payment Systems Regulator has
the stated purpose of making payment systems work well for those who use them,
with objectives to promote competition and innovation, and to ensure that systems
work in the interests of end-users.
The Payment Systems Regulator oversees all domestic payment systems that are
brought into the regulator’s scope by being designated by HM Treasury. Once a
system is designated, the Payment Systems Regulator will have a range of powers
over its participants, eg operators, infrastructure providers and payment service
providers. The PSR has the following general powers:
u authority over requirements regarding system rules; and
u authority to give directions to participants in designated payment systems.
It also has further specific powers to:
u require access to designated payment systems for a payment services provider;
u vary agreements relating to designated payment systems (including fees and
charges); and
u require owners of payment systems to dispose of their interests in them −
subject to the satisfaction of certain pre-conditions and subject to HM Treasury
approval.
In addition, the Payment Systems Regulator has enforcement powers to:
u publish details of compliance failure; and
u impose financial penalties in respect of a compliance failure.
The Payments Systems Regulator also has Competition Act powers, which it
operates concurrently with the Competition and Markets Authority.

For stability purposes, the Bank of England oversees recognised inter-bank

payment systems, under the Banking Act 2009.
Source: https://www.psr.org.uk/.
Review questions
1. What was the purpose of introducing a new Conduct of Business Sourcebook

in November 2007?
2. Under COBS what are the three client classifications?
3. What type of property is covered by MCOB regulation?
4. Describe the MCOB rules relating to financial promotions.
5. Which Sourcebook covers the sale of general insurance?

6. What are the rules laid down for cancellation of insurance policies?
7. What was put in place to cover areas of banking not dealt with in BCOBS?
8. What are the post-sale requirements under BCOBS?
9. Which firms are affected by the Payment Services Regulations?
10. Which type of account is not covered by the PSRs?

Topic 4
Complaints and compensation
Learning objectives
u explain the regulatory requirements concerning complaints;
u summarise the role of the Financial Ombudsman Service;
u summarise the role of the Pensions Ombudsman;
u explain the Financial Services Compensation Scheme.
4.1 Introduction
This topic is concerned with the key elements of the rules for dealing with
complaints and compensation. There are various organisations that deal with
complaints and compensation. One of the main objectives of the FCA is to
‘secure an appropriate level of protection’ for consumers of financial services
and products. One step towards the achievement of this objective is to make it
easier for customers to know how to complain when they feel that they have been
badly treated by a financial institution or by an individual working in the industry.
Customers who are not satisfied with a firm’s response to their complaint can refer
the matter to the Financial Ombudsman Service (FOS), a dedicated independent
ombudsman bureau. In some circumstances, customers who have lost money can
receive compensation.
It must always be borne in mind, however, that consumers cannot be given
100 per cent protection, and they should take some responsibility for the
purchasing decisions that they make. Examples of this from the financial services
industry are that investors cannot be protected from falls in stock market values
(although it will attempt to educate consumers about the risks involved) and
that the Financial Services Compensation Scheme sets limits on the amounts of
compensation it can offer.
4.2 Regulatory requirements concerning

complaints
We saw in Topic 2 that the FCA has rules for dealing with complaints and
compensation. These rules are set out in the Handbook called ‘Dispute Resolution:
complaints’ (more commonly referred to by its FCA reference code of ‘DISP’), and in

4: Complaints and compensation
the ‘Compensation’ Handbook, referred to as ‘COMP’, the rules governing eligibility

under, and levies for, the Financial Services Compensation Scheme. DISP covers
how complaints are to be dealt with by firms, payment providers and the Financial
Ombudsman Service (FOS). The DISP rules were subject to some changes from
30 June 2016, and this text details the current position. The FOS will be looked at
in more detail in section 4.3, but it is important to understand that before the FOS
can look into a complaint, the complainant must first have brought the matter to
the attention of the firm concerned and given the firm the opportunity to resolve
the matter. Should the complainant then remain dissatisfied they can then refer
the matter to the FOS.
There is a significant emphasis on the fair treatment of customers, and the rules
and guidance on complaint handling aim to ensure that complainants are dealt
with promptly and fairly. The key requirements for firms’ complaints procedures
are that firms must:
u have appropriate and effective complaint-handling procedures;

u make consumers aware of these procedures − this is normally done through
the client agreement or initial disclosure document;
u aim to resolve complaints promptly;

u notify complainants of their right to approach the FOS if they are not satisfied;
u report to the FCA on their complaint-handling on a six-monthly basis;

u investigate the root cause of complaints and take action to prevent the
recurrence of similar issues in future.
The FCA defines a complaint as ‘any expression of dissatisfaction, whether oral or

written, and whether justified or not, from or on behalf of an eligible complainant
about the firm’s provision of, or failure to provide, a financial service’.
Complaints covered by the FCA rules are those that are received from eligible
complainants, which means:
u private individuals; or
u micro enterprises (ie with an annual turnover of under ¤2m and employing
fewer than 10 people); or
u charities with an annual income of under £1m; or
u trustees of a trust with assets of under £1m.

Complaints may be received orally (in person or by telephone) or in writing. One of
the recent changes to the FCA’s complaint handling rules, in 2015, was to ban firms
from using premium rate phone numbers for customers to report complaints. All
complaints must be investigated promptly and thoroughly by a person of sufficient
competence who, wherever possible, was not directly involved in the matter under
complaint. The overall aim should be to ensure that any specific problem identified
by the complainant is remedied.
The previous distinction between reportable and non-reportable complaints has
been removed and all complaints must now be reported to the FCA. A simplified
reporting system applies in respect of firms who receive less than 500 complaints
during a six-month period.

Regulatory requirements concerning complaints
4.2.1 Complaints that can be resolved quickly

Firms are able to adopt a less formal approach to resolving a complaint where the
complaint can be resolved by close of business on the third working day following
receipt. This may apply to more straightforward issues, for example where a
complaint involves minor service issues such as rudeness by a staff member, or
the misspelling of a name or address on a communication. More significant issues
such as an allegation of poor advice or mis-selling would generally take longer to
investigate.
Where a complaint can be resolved quickly in this way, there is no need for the
firm to provide a final response letter. However, the firm must provide a summary
resolution communication to the complainant. This informs the complainant of
their right to refer the matter to the FOS, should they remain dissatisfied with
the firm’s response. The format of the summary resolution communication is
prescribed in DISP. It may be the case that the firm believes the matter has
been resolved; however, the summary resolution communication will explain that,
should the complainant remain dissatisfied, they can still refer the matter to the
FOS.
4.2.2 Complaints that cannot be resolved within three

business days
Firms must attempt to resolve all complaints ‘promptly’, within a period of eight
weeks. There will be many situations where a matter cannot be resolved, using the
less formal approach, within three business days, particularly where the issues are
complex and require investigation / discussion with staff members. At the outset
the firm must issue the customer with written confirmation that the complaint
has been received and that they are dealing with it. The firm can then begin to
investigate the matter. The firm is required to provide regular updates on progress
but DISP rules are not specific as to what this requires.
If the matter cannot be resolved within eight weeks then the firm must issue the
complainant with an update and guidance on when they think the matter will be
resolved. Once the firm has reached a final decision, they will issue a final response
letter detailing their findings, whether the complaint has been rejected or upheld
and, if applicable, the suggested course of action to resolve the matter. Should the
complainant be dissatisfied, either with the update after eight weeks or the firm’s
final response whenever it is issued, they can refer the matter to the FOS.
It is important for providers to identify the root cause of any recurring complaints
and their impact on other processes or products, even though they may not be
directly connected. These problems should be corrected where it is reasonable
to do so, as a failure to do so could lead to a reputational risk for the provider.
A firm is required to have appropriate management controls and take reasonable
steps to ensure it identifies and remedies any recurring or systemic problems. This
would include analysing the causes of individual complaints so as to identify root
causes common to types of complaint; considering whether such root causes may
also affect other processes or products, including those not directly complained
of; and correcting, where reasonable to do so, these root causes.
Recognising the importance of complaints to the industry and to customer
protection, financial services providers are required to identify a senior individual
who is responsible for complaint-handling within the firm.

4.2.3 Complaints example − queuing times
Example 1
A shopkeeper goes in to his local bank branch at peak time to pay in some
takings. Whilst the branch is fully staffed and customers are being seen quite
quickly, it is not quick enough for him. When he gets to the cashier, he
expresses his frustration and that he is not happy at how long he has had
to wait.
Example 2
An elderly lady goes into her building society branch at a normally quiet time
to pay in a cheque. There is only one cashier working due to staff sickness and
there is a long queue. The lady is very worried as she needs to visit a friend,
who is very ill in hospital. She is worried that she will miss her bus meaning
that she will have to get a taxi, which she can’t afford. When she eventually
gets to the cashier she expresses her dissatisfaction and her worry that she
might miss the visiting hours.
These cases are both complaints. In example 1, the complaint may be able to be
dealt with relatively quickly and within three business days of receipt, as there is
no financial loss and there is no indication that the inconvenience is considered by
the customer as material. A simple apology may be all that is required to resolve
the matter to the customer’s satisfaction. In example 2, the consequences for the
customer are likely to result in financial loss and the distress would certainly be
material from the customer’s perspective. It may be that the matter can be resolved
within three business days, for example by adding the value of the taxi fare to the
customer’s account as compensation. However, the circumstances may require
careful investigation and if a solution cannot be agreed with the customer, ie if
the customer does not accept this, then the firm has eight weeks to try to agree a
suitable outcome.
4.2.4 Record keeping

The general rule is that records of complaints have to be retained for at least three
years. Where the complaint relates to MiFID business, records must be retained
for at least five years.
4.2.5 Reporting
Six-monthly reports about the progress of complaints are required by the regulator,
showing:
u the total number of complaints received by the firm;
u the number of complaints closed by the firm (within four weeks or less of
receipt; more than four weeks and up to eight weeks of receipt; and more than
eight weeks after receipt);
u the number of complaints upheld by the firm in the reporting period;

Financial Ombudsman Service
u the number of complaints outstanding at the beginning of the reporting period;

u the total amount of redress paid in respect of complaints during the reporting
period; and
u the root causes of complaints and corrective action taken to prevent recurrence.
As mentioned in 4.2 above, reporting requirements are simplified where a firm
receives fewer than 500 complaints in a six-month period.
4.2.6 Data publication

In the interests of transparency, firms are required to publish complaints data
and information on relevant root causes themselves if they receive 500 or more
complaints over a six-month period.
4.3 Financial Ombudsman Service

The Financial Ombudsman Service (FOS) is an independent body that aims to
resolve disputes quickly and with the minimum of formality. The concept of an
ombudsman, as a person or organisation providing an independent facility for the
resolution of complaints and disputes relating to public bodies and commercial
organisations, has been with us for many years. Indeed, in the past, a number
of separate ombudsman bureaux operated in the financial services marketplace,
each of them dealing with problems arising in a particular sector. However, such
a fragmented system was neither helpful nor efficient and the FOS replaced the
existing ombudsman schemes in December 2001. It deals with complaints and
disputes arising from almost any aspect of financial services (although certain types
of pension and aspects of pension arrangements are dealt with by the Pensions
Ombudsman − see section 4.4).
The FOS service is free to customers and is open to eligible complainants described
in section 4.2. It bases its decisions on what is fair and reasonable depending on
the circumstances of each case. The FOS does not make the rules under which firms
are authorised, nor can it give advice about financial matters or debt problems.
Membership is compulsory for all firms authorised under the FSMA 2000. It is
funded by the firms that are members of the FOS. In addition to paying a general
levy, firms are charged a case fee for the 26th and each subsequent case, which in
2016/17 is £550 (maintained at the same level as for the previous two years).
As already mentioned, complainants must first complain to the firm itself; the FOS
will become involved only when a firm’s internal complaints procedures have been
exhausted without the customer obtaining satisfaction.
Complaints to the FOS must be made:
u no more than six months after the date on which the firm sent the complainant
its final response to the complainant; or
u within six years of the event that gives rise to the complaint; or
u within three years of the time when the complainant should reasonably have
become aware that they had cause for complaint, whichever is the later.

The FOS may consider cases outside of these timescales in exceptional

circumstances. The FOS will not usually consider any complaint that is the subject
of a court case.
The maximum award that the FOS can make is £150,000 plus interest and the
complainant’s reasonable costs. Awards are binding on the firm but not on the
complainant, who is free to reject the FOS decision and pursue the matter further
in the courts if they wish. An award is not intended to punish the firm, but to put
the complainant back into the same financial position in which they would have
been had the event complained about not taken place.
4.3.1 Super complaints

The Financial Services and Markets Act 2000 gives designated consumer bodies
the right to make a ‘super-complaint’ to the FCA where they consider that
there are features of a financial services market in the UK that are or
which may be significantly damaging the interests of consumers. The FCA
super-complaints regime for financial services markets is distinct from the
cross-sectoral super-complaints regime provided for in the Enterprise Act 2002.
Through the Financial Services Act, designated consumer bodies, regulated

persons and the Financial Ombudsman Service (FOS) will be able to make a
super-complaint to the FCA.
The FCA is required to respond to a super-complaint or reference within 90 days
setting out how it proposes to deal with the complaint and any possible actions.
The FCA’s response might, for example:
u announce plans to consult on an issue;
u set out a timetable for regulatory action which would allow the FOS to consider
whether or not to place a hold or stay on complaints;
u explain how the FCA is already taking action to address an issue; or
u explain why it is not taking any action. It can also carry out wider enquires
with a view to testing the evidence like internal research, public requests of
information and carry out a review of the relevant regulated firms.
4.4 Pensions Ombudsman

The Pensions Ombudsman was created by the Social Security Act 1990 to deal
with complaints relating to occupational pension schemes and certain aspects
of personal pension schemes. It also deals with complaints about NEST schemes
(see section 15.3.3). The Secretary of State for Work and Pensions appoints the
Ombudsman.
The Pensions Ombudsman can decide about complaints and disputes relating to
the running of pension schemes. The Ombudsman does not deal with complaints
about the sales and marketing of pension schemes − these are the province of the
FOS (see section 4.3) − or with complaints about state pensions.
Complaints are related to cases of maladministration, and it must be shown that
this has led to injustice (financial loss, distress, delay or inconvenience). Disputes
are disagreements about facts or about law.

Financial Services Compensation Scheme
Complaints and disputes can be made by a wide range of people: individuals,

managers, trustees or employers. They are commonly made by:
u members or ex-members of schemes;
u spouses of members or ex-members of schemes;

u widows or dependants of members who have died;
u solicitors or others representing the interests of such people.

Complaints or disputes should first be addressed to the pension scheme’s
managers or trustees. If this does not result in agreement, the next point of
reference should be to address the matter to The Pensions Advisory Service (TPAS),
which tries to resolve disputes through conciliation and mediation. TPAS decisions
are not legally binding and cases that cannot be agreed are normally then referred
to the Pensions Ombudsman.
Complaints and disputes must be communicated to the Pensions Ombudsman in
writing within three years of the event being complained about. Any time spent
trying to resolve the matter using the scheme’s internal complaints procedures, or
through TPAS, is normally excluded from this time period.
The Pensions Ombudsman’s decision is binding on all parties and can be enforced
in the courts.
Under the government’s reorganisation of quangos in 2010 it was decided that
the Pensions Ombudsman would be merged with the Pension Protection Fund
Ombudsman to form a single tribunal. This merger has now taken place although
the two names of the organisations remain.
4.5 Financial Services Compensation Scheme

The Financial Services Compensation Scheme (FSCS) operates under rules laid
down in the FCA’s ‘COMP’ Handbook (section 4.2). This Sourcebook is one of
the means by which the FCA / PRA meet regulatory objectives of ‘securing the
appropriate degree of protection for consumers, contributing to the protection
and enhancement of the financial stability of the United Kingdom and maintaining
confidence in the UK financial system’.
By setting up the FSCS, and making rules that allow the FSCS to provide
compensation at a level appropriate for the protection of retail consumers and
smaller businesses, the regulators enable consumers to participate in the financial
markets with the confidence that they will be protected, at least in part, should the
provider with whom they are dealing be unable to satisfy claims against it.
The FSCS is funded by an annual levy on every authorised firm. This goes towards
the running costs and the compensation payments made by the FSCS. In January
2013, the FSCS initiated a programme to raise awareness of FSCS protection that
customers receive should their financial provider fail through insolvency. The
campaign included advertising on radio, in the press and online and encourages
customers to ask their financial services provider about FSCS or to visit the
website. Providers are expected to help promote the FSCS as it improves trust
and confidence in the industry.

Compensation arrangements for customers who have lost money through the
insolvency of an authorised firm causing the firm to fail, comprise a number of
sub-schemes relating to:
u loss of deposited funds;
u investments;
u home finance;
u insurance business;
u insurance mediation.
Payment under the FSCS deposit sub-scheme is triggered when a firm authorised
to accept deposits by the Prudential Regulation Authority (PRA), such as a bank
or building society, goes out of business, for example if the firm goes into
administration or liquidation, and is unable to repay its depositors. FSCS can also
be involved if the PRA considers that an authorised firm is unable, or likely to be
unable, to repay its depositors.
In respect of loss of deposited funds, the protection is 100 per cent of the first
£75,000 (with effect from 1 January 2016). There is additional cover of up to £1m in
respect of ‘temporarily high balances’ that have been held for a period of less than
six months. This applies, for example, where a person’s savings are temporarily
boosted by certain life events such as receipt of an inheritance, sale of a property
or taking a lump sum from a pension. The majority of cases are paid within seven
days, with more complex cases taking up to 20 days.
The investment sub-scheme covers situations of loss due to insolvency of a
firm carrying out investment business regulated under FSMA 2000. Typically this
includes the insolvency of a firm advising on or arranging investments. Cover is
100 per cent of the claim up to a maximum of £50,000.
The home finance sub-scheme protects customers of authorised mortgage firms
in respect of business conducted on or after 31 October 2004. FSCS can provide
protection if a mortgage firm is unable, or likely to be unable, to pay claims against
it. FSCS is triggered when a firm authorised to advise on or arrange mortgages by
the Financial Conduct Authority (FCA), goes out of business, for example if the
firm goes into administration or liquidation. Where a claim is made against a firm
involved in home finance (mortgage) advice or arranging, the maximum claim is
100 per cent, up to a maximum of £50,000.
The sub-scheme for insurance business covers claims for compensation that arise
following the failure of an authorised insurer (life and general). The level of cover
depends on the nature of the policy.
u For all long-term insurance and for certain types of general insurance
compensation is 100 per cent of the value of the policy, with no upper limit
(policies with 100 per cent protection include long-term and general insurance
policies that provide benefits on death / disability only).
u Where a policy includes both a protection element and a savings element then
the protection element has 100 per cent compensation.
u If the insurance is compulsory (such as employer’s liability cover or some types
of motor insurance), the figure is 100 per cent of the whole amount.
u Annuities also receive 100 per cent cover should the insurance company
providing the income become insolvent and therefore unable to continue to
make payment under the annuity contract.

Financial Services Compensation Scheme
In respect of insurance mediation, the process of arranging insurance, the FSCS will
safeguard policyholders if an authorised firm is unable, or likely to be unable, to
pay claims against it, for example if it has been placed in provisional liquidation or
administration. Compensation is 90 per cent with no upper limit. If the insurance is
compulsory (such as employer’s liability cover or some types of motor insurance),
the figure is 100 per cent of the whole amount.
Claims cannot be made against the FSCS for other losses, ie those due to
negligence, poor advice or simply due to a fall in stock market values.

Review questions
1. How does the FCA define a complaint?
2. What should a ‘final response’ letter to a customer do?

3. In what circumstances does a provider not have to report a complaint to the
FCA?
4. What are the three different areas into which the Financial Ombudsman Service
divides complaints?
5. Describe the awards that the FOS can make to a customer.
6. Distinguish between a ‘complaint’ and a ‘dispute’ that can be referred to the

Pensions Ombudsman.
7. Who is bound by decisions of the Pensions Ombudsman?
8. Who does the Financial Services Compensation Scheme afford protection to?
9. What is the purpose of FSCS compensation?

10. What cannot be claimed for from the FSCS?

Topic 5
Other rules and regulations relevant
to advising financial services
clients
Learning objectives
u explain the role of the Competiton and Markets Authority;

u describe consumer credit legislation;
u explain the role of the Pensions Regulator (TPR);

u summarise unfair contract terms;
u explain the role of the Advertising Standards Authority;
u summarise the Standards of Lending Practice;

u explain the Data Protection Act.
5.1 Introduction
In addition to the legislation already described in the topics concerning the PRA
and FCA, the interests of financial services customers are safeguarded by aspects
of a range of other laws and regulations. Some of these relate closely to financial
services, while others are aimed more broadly at the rights of consumers in general.
Many of these regulations are the result of EU directives and regulations − touched
upon in section 1.4.1.
This topic shows how a range of non-tax laws and regulatory schemes affect
different aspects of financial services including consumer credit, the terms
and conditions relating to customer agreements, pensions, advertising and
safeguarding customer information.
5.2 The Competition and Markets Authority

The Competition and Markets Authority (CMA) is a non-ministerial government
department of the Department for Business, Innovation and Skills. It works to
promote competition for the benefit of consumers within and outside of the UK. Its
aim is to make markets work well for consumers, business and the economy. The
CMA’s powers were acquired in April 2014 when it took over many of the functions
and responsibilities of the Competition Commission and the Office of Fair Trading.

5: Other rules and regulations relevant to advising financial services clients
The CMA is responsible for:

u investigating mergers that could restrict competition and so be detrimental to
consumers;
u conducting market studies and investigations where there may be competition
and consumer problems;
u investigating where there may be breaches of UK or EU anti-competition law and
abuses of dominant positions;
u bringing criminal proceedings against individuals who commit the cartels
offence under the Enterprise Act 2002;
u enforcing consumer protection legislation under the Consumer Protection from
Unfair Trading Regulations 2008 to address practices and market conditions
that adversely affect consumers’ ability to exercise choice;
u co-operating with sector regulators and encouraging these regulators to use
their competition powers (CMA, no date).
5.3 Consumer credit legislation

The regulation of consumer credit in the UK (with the exception of most mortgage
lenders) is the result of the Consumer Credit Acts of 1974 and 2006. The 1974
Act established the basic principles of consumer credit regulation, many of which
are still in force today. The 2006 Act consolidated, expanded and brought up
to date the earlier Act and has been further strengthened by the Consumer Credit
Regulations 2010. In April 2014, the FCA took over responsibility for the regulation
of consumer credit from the Office of Fair Trading. It issued a new sourcebook, the
Consumer Credit Sourcebook (CONC); some of the existing regulations relating to
advertisements and the provision of quotations have been repealed and replaced
with new sections within CONC, but the majority of the provisions of the Consumer
Credit Acts continue to apply.
Under the Consumer Credit Act 1974 the FCA is responsible for licensing consumer
credit businesses. This includes lenders and brokers of credit, and all businesses
‘concerned with the provision of credit’. The FCA assesses whether a business is
fit to hold a licence before granting one. All licensees are monitored by the FCA to
ensure that they are operating responsibly.
The FCA also applies the approved persons regime. This means it will require
individuals in consumer credit firms who undertake significant or management
functions (known as controlled functions) to be approved by the FCA before they
do so.
5.3.1 Consumer Credit Act 1974

The purpose of the Consumer Credit Act 1974 is to regulate, supervise and control
certain types of lending to individuals, and to provide borrowers with protection
from unscrupulous lenders. The provisions of the Act, and those of the 2006 Act,
are regulated by the FCA.
There are many types of lender in the market for financial services, ranging
from large multinational banks to individual moneylenders. The Act sets out
standards by which all lenders must conduct their business. It includes a number

Consumer credit legislation
of safeguards under which potential borrowers must be made aware of the nature
and conditions of a loan, and of their rights and their obligations.
The Act affects most aspects of a bank’s lending activities, including personal
loans and revolving credit such as credit cards. Not all loans are covered by the
Act. Loans for the purchase of a private dwelling are exempt and further loans for
the improvement or repair of a private dwelling are also exempt, provided that
they are from the same lender as the original mortgage loan. Loans raised on the
security of a dwelling but used for other purposes are not exempt (unless on a first
charge basis).
Regulated mortgages are exempt from the Act but they are regulated by the
FCA. Therefore, further advances are exempt, regardless of their purpose. Second
charge loans are also now regulated by the FCA. A regulated mortgage contract is
one that is secured on land, at least 40 per cent of which is used, or intended to
be used, as or in connection with a dwelling. There is an exception for ‘consumer’
buy-to-let mortgages, which also fall under MCOB regulation even though they do
not meet the 40 per cent rule.
The main elements of the Act’s provisions are as follows.

u Suppliers of loans and credit as defined in the Act must be licensed.
u Clients must receive a copy of the loan agreement for their own records.
u Prospective borrowers have a cooling-off period during which they can review
the terms of the loan and, if they wish, decide not to proceed with the
transaction. This applies to all loans regulated by the Act, unless the loan
agreement is signed on the lender’s premises.
u Undesirable marketing practices are forbidden: for instance, advertisements
must not make misleading claims.
u Credit reference agencies must, on request, disclose information held about
individuals and must correct it if it is shown to be inaccurate.
One of the Act’s most significant innovations was a system for comparing the price
of lending. This is the annual percentage rate (APR), which must be quoted for
all regulated loans. The APR represents a measure of the total cost of borrowing
and its aim is to allow a fair comparison, between different lenders, of the overall
cost of borrowing.
The calculation of the APR is specified under the Consumer Credit Act 1974 and it
takes account of two main factors:
u the interest rate − whether it is charged on a daily, monthly or annual basis;
u the additional costs and fees charged when arranging the loan, eg an
application fee.
The result is that the APR is higher than the actual rate being charged on the
loan. However, it gives consumers the opportunity to make comparison between
different providers with the ability to compare ‘like with like’ on the basis of total
cost rather than simply headline rates, which are often used to attract customers.

5.3.2 Consumer Credit Act 2006

Following a three-year review of consumer credit law, the government decided to
reform the Consumer Credit Act 1974 in order to better protect consumers and
to create a fairer and more competitive credit market. The aim has been to make
improvements in three broad areas.
u To enhance consumer rights and redress. Consumers are able to challenge
unfair lending and will have access to more effective options for resolving
disputes.
u To improve the regulation of consumer credit businesses by ensuring fair
practices and through ‘targeted action to drive out rogues’.
u To make regulation more appropriate for all kinds of consumer credit
transaction. Protection is being extended to all consumer credit aiming to create
a fairer regime for business.
This reform was implemented through primary and secondary legislation. The
primary legislation is the Consumer Credit Act 2006, which was introduced in
three stages, the main elements of which were as follows.
u April 2007: The scope of the Financial Ombudsman Service (FOS, see
section 4.3) was expanded to incorporate consumer credit disputes. At the same
time, the Unfair Relationships Test was introduced for new agreements: this
enables borrowers to challenge credit agreements in court on the grounds that
the relationship between themselves and the lender is ‘unfair’. This replaced the
previous concept of ‘extortionate’ credit and broadens the rest of the agreement
to include relevant factors other than cost, which might include, for example,
the financial skill/experience of the borrower.
u April 2008: The upper limit on the size of loans regulated by the Act was
removed (it had previously been £25,000), so that all new credit agreements −
unless exempt − are now regulated. The Unfair Relationships Test, introduced
a year earlier, was extended to cover both new and existing credit agreements.
u October 2008: New rules require lenders to supply borrowers with more
information about their accounts on an ongoing basis, for instance annual
statements, and arrears notices if they fall into arrears.
5.3.3 The Consumer Credit (EU Directive) Regulations

2010
These regulations implement the EU Consumer Credit Directive 2008 in the UK.
The following summarises the main requirements:
u Advertising and APR − anywhere where there is reference to the interest rate
or any amount relating to the cost of credit, it must include a representative
example including the APR. The representative APR must reflect at least
51 per cent of the business expected to result from the advertisement. The
rules for the calculation of the total cost of credit and therefore the APR differ
from previous requirements.
u Creditworthiness and adequate explanations − lenders are required to
assess the borrower’s creditworthiness before granting credit or significantly
increasing existing facilities. This assessment must be based on information
from the borrowers and from a credit reference agency. The borrower must be

The regulation of occupational pensions
provided with adequate explanation of the credit agreement and the borrower
must be able to ask questions about the agreement or to request further
information.
u Pre-contractual information and agreements − this must be given in good

time before the borrower enters into the agreement. It must be clear and easily
legible and the borrower must be able to take it away and shop around if they
wish.
u Right of withdrawal − the borrower can withdraw from an agreement within
14 days after they have taken out the borrowing or 14 days after receipt of a
copy of the completed agreement or notification of the credit limit on a credit
card if this is later. The borrower must repay the amount outstanding plus
interest for each day the borrowing was taken.
u There are also a number of other changes mainly relating to information that
should be made available to the borrower.
5.3.4 Other consumer credit regulations

Much of the previous legislation relating to the provision of quotations
and advertisements, including the Consumer Credit (Content of Quotations)
Regulations 1999 and the Consumer Credit (Advertisements) Regulations 2004
and 2010, has been repealed. These issues are now addressed in CONC section 3:
financial promotions and communications with customers.
Section 3 sets out what is considered to be a ‘communication’ with a customer
in relation to a credit agreement, and advises that communications should be fair
and not misleading. Providers must ensure they use plain and understandable
language, specify who is making the offer of credit and only make credit available
based upon the customer’s financial circumstances.
One of the new aspects of CONC is that it provides rules relating to risk warnings
for high-cost short-term credit, such as that offered by pay-day lenders. Any such
credit must carry the following message: ‘Warning: Late repayment can cause you
serious money problems. For help, go to moneyadviceservice.org.uk’ (FCA, 2015).
The purpose of this warning is to make consumers aware of the potential risk
of taking out such short-term borrowing, which often carries very high interest
charges that can be difficult to meet if consumers are unable to repay on time.
5.4 The regulation of occupational pensions

The regulation of occupational pension schemes (ie schemes that are run by
employers with the objective of providing retirement benefits to a company’s
employees) remains quite separate from the regulation of other financial services,
separate even from the regulation of private pension arrangements such as
personal pensions and stakeholder pensions. Nevertheless, financial advisers and
planners should clearly have a good knowledge of matters relating to occupational
schemes in order to be able to advise, for instance, individuals who are members
of such schemes or employers who may be considering establishing a scheme.

5.4.1 Pensions Acts

The context for much of the pension legislation enacted in the UK over the last
30 years or so is a worsening pension crisis. People are failing to make adequate
provision for their own retirement, with this lack of personal provision putting a
greater strain on the state pension system. At the same time, an ageing population
means that the capability of the state scheme to provide benefits is reducing.
Therefore much of the pension legislation is aimed at encouraging people to start
saving or to save more towards their retirement. Efforts to achieve this have focused
on building confidence in and enhancing understanding of pensions, reducing state
pension benefits and incentivising / compelling people to join a pension scheme.
The Pensions Act 1995 introduced changes to several aspects of pension provision
and supervision, not least of which related to concern about the security of
occupational pensions. Public confidence in the security of occupational pension
schemes had been severely dented by the Maxwell affair, where pensioners’ funds
were used to meet the general financial obligations of the company that scheme
members worked for. The government sought to restore confidence with measures
designed to prevent fraud and to improve the administration of occupational
schemes.
The later Pensions Act 2004 was, in part, a response to the worsening pensions
crisis in the UK. Two particularly important elements of the 2004 Act were the
establishment of the Pension Protection Fund and the transfer of regulatory
responsibility for occupational pension schemes from the Occupational Pensions
Regulatory Authority (OPRA) to the newly created Pensions Regulator. The Pension
Protection Fund provides a degree of security to the members of defined-benefit
occupational pension schemes in the event that the employer providing the scheme
becomes insolvent.
The Pensions Act 2008 built on these provisions and is aimed at enabling and
encouraging more people to build up a private pension income to supplement
the money they will receive from their basic state pension. A key element was
the introduction in 2012 of the process of auto-enrolment; this applies to many
employees and means that they will automatically become members of a qualifying
workplace pension.
The Taxation of Pensions Act 2014 introduced a range of new options in respect
of the way that members of money purchase pension schemes could take their
pension benefits. The stated objective was to provide greater freedom and choice
in respect of pension benefits.
5.4.2 The Pensions Regulator

The Pensions Regulator (TPR) takes a proactive and risk-focused approach to
regulation. Its mission statement is that it will work ‘to improve confidence
in work-based pensions by protecting the benefits of scheme members and
encouraging high standards and good practice in running pension schemes’.

The regulation of occupational pensions
Like the FCA, TPR has a set of statutory objectives, through the Pensions Acts 2004
and 2008.
u To protect the benefits and rights of members of occupational pension schemes.
u To protect members of personal (and stakeholder) pension schemes where
employees have direct payment arrangements.
u To promote, and improve understanding of, the good administration of
work-based pension schemes.
u To reduce the risk of situations arising that may lead to claims for compensation
from the Pension Protection Fund.
u To maximise employer compliance with employer duties and safeguards
under the Pensions Act 2008 (including the requirements in respect of
auto-enrolment).
u (In carrying out its duties) to minimise any adverse impact on the sustainable
growth of an employer.
TPR aims to identify and prevent potential problems rather than to deal with
problems that have arisen. It will do so by assessing the risks that may prevent
it from meeting its statutory objectives. These risks might include inadequate
funding, inaccurate record keeping, lack of knowledge or understanding by the
trustees, or even dishonesty or fraud. TPR will consider the combined effect of two
factors related to each risk: the likelihood of the event occurring and the impact
of the event on the scheme and its members. Schemes that are judged to have a
higher risk profile will be more closely monitored than those with lower risk.
TPR has a range of powers that enable it to protect the security of members’
benefits. These fall broadly into three categories.
u Investigating schemes in order to identify and monitor risks. All schemes
must make regular returns to the Regulator. In addition, trustees or scheme
managers must give notification of any changes to important information, such
as the types of benefit being provided by the scheme. TPR also demands
to be informed quickly if the scheme discovers that it cannot meet funding
requirements, so that remedial action can be taken at an early stage.
u Putting things right if they have gone wrong, which can include:
− requiring specific action to be taken to improve matters within a certain time;
− recovering unpaid contributions from an employer who does not pay them
to the scheme within the required period (by the 19th day of the month
following that in which they were deducted from the member’s salary);
− disqualifying trustees who are not considered fit and proper persons;
− imposing fines or even prosecuting certain offences in the criminal courts.
u Acting against avoidance, ie preventing employers from deliberately
avoiding their pensions obligations and so leaving the Pension Protection Fund
to cover their pension liabilities. The main actions TPR can take are to issue:
− contribution notices, requiring the employer to make good the amount of
the debt either to the scheme or to the Pension Protection Fund; or
− financial support directions, which require financial support to be put in
place for an underfunded scheme.

The Pensions Act 2004 requires TPR to issue voluntary codes of practice on a
range of subjects. The codes provide practical guidelines for trustees, employers,
administrators and others on complying with pensions legislation, and set out the
expected standards of conduct.
The Act also requires trustees to have a sufficient knowledge and understanding of
pension and trust law, and of scheme funding and investment. Trustees also must
be familiar with the trust deed and other important documents such as the scheme
rules and the statement of investment principles. These requirements came into
force in April 2006.
5.4.3 Pension Protection Fund (PPF)

The Pension Protection Fund (PPF) protects members of private sector final salary
(defined-benefit) and hybrid pension schemes. A hybrid scheme is a pension that
combines defined-benefit and money purchase benefits within a single scheme; the
PPF applies to the defined-benefit element. The PPF provides protection in respect
of schemes where contributions have stopped being made because the employer
is insolvent and has insufficient funds to maintain full benefits for all the members.
In addition to this responsibility, the PPF compensates members of both

defined-benefit and defined-contribution (money-purchase) schemes in cases of
fraud and misappropriation.
The PPF will ensure that, where a company with an eligible defined-benefit scheme
becomes insolvent, with an insufficiently funded scheme, members of that scheme
will still receive the core of the benefits to which they are entitled. The PPF will
provide compensation of:
u 100 per cent for scheme members who have reached the scheme’s normal
pension age, members already in receipt of a pension on grounds of ill health
and members in receipt of a survivor’s benefit (where the original member has
died);
u 90 per cent for current and ex-scheme members who are aged below the
scheme’s normal pension age, subject to an overall benefit cap.
The upper percentage limits outlined above are increased by 3 per cent per year
for long service members, ie those with more than 20 years’ pensionable service.
This is subject to an overall limit on compensation of twice the overall benefit cap.
To ensure that PPF compensation retains its value over time, pensions in payment
will be increased in line with the retail price index (RPI) up to a maximum of
2.5 per cent.
Compensation will be funded in two ways: firstly, by taking over the assets of
pension schemes with insolvent employers, and secondly by means of a levy on all
private sector defined-benefit schemes and the defined-benefit element of hybrid
schemes. The levy is split into three parts.
u A pension protection levy which is made up of a scheme-based levy and
a risk-based levy. The risk-based levy is based on risk factors, including
underfunding, credit rating and investment strategy. Eventually, this is expected
to constitute at least 80 per cent of the total amount collected by the PPF. The

Unfair contract terms
scheme-based levy is based on scheme factors, such as the numbers of active

and retired members.
u An administration levy, covering the set-up and ongoing costs of the PPF.
u A fraud compensation levy, to compensate pension holders of insolvent
employers, who suffer a loss that can be attributable to an offence
involving dishonesty.
5.5 Unfair contract terms

Consumers have the right to buy products and services with confidence, and have
rights when things go wrong. In particular, they have a right to:
u clear and honest information before they buy;
u get what they pay for;
u goods being fit for purpose and services being performed with reasonable care
and skill;
u any faults being corrected (free of charge) or a refund / replacement to be
provided.
Many financial services products are too technical for customers to understand and
there is a risk that they are one-sided in favour of the supplier. This can lead to
some contracts containing unfair terms.
For many years consumer law in the UK was governed by The Supply of Goods and
Services Act 1982 and the Unfair Terms in Consumer Contracts Regulations 1999.
On 1 October 2015 consumer law changed when the Consumer Rights Act 2015
took effect.
5.5.1 The Consumer Rights Act 2015

The Consumer Rights Act 2015 (the Act) gives consumers enhanced rights when
things go wrong in relation to goods and services.
The Act covers:
u what to do when goods are faulty;
u how services should match up to what has been agreed, and what should happen
when they do not;
u what should happen when goods and services are not provided with reasonable
care and skill;
u unfair terms in a contract;
u the greater flexibility for public enforcers, such as the FCA or Trading Standards,
to respond to breaches of consumer law.
Most of the changes update existing laws but one important change is that, for the
first time, there are rules detailing what should happen if a service is not provided
in the manner agreed or with reasonable care and skill; essentially, the business
that provided the service must align it with what was agreed or, if this is not
realistic, provide a full or partial refund.

One of the aims of the Act is to reduce incidences of disagreements between

businesses and consumers and to reduce the number of such disputes ending
in court action. It is also hoped that the speed with which disputes are resolved
will be improved and the associated costs reduced. In pursuing these goals, an
alternative dispute resolution (ADR) has been available since July 2015. ADR is
open to all businesses and aims to help when a dispute with a consumer cannot be
settled directly. The business involved in the dispute will engage the services of a
certified alternative dispute resolution provider and must ascertain whether or not
the consumer is willing to use the service.
ADR takes different forms and can involve:
u mediation, where an agreement is facilitated between parties;
u adjudication;
u arbitration.
In respect of adjudication and arbitration, the ADR provider will make a decision
based on information provided by the parties. An adjudicator’s decision can be
appealed in the courts; a decision by an arbitrator cannot (other than in limited
circumstances). Decisions taken by either an arbitrator or an adjudicator are
binding on both consumer and business and can be enforced by the courts.
5.5.2 Unfair Contract Terms

Until the implementation of the Consumer Rights Act 2015, the main legislation
dealing with unfair contract terms was the Unfair Terms in Consumer Contracts
Regulations 1999. These regulations have been revoked by the Consumer Rights
Act 2015, which reforms and consolidates the previous regime.
The legislation in respect of unfair contract terms applies to consumer contracts,
between a business and a consumer, and to any notice that relates to the rights
and obligations between a business and a consumer or purports to exclude or limit
a business’s liability to a consumer.
The main areas covered by the legislation are as follows.
5.5.2.1 Fairness
The main requirements are that all terms in regulated contracts should:
u be fair, with a contract or notice being deemed to be unfair if it causes a
significant imbalance in respect of the rights and obligations of the various
parties to the contract to the detriment of the consumer;
u adhere to the requirement of good faith (see section 5.5.2.3).
Any unfair term or notice will not be binding on the consumer unless they choose
to be bound by it. Where an element of the contract is deemed to be unfair then
the rest of the contract can continue to take effect, as long as this is practicable.
Terms that may be deemed as unfair include:
u disproportionately high charges where the consumer decides not to proceed
with services that have yet to be supplied;
u terms allowing the business to determine the characteristics or subject matter
after the consumer is bound;
u terms allowing the business to determine the price after the consumer is bound.

Advertising Standards Authority
5.5.2.2 Transparency
The written terms of a contract should be transparent and expressed in clear, easily
understood language. If there is any doubt about the meaning of a written term,
the interpretation most favourable to the consumer will be adopted.
5.5.2.3 Good faith

A term that causes a significant imbalance between the rights and obligations of
the various parties to the contract to the detriment of the consumer will be deemed
to be in breach of good faith.
5.6 Advertising Standards Authority

In addition to abiding by the rules laid down in industry-specific regulations,
advertisements for financial services and financial products must meet the
standards laid down in Advertising Codes under the supervision of the Advertising
Standards Authority (ASA).
The ASA was set up in 1962 and is an independent self-regulatory body, which
administers the UK Code of Non-broadcast Advertising, Sales Promotion and Direct
Marketing, and the UK Code of Broadcast Advertising.
These codes cover virtually all advertisements, ie those that appear in:
u the national and regional press, magazines and free newspapers;
u posters, hoardings and transport sites;
u direct mail leaflets, brochures, catalogues and circulars;
u cinema commercials, videos, CD-ROMs and the internet;
u pack promotions, competitions and prize draws;
u television and radio programmes.
The ASA can take action against individuals and organisations whose advertising
contravenes the code. The first step is usually to discuss the offending
advertisement with the advertiser and − if an acceptable explanation is not given
− to require that the advertisement is changed or withdrawn.
A number of sanctions are used against offenders, ranging from the adverse
publicity generated by its adjudications, to legal proceedings in the case of
persistent or deliberate offenders. This legal action is available through a referral
of the advertiser, agency or publisher to Trading Standards.
The Advertising Codes require that advertisements should be prepared with a
sense of responsibility to consumers and society, and should respect the generally
accepted principles of fair competition in business. Specifically, the codes require
that all advertisements should be:
u legal, ie containing nothing that breaks the law, or incites anyone to do so, and
omits nothing that the law requires;
u decent, ie containing nothing that is likely to cause serious or widespread
offence, judged by current prevailing standards of decency (account is taken

of the context of the advertisement, the medium used and the likely audience;
particular care should be taken with sensitive issues such as race, religion, sex
or disability);
u honest, ie not exploiting the credulity, lack of knowledge or inexperience of

consumers;
u truthful, ie not misleading by inaccuracy, ambiguity, exaggeration, omission
or any other means.
Advertisers are permitted to express opinions, including opinions about the
desirability of their products, provided that it is clear that it is opinion and not
a statement of fact. Assertions or comparisons that go beyond subjective opinion
must be able to be objectively substantiated.
5.7 The Standards of Lending Practice

Lending is not covered by BCOBS. Although the FCA’s CONC Sourcebook applies,
there is also a degree of self-regulation by the industry in this area. The Lending
Standards Board (LSB) publishes standards to which firms that are registered with
the LSB must adhere.
As of 1 October 2016, the Standards of Lending Practice replaced the provisions of

the Lending Code for lending to personal customers. The Lending Code continues
to apply to lending to micro-enterprises but will be replaced during 2017.
The Standards of Lending Practice set out a number of principles, covering six
main areas:
u financial promotions and communications;

u product sale;
u account management and servicing;

u money management;
u financial difficulty;
u customer vulnerability.
There is also a section on governance and oversight, which sets the framework
that registered firms should have in place to ensure effective implementation of
the standards.
The standards cover the following products:
u unsecured loans;
u credit cards;
u overdrafts.
Registered firms must at all times comply with the Consumer Credit Act 1974,
the Consumer Credit (EU Directive) Regulations 2010, the FCA’s Consumer
Credit Sourcebook (CONC), the Equality Act 2010 and other relevant legislation.
Compliance is monitored and enforced by the Lending Standards Board.

The Standards of Lending Practice
Overarching principles
The LSB details overarching principles of lending that registered firms should
adhere to when dealing with their customers. Registered firms will ensure that
their customers:
u are told about the products the firm offers, do not face unreasonable barriers
in accessing the products and are provided with clear information to help them
select a product;
u are assured that firms are committed to promoting their products responsibly;
u are provided with clear information about the application process, including
making customers aware of the impact of any application on their credit rating;
u are aware of the factors on which the firm will base their decision to lend and,
if declined, the main reason for this;
u are provided with clear and understandable documentation and information
that details both parties’ rights and obligations;
u will be supported if they anticipate, or the firm becomes aware, that they have
or are having difficulties in repaying their borrowing;
u understand what happens when they have repaid their borrowing.

The key requirements of the principles are as follows:
u Financial promotions and communications − must be clear, fair and not

misleading.
u Product sales − customers will only be provided with a product that is
affordable and meets their needs.
u Account maintenance and servicing − customer requests will be dealt with
in a timely, secure and accurate manner. Information provided will be clear and
detail any action required by the customer.
u Money management − customers will be helped to manage their finances
through proactive and reactive measures designed to identify signs of financial
stress and help avoid financial difficulties.
u Financial difficulty − customers in financial difficulty will receive appropriate
support and fair treatment.
u Customer vulnerability − firms are expected to provide inclusive products
and services that take account of the broad range of customers and are flexible
enough to meet the needs of customers who are classed as vulnerable. This
includes firms having a vulnerability strategy.
u Governance and oversight − firms are expected to put in place policies and
procedures that ensure customers receive a fair outcome when taking out a
consumer credit product and throughout all their dealings with the firm.

5.8 The Data Protection Act 1998

The Data Protection Act 1998 (DPA 1998) replaced an earlier Act (the Data
Protection Act 1984) when it became necessary for UK law in this area to comply
with an EU data protection directive issued in 1995. The 1998 Act is much wider
in its scope than the earlier Act: in particular, it extends the regulations to cover
not only computerised data (as in the 1984 Act) but also ‘any structured set of
personal data’. It can therefore include data held in manual filing systems.
The purpose of the legislation is, broadly speaking, to give private individuals
control over the use of personal data about themselves held by commercial (and
other) organisations. It does so by establishing a series of data protection principles
and enforcement processes.
5.8.1 Definitions
The DPA 1998 uses a number of words and phrases that have precise meanings
within its terms. These include the following.
u Data subject: an individual whose personal data (see below) is processed.
u Personal data: the Act relates only to personal data, which is defined as
‘information relating to a living individual who can be identified from that
information or from a combination of that information and other information in
the possession of the data controller’ (see below).
u Sensitive personal data: this data can only be processed if the individual
has given explicit consent (in other words, it is not sufficient to claim that the
individual has never specifically withheld their consent). Sensitive data includes
information about an individual’s:
− racial origin;
− religious beliefs;
− political persuasion;
− physical health;
− mental health;
− criminal (but not civil) proceedings.
u Processing: this has a very broad meaning, covering all aspects of owning
data, including:
− obtaining the data in the first place;
− recording of the data;
− organisation or alteration of the data;
− disclosure of the data by whatever means;
− erasure or destruction of the data.
u Data controller: this is the ‘legal’ person who determines the purposes for
which data is processed and the way in which this is done. It is normally an
organisation/employer, such as a company, partnership or sole trader. The

The Data Protection Act 1998
data controller has prime responsibility for ensuring that the requirements of
the Act are carried out.
u Data processor: this is a person who processes personal data on behalf of the
data controller.
5.8.2 Data protection principles

The basis of the DPA is a set of eight data protection principles. These are
described below; they all relate to the processing of personal data (as defined in
section 5.8.1).
1. Data must be processed fairly and lawfully. This includes the specific
requirement for the data controller to tell the individual what information will
be processed and why, and whether it will be disclosed to anyone else. Data
must not be processed unless the data subject has given their consent or the
processing is necessary for one of the following reasons:
a. to perform the data controller’s contract with the data subject or to protect
the interests of the data subject;
b. to fulfil a legal obligation or to carry out a public function;
c. to pursue the legitimate interests of the data controller − unless this could
prejudice the interests of the data subject.
2. Data must be obtained only for a specified lawful purpose or purposes and must
not be processed in any way that is not compatible with the purpose(s) − this
includes the use of the data by any person to whom it is later disclosed.
3. Data must be adequate (but not excessive) and relevant to the purpose for which
it is processed. This should be borne in mind by advisers when determining how
much information it is appropriate to collect and retain in a factfind document.
4. Data must be kept accurate and up to date.
5. Data must not be kept for longer than is necessary. This will be dictated to
some extent by FCA rules on how long information must be kept.
6. Data must be processed in accordance with the rights of data subjects. These
include:
a. the right to receive (on payment of a fee of £10) a copy of the information
being held (the information must be provided within 40 days of a written
request);
b. the right to have the information corrected if it can be shown to be incorrect.
7. Data controllers must take appropriate technical and organisational measures to

keep data secure from accidental or deliberate misuse, damage or destruction.
This includes taking reasonable steps to ensure the reliability of any employees
of the data controller who have access to the data.
8. Data must not be transferred to a country outside the European Economic Area
(EEA) unless that country’s data protection regime ‘ensures an adequate level
of protection for the rights and freedoms of data subjects’. Broadly speaking
that means that it should be comparable to that within the EEA.

5.8.3 Enforcement
The Information Commissioner oversees the application of the DPA. The
Commissioner’s responsibilities are:
u to educate organisations about their responsibilities under the Act, and

individuals about their rights;
u to take action where necessary to enforce the provisions of the Act.
The Commissioner can act as follows if the Commissioner believes that there has
been an infringement of the terms of the Act:
u serve information notices requiring organisations to provide the Information
Commissioner’s Office with specified information within a certain time period;
u issue undertakings committing an organisation to a particular course of
action in order to improve its compliance;
u serve enforcement notices and ‘stop now’ orders where there has been a
breach, requiring organisations to take (or refrain from taking) specified steps
in order to ensure they comply with the law;
u conduct consensual assessments (audits) to check organisations are
complying;
u serve assessment notices to conduct compulsory audits to assess whether
organisations processing of personal data follows good practice (data
protection only);
u issue monetary penalty notices, requiring organisations to pay up to
£500,000 for serious breaches of the DPA occurring on or after 6 April 2010 or
serious breaches of the Privacy and Electronic Communications Regulations;
u prosecute those who commit criminal offences under the Act; and
u report to Parliament on data protection issues of concern.

The enforcement powers of the Information Commissioner include the power to
prosecute a data controller who fails to comply with an information notice or
enforcement notice. This is a criminal offence and there are two further criminal
offences under the Act.
u It is an offence to ‘fail to make a proper notification’ to the Information

Commissioner. ‘Notification’ is the way in which a data controller effectively
registers with the Office of the Information Commissioner, by acknowledging
that personal data is being held and by specifying the purpose(s) for which the
data is being held.
u It is also an offence to process data without authorisation from the
Commissioner.
The maximum penalty for these offences is £5,000, unless the case goes to the
Crown Court, in which case there is no limit on the possible fine.

The Data Protection Act 1998
5.8.4 General Data Protection Regulation

The EU data protection legislation in force is the Data Protection Directive of 1995.
To update the legislation, particularly in relation to online activity and the rise of
social media, a General Data Protection Regulation was approved by member states
in May 2016 and will take effect from 25 May 2018.
Under the revised EU Data Protection Regulation:
u individuals must be provided with the option to be ‘forgotten’, to have their

personal details erased from records and the right to have their personal data
transferred to another party (as long as they provide consent);
u explicit consent must be provided by the data subject before the details are
added to mailing lists and used for marketing purposes;
u businesses must be able to prove that the consent of both new and existing
subscribers has been gained;
u businesses need to advise their customers, in an easily understandable way,
how their data will be used;
u individuals are more easily able to access the data held about them;
u individuals have a right to be informed if their data has been ‘hacked’;
u there is a system of sanctions that can be enforced in law, with penalties as

high as 4 per cent of a business’s annual turnover.
Processing of personal data by businesses established in more than one EU country
will be monitored by one single data processing authority (DPA) − the ‘lead
authority’. The lead authority will be the DPA of the country where the business
has its main offices, ie where it carries out its central administration or where the
majority of management decisions take place.
The new rules will also apply to businesses based outside the EU that offer their
goods and services to EU customers based in the EU. For example, a US company
with a subsidiary in the EU will have to comply with the EU data protection law as
well as local US laws.
References
CMA (no date) [online]. Available at: https://www.gov.uk/government/organisations/competition-and
-markets-authority/about [Accessed: 19 May 2016].
European Commission (2016) Protection of personal data [online]. Available at:
http://ec.europa.eu/justice/data-protection/ [Accessed: 19 May 2016].
FCA (2015) CONC 3.4 Risk warning for high-cost short-term credit [online]. Available at:
https://www.handbook.fca.org.uk/handbook/CONC/3/4.html [Accessed: 13 June 2016}
Web Analytics World (2012) Summary of the proposed new EU Data Protection Regulation [online].
Available at: http://www.webanalyticsworld.net/2012/03/summary-of-the-proposed-new-eu-data-
protection-regulation.html [Accessed: 19 May 2016].

Review questions
1. If a business wishes to offer credit to consumers what should it do?
2. Explain annual percentage rate.

3. What was the purpose of the Consumer Credit Act 2006?
4. What is the role of The Pensions Regulator (TPR)?
5. Describe the areas covered by the Consumer Rights Act 2015.

6. What are the four main requirements of the Advertising Code?
7. The Standards of Lending Practice detail principles covering six main areas.
What are these areas?
8. What type of lending is not covered by the Standards of Lending Practice?
9. Under the Data Protection Act 1998 what does ‘processing data’ mean?
10. Explain the main rights that customers have in relation to factfind information
held by a financial services provider.

Topic 6
Clients’ needs and managing
money
Learning objectives
u define consumers’ goals, needs and objectives;

u explain budgeting;
u explain the need for financial protection;
u evaluate the consumer implications of borrowing and debt.
6.1 Introduction
Clients often have a range of financial needs, even when they approach an adviser
with one particular need in mind. In order to give the most appropriate advice,
advisers must be aware of the nature of all of the needs that clients may have
and must be able to recognise those needs even where clients themselves are not
aware of them. Some needs may be immediate, such as family protection, while
others, particularly retirement needs, may seem a long way off.
In this topic we will consider how an adviser can determine a client’s financial goals,
needs and objectives, which will be influenced to some degree by where they are
in their ‘financial life cycle’. Goals are a client’s non-financial future aspirations;
needs are the financial requirements that help them achieve those goals; and
objectives are the actions a client needs to take to help them achieve their goals.
Part of considering the client’s current circumstances will be to assess how they
manage their income and expenditure through budgeting. We can appreciate that
there are events in a person’s life which lead to a deficit situation in their monthly
income; this could be, for example, from the loss of a job. This deficit can be met
by the benefits from a financial protection product. If a person wishes to make a
substantial purchase, for example a house, then borrowing by way of a mortgage
loan would fill this need. The adviser has to ensure that the mortgage loan
repayments are affordable for the customer and must explore with the customer
how unforeseen events could affect their ability to repay. We will look at a range
of these issues in this topic.

6: Clients’ needs and managing money
6.2 Consumer goals, needs and objectives

Regulations under the Financial Services and Markets Act 2000 oblige advisers
to ensure that any advice offered is suitable for the client, based on the client’s
circumstances, experience, goals, needs and objectives. Advisers must be able to
identify the client’s goals and needs, which are the starting point for the sales
process.
Most, if not all, advisers will complete a comprehensive computer- or paper-based
factfind to obtain their client’s details. An adviser’s responsibility during the
factfind is to define the client’s goals, needs and objectives quickly and accurately,
so understanding their aspirations for the future.
To gather appropriate information it is necessary to ask questions in respect of the
following:
u the client’s financial situation;
u the client’s existing and future needs;
u their ability to provide for them;
u their attitude towards providing for them;
u the client’s objectives;
u the client’s knowledge and experience of investment (where relevant to the
service the adviser will provide). This will support an assessment of the client’s
ability to understand and accept investment risks.
This means, in practice, that any factfind should look at both the client’s
circumstances and preferences.
We can categorise an individual’s financial needs into the following five areas:
u protecting dependants from the financial effects of either a loss of income or a
need to meet extra outgoings in the event of premature death;
u protecting self and dependants from the financial effects of losing the ability to
earn income in the long term;
u providing an income in retirement, sufficient to maintain a reasonable standard
of living;
u wanting to increase and/or to protect the value of money saved or invested;
wanting to increase income from existing savings or investments; wanting to
build up some savings in the first place;
u saving tax.
In seeking to assess any of these areas, an adviser should look for examples of
typical things that clients either do wrong or fail to do at all. These might include,
for example, the following.
u A young family, with few or no savings, relying solely on mortgage protection
cover as their only form of protection in the event of death. It would repay the
mortgage but is not designed to meet the ongoing costs of running the house
and bringing up the family.
u A low level of life assurance premiums being paid, suggesting that cover might
need to be increased for the required protection to be adequate.

Consumer goals, needs and objectives
u Unnecessarily large amounts being held on deposit in banks and building

society accounts over the long term and so not gaining access to better returns
available elsewhere.
u Substantial taxable investment income being received by an individual who pays

higher-rate income tax.
u A non-taxpayer holding investments where tax on interest received cannot be
reclaimed.
u Too many small holdings of shares over a wide range of companies, causing
administration and monitoring difficulties.
u A married couple owning most of their assets in an individual’s sole name and
paying more tax as a result.
u Few or no contributions being paid towards saving for retirement, which will
mean being dependent upon state benefits unless action is taken.
u People who have not made a valid will, whose assets on death may therefore
not be distributed as desired.
The adviser’s role is to define the client’s goals, needs and objectives accurately, to
enable the client to see the key issues facing them, and to recommend and discuss
a priority order for action.
Failing to establish a priority order with the client can result in a client ignoring
an adviser’s recommendations. The client’s priorities may well differ from those
that the adviser feels appropriate, and so the process is one of discussion and
agreement rather than straightforward selection by any single person. In the end,
however, deciding a plan of action and agreeing its priority order remains the
client’s decision, assisted by the adviser’s recommendations.
6.2.1 The financial life cycle

It is well established that the financial needs of individuals and families change
as people pass through the different stages of life. While accepting that everyone
is different, there are some broad statements that can be made about a typical
financial life cycle. A consumer’s goals, needs and objectives will be influenced
by which of these life stages they are at.
6.2.1.1 School-age young people

The very young may be attracted by small lump-sum or regular savings schemes;
it is typical for accounts to be opened for young people by grandparents or other
relatives, at birth or later as birthday gifts. Financial services products that provide
income without UK income tax pre-paid are popular for this group.
6.2.1.2 Teenagers and students

Few teenagers and students have any surplus income, although some who have
started to work full-time or during holidays may be able to accumulate savings.
Some may borrow to purchase a car or to fund a holiday. Many students now have
to borrow to finance their college or university studies, mainly through special
schemes established for that purpose.

6.2.1.3 Post-education young people

The ability to save increases for those young people in employment, with the
possibility of higher incomes as careers progress. If they establish a home of
their own (often initially by renting), their savings may be modest at first. Some
may decide to save towards a deposit for a first home purchase. Short-term
accessible saving schemes are their most likely choice. Many telephone-based and
internet-based financial services are aimed at this market.
6.2.1.4 Young families

Although statistics indicate that fewer young people today get married, many still
form relationships and raise families. This often leads to increased borrowing,
particularly for a mortgage. At the same time, income may be reduced if one partner
gives up work to look after children or, alternatively, outgoings may increase if a
childminder is employed. Similar factors affect the growing number of one-parent
families. Whatever the situation, there is often little scope for savings at this stage.
Protection of earners’ income against illness or death becomes very important.
Young people should also begin to think about pension provision, although in
practice very few do.
6.2.1.5 Established families

As families settle into an established lifestyle, they tend to become better off
financially. There may be a return to a two-income situation. People often trade
up to a larger house, increasing their borrowing accordingly. Creditworthiness,
through the establishment of a good track record with lenders, may improve,
enabling greater borrowing for cars and household goods. This is also the
beginning of the stage when wealth may be increased by the receipt of inheritances
from the estates of parents or other relatives.
6.2.1.6 Mature households

Maturity is generally the period of highest earning potential and outgoings may
also decrease as children leave home and mortgages may be paid off. At this stage,
pension provision becomes a priority for many people as they begin to realise that
they may not have as high an income in retirement as they had hoped.
6.2.1.7 Retirement
Prior to retirement, most people’s financial planning is centred on converting
income into lump sums (or lump sums into bigger lump sums). At retirement,
when income from employment ceases, the focus changes: the requirement is now
to produce income from capital. Other factors also become more relevant: the need
to prepare for possible inheritance tax liabilities should be considered. Similarly
the cost of health care, and possibly of long-term care in old age, may become an
issue.
The above stages can be used by providers to categorise customers into ‘market
segments’ for marketing and promotional purposes. Age or time of life is not,
of course, by any means the only way in which market segments can be defined,
but it has been analysed in detail to give an illustration of the concept. Other
breakdowns are possible, for instance, by the level of annual income or by an
individual’s attitude to investment risk. Both of these characteristics can contribute

Protection
to determining the appropriate financial product for a particular investor or

borrower.
6.3 Budgeting
The need to budget underpins all other forms of financial planning. At its simplest,
it reflects the need to have sufficient funds to purchase the necessities of daily
living. It also encompasses the need to determine how much can be spent on other
items: on capital purchases; on leisure pursuits and holidays; on provision for a
secure retirement.
Many savings products can be used to budget for future capital and income needs,
but advisers must be careful not to put pressure on the client’s current and future
income when selling products paid for out of that income. An increase in mortgage
interest rates, for example, could push a family’s expenditure beyond its means.
It might be argued that the need to balance the budget on a weekly/monthly basis
is not as great as it once was: despite the credit crunch, credit is still more readily
available than it was for previous generations, but all borrowing must be repaid at
some point, and advisers should exercise caution when considering clients’ likely
future income and expenditure levels.
Conversely, the need to be able to budget is of great importance when a client is
being considered for mortgage finance, as affordability is one of the key factors a
lender will take into account when assessing a mortgage loan application. In this
situation it would not be acceptable for an applicant to make up any shortfall in
monthly income by relying on their overdraft. Advisers in this instance do have
to discuss with clients the impact of increases in interest rates, particularly when
lenders offer discounted rates in the early years of the mortgage term.
A budget can be prepared on a monthly or annual basis by totalling all of the
client’s income and subtracting all their regular outgoings. The clients may then
consider any large items of expenditure they wish to make. If expenditure is greater
than income then the client has to consider how they will close this ‘gap’, either by
reducing costs (say by downsizing their property) or increasing income (by taking
in a lodger, for example). This can be a useful exercise for the client as it prevents
them from ignoring problems of overspending.
Once the budget has been prepared the client will be able to see how much they
need each month to meet their regular outgoings. They should be encouraged to
start saving for an emergency fund, ie a pot of money they can use should the
unexpected happen, for example the loss of their job or a serious accident that
prevents them from working. As a general rule, the amount of the emergency fund
should be three times their monthly outgoings. There are several products where
this fund can be safely kept with immediate access, such as a deposit account (see
section 13.3.1).
When advisers make recommendations it is important that they assess affordability
to ensure that the client can maintain any financial plans they have taken out.
6.4 Protection
The need for financial protection comes from the fact that life can be uncertain
and it is not possible to avoid all the dangers and difficulties that it can bring. It is,
on the other hand, possible to take sensible precautions against the impact of the

risks that affect people, their lives, health, possessions, finances, businesses and
their potential inheritances.
Many people, however, make little or no provision for minimising the financial
consequences of death or serious illness. This may be because they are not aware
of the size of the risk or because they believe that they cannot afford to provide
the cover, not realising how cheap it can be, especially if taken out when young.
Statistics for the UK from the Office for National Statistics, based on mortality rates
between 1981 and 2014, and assumed mortality rates from 2014, suggest that, in
2015, a newborn male would expect to live to the age of 79.4 years and a newborn
female to live to the age of 83.4 years, which would suggest significant periods of
time in retirement (ONS, 2015).
In 2011 (the most recent year for which figures are available), 40 per cent of all
adults aged over 20 in the UK had a longstanding illness. In respect of males and
females aged over 20 with longstanding illness the percentages are as follows:
u 39 per cent of males;
u 41 per cent of females (ONS, 2016a).
In 2014 there were 296,893 newly diagnosed cases of malignant cancer in England
(ONS, 2016b).
It can therefore be seen that, for people of working age, the risk of illness is much
greater than that of dying.
Regardless of the risks, many people take an ‘it won’t happen to me’ attitude but,
the simple fact is, it might!
6.4.1 Family protection
6.4.1.1 The financial impact of death

A person who stands to suffer financial loss from an event has an ‘insurable
interest’ in the property or interest which means they can then insure the property
against the financial loss arising if the event occurs. The event must create on the
insured a commercial loss or liability, or it must affect a right of the insured that is
recognised and protected by the courts. For example, a family have an insurable
interest in the family breadwinner as the loss of that income on the death of
the breadwinner usually causes a reduction in a family’s quality of life. For most
families, it is income rather than savings that enables them to enjoy their standard
of living.
State benefits may be available, but they generally do little more than sustain a very
basic lifestyle, and increasing pressure on government funding means that they
are more likely to reduce than increase in real terms in the future. The surviving
spouse/partner may, therefore, have to become the earner, leaving a problem of
who will look after the children (or alternatively, the problem of funding the cost
of childcare).
Another consequence of the death of the main earner is that dependants may not
be able to make loan repayments, particularly mortgage repayments. If the loan
cannot be serviced, the property may have to be sold and the family rehoused
in less suitable circumstances. This problem can be addressed either by making
provision for a monthly income equal to the loan repayments, to be payable for

Protection
the remainder of the loan term, or by providing for a lump sum to pay off the
outstanding loan capital.
It is equally important for the life of a dependent spouse or homemaker to be
insured, even though they are not the family’s earner. In the event of their death,
the normal earner may have to give up work in order to look after the children, or
may have to pay the cost of full-time childcare.
6.4.1.2 The financial impact of sickness

Many of the arguments for protection against the adverse financial consequences
of death apply equally to the need for protection against the impact of long-term
illness. In fact, the arguments for protection against financial loss through sickness
may be even stronger than those for protection against that from death, not just
because the likelihood of a person of working age suffering a long-term illness is
greater than that of death, but also because the financial impact on a family of
long-term sickness can be even more severe than that resulting from a death.
Protection against the impact of sickness may fall into a number of categories:
u an income to replace lost income (for instance when the main earner suffers a
long-term illness);
u an income to pay for someone to carry out the tasks normally undertaken by a
person who is ill;
u an income to pay for continuing medical attention or nursing care during an
illness or after an accident;
u a lump sum to pay for private medical treatment;
u a lump sum to pay for changes to lifestyle or environment, such as alterations
to a house or a move to a more convenient house.
As in the case of protection against death, there may be a requirement to cover
not just a main breadwinner, but also a dependent spouse.
A number of factors contribute to the amount and type of cover required, including
the following:
u the ability of the insured person to adapt to other types of work;
u the extent to which an employer might continue to pay salary during an illness;
u the number and ages of children and other dependants;
u the availability of help from family and friends;
u the nature and amounts of state benefits available.
6.4.1.3 Financial impact due to unemployment

The problems resulting from unemployment/redundancy are, in many ways, similar
to those caused by illness, but it is much more difficult for insurers to predict
statistically the likelihood of loss of employment than it is to predict loss of health
or loss of life. Unemployment cover is, consequently, much more difficult to obtain
as a stand-alone insurance and, when it is available (normally only in conjunction
with sickness cover and often only in relation to covering mortgage repayments),
it is usually subject to a number of restrictions.

6.4.2 Business protection

There are a number of business situations in which the loss of a colleague can
have severe implications for the financial health of an organisation. Life or sickness
insurance can be used to mitigate the financial loss that may result. The main needs
are described below.
6.4.2.1 Death of a key employee

The death of an important employee, particularly in a small company, can have
a devastating effect on a firm’s profits. Key personnel, though more often found
among the management of companies, can actually be involved at all levels of
a company. People with different roles may, for very different reasons, be key
personnel on whom the company’s profits depend. For example:
u a managing director with a strong or charismatic personality;
u a research scientist with specialised knowledge;
u a skilled engineer with detailed understanding of the company’s machinery;
u a salesperson with a wide range of personal contacts.
The company can take out a term assurance (life cover) on the life of the employee,
for the period during which the employee is expected to be a key person. This may
be until retirement, or until the end of a contract or a particular project. If a term
assurance of five years or less is chosen, the premiums are likely to be allowed as
a business expense, which the firm can set against corporation tax. In the event of
a claim, however, the policy proceeds will then be taxed as a business receipt and
subject to corporation tax.
6.4.2.2 Death of a business partner

A partnership is defined in the Partnership Act 1890 as ‘the relationship that exists
between persons carrying on a business in common with a view to profit’. Groups
of professionals such as solicitors and accountants normally work together as
partners.
On the death of one of the partners, the beneficiaries of that partner’s estate (often
their spouse and/or family) may wish to withdraw their share of the partnership’s
value. This can cause problems for the remaining partners because it might mean
that they will have to sell partnership assets to pay the deceased partner’s family.
Since much of the value may be in the form of ‘goodwill’, it may not be possible
to realise it except by selling the whole business. ‘Goodwill’ is that intangible and
yet real portion of the value of a business that relates to the firm’s good name or
reputation.
Death of the partner in such circumstances shows the need for partnerships to
insure against the death of each partner with partnership protection, in order to
buy out their share.
6.4.2.3 Death of a shareholder in a small business

Small businesses are often run as private limited companies with a small number
of shareholders, who are often family members or close relatives or friends. In
the same way that partners may wish to buy out the share of a deceased partner,
surviving shareholders in a small business will probably want to buy the shares of

Borrowing and debt
a deceased shareholder to prevent the shares from going out of the close circle of
existing shareholders.
6.4.2.4 Sickness of an employee

If sickness prevents a key employee from working, the effect on profits can be
just as serious as in the case of that employee’s death. The company may need
funds with which to pay the salary of a replacement who can supply the skills and
attributes lost through sickness.
6.4.2.5 Sickness of a business partner

If a partner falls ill, they may be able to continue to draw income from the
partnership for some time, even if not contributing their skills to the partnership’s
earning capacity. There will be a need to provide a replacement income to avoid
the partner becoming a drain on the partnership’s resources. In the event of the
partner being unable to return to work, the remaining partners may even wish to
buy the sick partner’s share of the business.
6.4.2.6 Sickness of a self-employed sole trader

Although sole traders may employ others to work for them, they often do much
of the key work themselves, including accounting and decision-making. If a sole
trader ceases working, their income is likely to stop very quickly. Worse still,
their customers may be lost to competitors, causing the business to collapse. The
pressure and anxiety resulting from such a situation is likely to hinder recovery
from the very illness by which it was caused.
6.5 Borrowing and debt

Borrowing has become a ‘necessary evil’ in today’s modern consumerist society.
It is available from a wide range of providers, many of whom also sell goods for
which the credit is used, and borrowing is easily accessible to many consumers
who have a reasonable credit history. It is considered quite normal to have an
overdraft, credit cards, personal loans and a mortgage loan. While debt is deemed
socially acceptable, there are a number of issues that a financial adviser or planner
has to consider.
The amount of debt a client has will impact on their overall financial well-being and
stability. For example house purchase is, for the majority of people, the largest
financial transaction of their lives and, since most people are not able to fund the
price of a house out of their own capital, a loan from a bank, building society or
other source is normally required.
Since a mortgage loan is such a large and long-term commitment, the
consequences of making a mistake can be very serious. It is therefore particularly
important for an adviser to choose wisely and to ensure that the products chosen
match the client’s needs and circumstances. Choosing the wrong lender or the
wrong interest scheme, for example, could lead to the client paying more than is
necessary for the loan. For people who may wish to make their interest payments
early, a daily interest scheme could help them to save money; a flexible mortgage
might give yet more freedom, allowing overpayments, underpayments and even
payment holidays.

The exact nature of what constitutes suitable advice in a particular case will depend
on a variety of factors, including the term, affordability (at outset and on an ongoing
basis), any preferences for stability of payments or special features, and the client’s
employment status. Failing to protect the outstanding capital or the repayments
against sickness, death or redundancy can leave a client’s family destitute or lead
to their having to leave their home. Many clients are unaware of the magnitude of
the risk, or of the ease with which it can normally be mitigated.
A low level of interest rates coupled with strong house price inflation led, before
the credit crisis, to a large increase in individual and family indebtedness in the UK,
with many people increasing the proportion of their net income that they spend
on mortgage and other loan repayments. Increases in interest rates or a reduction
in income can leave people unable to service the high levels of debt that they have
taken on.
Borrowers can suffer from ‘over-indebtedness’, which broadly means that a
borrower has taken on too much debt, often from a variety of different sources,
and for some reason starts to have difficulty in repaying. As soon as the borrower
is late paying loan repayments (arrears) or goes over overdraft limits (excesses)
their credit rating is downgraded and they will have problems borrowing further
to ‘catch up’. Before the 2007/08 credit crunch, home owners in this position
were able to extend their mortgage loans, so using the increasing value of their
properties to fund their spending habit and clearing their outstanding overdrafts
and credit cards, only to start again.
The advantage of this refinancing is that the overall monthly repayments are
reduced, because the new loans are now subject to a lower rate of interest and
a longer repayment term. A serious downside to doing this is that the formerly
unsecured loan is now secured on the property, adding to the borrower’s problems
if they default on the repayments of the consolidated loan. Borrowers can then find
themselves in a position of ‘insolvency’, which means they are unable to pay their
debts as they fall due. They are no longer deemed creditworthy and have a number
of possible routes to take, the most serious of which is bankruptcy, which we
will consider in section 20.7. A further consideration is that, whilst monthly loan
repayments may reduce, the total cost of repaying the loan increases as a mortgage
generally runs over a much longer time period than an unsecured debt.
An adviser should also be prepared to counsel an individual on the risks of using
short-term ‘payday’ loans to overcome a temporary financial shortfall. The rates
charged are usually extremely high and there is a risk that borrowing on such a
basis becomes habitual, making getting out of debt more problematic.
From an adviser’s or planner’s perspective it is important to understand the total
picture in relation to a client’s past, current and future borrowing requirements,
and to link this to their life cycle stage. It would not be professional to make
recommendations that could lead a customer into financial hardship.
References
ONS (2015) Expectation of life, high life expectancy variant, United Kingdom [online].
Available at: http://www.ons.gov.uk/peoplepopulationandcommunity/birthsdeathsandmarriages
/lifeexpectancies/datasets/expectationoflifehighlifeexpectancyvariantunitedkingdom
ONS (2016a) Proportion of people with a long standing illness and limiting long standing
illness and limiting long standing illness by age and sex 2011 [online]. Available at:
http://www.ons.gov.uk/peoplepopulationandcommunity/healthandsocialcare/disability/adhocs/

Review questions
005477proportionofpeoplewithalongstandingillnessandlimitinglongstandingillnessbyageandsex2011
ONS (2016b) Statistical bulletin: Cancer registration statistics, England: First release: 2014 [online].
Available at: http://www.ons.gov.uk/peoplepopulationandcommunity/healthandsocialcare/
conditionsanddiseases/bulletins/cancerregistrationstatisticsengland/firstrelease2014 [Accessed:
19 May 2016].
Review questions
1. Distinguish between a customer’s financial goals, needs and objectives.

2. Why might a financial services provider categorise groups of customers by
their life stages?
3. Explain why a financial services provider asks for a budget from a prospective
mortgage loan customer.
4. In terms of family protection, which are the three main risks that customers
should consider insuring themselves against?
5. Why is it important to consider protection insurance for a dependent spouse
or homemaker?
6. Why is it good practice for business partners to arrange life assurance?
7. What is ‘over-indebtedness’?
8. Why did increasing house prices (pre-credit crunch) fund poor spending habits?

Topic 7
Customer needs for future income
Learning objectives
u explain the concepts of risk and reward;

u explain the concepts of investment and saving;
u summarise provisions for retirement planning;

u explain the need for estate planning;
u summarise the concept of tax planning.
7.1 Introduction
This topic is about understanding the main priorities of customers in relation to
their need for future income. One of the key factors customers should consider
is how much risk they are prepared to take in order to gain future income and,
depending on their circumstances and experience, this will differ from person to
person. From a financial advice perspective it is important to ensure the customer
is realistic in their attitude to risk and is provided with appropriate products. We
will take quite a detailed look at risk as it can feature in a number of ways, all of
which affect the retail customer.
We will look in this topic at several areas that relate to future income. Investments
and saving are key activities for a customer who wishes to plan ahead − the
activities are subtly different, although some would argue they are the same.
Retirement planning is another key activity for providing future income, although
not one that many people consider soon enough. Tax planning, the final section of
this topic, is something that everyone needs to be aware of, whatever their levels
of current and future income.
Students should, however, be aware that there are some limitations to the advice
that can be given. It will depend heavily on the quality of the information collected
and how forthcoming the client decides to be with that information. It will also
depend on the quality of the historic data on the performance of financial products,
such as investments, and the organisations that provide them.

7: Customer needs for future income
7.2 Risk
Risk is commonly understood in terms of the loss of the amount invested or of
making little return on the investment. We sometimes forget, though, that there is
the risk of lost opportunities − what might have been earned had the investment
been made elsewhere.
Time is an important risk factor. Consider an investor who has £1,000 to invest
for one year. If that £1,000 is invested in a building society account, the capital is
secure and the investor will receive interest at the rate applicable during that year.
If they were to invest the £1,000 in shares, the investment might fall in value and
the investor could not be sure how much dividend income they would receive,
if any.
If, however, the investor intended to invest for ten years rather than one, the risks
alter. Even though stock market investments are volatile, over the longer term the
stock market has consistently outperformed deposit accounts. Although shares
are still riskier in some respects, extending the time involved in the investment
changes the picture.
Generally, deposit accounts provide a more secure investment because interest is
added to the investment and the capital is not put at risk at any point. Even if
the provider were to pay no interest, the capital would be secure − but deposit
accounts pay interest at low rates, often not even equal to the rate of inflation.
Stock-market-linked investments are termed ‘asset-backed’ investments because
their value is backed by the value of the assets (or businesses) underlying the
shares. The assets themselves may increase in value; they may also lose value. Over
the longer term, asset-backed investments are more likely to provide protection
against inflation.
This is an important concept when making recommendations to clients.
Deposit-based investments may be more appropriate if a client’s investment
objectives are short term, but asset-backed investments will be more appropriate
for the longer term.
7.2.1 Risk and reward

In general, the higher the risk, the higher the potential reward or loss. A ‘low-risk’
investment is likely to fluctuate less widely than a ‘higher-risk’ investment but
may offer limited potential for gains. A ‘high-risk’ investment has the potential for
making larger gains but also has the potential for suffering larger losses.
This is commonly known as the concept of risk versus reward. In general, the
higher the risk, the higher the potential reward or loss, but, when looking at the
risk factor, it is important to understand exactly what we mean by risk.
7.2.2 Types of risk

Risk can be subdivided into a number of categories.
u Capital risk is the risk of losing some, or all, of the original investment. For
example, investors in Marconi a few years ago lost almost all of their investment.
The company accumulated massive debts and had to restructure to remain in
business. The restructuring resulted in the loss of almost the entire value of the
original shares.

Risk
u Shortfall risk is a risk that an investment chosen for a specific purpose may not
meet expectations. For example, many investors who took out endowments to
support an interest-only mortgage loan have been warned that their endowment
policies are unlikely to match the mortgage amount on maturity. While riskier
investments might offer the potential for better growth, they also pose a higher
shortfall risk.
u Interest risk can show itself in four main ways.

− Borrowers with a variable-rate mortgage loan run the risk that the interest
rate will rise and increase their costs.
− Savers in variable-rate accounts run the risk that the interest rate will reduce.
This is a particular risk for those who have retired and who depend on income
from savings.
− Those with a fixed-rate mortgage loan run the risk that a reduction in
variable rates will leave them paying more than they would in the current
market. Many borrowers will take comfort in the security of knowing that
their mortgage payments will not increase over the fixed term and may be
prepared to accept the downside.
− Those saving in fixed-rate savings accounts may receive a lower rate relative
to the market if rates increase, but will be unable to withdraw their money
without penalty.
u Inflation risk − there is a risk that inflation over time will reduce the real value
of capital and reduce the buying power of the cash saved. Investors should look
for investments that are likely to provide a real return over time.
u Systematic (or market) risk is the possibility of an entire market, or

sector of the market, performing badly. The individual investor has no control
over systematic risk. The whole market may perform badly due to economic
problems in the country as a whole or due to other factors affecting the
markets, such as pessimism or international issues. Even a portfolio that has
been diversified is likely to suffer in this situation. The economic downturn
that began in 2008 saw many stock markets across the world suffer heavy falls
across the board − a classic illustration of systematic risk.
u Non-systematic risk is risk specific to a particular share or sector and can
be reduced by diversifying the portfolio over a number of companies’ shares
or over a number of market sectors. For example, the sensible investor might
invest in a selection of banks, builders, telecoms and engineering shares rather
than put everything in telecoms. If the telecoms sector were to perform badly,
the investor would be cushioned by the other shares. In the economic downturn
of 2008−09, banking shares suffered dramatically. Those heavily invested in
banks suffered even more than those affected by systematic risk.
u Provider risk is the risk that the product provider might fail to meet its
obligations, either in terms of the return offered or the safety of capital. Gilts
and National Savings products are seen as the least susceptible to provider risk
because the government underwrites them. There are schemes to protect the
investor (such as the Financial Services Compensation Scheme (see section 4.5)
although none will return all of the investor’s capital if over the maximum limit.
For this reason, the investor should take care to choose a provider with proven
financial strength. It is also a sensible precaution to spread a large investment
across a number of providers.

u Currency risk − where an investment is made overseas or in a fund that invests

overseas, there is currency risk: the risk that currency fluctuation might erode
the value of the investment. When sterling rises in value in relation to foreign
currency, it has the effect of reducing the value of the investment in sterling
terms. Conversely, when sterling falls against foreign currency, the value of the
investment rises in sterling terms.
u Taxation risk − other than individual savings accounts (ISAs) and some
National Savings products, investments are taxed. It is possible, however, to
reduce the effect of taxation risk by choosing the right investment. Obviously,
tax-free investments should be considered first − providing they meet the
investor’s other needs. After that, the selection should consider how a product’s
taxation treatment might affect the investor. For example, a higher-rate
taxpayer might be better with a product that offers a lower return but has a
more favourable tax regime. Non-taxpayers would be best advised to avoid
products for which they cannot reclaim tax deducted. Changes in taxation rules
can also present a risk, and what may have been a good strategy could cease to
be so after government Budget announcements. Examples of this are changes to
the way in which death benefits from pension schemes are taxed, and changes
to the lifetime and annual allowances for pension contributions.
7.2.3 Other considerations

There are a number of other considerations to be taken into account when
exploring risk with the customer.
7.2.3.1 The timescale

The period of the investment will influence the level of risk that a client will be
prepared to take. Some investments fluctuate in value in the short term. Over the
longer term, however, they may experience good growth. This sort of investment
can be considered as higher risk in the short term, especially if the client may need
access to funds at short notice. In the longer term, fluctuations may not be seen
as such a problem, particularly if the client has some control over when the money
is needed.
Where the objective is short term, deposit-based investment is almost always the
most prudent approach. The capital is needed in a relatively short time and it is
not wise to invest in asset-backed investments: there would be a danger that the
capital value could be reduced over the short term. Security of capital is important
because there will be little time to make up any losses.
Where the objective is medium to long term, the investor might consider
asset-backed investment, but only where they are confident that a reduction in
capital will not be a major blow. Those considering asset-backed investments are
advised to allow a minimum investment period of five to seven years in order
to allow the capital to ride out fluctuations in value. Even then, there is a risk
that the investment may either not have grown or may have reduced in value.
Clearly, the longer the time span until the investment is needed, the more likely
that asset-backed investment will be suitable.

Risk
7.2.3.2 Age and the life cycle

We looked at the stages in a customer’s life in section 6.2.1. The customer’s
attitude to risk will be affected by the stage at which they find themselves.
u Those who are in the early stages of working life may have little disposable
income from which to fund investment or savings. If they feel a need to invest
at all, it is likely to be to save for a house or to build an emergency fund. Both
of these objectives are best served by low-risk investments.
u Early married life brings with it a number of financial challenges. There may
be two incomes, but there is also likely to be a desire to build a deposit for house
purchase and/or to put money aside for future needs, particularly children. If
the couple manage to buy a house, their disposable income will be stretched
and investment will take a low priority. For this reason, much of the investment
focus will be on low-risk investments, providing easy access and capital security.
If children arrive, it is more likely that the couple will be dipping into savings,
rather than putting money aside for the future. Any cash they do manage to
save is likely to be kept on deposit for emergencies and short-term needs.
u Middle age often sees customers at their most affluent: they have more
disposable income and are more disposed towards saving. They may even have
built up some capital. In today’s society, as home ownership is common and
prices escalate, it is those in their 50s who are the largest recipients of inherited
wealth; much of this wealth will be invested. Those in middle age can often
afford to take a medium- to long-term approach to saving and are likely to be
interested in building up capital and income for retirement. This means that
they will consider investing in schemes that offer the prospect of capital growth
but increased risk.
u Those in retirement are unlikely to be able to invest from their income; in fact,
it is likely that they will use existing investments to supplement their retirement
income. This means that they may move existing investments to provide income
and that they will wish to protect their capital to ensure a continuing income.
The retired investor is likely to select low- to medium-risk investments to achieve
this goal.
7.2.3.3 The client’s current and future financial circumstances

In general, the more the customer is likely to need access to the money, the lower
the risk that should be taken. It is not wise to tie up money that may be needed
at short notice in shares or other longer-term investments: it may be difficult to
release the money at short notice or it may be necessary to cash in at the ‘wrong
time’. In order to assess the most suitable investment, the adviser should look
first at the customer’s present position. This will indicate how much capital or
income they have available to start, or continue, saving and investing, and to what
extent. It is also important to consider other, more pressing needs that might
impact on their ability to invest. A customer investing £50,000 can adopt a much
more adventurous approach if this sum is a fraction of their total wealth rather
than its whole. They might, however, have upcoming events that require capital
outlay and, for these reasons, it is important to get a full picture of the customer’s
circumstances.

7.2.3.4 The customer’s objectives

The customer’s objectives will be a significant factor in deciding the level of risk
they are prepared to take. If the objective of the investment is very specific, loan
repayment for example, they will want to know that their target will be met. This
may lead to a more conservative approach than for an objective that is not as
important or where the target amount is not so definite.
In the case of a longer-term objective, even where meeting the target is imperative,
it may be possible to take a more speculative approach in the initial stages, with
a view to transferring some, or all, of the value into lower-risk investments nearer
the end of the term. This will consolidate the gains made to that date and provide
a greater degree of security when the funds are required. Where the main objective
is to provide income, the investor is likely to choose investments that produce
a relatively high level of interest or dividend income based on the profits of the
companies in which the shares are held. This might mean that capital growth is
sacrificed to some extent; this is a form of risk in itself. The customer should be
aware that low capital growth might reduce the real value of the income in future
years. If the investment is not for a specific purpose, then security may be less
important to the customer and more speculative investments can be considered,
particularly if they have other funds that are sufficient to compensate for any loss.
7.2.4 Attitude to risk

Customers often have a number of objectives, each with a different priority and
timescale, and it is not unusual for a customer to state a different attitude to risk
for each of these objectives. For example, objectives might be agreed as follows:
u mortgage loan repayment − low risk;

u retirement provision − medium risk;
u capital accumulation − high risk.
Establishing the customer’s attitude to risk, both generally and towards the specific
investment under consideration, is therefore an important part of the adviser’s role.
If the customer already holds other investments, they might hold a different view
of the risks to take with the new investment. Where it is their only capital, they
are likely to prefer a more safety-conscious approach. All of this means explaining
the relationship between risk and reward, and identifying the customer’s feelings
about the capital − are they prepared to take a degree of risk to achieve their target
or is safety the most important factor for them?
Another important factor that advisers should consider is a customer’s ‘capacity
for loss’. This can be described as the customer’s ability to absorb falls in the value
of their investment. If any loss of capital would have a materially detrimental effect
on their standard of living, this should be taken into account in assessing the risk
that they are able to take.
The customer’s attitude to risk may also be affected by previous experiences.
For example, a customer who lost money in a previous share investment may be
reluctant to take the same risk again. Conversely, a customer who made significant
gains through a high-risk investment may be keen to repeat their success. While
customer experience is an important factor in the risk decision, the adviser should
explore that experience and help the customer to understand what happened and
why.

Saving and investment
The customer’s attitude to risk can be established by asking appropriate questions,

which include:
u what investments they might already have (or have had);
u how they feel about these investments;
u how the investment has performed;
u whether there is anything that concerns them about the investments;
u how they would feel if the value of their investment were to go down;
u how they feel about the risk−reward relationship;
u what they need the proposed investments to achieve;
u how important it is to achieve that objective;
u how important is the security of capital.
The answers to these questions should be considered together with the customer’s
objectives and the timescale.
Some providers illustrate the risk in terms of a ‘risk meter’ with categories being
(for example) low, medium, high and adventurous. The adviser would then discuss
with the customer where they think they fit on this scale.
7.3 Saving and investment

It is important at this stage to make a distinction between saving and investment,
because the terms can have different implications, even though many of the rules
for providing a solution to clients’ objectives are the same for both.
There is a well-established pattern to the way in which most savers and investors
build up and hold their assets. It begins with savers’ attitudes to the need for
liquidity and safety and then, as incomes and savings grow, moves gradually away
from liquidity and towards a willingness to set money aside for longer periods,
possibly into products with greater risk.
The first stage in the saving pattern is cash; after that, a current account with a
debit card is virtually as good as cash. People do not generally hold any other
form of asset until their cash requirements are met. The next stage is secure,
short-term investment such as instant access (or short-notice) bank and building
society deposits.
With a sufficient balance in short-term savings, customers look next at products
with less flexibility but a greater return, such as fixed-term bonds.
Further down the line, individuals may be attracted to products that offer
greater long-term potential but at the risk of short-term loss. Shares and other
equity-linked investments, such as unit trusts, are good examples. In times of
stock market volatility, however, these investments may prove considerably less
popular.
Saving is usually accepted to be the periodic (whether regular or not) setting aside
of money from income, usually with a view to building capital. Investment can be
defined as the use of lump sums (capital) to produce income or capital growth (or
both). For the purposes of this text, we will use the term ‘investment’ to cover both

saving and investment unless there is a specific need to differentiate between the
two.
7.3.1 The purpose of investment

There are two broad purposes behind why people invest, which are:
u to provide an income − either now or in the future; or
u to gain a return on a capital lump sum.
When we look at the underlying reasons, we might see the following:
u short-term emergencies;
u specific purchases, such as a new car;
u school fees;
u a wedding;
u gifts to children;
u buying into a business;
u loan repayment;
u retirement;
u a feeling of security (‘rainy day’ provision).
Occasionally, people save and invest without having a specific purpose in mind.
Saving and investment needs change over the course of a lifetime, as explained
in section 7.2.3. The financial services industry provides a very extensive range
of savings and investment products to meet the needs of a wide spectrum of
customers. When considering which product is the most suitable, a variety of
factors need to be taken into consideration.
7.3.2 The effect of inflation

One of the factors that is least understood by clients is the impact of inflation on
investment returns. As long as there is inflation, the purchasing power of a given
amount of money will fall. For example, the purchasing power of £1,000 after
10 years of 3 per cent inflation will have fallen to under £750. Before an investment
can grow in real terms it must first increase in line with inflation: the aim of any
investment should be to provide a real return. Over the long term, equity-linked
investments have proven most likely to offer growth rates over and above the rate
of inflation.
Inflation, as measured by the consumer prices index (CPI), in the UK was
0.1 per cent in November 2015, having been negative (deflation) in earlier
months of 2015. Such low levels of inflation are, generally, unusual, particularly
over the longer term, considering that the inflation target for the government
is CPI at 2 per cent. It is important that advisers educate customers about
the impact of inflation on potential returns from investments. The significant
measure for an investment is the real rate of return, which reflects the true
purchasing power of invested funds. The real rate of return can be estimated

Retirement planning
by subtracting the rate of inflation from the interest / growth rate obtained on the
investment: an investment paying 1.5 per cent interest at a time when inflation is
1 per cent is providing a real rate of return of only about 0.5 per cent. If the rate
of interest is less than the rate of inflation, the real rate of return will be negative
and the purchasing power of the invested funds will fall in real terms.
Low inflation and low interest rates tend to go together, and one effect of this is
that people tend to suffer from the so-called money illusion − ie they tend to think
of interest rates in their nominal sense and not to adjust their thinking to allow for
inflation. Both savers and borrowers can be affected.
u Savers feel that the low interest rates currently being paid on savings are a poor
return for their money. They may, therefore, react to lower inflation by putting
their money into riskier assets in order to seek higher returns − demand for
high-yield bonds has certainly increased in recent years. However, if a large
number of people on average incomes lose their money because of opting for
riskier investments, they may not be able to afford to retire and social problems
will result.
u Borrowers (particularly those repaying mortgage loans) feel that they are
gaining from the lower monthly repayments that have resulted from interest
rate falls. This may persuade them to take out a larger mortgage since they feel
they can more easily afford the monthly repayments. This is a misconception as,
although less cash flows out in interest payments at the start of the mortgage
term, a higher proportion of cash flow will be necessary to repay the capital.
Again, problems may be stored up for the future as people take on debt
they cannot afford, especially if interest rates rise again. In the meantime, an
increased demand for houses can push up house prices and threaten price
stability.
Inflation will be considered further in section 9.2.
7.4 Retirement planning

One of the great difficulties faced by UK governments in recent years has been to
convince the population, brought up for the most part in the era of the welfare
state, that changes in its demographic structure and social environment make
it increasingly difficult for the state to provide the social security benefits, and
particularly pensions, that will be needed to maintain people’s lifestyles, while
representing a realistic and acceptable cost to the taxpayer.
There are three main sources of pension provision − from the state, employers
and personal contribution. These will be covered in some detail in Topic 15.
State pension provision is generally set at about one quarter of the level
of national average earnings and is clearly inadequate for anything more than
subsistence living, yet many people are continuing to reach retirement age with
little or no pension provision to look forward to apart from a state pension. This
is particularly, although by no means exclusively, true of people at the lower end
of the earnings scale. They are often financially unsophisticated and unaware of
products such as stakeholder pensions that could have been used to boost their
pension. Even when aware, these people may have more pressing demands on
their income; and if they do know of the products, they may have been put off by
talk of high charges or of product mis-selling.
It is not unrealistic to refer to the situation as a crisis. Statistics show that
90 per cent of people now live to the age at which they receive their state pension,

compared with 66 per cent of people only 50 years ago, and those who do collect
their pension receive it on average for eight years longer than did pensioners in
the early 1950s.
Successive governments have been increasingly aware of the potential problem,

and have introduced certain measures to attempt to counteract it, such as
the introduction of stakeholder pensions, increasing the age at which state
pension benefits are paid and introducing auto-enrolment into workplace pensions.
Stakeholder pensions have not proved to be particularly successful. They were
targeted at people in the income range £9,000 to £20,000 − believed to include
the greatest proportion of people who are failing to make adequate provision for
their retirement. The product was designed with a number of features intended to
attract the savings of this particular group, including low charges and low minimum
contributions.
Despite this, evidence suggests that there has been very little take-up of
stakeholder pensions among this main target group, with most of the sales being
to people who would have been making pension provision anyway through other
schemes, and who have chosen stakeholder pensions because of the lower costs.
Some people feel that one of the reasons for the low demand for these pensions
is that the maximum charge providers can incorporate is 1.5 per cent of the fund,
giving them little incentive to market the product effectively.
The reforms in the Pensions Act 2008 focus on auto-enrolment into workplace
pensions for employees whose earnings exceed an ‘earnings threshold’, and
who are not already members of a pension scheme. Auto-enrolment began in
October 2012. The criteria for auto-enrolment are that the employee:
u is not already in a pension at work;
u is aged 22 or over;
u is under state pension age;
u earns more than an ‘earnings trigger’ (£11,000 for the tax year 2016/17);
u works in the UK.
The Act also introduced changes to the state pension age timetable. From
April 2016, women’s state pension age will rise faster than originally planned,
equalising with men’s at 65 by November 2018. Between December 2018 and
October 2020, the state pension age for men and women will rise from 65 to 66.
State pension age will increase from age 66 to 67 between 2026 and 2028. Going
forward, state pension age will be reviewed at least once every five years, with the
aim of enabling people to spend one third of their adult life in retirement.
The Act also changed the measure of inflation for revaluation and indexation of
benefits from occupational pension schemes from RPI to CPI.
The Taxation of Pensions Act 2014 introduced new flexibility in the way benefits
from money purchase pensions schemes can be accessed, from 6 April 2015.
It remains a fact, however, that individuals will increasingly have to take
responsibility for their own retirement provision, and they will need advice to help
them through this complex area of financial services. It should also be borne in
mind that many employers are closing their pension schemes to new employees
as the performance of their pension funds fails to meet the projected values.

Tax planning
7.5 Estate planning

When someone dies the value of their estate (their assets less their liabilities at
the time of their death) is taxable if it totals over a certain amount. The largest
component of most people’s wealth is the property in which they live. It is not
possible to avoid inheritance tax (IHT) by giving the property away while continuing
to live in it, as this would be caught by the HM Revenue & Customs’ ‘gift with
reservation’ rule, which specifies that if the donor retains any benefit from a gifted
asset, the asset is treated for tax purposes as remaining in the donor’s estate.
Customers with an estate that is likely to exceed the IHT nil-rate threshold should
consider how this tax will be paid in the event of their death.
There are basically two approaches that people can take to minimise the impact of
IHT: one is to try to avoid having to pay it and the other is to make provision for
paying it when it is due.
To avoid paying IHT, it is necessary to reduce the value of the estate to below the
nil-rate threshold. This can be done by making use of various exemptions to make
tax-free, or potentially exempt, gifts during one’s lifetime. Another method is to
place assets in trust, since trust property no longer forms part of the deceased’s
estate. Life policies can be bought specifically for the purpose of paying IHT and
placed in trust to meet the tax liability.
This is usually a specialist area and customers should consider this along with
making wills. Making a will is important as it directs how their assets will be
distributed. Dying ‘intestate’ (without having made provision) means that assets
are distributed in accordance with state guidelines, which may not be according to
the owner’s wishes. These issues are covered in section 20.6.
7.6 Tax planning

The recommendation of a financial product should always take account of the
product’s impact on the client’s tax situation, but not in isolation: it should be
considered in context, in conjunction with other features of the product. For
instance, contributions to a pension arrangement are often the most tax-efficient
way for an individual to invest, but this should never be the main reason for
recommending a pension product.
Financial advisers and planners should normally avoid becoming involved in
complex tax planning schemes, which should be left to taxation experts. On the
other hand, it is important to be able to choose appropriate products that can
complement and improve a client’s current tax situation. There are three main
taxes to be aware of: income tax, capital gains tax and inheritance tax. We will
look at each of these taxes in Topic 10.
Advisers should be aware of circumstances where tax that has been paid (in effect
on behalf of the investor) cannot be reclaimed even though the investor is not
a taxpayer. An example of this would be an endowment policy or a life office
investment bond, where gains made within the life company’s funds are taxed at
20 per cent: this deduction cannot be reclaimed by a policyholder who does not
pay capital gains tax. By contrast, unit trust managers are not taxed on gains within
their funds; holders of units are liable for CGT if they sell their units at a profit but
they may be able to avoid this by use of their annual CGT exemption.
Tax is an important topic and will be discussed in more detail in Topic 10.

Review questions
1. When making recommendations to clients what are the benefits and drawbacks
of deposit accounts?
2. What is the concept of ‘risk and reward’?
3. Explain interest rate risk.

4. What considerations need to be taken into account when assessing risk?
5. What types of questions are suitable for finding out a customer’s attitude to
risk?
6. Why do people want to invest?

7. What is the ‘money illusion’?
8. What are the three main ways that pensions are provided in the UK?
9. Why should people be encouraged to make their own pension provision?
10. What are the three main taxes that advisers and planners need to be aware of?

Topic 8
Overview of financial services
products
Learning objectives
u summarise the main options for savings and deposits;
u explain the purpose of financial protection;
u explain the purpose of mortgages and other loans;
u summarise direct investment;
u explain collective investments;
u summarise retirement funding options.
8.1 Introduction
Having considered the main priorities of consumers in terms of their financial
goals, needs and objectives, we are now going to take an overview of how these
can be served by the retail financial services industry. The product areas that relate
to financial advice and planning will be covered in more detail in later topics, but
at this point it is useful to understand the full range of products at a high level.
This enables them to be seen in the context of other factors that affect consumers
such as economic conditions (Topic 9) and taxation and state benefits systems
(Topic 10).
8.2 Savings and deposits

Deposit-based savings accounts are those in which the capital element is fixed but
the income may vary.
Investors place money in savings accounts for a number of reasons. Some consider
their capital to be secure. In one respect this is true − ie the amount of capital
invested remains intact − but inflation reduces the value of capital and, in times
of high inflation, the value of deposits can quickly be eroded in real terms.
There is also the risk of loss of capital if the institution becomes insolvent. This
is rare with banks and building societies, but is not unknown. In the event of
insolvency, investors may be able to reclaim some of their funds through the
Financial Services Compensation Scheme.

8: Overview of financial services products
The convenience of the ready accessibility of banks and building societies is a

strong reason for investors to deposit money with them; it is believed that, to
some extent, inertia inhibits investors from searching for a more rewarding home
for their deposits.
If the reason for saving money is for a short-term purpose (next year’s holiday or
a new car, perhaps) then few would argue that a deposit-based savings account is
a sensible place in which to invest the money. It is prudent to have a part of an
investment portfolio that is easily accessible in, for example, a no-notice deposit
account; this is often referred to as money put by for a ‘rainy day’ or an emergency
fund. Most investors maintain a part of their funds in readily accessible form. Cash
can be placed in notice accounts (the length of time funds are tied up can vary) in
which savers forgo immediate access for a higher rate of interest.
In general, three types of interest-bearing account are offered by financial services
providers:
u deposit accounts;
u money market deposit accounts, for large amounts often in excess of £50,000,
and often with notice required;
u interest-bearing current accounts, although the interest rates offered tend to
be very low.
There are also other ways of saving cash.
u Individual savings accounts (ISAs) − these are tax-free savings accounts

that allow deposits up to a certain limit each year.
u National Savings and Investments products − a range of savings and
investments backed by HM Treasury, some of which have tax advantages. There
are more details on NS&I products in section 13.3.6.
8.3 Financial protection

Although protection policies cannot alleviate the sadness and upset associated
with death or illness, adequate provision can help reduce some of the financial
burden, by providing funds to meet practical needs in one or more of the following
ways:
u replacing earned income;
u repaying debts;
u meeting additional living expenses (eg adapting a property, paying for
childcare);
u ensuring existing plans can be completed;
u providing specific medical treatment or care;
u enabling inheritance tax liabilities to be met without having to sell property.

When advising on these types of product, advisers have to take into account the
range of state benefits available to customers (see Topic 11) and any employers’
benefits that may be available.

Financial protection
When people do make provision against the financial difficulties caused by death
or sickness, they often refer to three main factors that influence their decision to
do so.
u Peace of mind − security and peace of mind come from knowing that in the
event of premature death or long-term inability to work, their dependants will
not face financial hardship.
u Control − death or long-term incapacity can often mean having to rely on state
benefits, family generosity or charity. Adequate protection means control over
the availability of funds that enable the family to make their own choices.
u Value for money − protection policies can provide a way to ensure the
payment of very large amounts of money to safeguard the family’s future. The
amounts are generally much greater than could be amassed by saving and yet
the cost of the cover (ie the premium payments) is relatively small, especially if
the policy is started at a young age.
8.3.1 The main types of protection plan

One of the features of the various protection plans that are available is that their
names tend to give a fairly good description of what each policy sets out to provide.
The following is intended as a summary of the main types of protection plan.
8.3.1.1 Protection in the event of death

u Whole-of-life policies do exactly as their name suggests − provide a lump
sum of money, upon death, whenever that death occurs.
u Term assurances, again, do as the name suggests. If a death occurs during

the specified term of the plan, a sum of money agreed at the start of the plan
will be paid out. This is usually a lump sum, but one version of term assurance,
called a family income benefit, will pay out an income upon death during the
term.
There is also a range of different types of endowment policy that provide protection
benefits combined with an investment element. The protection need not be
confined to life cover: critical illness cover may also be available depending on
the terms of the contract.
8.3.1.2 Protection in the event of accident or illness

u Critical illness cover provides a lump sum in the event of diagnosis of one
of a range of defined serious conditions, or if the insured suffers a serious and
permanent disability.
u Income protection insurance (historically referred to as permanent health
insurance (PHI)), is designed to replace earned income if the insured suffers
an illness or accident. It can also be used to offset the financial consequences
of illness or accident for non-workers.
u Personal accident, sickness and unemployment insurance (ASU) is
designed to provide a scale of income and / or lump sum benefits should the
insured suffer an accident or become unemployed. In the event of a claim as a

result of an accident or illness, the amount paid out will depend on the severity
of the effects of the illness / accident.
u Mortgage payment protection insurance is also designed to provide an
income in the event that a person cannot carry out their job due to illness. The
amount of benefit may be linked to the level of monthly mortgage repayments,
although it is sometimes possible to build in extra cover to meet some
household bills.
u Payment protection insurance is designed to provide income in the event
of accident, illness or redundancy. It covers loan repayments and is often sold
alongside personal borrowing.
8.3.1.3 Providing for the costs of care / medical treatment

u Long-term care insurance is designed to help with the costs associated with
the provision of medical or nursing care for the elderly who may no longer be
able to look after themselves fully.
u Private medical expenses insurance is designed to enable people with the
financial means to seek medical treatment from outside the National Health
Service.
8.4 Lending products

Most large purchases, such as houses, cars and holidays, are now made with the
aid of borrowed money, and the success of most Western economies is based
on credit. Financial services providers have not been slow to develop products to
satisfy the wide-ranging needs of borrowers.
8.4.1 Mortgages
Since a mortgage is usually a large, and long-term, transaction the consequences
of selecting an unsuitable product can be very serious. It is therefore particularly
important for an adviser to choose wisely and to suit the products chosen to the
client’s needs.
u Choosing the wrong lender or the wrong interest scheme can lead to the client
paying more than is necessary for the loan.
u Choosing the wrong investment product to repay an interest-only mortgage can

lead, at worst, to the mortgage not being repaid in full at the end of the term.
At best, it will mean that the client misses out on possible surplus funds.
u Failing to protect the outstanding capital or the repayments against sickness,
death or redundancy, can leave a client’s family destitute or result in them
having to leave their home.
A house purchase loan is usually known as a mortgage because the borrower

mortgages the property, in other words creates a legal charge over the title deeds
to the lender as security for the loan. This gives the lender certain rights over the
property in the event of the borrower defaulting on repayment.

Lending products
The parties involved in a mortgage are:

u the mortgagor: the individual borrower who transfers their property to the
lender for the duration of the loan;
u the mortgagee: the lender (bank, building society or other institution) that has
an interest in the property for the duration of the loan.
8.4.1.1 Capital and interest (repayment) mortgages

With a capital and interest repayment mortgage (also known simply as a repayment
mortgage), the borrower makes monthly repayments to the lender and each
monthly amount consists partly of interest and partly of capital repayment: the
higher the interest rate (for any given mortgage amount and term), the higher the
monthly repayment.
The repayment is calculated in such a way that, provided interest rates do not
change, it will remain the same throughout the term of the mortgage. If interest
rates do go up or down, the repayment is increased or decreased, or alternatively
the mortgage term could be extended or shortened to keep repayments at the
same amount.
As the repayment remains unchanged (ignoring fluctuations in the interest rate),
the relative proportions of capital and interest change throughout the term: for
example, at the beginning, when very little capital is repaid, the repayment is
mainly interest; then, as more capital is repaid, the interest proportion of the
repayment shrinks. The result is that the amount of capital outstanding decreases
by smaller amounts each month at the start compared with towards the end of the
term.
Two important factors that should be noted are the following.

u The mortgage will be repaid at the end of the term, provided that changes in
interest rates have been allowed for and that all repayments have been made
when due.
u If the borrower, or the breadwinner in the borrower’s family, dies before the
end of the mortgage term, the repayments will have to be continued or the
outstanding loan repaid. A separate life assurance policy is advisable to cover
this possibility.
8.4.1.2 Interest-only mortgages

In the case of an interest-only mortgage loan, the monthly payments made to the
lender are solely to pay interest on the loan. No capital repayments are made to the
lender during the term of the loan and the capital amount outstanding therefore
does not reduce at all.
The borrower still has the responsibility of repaying the amount borrowed at the
end of the term, and this is normally achieved through the borrower making regular
payments to an appropriate savings scheme, although the loan might be repaid out
of other resources, eg from the proceeds of a legacy. The main schemes that have
generally been used for this purpose are individual savings accounts (ISAs) and
personal pension or stakeholder pension plans. Endowment policies used to be
popular, but are now less common after many policies failed to provide sufficient
sums to repay capital amounts outstanding.

Borrowers should be made aware of the risks involved in taking out an interest-only
mortgage, in particular that repayment of the mortgage is dependent on the
performance of an investment plan achieving a predetermined rate of return. If
this is not achieved, then the borrower will be left with a shortfall: the value of the
policy or plan will be lower than that of the total debt.
Following changes to the FCA’s MCOB rules from April 2014, interest-only
mortgages can now only be arranged in limited predetermined circumstances,
including where the borrower has investments that provide a pre-determined level
of benefit. In the run up to the changes, and in the period following the changes,
most mainstream lenders withdrew from the interest-only mortgage market and
offered mortgages only on a repayment basis. More recently, lenders have begun
to offer interest-only mortgages again.
Mortgage loans and associated products are considered further in Topic 16.
8.4.2 Other secured private lending

With all secured loans, the borrower offers something of value as security for the
loan so that, in the event of default, the lender can take and sell that asset (this is
called ‘realising the security’) and be repaid out of the proceeds.
When property values increase significantly, as they did during the 1990s and the
early years of the twenty-first century, it was common for people to borrow against
the increased ‘equity’ in their property (ie the excess of the property value over the
amount owing on the mortgage loan). They then used the loan to fund purchases
not related to the house purchase but which aimed to improve their lifestyle in
other ways.
This may be done by way of a further loan from the existing mortgage lender (a
further advance), a second mortgage from a different lender or by remortgaging
for a larger amount.
Secured lending on ‘bricks and mortar’ does not have to be directly, or even
indirectly, related to house purchase or improvement.
8.4.2.1 Second mortgages

A second mortgage is one that is created when the borrower offers the property
for a second time as security while the first lender still has a mortgage secured on
the property. The new lender takes a ‘second legal charge’ on the property. The
original lender’s first charge takes precedence over this second mortgage and any
subsequent charges. This means that, in the event of a sale due to default, the
original lender’s claim will be met first in full (if possible) and, if sufficient surplus
then remains, the second mortgagee’s charge will be met.
Lenders will, of course, only offer a second mortgage if there is sufficient equity in
the property and, since second mortgages represent a higher risk to lenders, they
are likely to be offered at higher rates of interest than first mortgages.

Lending products
8.4.2.2 Equity release schemes for the elderly

Elderly clients who do not wish to move house but have a large amount of equity
in their property can release some of this value to use for other purposes, often
to supplement income in retirement. There are two ways of doing this: through
a lifetime mortgage or a home reversion scheme. These schemes are explained
more fully in section 16.4.
8.4.2.3 Bridging loans

A bridging loan is taken out to fund a short-term need, with one of the commonest
uses being to finance the purchase of a new home before the old one is sold. The
name can be used to refer to any loan that is intended to be prepaid from the
proceeds of another asset that is yet to be sold. A bridging loan could also be
repaid from the maturity proceeds of an investment that is due to mature soon.
Bridging loans for house purchases are often used when a borrower cannot sell
their old property quickly and has an existing mortgage loan on it, but needs
to move quickly, perhaps to another area of the country for work reasons. The
disadvantage is that if the old property fails to sell promptly they will have to
continue servicing a debt until it does. This is made more expensive because
lenders see such loans as riskier because of the borrower’s high indebtedness.
They are likely to levy premium interest rates to compensate for this additional
risk.
Lenders tend to prefer ‘closed’ bridging loans where contracts for the sale of the
old property have been exchanged. This gives the lender more certainty that the
sale will proceed. Many lenders do not offer funds for ‘open’ bridging loans where
no contracts have been exchanged, as there is no certainty that the sale will take
place.
Bridging loans are regulated by the FCA under its Mortgage Conduct of Business
(MCOB) rules. Assessing affordability is a particularly important consideration.
8.4.3 Unsecured loans

In contrast to secured loans, an unsecured loan relies on the personal promise,
or ‘covenant’, of the borrower to repay. Unsecured loans are, therefore, generally
higher risk than secured lending, with the consequence that they are subject to
higher rates of interest and are normally available only for much shorter terms. For
example, while a mortgage secured on a property will be available for 25 years or
even longer, a personal loan is rarely offered over much more than six or seven
years.
Unsecured personal lending takes a number of forms and is regulated by the
FCA under provisions detailed in its Consumer Credit (CONC) sourcebook. The
provisions in CONC are based on the Consumer Credit Acts of 1974 and 2006. The
most common types of unsecured borrowing are described below.
8.4.3.1 Personal loans

These are offered by banks, building societies and by some finance houses, and
we know them as ‘in-store’ finance. They are normally for a term of one to five
years; the interest rate is generally fixed at the outset and remains unchanged
throughout the term. Many of the larger lenders operate a centralised assessment

of loan applications through telephone call centres, using a form of credit scoring
to assess the suitability of the borrower.
The loan can be used for any purpose by the customer: typically it might be used
to purchase a car, fund a holiday, or consolidate an existing higher-cost borrowing
such as a credit card balance.
8.4.3.2 Overdrafts
An overdraft is a current account facility, offered by all retail banks and some
building societies, which enables a customer to continue to use the account in
the normal way even though their own funds have been exhausted. The bank sets
a limit to the amount by which the account can be overdrawn. An overdraft is
a convenient form of short-term temporary borrowing, with interest calculated
on a daily basis, and its purpose is to assist the customer over a period in
which expenditure exceeds income − for instance, to pay an unexpectedly large
household bill or to fund the purchase of Christmas gifts.
As it is essentially a short-term facility, the agreement is usually for a fixed period,
after which it must be renegotiated or the funds repaid. Overdrafts that have been
agreed in advance with the provider are normally a relatively inexpensive form of
borrowing, although there may be an arrangement fee. Unauthorised overdrafts,
on the other hand, attract a much higher rate of interest.
8.4.3.3 Revolving credit

Revolving credit refers to arrangements where the customer can continue to borrow
further amounts while still repaying existing debt. There is usually a maximum limit
on the amount that can be outstanding, and also a minimum amount to be repaid
on a regular basis.
The most common way of providing revolving credit is through credit cards,
although some providers offer revolving personal loans that allow the borrower
to draw down funds as the original debt is repaid.
It is hard to believe that plastic cards, now an integral part of most people’s
financial affairs, have only been around for the last 40 years. Their development
and their impact have gone hand-in-hand with the rapid advance of the electronic
processing technologies on which their systems now largely depend. Many cards
can now hold a wealth of information about cardholders and their accounts, and
can therefore interact directly with retailers’ and banks’ electronic equipment:
these cards are often referred to as smart cards.
8.5 Direct investments

Direct investments are those where the customer personally can keep control over
where the funds are invested. The customer has to use their own judgment to
decide on the suitability of the investment and must also bear the transaction
costs of obtaining and disposing of the investment. They effectively are solely
responsible for whatever risk the investment poses. The customer has three
main options: fixed-interest securities, equities and other company finance, and
property.

Direct investments
8.5.1 Fixed-interest securities

u Government stocks (gilt-edged securities, commonly known as gilts) are UK
government securities and represent borrowing by the government. Gilts are
considered safe investments because the government will not default on interest
or capital repayments.
u Local authority stocks − local authorities can borrow money by issuing stocks
or bonds, which are fixed-term, fixed-interest securities. They are secured on
local authority assets and offer a guaranteed rate of interest, paid half-yearly.
u Permanent interest-bearing shares (PIBS) are issued by building societies

to raise capital.
u Corporate bonds are similar in nature to gilt-edged stocks, but they represent
loans to commercial organisations rather than to the government and therefore
are not considered as safe for investors.
8.5.2 Equities and other company finance

When companies need to raise money in order to commence or to expand their
business, there are various ways in which this can be done.
u Ordinary shares, also known as ‘equities’, are the most important type of
security that UK companies issue. They can be, and are, bought by private
investors, but most transactions in equities are made by institutions and by life
and pension funds.
u Loan stocks and debentures are also issued by companies to raise finance.
These types of borrowing are usually over the longer term, which helps the
company to make long-term business plans.
8.5.3 Property
Customers can invest in property (real estate) and, in broad terms, investment in
real estate falls into three categories:
u residential property;
u agricultural property;
u commercial and industrial property.
The vast majority of investors will only ever be involved in residential property. For
most people this does not extend beyond the purchase of their own home, although
an increasing number of people are buying residential properties specifically as an
investment. The significant fall in property values in 2008 was a timely reminder
that property can prove to be a risky investment in the short term.

8.6 Collective investments

Where investors choose to invest in the stock market by pooling their money with
that of other investors in one or more funds it is termed collective investment.
This helps to spread risk and costs, and uses the expertise of professional fund
managers. It is a form of indirect investment.
Individual small investors can contribute, by means of lump sums or regular
savings, to a large investment fund. Pooled investments offer a number of
advantages to individual investors.
u The services of a skilled investment manager are obtained at a cost that is
shared among the investors. Individual investors do not need to research
particular companies, nor do they need to understand and deal with occurrences
such as rights issues (the ‘right’ for existing shareholders to buy shares at a
preferential price).
u Investment risk can be reduced because the investment manager spreads the
fund by investing in a large number of different companies, so that if one
company fails, the whole investment is not compromised. Such a spread could
not normally be achieved with small investment amounts.
u Fund managers handling investments of millions of pounds can negotiate

reduced dealing costs for their investors.
u There is a wide choice of investment funds, catering for all investment
strategies, preferences and risk profiles.
Investment funds can be categorised in a number of ways − for example:
u by location, eg UK, Europe, America, Far East;
u by industry, eg technology, energy;

u by type of investment, eg shares, gilts, fixed-interest, property;
u by other forms of specialisation, eg recovery stocks, ethical investments.

Many funds are based on more than one categorisation − eg a UK equity fund.
Most companies also offer one or more managed funds. This is an unfortunate
choice of name, since it seems to imply that other funds are not managed.
Nevertheless, the name has become accepted as applying to the type of fund
where its managers sometimes invest appropriate proportions in a range of the
company’s other funds to meet the managed fund’s objectives. Most managed
funds are ‘middle-of-the-road’ in terms of risk profile, and are often chosen by
people seeking steady, market-related growth in situations where risk of loss needs
to be kept to a minimum, such as pension provision or mortgage repayment.
A further categorisation is possible: into funds that aim to produce a high level of
income (perhaps with modest capital growth); those that aim for capital growth at
the expense of income; and those that seek a balance between growth and income.
The main forms of collective investment are:

u unit trusts;
u investment trusts;

Pension products
u investment bonds; and

u open-ended investment companies (OEICs).
Although they may appear broadly similar to the unsophisticated investor, they are
in fact very different, both in the way they operate and in the taxation treatment
of both the fund managers and the investors. We will consider these products in
more detail in later topics.
8.7 Pension products

Individuals who have made sufficient National Insurance contributions will be
entitled to a state pension. The previous system of a basic state pension and
additional state pension has been replaced by a ‘single-tier’ state pension for those
who retire after 6 April 2016. Those who retired before this date continue to receive
their state pension benefits based on the previous system. However, state pensions
are set at a fairly low level and most people would prefer a higher level of income
in retirement than the state provides.
People who are employees may also be members of an occupational scheme,
although not all employers offer occupational pensions. Occupational schemes
fall into two types according to their underlying benefit structure.
u Defined-benefit (final salary) − the employee will receive a pension that
is calculated using a set formula. A defined-benefit scheme accrues pension
benefits at an agreed rate for each year the employee is a member, for example
at a rate of 1/60th. At retirement the percentage of final salary (the salary
at or near retirement) that has been accrued is paid as pension. The longer
the employee has been a member of the scheme, the higher the percentage;
if someone had been a member of a scheme with a 1/80th accrual rate for
40 years they would have built pension rights equivalent to 50 per cent of final
salary.
u Money-purchase (defined-contribution) − an agreed contribution is
invested for each member. On retirement, the accumulated fund is used to
purchase benefits. The level of benefits is not guaranteed by the employer and
depends on the size of the fund which, in turn, depends on how much has been
paid in and the investment growth achieved.
As people are now living longer in retirement, employers are finding
defined-benefit schemes prohibitively expensive to run. As a result, many have
reduced their commitment and transferred responsibility to individuals by closing
defined-benefit schemes and switching provisions to a money-purchase basis.
Many individuals may therefore wish to supplement retirement income by
contributing to private arrangements. The following are tax-efficient pension
arrangements:
u additional voluntary contributions (AVCs);
u free-standing additional voluntary contributions (FSAVCs);
u personal / stakeholder pension plans (PPP / SHPs);
u self-invested personal pensions (SIPPs).
AVCs and FSAVCs are available to employees who are members of occupational
schemes. Personal / stakeholder pensions are generally available to anyone under

the age of 75. Some AVCs are final salary arrangements, although most are
money purchase. All FSAVCs, PPP / SHPs are money-purchase schemes. SIPPs allow
investment in a broader range of investments that are not permitted in normal
personal pensions; however, they are primarily for people with more complicated
arrangements and larger pension funds.
Pension funds do not pay capital gains tax, pay no income tax on savings income
and no income tax on dividend income.
Any individual who is a UK resident and under the age of 75 can receive income
tax relief at their highest marginal rate on annual contributions to occupational
and private pension schemes up to a maximum of the higher of:
u 100 per cent of UK earnings (to a maximum amount of £40,000 for 2016/17,
the annual allowance); or
u £3,600 (this includes where the individual does not have earned income).
If the combined total of employer and employee contributions in a year exceeds

this figure, tax will be charged on the excess.
Benefits can (normally) be taken from the schemes from age 55 onwards and
25 per cent of the fund can be taken as a tax-free cash lump sum, while the
remainder must be used to provide taxable benefits. Beyond the tax-free lump
sum, benefits from a defined-benefit pension will be in the form of an income.
Money-purchase schemes can offer more flexibility and it may be possible to take
benefits as further (taxable) lump sums and / or income.
A defined-benefit pension scheme will generally provide income via a scheme

pension, paid direct from the pension fund. A money-purchase pension may also
offer a scheme pension and the member will also have the option of taking the fund
and purchasing an annuity, which involves payment of a lump sum in exchange for
an income. It is not essential to buy the annuity from the company that supplied
the pension plan. An individual can ‘shop around’ to see if higher annuity rates are
available from other providers. This facility is known as an open-market option
and the investment of the pension funds’ benefits to provide an income is known
as ‘vesting’.
As an alternative to purchasing an annuity, an individual with a money-purchase
pension may, subject to their pension provider giving the option, be able to make
regular withdrawals of capital from the fund, which is referred to as drawdown
or pension fund withdrawal. This allows an income and / or lump sums to be
drawn whilst leaving part of the pension fund invested, with the potential benefit
of further investment growth.

Review questions
Review questions
1. What are the main reasons why investors deposit money with banks and
building societies rather than other forms of investment?
2. What are the three factors that influence people to make provision for financial
protection?
3. Explain the two types of family protection plan that provide benefits in the
event of the death of a policyholder.
4. What is the purpose of critical illness cover?
5. Who are the parties to a mortgage loan?
6. Explain the difference between a repayment mortgage and an interest-only
mortgage.
7. What is a second mortgage?
8. What types of unsecured borrowing are available to consumers from banks
and building societies?
9. How can consumers invest directly in companies?
10. What are the benefits of a ‘collective investment’ to a consumer?

11. Explain the two types of occupational pension scheme.
12. What is a SIPP?

Topic 9
Economic factors
Learning objectives
After studying the topic you should be able to:
u explain inflation, deflation and disinflation;
u explain the difference and impact on consumer arrangements of fixed and
variable interest rates;
u summarise the impact of socio-economic factors;
u identify key economic indicators.
9.1 Introduction
This topic is about understanding the impact of various economic factors on
consumers and their financial well-being.
The first of these is inflation: we will consider the effects of inflation on individuals
and their financial circumstances.
We will then go on to look at the impact of interest rate movements on borrowers
and savers. Any movement in interest rates will affect these two groups in different
ways, depending on whether they have fixed or variable interest-rate arrangements
and the direction in which rates are moving.
Socio-economic factors can affect financial markets in a variety of ways, and global
events can influence the domestic outlook. We will touch on the main factors at
play here, together with a brief look at international relations that have affected
world stock markets and economies in recent times.
The final part of this topic focuses on key economic indicators for the UK and why
some of these are important in assessing the health of the economy. You should
aim to keep up to date with these matters from your own reading so that you are
able to have an understanding of them when talking with clients.
9.2 Inflation
Inflation is the term used for general increases in the price of goods and services
over a period. If an article were to cost £100 today and £101.50 in a year’s time,
it would have been subject to inflation of 1.5 per cent over the year.

9: Economic factors
When talking about investment, inflation is often described as a reduction in the

buying power of money. For example, if inflation were to run at 2 per cent over a
year, an item costing £100 at the start of the year would cost £102 by the end of
the year. This means that the original £100 would have been reduced to just over
98 per cent of its original buying power. Where this is repeated over a number of
years, buying power is dramatically reduced. In this situation, the investor would
aim to achieve a rate of growth that exceeds the rate of inflation in order to protect
the ‘value’ of their money.
A moderate rate of inflation, perhaps of between 2 per cent and 3 per cent, is seen
as desirable for a healthy economy.
u Disinflation is the term for falling inflation. It should not be confused with
deflation, because, with disinflation, prices still rise, but not at the previous
rates.
u Deflation is a sustained period of price falls below their previous levels across
an entire economy. Deflation generally runs alongside falls in output and
demand, largely because buyers are prepared to delay buying to see if prices
fall further.
9.2.1 Measuring inflation

It is important for the government to be able to keep track of inflation. There are a
number of ways in which inflation can affect the economy and so various measures
have been developed.
u Retail Prices Index (RPI) − an index based on a ‘basket of goods and services’
selected to reflect the expenditure of an average household. The rate of RPI will
increase or decrease in line with changes in the prices of the goods and services
included in the basket. The RPI is used to calculate increases in pensions,
benefits and index-linked gilts.
u RPIX (underlying rate of inflation) − the largest single factor in the basket
of goods used to calculate the RPI is mortgage payments. As a result, the RPI
will be affected by interest rate movements and may not reflect the real picture.
This is because interest rates are often used to counter future inflation, and so,
a rise in interest rates would result in higher borrowing costs, which would be
reflected in the RPI. However, the apparent rise in inflation through the RPI will
actually mark the fact that inflation is now under control. The RPIX reflects the
underlying rate of inflation and is calculated as the RPI less mortgage payments.
u Producer Price Index − this index is made up of the costs of raw materials
and the price of goods as they leave the factory. The Producer Price Index is
often regarded as an indicator of how the RPI may change in the near future
since higher production costs will feed through into higher retail prices.
u Average Weekly Earnings (AWE) − measures the rate of change of earnings.

The AWE will generally increase more quickly than the RPI because wages tend
to rise above inflation. In times of very high inflation, however, wages may not
keep up with the RPI.
u Consumer Prices Index (CPI) − this is based on the standard European

measure, the Harmonised Index of Consumer Prices (HICP), which the UK
has been using for some years, although not as a main measure. The principle
of the index is similar to the RPIX but some of the goods and services, and their

Inflation
weightings, are different. The name has been changed to the CPI to keep it in
line with other indices with which the UK public is already familiar.
9.2.2 The effect of inflation on individuals

Inflation is not good for those who have fixed incomes or fixed-rate savings paying
a return less than the rate of inflation. Pensioners and those on benefits are likely
to suffer most because their income will increase at a lower rate than those who
are working. Successive governments since the early 1980s linked increases in
pensions to the RPI rather than the growth in earnings; as a result, the relative
value of state pensions fell further and further behind wages. Since 2010, state
pensions have benefited from the ‘triple lock’ guarantee, increasing by RPI, AWE
or 2.5 per cent, whichever is the greater.
Those who save in interest-bearing savings schemes (deposit accounts) and gilts
are also at risk from inflation. The real rate of return is the term used for
the interest rate minus the rate of inflation. It shows the real ‘profit’ made on
an investment. For example, if the interest rate is 2.5 per cent and inflation is
0.5 per cent, the real rate of return is 2 per cent. This is an approximate figure,
which serves most purposes; economists will use a more complex calculation to
arrive at an exact figure.
When inflation is low, deposit-based investment is likely to produce a positive

real rate of return. In other words, the rate of interest paid will be slightly higher
than the rate of inflation, meaning that the investor will make a small gain in the
purchasing power of their investment.
When inflation is higher, interest rates will often fall behind the rate of inflation.
This leads to a negative real rate of return. This is best illustrated by looking
back to the 1970s. In December 1975, the value of a building society account
had increased by 7.2 per cent over the previous 12 months. If we adjust that figure
to allow for the RPI over the same 12-month period, the real value dropped by
14.2 per cent − a negative real rate of return. This means that the investment was
able to buy 14.2 per cent fewer goods.
Some people benefit from inflation, particularly borrowers: the effect of inflation
will reduce the real capital value of their mortgage or loan. For example, £1,000
borrowed in January 2000 was worth £796 in December 2009 in real terms, using
the RPI as a measure.
For the past few years, the UK has benefited from a sustained period of relatively
low inflation. This has led the UK regulators to reduce the assumed growth rates
for investment products − ISAs, pensions and so on. Investors should be advised
of the link between returns and inflation, and that earlier expectations might not
be realistic in a low inflation environment. Low inflation generally means lower
equity returns and lower annuity rates.
9.2.3 Controlling inflation

The Bank of England can use various measures to try to control inflation and it
has the responsibility for doing so, being tasked by the government to achieve an
inflation target of CPI at 2 per cent. It can reduce inflation by increasing interest
rates, which will reduce the amount of disposable income available to spend.
Reduced spending will lead to lower prices.

9: Economic factors
Lowering interest rates, however, can increase inflation: this will increase the
amount of disposable income and boost spending.
Using interest rates can be a crude tool because the effect will not be felt for some
months.
9.3 Interest rates

Interest is paid on deposit-based investments and charged on borrowing. The rate
paid or charged will depend on the nature of the investment or the loan. Interest
charged on borrowing is usually higher than interest paid on investments, although
both will move in the same direction as rates change.
9.3.1 Interest on borrowing

The interest charged on borrowing depends on the type of borrowing. In general,
the higher the risk to the lender, the higher the rate.
u Mortgages and loans secured on property tend to charge relatively low rates of
interest. Secured borrowing is less risky because there is an asset that can be
sold to repay the debt if necessary.
u Credit cards generally charge high rates of interest. The borrowing is not
secured, the term is open-ended and the providers must cover the cost of fraud
protection and other requirements.
Whether the loan is secured or unsecured, loans with variable interest rates will
be advantageous to the borrower when the general level of interest rates is low
(usually related to Bank base rate set by the Bank of England’s Monetary Policy
Committee). When rates are high, then the interest charged becomes higher and
more costly for borrowers to repay. Some borrowers take loans out when rates are
low only to find these loans become unaffordable when interest rates rise.
To deal with this risk some mortgage loan lenders offer fixed-interest-rate deals
whereby the borrower can fix the interest rate for an agreed time (usually two to
five years depending on market conditions). These rates will usually be higher than
variable rates and will take into account what the lender thinks long-term interest
rate movements are likely to be. It does however provide the borrower with some
stability in mortgage repayment amounts, so enabling them to budget and manage
household finances more easily.
9.3.2 Interest on savings and investments

The amount of interest paid depends on the type of investment and the degree of
risk taken by the investor.
Building society deposit accounts and bank savings accounts pay low rates of
interest, barely above inflation in most cases and sometimes below inflation. The
rate moves up or down in line with interest rates in general.
If the investor is prepared to tie their money in for an agreed period, the rate will
be better and will often be fixed. While this may provide a degree of certainty, an
increase in rates generally during the fixed period might lead to the real return
falling. This risk is reflected in the higher rate offered.

Socio-economic factors
It is also important to consider taxation. If the interest rate were 4.5 per cent, a
person who is liable to basic-rate tax on their interest would end up with a net
(after-tax) interest rate of 3.6 per cent on the portion of their interest subject to
tax. A person who is liable to higher-rate tax on their interest would end up with
an after-tax rate of 2.7 per cent on the portion of their interest subject to tax. If
the real rate of interest (after inflation) were 2.5 per cent, the real rates of return
would be 1.1 per cent and 0.2 per cent respectively.
Those with savings in UK-based building societies and banks are protected by the
Financial Services Compensation Scheme, meaning that the investor is taking a
low level of risk. Investors have to consider the risks of placing large amounts,
which are over the compensation scheme limits, with one institution. Other
interest-bearing investments may carry a higher level of risk and, as a result, offer
higher rates of interest.
For example, companies often borrow funds by issuing loan stock. Institutions and
individuals lend money to the company in return for an agreed rate of interest. The
investor is usually low on the list of creditors and may not receive their money
back if the company defaults or ceases trading. The risk is reflected in the rate of
interest paid.
9.3.3 Influences on general interest rates

A number of economic factors will influence interest rates.
u The level of government borrowing − when the government needs to raise
money for public spending, it can either raise taxes or borrow. Borrowing is
less likely to cause political problems but upward pressure is placed on interest
rates when the government increases borrowing significantly.
u Higher levels of individual borrowing − rates tend to move up when there
is high public demand for borrowing. Too much borrowing at an individual
level is a worry for governments because money floods into the economy and
prices creep up. If people borrow against the equity in their property in order
to buy cars and other consumer goods they can find themselves overstretched
if interest rates rise.
u Monetary policy − the use of interest rates and the level of money supply to
manage the economy.
u Fiscal policy − the way in which the government uses taxation and government
spending to influence economic activity.
u Foreign interest rates − the value of sterling against foreign currencies is
affected by interest rates. When UK interest rates are higher than those abroad,
the pound is popular and the exchange rate increases. This can have a negative
effect on industry, because UK goods become expensive abroad and sales may
be affected. On the positive side, new materials are cheaper to import.
9.4 Socio-economic factors

Demographic and social issues can affect investment markets. The population of
the UK is ageing, and we are all aware that pensions and healthcare for the elderly
have caused a lot of controversy in recent times. As a result, there is a need for
strong government action to control inflation: it is important to ensure, as far as

9: Economic factors
possible, that savings and pensions for the elderly are protected from losing their
real value. The end of the 1939−45 war signalled a boom in the number of babies
born. These babies, born between the mid-1940s and the 1960s, are now well into
middle age and represent a significant part of the invested wealth in the UK. In
modern Britain, the over-50s have inherited more than ever before because the
house-buying ‘revolution’ enabled their parents to leave them a legacy.
Research has shown that increased saving by those aged over 55 was a significant
factor in the increase in equity values in the late 1990s. Conversely, when
this generation enters retirement, they will be drawing on their investments to
supplement retirement. The next generation represents a smaller proportion of
the population and may not be able to maintain the investment pace, although
they are likely to inherit more than previous generations due to their parents’
increasing wealth.
One interesting consideration is that, with an ageing population, companies that
provide goods and services for the elderly are likely to benefit from increased
profits. This may lead to a shift in the relative value of some sectors of the equity
market.
Other social factors that affect both the economy and the financial markets are as
follows.
u Living standards are generally increasing and the expectations of the population
are high.
u There has been a move from manufacturing to a more service-based economy.
This has led to a reduction in the industrial sector and more cheap imports from
abroad. This, in turn, affects the balance of payments (see section 9.5.3.4).
u The attitude of government towards wealth distribution: while some
governments take steps to redistribute wealth through social policies, taxation
and benefits, markets tend to be nervous of this ‘social engineering’.
u Employment and productivity: in times of high unemployment, the state is
required to pay more in benefits, which means more money is needed for public
spending. Those in employment are likely to cut spending because they feel
vulnerable. Where the level of employment is high and productivity is good,
companies make more profit, share values rise, and employees spend more,
which increases demand.
u A relaxation in attitudes to debt has led to over-borrowing by some and potential
financial hardship. As there is less stigma attached to bankruptcy, many see this
as a possible way out of their money problems. We will look at this in more detail
in section 20.7.
9.4.1 The global perspective

In the modern world, international economies operate less in isolation than has
previously been the case: ‘When Wall Street sneezes, London catches a cold’ is a
familiar saying. The major economies are closely linked, and problems in one tend
to have an impact on others: look at the problems in the UK, the USA, and European
economies when oil prices rise; look at what happens when the US stock market
falls − the rest tend to follow.
The world is a more open and global trading platform than ever before. This has
led to similar trends in international economies, although, on occasion, one might
deviate from the rest, and there is no denying the influential position of the USA. In

Key economic indicators
many ways, the world’s largest economy sets the trend for the rest, particularly its
major trading partners. Recession or recovery in the USA leads to similar problems
in the rest of the world, as can be seen in the recent economic downturn.
The expansion of the European Union has resulted in a major economic bloc
emerging. The plan is to harmonise taxes and interest rates throughout the
EU. However, there have been concerns about the role and strength of the
euro in the aftermath of the financial crisis that developed in 2008. Several
eurozone countries have experienced difficulties and have had to be helped out of
potential bankruptcy.
International relations can also influence world stock markets and economies.
u Problems in the Middle East in the early 1990s led to reduced consumer
confidence in the USA.
u German reunification in 1990 meant internal interest rates had to be raised
to counter inflationary pressures. In view of the interlinking of European
economies, it was no surprise that the rest of Europe suffered too.
u The terrorism problems of 2001, aimed at the USA, affected the entire global
economy. The world’s markets continue to become unsettled when there is bad
news from Iraq.
The US and the UK equity markets are larger, relative to the economy, than those
of other major countries and have significant influence over how companies are
run.
Attitudes towards companies are also different from country to country. In Europe
and Asia, more emphasis is placed on the employee and on other interested parties,
while in the UK and the USA, investor returns and value tend to dominate company
thinking.
9.5 Key economic indicators

Ways of measuring inflation have been explained in section 9.2.1. There are also
other indicators that are useful when assessing the state of the economy and the
effectiveness of government policy in promoting the prosperity of the UK. The
following explain many of the terms you will read in the financial press and you
should make sure you understand these.
9.5.1 Economic growth and gross domestic product

If we add together all of the individual income earned in the UK, we arrive at the
national income: the higher the national income, the higher the potential for
spending it. When national income is high and spending increases, businesses
are likely to produce more goods and services to satisfy the demand, leading to
a healthy economy and higher living standards. This is, of course, a simplified
explanation of a complex subject, but does outline the general principle.
The growth in national income is referred to as economic growth and is a
target for governments. As you will appreciate, most UK income is generated by
economic activity in the UK, and this is known as the domestic product. The
gross domestic product (GDP) is the term used for the total of income from UK
economic activity and is a measure of growth.

9: Economic factors
9.5.2 Business cycles

As you will probably have experienced, business moves through phases of growth
and decline. In most cases, the phases follow a pattern and together are called the
‘business cycle’.
The four common phases of the business cycle are as follows.
u Recession (or decline) − consumers become cautious and spend less,

demand for goods reduces, firms cut investment for future development, stock
is reduced due to lost orders and some firms fail. Unemployment rises during
a recession. Recession is usually defined as two or more successive quarters
of falling GDP and can be described as a ‘small’ decline in the economy. When
an economy is in recession, the government will do all it can to stimulate the
economy and so avoid a depression.
u Depression − a big decline, indicated by high levels of business failure, high

unemployment and little money circulating in the economy.
u Recovery − the economy improves because people start to spend more, which
means providers start to increase production and the level of employment
improves.
u Boom − the economy is strong, people have jobs and will buy goods and
services. Suppliers try to increase prices to gain maximum profit, and inflation
is likely to rise.
Interest rates tend to follow this cyclical pattern, although they generally tend to lag
behind it. In times of boom for example, interest rates will be high, and in decline
they will tend to be low. However, the lag when the economy is booming means
that interest rates are high as the economy tips into recession, thus accentuating
the fall as it occurs.
Equity prices are very sensitive to the market view of the current state of the
business cycle, and sometimes a share will be driven down in value purely based
on perception rather than on fact. In times of recession, share prices will fall, due
to pessimism about economic prospects; if the market senses a recovery, prices
will rise.
u A bull market is the term used to describe a period when investors are
confident prices will rise and adopt a ‘bullish’ approach to the market, by buying
to hold long term.
u A bear market describes a pessimistic feeling in the market with investors
looking to sell in the short term.
9.5.3 Fiscal and monetary policy

The government’s fiscal policy concerns its approach to spending in the public
sector, borrowing and tax. Monetary policy covers the use of the money supply
and interest rates to control inflation and the economy.

9.5.3.1 Government spending

Local and national government spending is a major factor in the national economy
− think of all of the public services available and the money needed to provide
them. The government can use this spending to influence the economy: increasing
public spending will create more jobs and higher incomes, but a side effect might
be increased inflation.
9.5.3.2 Government income

In a perfect world, the government would raise all the money it needs for its
spending plans from taxation and payments received for services. Unfortunately,
this is not usually a practical approach − high taxes are politically unpopular
and can be a demotivational factor in the economy. If government spending
requirements exceed income, the alternative is to borrow to fund some of the
spending. The amount of borrowing is known as the public sector net cash
requirement. The government will not be keen to finance a significant amount of
its spending from borrowing because it will have to pay interest.
One way for the government to stimulate the economy is to cut taxes. This creates
more disposable income and increases spending − it might also increase inflation.
The tax ‘take’ will, however, reduce and more borrowing will be needed to pay for
government spending. As an alternative to borrowing, the government may reduce
public spending.
9.5.3.3 Stock market cycles

Share prices are affected by ‘fundamentals’ − company profits, the economy and
so on. Cycle theory contends that share prices also move in response to cyclical
forces over periods of time.
There are two main elements of the cycle − peak and trough. The peak is when
the price of a share is at the top and is unlikely to increase in the short term. The
trough (or bottom) is when the share reaches its lowest price. We have all heard
of the maxim ‘buy low and sell high’ − the ideal time to sell a share is at the peak,
before it starts to fall, and the ideal time to buy is when the share has just started
to move back up from its trough.
Cycle theorists believe they are able to predict peaks and troughs over defined
time periods − typically 39 and 78 weeks. Armed with this information, investors
can buy or sell at the supposed optimum point in the cycle.
9.5.3.4 The balance of payments

The balance of payments is the record of one country’s trade with the rest of the
world; in the case of the UK, it is calculated in sterling. Money coming in to the
country is known as a credit and money going out is known as a debit.
The current account records trade in goods and services. Goods are known as
visible trade and services as invisible trade. The balance on the current account
is simply the credits minus the debits. Where the credits exceed the debits, the
account is in surplus; where the balance is negative, the account is in deficit.

9: Economic factors
A deficit can be corrected by discouraging imports and encouraging exports,

through:
u borrowing foreign currency;
u increasing interest rates to encourage overseas investment;

u imposing tariffs and import quotas;
u imposing exchange controls.

The capital account works on the same principle, but this time looks at capital
transfers − the inflow and outflow of capital. This will include investment, grants,
borrowing and so on.
9.5.3.5 Foreign exchange rates

Most countries have their own individual currency: for example, the UK uses
sterling (£), the EU states within the eurozone use the euro (¤) and the USA uses the
US dollar ($). Individuals and companies within each country (or group of countries,
in the case of the euro) use the domestic currency within that country’s boundaries.
When transactions take place between individuals and companies from different
currency areas, purchasers and investors need to obtain the appropriate foreign
currency. For instance, if a UK company buys components from a French supplier,
the UK company wants to pay in sterling but the French supplier wants to receive
payment in euros. So the UK purchaser needs to exchange sterling for euros and
this is done on the foreign exchange market.
The foreign exchange market is an international market where currencies are

exchanged. The main participants in the market are banks, central banks and other
financial institutions, which need to transfer one currency into another either for
their own account or on behalf of their customers. The market is not situated in
one place but is the result of all buying and selling transactions originating from
bank dealing rooms all over the world. Technology has made it possible for foreign
exchange to take place on a 24-hour basis. Millions of individual transactions are
thus taking place every hour and the changing price of one currency in terms of
another reflects all the amounts demanded and supplied.
The two main reasons why individuals or companies need to exchange currency are
international trade and investment. As regards trade, there is a huge international
trade in both goods and services.
u Goods: companies in different countries purchase raw materials, components
and finished goods from each other. For example, the UK imports cars from
Japan and Germany and exports Scotch whisky all over the world.
u Services: companies buy financial services from banks and insurance
companies in other countries and deliver their goods overseas using
foreign-owned transport; individuals go to other countries for the purposes
of tourism or education.
Movements in exchange rates will affect buyers and sellers: depending on which
way the rates move this can be to the benefit or detriment of both parties to the
transaction. Imagine that sterling is high against other currencies. This will make
it expensive for UK products and services to be bought by overseas buyers, which
will affect the balance of payments (section 9.5.3.4). If sterling falls against other
currencies, then UK products and services become cheaper compared with those
abroad and exports rise, so improving the balance of payments.

9.5.3.6 The money supply

The money supply is simply the amount of money in circulation in the economy
and is a feature of monetary policy. Many economics theorists claim that growth
in the money supply ahead of the country’s potential output will lead to increased
prices and, therefore, inflation.
There are two main measures of UK money supply.
u M0 − known as ‘narrow money’, which measures the cash base in the UK. It
comprises notes and coins in circulation and the operational balances of banks
held at the Bank of England. Some 99 per cent of M0 is held in notes and coins.
u M4 − known as ‘broad money’, which measures bank and building society

deposits, and new money created by loans and overdrafts.
In March 2009 the Monetary Policy Committee (MPC) announced it would start to
inject money directly into the economy in order to raise inflation to its target of
2 per cent. It was unable to reduce Bank Rate any further from 0.5 per cent. The
emphasis shifted towards the quantity of money provided rather than its price
(Bank Rate). Influencing the quantity of money directly is essentially a different
means of reaching the same end.
The MPC decided it needed to provide further stimulus to support demand in

the wider economy. If spending on goods and services is too low, inflation will
fall below target. The supply of money is boosted by purchasing assets such as
government and corporate bonds − a policy often known as quantitative easing
(QE). The Bank of England supplies extra money directly, which does not involve
printing more banknotes. Instead the Bank buys these assets by creating money
electronically and crediting the accounts of the companies it bought the assets
from. This extra money supports more spending in the economy to bring future
inflation back to the target. Further QE was undertaken in October 2011, February
2012 and July 2012 in an attempt to stimulate the economy again. In total £375bn
of new money was injected into the UK economy through the process of QE; no
new quantitative easing has been undertaken in the UK since 2012.
9.5.3.7 Taxation
Taxation is the government’s main source of income, but the amount by which
taxes can be increased is a political issue and may limit the options available.
Reducing taxes can stimulate the economy by increasing the amount of disposable
income.
Taxes can also be used to redistribute the money in the economy. Increasing the
higher income tax rate or reducing the point at which higher-rate tax is paid can
reduce the taxation burden for the majority of taxpayers. Whether this is a desirable
or acceptable approach is largely a matter of political ideology. We will consider
taxation in more detail in Topic 10.
9.5.3.8 Unemployment
Unemployment measures relate to all people aged 16 and over who can
be classified into one of three states: in employment; unemployed; or
economically inactive. The figures are collected by the Office for National Statistics
(www.statistics.gov.uk) and provide an insight into the state of the economy. The
statistics cover people’s participation in the labour force, working patterns and

9: Economic factors
the types of work they do. The statistics also show any earnings and benefits they
receive and are available on a quarterly basis.
9.5.3.9 The credit crunch and global downturn

By the early part of 2009 the UK was well and truly suffering from the effects of the
credit crunch and the so-called global economic crisis. The government’s approach
was to stimulate the economy through a combination of factors:
u reducing interest rates to encourage spending and to reduce the cost of
borrowing;
u increasing public spending to increase jobs;

u reducing taxation;
u increasing the money supply.

Before the success of these policies could be fully assessed, the 2010 general
election took place; the new government took a markedly different approach to
public spending. Public spending was kept under much tighter control with a focus
on reducing the budget deficit − the gap between the money the government raises
and that which it is spends − over a number of years.
Review questions
1. What is ‘disinflation’?
2. What is RPI?
3. Which types of investor are at risk from inflation?
4. Why are interest rates on mortgage loans less than on credit card borrowings?
5. What tends to influence interest rates?
6. Which main socio-economic factor affects pensions and the rising costs of
healthcare in the UK?
7. How is economic growth measured?
8. What tends to follow the business cycle?

9. Explain the difference between fiscal and monetary policy.
10. What is the ‘balance of payments’?

Topic 10
UK taxation and state benefits
Learning objectives
u explain income tax;
u explain capital gains tax;
u explain inheritance tax;
u summarise other personal and business taxes.
10.1 Introduction
This topic will enable you to understand taxation and the state benefits system
and how they affect personal financial arrangements. We will focus on three of the
main taxes in the UK: income tax, which is applied to most forms of income; capital
gains tax, charged on gains or profits from the disposal of assets; and inheritance
tax, which applies to the value of a person’s estate on death. From an adviser’s
and planner’s perspective it is important to understand taxation of income whether
this is from earned income, investment income or from state benefits.
Governments use taxation not only for the basic process of raising revenue but
also as a means of controlling the money supply (see section 9.5.3). This topic will
give an overview of the main UK taxes, together with some detail, but it is not
intended to equip its readers to give professional taxation advice.
Each year, following delivery of the Chancellor’s Budget Statement, a Finance Bill
is published containing the taxation proposals made. When the Bill is approved by
Parliament and receives royal assent it is passed into law as a Finance Act. The new
tax measures take effect at dates provided in the legislation, which can sometimes
be several years in the future.
The new Act becomes a part of the substantial body of legislation that forms the
basis of the rules relating to income tax and other taxes.
Changes in taxation affect the market for financial services and products in two
main ways.
u Increased general taxation reduces the amount of money available for
investment or to repay borrowing.
u The taxation regime can be used to encourage or discourage the demand for
financial products by making them more or less attractive. An example of the

10: UK taxation and state benefits
government encouraging people to save is through the tax advantages attached

to individual savings accounts (ISAs) and pensions.
When considering taxation of investments, this can be examined at three different
stages:
u When contributions are made, is there tax relief on contributions?
u While money is invested, how is the investment fund taxed on income received
and gains made?
u When the proceeds of the investment are taken, are proceeds liable to income
tax, capital gains tax or both?
Whether or not an individual is liable to pay income tax or capital gains tax will
depend on their residence, in particular, whether they are UK resident. Liability to
inheritance tax will depend on an individual’s domicile.
u Residence mainly affects income tax and capital gains tax. Any person who
is present in the UK for at least 183 days in a given tax year is regarded as
automatically UK resident for tax purposes. A person who is in the UK for fewer
than 16 days in a tax year is regarded as automatically not resident in the
UK. Between these two extremes HMRC applies a series of tests to understand
whether someone has ‘sufficient ties’ to the UK to deem them as resident for a
particular tax year.
u Domicile is best described as the country that an individual treats as their
home, even if they were to live for a time in another country. Everyone acquires
a domicile of origin at birth. This is the domicile of their father on the date
of their birth (or the domicile of the mother if the parents are not married).
A person can change to a different domicile (known as domicile of choice) by
going to live in a different country, intending to stay there permanently and
showing that intent by generally ‘putting down roots’ in the new country and
severing connections with the former country. There is no specific process for
this.
Domicile mainly affects liability to inheritance tax. If a person is domiciled in the
UK, inheritance tax is chargeable on assets anywhere in the world, whereas for
persons not domiciled in the UK, tax is due only on assets in the UK. Persons
who are not UK-domiciled but have lived in the UK for at least 17 of the previous
20 years are, however, deemed to be UK-domiciled for inheritance tax purposes.
All the taxation figures for the tax year 2016/17 have been placed in Appendix A,
which should be read in conjunction with this topic.
10.2 Income tax

Income tax is one of the main sources of government revenue. Liability for income
tax is based on income received in a tax year or fiscal year that, in the UK, runs
from 6 April in one calendar year to 5 April in the next.
Income tax is due from individuals on their income from employment (including
the provision of benefits in kind, such as company cars, employer funded private
medical insurance or loans granted at low rates of interest. Income tax is also
payable on interest, dividends and other income received from investments. All UK
residents, including children, have a personal income tax allowance and may be
subject to income tax, depending on the type and amount of income they receive.
Certain state benefits are also taxable.

Income tax
The income of a child that arises from a settlement or arrangement made by the
parents will normally be treated as the parents’ income for tax purposes (subject to
a £100 threshold below which it is treated as the child’s). If treated as the parents’
income, a child’s unused tax allowances cannot be set against this income.
Not all of the income that an individual receives is taxable. Examples of types of
income that are taxable and of those that are not are given below.
Income assessable to tax includes:
u salary/wages from employment, including bonuses and commissions, and
taxable benefits in kind;
u pensions and retirement annuities, including state pension benefits;
u profits from a trade or profession;
u inventor’s income from a copyright or patent;
u tips;
u interest on bank and building society deposits (where in excess of the personal
savings allowance of £1,000 per year for basic-rate taxpayers and £500 per
year for higher-rate taxpayers);
u dividends from companies, where in excess of the £5,000 dividend allowance
(see section 10.2.8);
u income from government stocks and local authority stocks;
u income from trusts;
u rents and other income from land and property;
u the value of benefits in kind, such as company cars or medical insurance (see
Appendix A).
Income not assessable to tax includes:
u redundancy payments and other compensation for loss of office (see
Appendix A);
u interest on NS&I Savings Certificates (when available);
u the first £1,000 of interest received by a basic-rate taxpayer and the first
£500 received by a higher-rate taxpayer each tax year (the personal savings
allowance);
u the first £5,000 of dividend income received each tax year (the dividend
allowance − see section 10.2.8);
u income from ISAs;
u certain covenanted or Gift Aid payments;
u proceeds of a qualifying life assurance policy (in most circumstances);
u casual gambling profits (eg football pools, etc);
u lottery prizes;
u wedding presents and certain other presents from an employer that are not
given in return for one’s services as an employee;

u certain retirement gratuities paid by an employer (within limits);

u any scholarship or other educational grant that is received if one is a full-time
student at school, college, etc;
u certain grants received from an employer solely because an individual has
passed an examination or obtained a degree or diploma;
u war widows’ or widowers’ pensions;
u certain state benefits;
u housing grants paid by local authorities;
u the capital part of a purchased life annuity (but not the interest portion);
u interest on a tax rebate.
10.2.1 State benefits

We will cover the benefits available from the state in more detail in Topic 11.
As the purpose of state benefits is to maintain a threshold standard of living,
certain income-related state benefits, such as Income Support and income-based
Jobseeker’s Allowance are means tested on the income received / capital held by
the claimant. Therefore, when considering benefits that are means tested, it is
important to understand what is included in a claimant’s income or savings for the
purposes of their assessment.
10.2.1.1 Income
The amount taken into account is usually that which the claimant, and their
partner if appropriate, has left each week after paying things like taxes and rent
or mortgage. Typically this might include:
u earnings from full-time or part-time employment, or self-employment, or an
employment training scheme;
u income from pensions;
u income from other state benefits (income from a number of state benefits is
ignored, including that from Attendance Allowance, Disability Living Allowance,
Personal Independence Payment and Housing Benefit);
u maintenance payments to support an adult (child maintenance payments are
disregarded);
u payments from trust funds;
u student grants and loans;
u any other money coming in as regular amounts.
From this income can be subtracted certain specified outgoings, including:
u rent or mortgage interest;
u income tax and National Insurance contributions;
u half of occupational or personal pension contributions.

Income tax
The resulting figure is the amount of income that will be taken into account in
setting the level of benefit payment.
To try to avoid the risk that people are better off on state benefits than they
would be in work, there is a limit on the total amount of state benefits that most
people aged 16 to 64 can get. This is called the benefit cap. The cap is applied to
the total amount that people in any one household get from certain benefits. See
section 11.8 for more details.
10.2.1.2 Savings
If both claimant and partner are below state pension age and have savings of
more than £16,000 between them, they will not be entitled to the income-related
benefits, notably income-based Jobseeker’s Allowance and Income Support.
Benefits will be reduced if savings between £6,000 and £16,000 are held, although
savings below £6,000 will not affect benefits at all.
The definition of savings includes the following:
u money in current accounts and bank and building society deposit accounts;
u National Savings including Premium Bonds;
u gilt-edged stocks;
u shares, unit trusts, investment trusts.
Although pension funds are not taken into account in the means testing, income
from pensions in payment will result in a pound-for-pound reduction in benefit.
Personal possessions such as house contents are excluded from the assessment.
10.2.2 Allowances and tax rates

All UK residents, including children from the day of their birth, have a personal
allowance − ie an amount of income that can be received each year before income
tax begins to be charged. See Appendix A for the various allowances.
The Blind Person’s Allowance is an additional allowance available to those
registered with a local authority as blind. If the allowance cannot be used by the
blind person, it can be transferred to the spouse, even if the spouse is not blind.
Married couples, where at least one spouse was born before 6 April 1935, are
entitled to receive an additional allowance.
In addition to these allowances, taxpayers are permitted to make certain
deductions from their gross (pre-tax) income before their tax liability is calculated.
These include:
u pensions contributions (within specified limits) either to a scheme set up by

an employer or to a personal pension or stakeholder pension;
u allowable expenses, such as costs incurred in carrying out one’s employment
− for self-employed persons, these must be incurred ‘wholly and exclusively
for the purpose of trade’, while for employed persons they must be incurred
‘wholly, exclusively and necessarily’ while doing the job.

When all the relevant deductions have been made from a person’s gross income,
what remains is their taxable income. This is the amount to which the appropriate
tax rate or rates is applied in order to calculate the tax due.
Income tax rates and the bands of income to which they apply are reviewed by the
government each year. Any changes are announced in the Budget and included in
the subsequent Finance Act. Income tax rates are set out in Appendix A.
Where a person is employed and their financial affairs are straightforward, their
employer will calculate and collect any income tax due. Under self-assessment
rules, the self-employed, company directors and those with more than £2,500 per
year of untaxed income (and certain other individuals) are expected to complete a
tax return and submit it to HMRC for approval. The self-assessment tax return
is able to calculate the tax payable. Many self-employed persons engage an
accountant to prepare their accounts for them and to deal with HMRC on their
behalf.
The method of collecting income tax depends on the nature of a person’s work, as
follows.
10.2.3 Employees
Employees pay income tax under the pay-as-you-earn (PAYE) system, under which
the amount of tax due is calculated by their employers using tables supplied by HM
Revenue & Customs (HMRC), deducted from their wages or salary and passed on by
their employers to HMRC. In order to deduct the right amount of tax, the employer
is supplied with a tax code number for each employee: the tax code is related
to the amount of ‘free’ pay for the employee, including allowances, exemptions
and adjustments for fringe benefits and for amounts overpaid or underpaid from
previous years.
A P60 is issued to each employee by the employer in April each year. This shows,
for the previous tax year, total tax deducted, National Insurance contributions (see
section 10.3) and the final tax code.
On leaving an employer, an employee should be provided with a form P45 showing:
u name;
u district reference;
u code number;
u week or month of last entries on the employee’s deductions working sheet;
u total gross pay to date;
u total tax due to date.
A copy is sent to HMRC. The P45 provides the new employer with all the information
they require to complete a new tax deductions working sheet for the employee.
10.2.4 Self-employed persons

Self-employed persons (including partners in a business partnership) pay income
tax directly to HMRC on the basis of a declaration of net profits calculated from
their accounts. Net profits for a self-employed person are broadly the equivalent

Income tax
of the gross income of an employee − ie they are the amount on which income
tax is based. They are calculated by taking the total income of the business and
deducting allowable business expenses and capital allowances.
Self-employed persons pay their income tax (plus Class 2 and Class 4 National
Insurance contributions) in two equal parts. The first payment is due on 31 January
of the tax year in which their business year ends; the second is due on 31 July,
six months later.
10.2.5 Classification of types of income

Different types of income used to be classified under Schedules A, D, E and F.
These schedules have now been abolished for income tax purposes and replaced
by a new regime established under two pieces of legislation.
u Income Tax (Earnings and Pensions) Act 2003. This covers income from
employment, pensions and taxable social security benefits.
u Income Tax (Trading and Other Income) Act 2005. This covers:
− Part 2: Trading income, ie income from self-employment;
− Part 3: Income from property;
− Part 4: Income from savings and investment, including interest and
dividends.
10.2.6 Tax-paid investment income

Where investment income has been taxed at source, the recipient normally has no
further tax to pay, unless as a higher-rate or additional-rate taxpayer. Higher-rate
and additional-rate taxpayers are liable for the difference between the basic rate
taken at source and the higher / additional rate at which they pay tax.
Examples of investments that have income tax deducted at source include:
u interest on fixed-interest loans to companies (eg loan stocks and debentures);
u distributions from fixed-interest unit trusts;
u interest from certain finance company deposits.
In most cases, non-taxpayers can reclaim the tax deducted at source by completing
a tax return.
10.2.7 Taxation of proceeds from a life assurance policy

Premiums paid into a life policy will go into one or more of the company’s funds
and are invested in different assets such as property, gilts, shares, etc. The way
the life policy is structured and operated will then determine how the proceeds are
taxed.
In effect, the life company itself pays sufficient corporation tax on the income
generated by the fund to satisfy the income tax liability of basic-rate taxpayers.
Also, when the fund sells any of its assets at a profit, it incurs corresponding tax

on the capital gain, meaning there is no personal capital gains tax liability to pay
on the proceeds from a life policy.
The net result for the investor is that all benefits taken out of a life policy are
deemed to have already borne tax at the basic rate, so for the basic-rate taxpayer
there is no further liability. There may, however, be a tax liability for higher-rate
and additional-rate taxpayers.
This additional tax liability can only arise if the policy is ‘non-qualifying’. Qualifying
policies do not suffer any higher or additional-rate income tax when proceeds are
paid out. Where a payment is taken from a policy that is non-qualifying then a
higher- / additional-rate taxpayer, or a basic-rate taxpayer who is moved into the
higher-rate band by the payment from the life policy, will have further tax to pay in
respect of the liability over and above the basic-rate tax deducted within the fund.
Broadly speaking, in order to be a ‘qualifying’policy, a policy must meet the
following rules.
u Premiums must be payable annually, half-yearly, quarterly or monthly for at
least ten years. If premiums cease within ten years, or three-quarters of the
original term if less, the policy becomes non-qualifying.
u Premiums in any one year must not exceed twice the premiums in any other
year or one-eighth of the total premiums payable.
u The sum payable on death must be at least equal to 75 per cent of the total
premiums payable.
u Premiums paid by an individual to all qualifying policies held cannot exceed
£3,600 per year.
10.2.8 Taxation of proceeds from a unit trust

Unit trusts fall into one of two main categories.
A fixed-interest unit trust is one that has at least 60 per cent of assets invested in
cash / fixed-interest securities that pay interest. A unit trust that does not meet
this criteria is classed as an equity unit trust. The tax treatment of each type of
unit trust is different.
The investments within an ‘equity-based’ unit trust pay income in the form of
dividends. There is a dividend allowance of £5,000, which means that no tax is
paid on dividend income, regardless of an individual’s personal tax status and
regardless of the amount of non-dividend income a person receives. Dividend
income in excess of the £5,000 dividend allowance is taxed as follows:
u 7.5 per cent on dividend income within the basic-rate tax band.
u 32.5 per cent dividend income within the higher-rate tax band.
u 38.1 per cent on dividend income within the additional-rate tax band.
Where a unit trust is classed as a ‘fixed-interest’ trust, income is paid as interest, net
of tax at 20 per cent. A non-taxpayer or an individual who is not liable to pay tax on
their interest as the interest payment falls within their personal savings allowance
(£1,000 for basic-rate taxpayers, £500 for higher-rate taxpayers) can reclaim the
tax deducted. Higher-rate taxpayers, where total interest payments exceed their
personal savings allowance, and additional-rate taxpayers have a further liability

Capital gains tax
of 20 per cent and 25 per cent respectively. Unit trusts are exempt from capital
gains tax (CGT) but unit holders may have a liability if they sell units at a profit.
10.2.9 Calculation of income tax liability

The calculation of personal liability to income tax is broadly speaking a four-stage
process as follows:
1. Ascertain the total income.

2. Make appropriate deductions. For self-employed people, the expenses of
running their business are allowable deductions. Employees may also be able to
deduct certain expenses if they can show they were incurred ‘wholly, exclusively
and necessarily’ while doing their job. Contributions to a pension scheme
can be set against tax and, in the case of occupational schemes, this is
done by deducting contributions from gross salary. The tax relief for other
pension arrangements such as stakeholder pensions and free-standing AVCs is,
however, obtained by deduction from the contributions before they are paid, so
these are not deducted from income.
3. Deduct personal allowance and other reliefs (eg Blind Person’s Allowance).
4. The resultant figure is known as the taxable income and current tax rates are
applied to the appropriate bands of income, as described earlier.
For examples of income calculations see Appendix A.

If a person’s income comes from several different sources, there is an order of
priority in which different forms of income are taxed: earned income is taxed first,
then interest, and finally dividends. This may make a difference because the tax
calculation for dividends, for instance, is different from that for interest.
10.3 National Insurance

National Insurance contributions are a form of taxation in everything but name.
They are, in effect, a tax on earned income and are payable in different ways
according to whether the earner is employed or self-employed.
They are classified into four classes and the rates and limits are set out in
Appendix A.
10.4 Capital gains tax

Capital gains tax (CGT) is payable on the net gain made on the disposal of certain
physical assets and the realisation of many financial assets, including shares and
unit trusts. Most disposals relate to the sale of an asset but the full definition of a
disposal also includes transferring or giving an asset, or receiving compensation
for its loss or destruction.
There are some circumstances under which CGT is not due − in particular, it is not
payable when property changes hands as the result of a death (although there may
be inheritance tax − see section 10.5). There is a ‘deemed disposal’ of assets on
death, when the assets are deemed to be acquired by the personal representatives

at their market value at the time of death. This is to establish the cost of acquisition,
should it be necessary at some time in the future to calculate capital gains.
Similarly, there are certain assets that are exempt from CGT, including:
u main private residence;
u ordinary private motor vehicles;
u personal belongings, antiques, jewellery and other tangible movable objects
(referred to as ‘chattels’), provided each object is valued at £6,000 or less;
u gifts to the nation of items of national, historic or scientific interest;
u foreign currency for personal expenditure;
u UK government stocks (gilts);
u NS&I Savings Certificates and Save As You Earn schemes;
u Premium Bond winnings and lottery winnings;
u gains on qualifying life assurance policies disposed of by the original owners;
u individual savings accounts (ISAs).
If an individual makes a loss on disposal of an asset, this can be offset against
gains made elsewhere. It must be offset first against gains in the year the loss
occurred. Residual losses may then be carried forward to future years. A capital
loss cannot, however, be carried back to a previous year.
Tax is payable on net gains made in the tax year, after deducting any allowable
capital losses that were made in the same year or carried forward from previous
years. Each individual also has an annual CGT allowance (see Appendix A),rather
like the personal income tax allowances; this is the level of gains that can be made
in the tax year before CGT starts to be payable. This figure also applies to trustees
of a person with learning difficulties, and to personal representatives; half the
amount applies to most other trustees (see Appendix A).
The annual allowance cannot be carried forward to subsequent years if it is unused
in the year to which it applies.
Given that capital losses can be carried forward but the annual exemption cannot,
capital losses brought forward are used only to the extent necessary to reduce
gains to the level of the annual exemption. Residual losses are then carried forward.
10.4.1 Calculation of CGT

The calculation of the amount of a taxable gain is governed by a number of rules
that make it more complex than merely a simple subtraction of purchase price
from sale price. However, the process has been simplified from 6 April 2008 by
the removal of ‘indexation’ and ‘taper relief’.
u Costs of purchase can be added to the purchase price and selling costs can be
deducted from the sale price.
u The cost of improvements to an asset can be treated as part of its purchase
price (but costs of maintenance and repair cannot).
u Capital gains made prior to 31 March 1982 are not taxed so, for an asset
acquired before that date, its value on that date must be substituted for the
actual purchase price.

Inheritance tax
When the amount of the gain has been calculated, deduct the annual CGT allowance
(if this has not been used against other gains in the same tax year). Then deduct
any losses that can be offset against the gain. What remains is the taxable gain.
The rates used are set out in Appendix A, which also includes an example of a CGT
calculation.
One constant source of complaint about the capital gains tax regime is that CGT
is due on the whole gain in the year in which the gain is realised, even where
that gain has actually been made over a longer period. This means that only one
annual exemption can be set against what may be many years’ worth of gain. In
the past, some holders of shares and unit trusts sought to minimise the effect
of this by selling their holding each year and repurchasing it the following day,
thus realising a smaller gain that could be covered by that year’s exemption. This
was known as ‘bed and breakfasting’, but the government effectively outlawed the
process in the 1998 Budget. Since then, any shares and unit trusts that are sold
and repurchased within a 30-day period are treated, for CGT purposes, as if those
two related transactions had not taken place.
10.4.2 Payment of CGT

CGT is charged on gains arising from disposals in the period 6 April to 5 April in
the following year.
CGT is normally payable on 31 January following the end of the tax year in which
the gain is realised. For example, CGT for 2016/17 will normally be payable on
31 January 2018.
Details of chargeable assets disposed of during the tax year must be included in
an individual’s tax return.
10.5 Inheritance tax

Inheritance tax (IHT), as its name suggests, is levied mainly on the estates of
deceased persons and also on certain gifts made in a person’s lifetime. We looked
at this briefly in section 7.5. The IHT threshold and rate is set out in Appendix A.
Surviving spouses and civil partners can increase their own nil-rate band by the
proportion of unused nil-rate band from the earlier death of their spouse/partner.
For an example see Appendix A.
In order to prevent avoidance of tax by ‘death-bed’ gifts or transfers, the figure on
which tax is based includes not only the amount of the estate on death but also the
value of any money or assets that have been given away in the seven years prior
to death.
IHT is also payable in certain circumstances when assets are transferred from a
person’s estate during their lifetime (usually in the form of gifts). Most gifts made
during a person’s lifetime are potentially exempt transfers (PETs) and are not
subject to tax at the time of the transfer. If the donor survives for seven years after
making the gift, these transactions become fully exempt and no tax is payable. If
the donor dies within seven years of making the gift, and the value of the estate
(including the value of any gifts made in the preceding seven years) exceeds the
nil-rate band, inheritance tax becomes due.

The gifts are offset against the nil-rate band first and, if there is any nil-rate band
left, this is offset against the remainder of the estate, the balance being subject to
tax (see Appendix A). If the value of the gifts alone exceeds the nil-rate band, the
portion of the gifts that exceeds the threshold is taxed along with the remainder
of the estate (although the amount of tax on the gifts is scaled down by ‘taper
relief’). For an example of taper relief see Appendix A.
Some lifetime gifts − notably those to companies, other organisations and certain
trusts − are not PETs but chargeable lifetime transfers, on which tax at a
reduced rate (see Appendix A) is immediately due. This ‘lifetime’ tax is only payable
if the value of the chargeable lifetime transfer, when added to the cumulative total
of chargeable lifetime transfers over the previous seven years, exceeds the nil-rate
band at the time the transfer is made. As with PETs, the full tax is due if the donor
dies within seven years (subject to the same taper relief) and any excess over the
tax already paid then becomes payable.
There are a number of important exemptions from inheritance tax, as set out in
Appendix A.
10.6 Other personal and business taxes
10.6.1 Value added tax

Value added tax (VAT) is an indirect tax levied on the sale of most goods and the
supply of most services in the UK. See Appendix A for the current rate.
Some goods and services are exempt from VAT, including certain financial
transactions such as loans and insurance. The supply of financial advice is not
exempt and advisers who charge a fee for their service are subject to VAT in the
same way as solicitors or accountants.
The supply of health and education services is exempt and a number of related
goods and services are currently zero-rated. This is not technically the same
as being exempt: zero-rated goods and services are theoretically subject to VAT
but the rate of tax applied is currently 0 per cent (although this could change).
Zero-rated items include food, books, children’s clothes, domestic water supply
and medicines. Domestic heating is charged at a reduced rate (currently 5 per
cent).
Businesses, including the self-employed, are required to register for VAT if their
annual turnover (not profit) is above a certain figure (see Appendix A). Firms with
turnover below this figure can choose to register for VAT if they wish, but are not
obliged to. An advantage of registering is that VAT paid out on business expenses
can be reclaimed; two disadvantages are (i) the fact that the firm’s goods or services
are more expensive to customers (by the amount of the VAT that the firm must
charge) and (ii) the additional administration involved in collecting, accounting for
and paying VAT.

Other personal and business taxes
10.6.2 Stamp duty

Stamp duty is a form of tax, payable by the purchaser in respect of certain
transactions, notably purchases of securities and of land. It is a tax imposed on
the documents that give effect to the transaction (eg a conveyance of property or
stock transfer forms) and is calculated as a percentage of the purchase price.
It is important to ensure that the documents are stamped within the permitted
time period. Failure to do so means, for instance, that the conveyance of the land
cannot be registered or that share transfers will not be accepted for registration.
See Appendix A for limits and rates for stamp duty reserve tax and stamp duty
land tax.
10.6.3 Corporation tax

Corporation tax is paid by limited companies on their profits. It is also payable by
clubs, societies and associations, by trade associations and housing associations,
and by co-operatives. It is not, however, paid by either conventional business
partnerships or limited liability partnerships, or by self-employed individuals: these
are all subject to income tax as individuals.
Companies are taxed on all their profits arising in a given ‘accounting period’,
which is normally their financial year. The definition of profits includes:
u trading profits (less allowable expenses such as labour and raw materials);
u capital gains;
u income from letting;

u interest on deposits.
Companies resident in the UK pay corporation tax on their worldwide profits,

whereas companies resident elsewhere pay only on their profits from their
UK-based business.
Corporation tax rates are set out in Appendix A.
10.6.4 Withholding tax

The term ‘withholding tax’ refers to any tax on income that is levied at source
before that income is received. So, technically, income tax paid by UK employees
is a withholding tax.
However, the term is normally understood to apply to tax that is levied in a

particular country on income received in that country by non-residents of that
country; this could be earned income or investment income. The aim is to ensure
that the income does not leave the country without being taxed. In the UK, for
example, withholding tax (see the rate in Appendix A) is levied on the earnings
of non-resident entertainers and professional sportspeople. The UK has double
taxation agreements with over 100 countries to prevent the same income from
being taxed twice.

Review questions
1. List the forms of income on which income tax is due.
2. Which form does an employer use to advise their employees of the amount
of pay, income tax and national insurance contributions that have been made
during the last tax year?
3. Would a basic-rate taxpayer have a further tax liability on income gained from
dividends in UK companies?
4. John has total income of £44,075; £43,775 is earned income from his
employment and £300 is gross interest. Assuming he has a full personal
allowance of £11,000 (2016/17), calculate John’s income tax liability.
5. Julie is employed and her salary is £91,000 per annum. She receives £900
in interest from her building society savings account and £3,200 in dividend
income from shares. Assuming she has the full personal allowance available,
will she have any further tax to pay?
6. Which assets are exempt from CGT?

7. What is a PET?
8. Are financial advice fees subject to VAT?
9. What is stamp duty?
10. Who is liable to pay corporation tax?

Topic 11
Principles of financial protection:
Existing provision
Learning objectives
u summarise state benefits;

u explain the relevance of determining existing protection arrangements.
11.1 Introduction
In the UK, the government, through its system of state benefits, plays a vital role
in providing assistance to those people most in need. Although the ‘welfare state’
has had its critics in recent years, largely because it is increasingly expensive to
run, it still remains the envy of many other nations. Successive governments have
tried various ways to make savings through reducing benefits payments, tightening
eligibility criteria and trying to find ways of encouraging claimants back into work.
Students should keep abreast of changes in this area.
Whilst normally set at a modest level, state benefits impact financial planning in two
main ways: benefits can affect the need for protection; and financial circumstances
can affect entitlement to benefits as certain benefits are means tested. There is
a wide range of benefits covering many different circumstances. Many of them,
however, are small in amount and can do little more than prevent people from
suffering extreme poverty. The structure of the benefits system is complex and
it is not possible to cover every detail here. The main benefits are described in
the remainder of this topic, together with some information about them that is
relevant to the work of financial advisers and planners.
The main areas in which state benefits are provided are for those who are:
u on low incomes;
u out of work but looking for work;

u pregnant or bringing up children;
u ill or disabled;
u requiring care or nursing; and
u aged above state pension age.

11: Principles of financial protection: Existing provision
The Department for Work and Pensions (DWP) publishes a range of booklets that
provide detailed descriptions of the various benefits. These are available from DWP
offices or by visiting its website (www.dwp.gov.uk).
11.2 Support for people on low incomes

The two main benefits for those on a low income, or no income at all, are the
Working Tax Credit and Income Support.
11.2.1 Working Tax Credit

Working Tax Credit (WTC) is designed to top up the earnings of employed or
self-employed people who are on low incomes; this includes those who do not
have children. There are extra amounts for:
u working households in which someone has a disability; and

u the costs of qualifying childcare.
People with children can claim WTC if they are aged 16 or over and work at least
16 hours a week. Those without children can claim WTC if:
u they are aged 25 or over and work at least 30 hours a week; or
u they are aged 16 or over and work at least 16 hours a week and have a disability
which puts them at a disadvantage in getting a job; or
u they or their partner are aged 50 or over, work at least 16 hours a week and are
returning to work after claiming qualifying ‘out-of-work’ benefits.
11.2.2 Income Support

Income Support is a tax-free benefit designed to help people aged between 16 and
the qualifying age for state pension. To be eligible a person must:
u be pregnant, a carer or have a child aged under five or, in some cases, unable
to work due to illness or disability;
u have no income or a low income and savings of less than £16,000;
u work less than 16 hours per week (with a partner working less than 24 hours
per week);
u live in England, Scotland or Wales.
As can be seen, Income Support can be claimed by people with no income at all or
can be used to top up other benefits or part-time earnings.
Eligibility for Income Support is not dependent on the claimant having paid National
Insurance contributions (NICs). It is, however, means-tested in relation to both
income and savings. Where an individual has savings of between £6,000 and
£16,000 then they are assumed to have £1 per week of income for every £250
above £6,000, and this is deducted from their Income Support payments.

Support for bringing up children
The rules relating to Income Support are complex, and only a brief outline of them
can be given here.
11.2.2.1 Income Support payments

Payments are made up of three main components.
u Personal allowances (not to be confused with the tax allowances of the same
name) are meant to cover the day-to-day living expenses of the claimant, partner
and dependent children.
u Premiums (nothing to do with life policies) are additional payments given

to people who have extra needs, such as one-parent families or people with
disabilities.
u Other additions − these may include payments for mortgage interest and
certain other housing costs.
11.2.3 Jobseeker’s Allowance (JSA)

Jobseeker’s Allowance (JSA) is a benefit for people who are unemployed and actively
seeking work. There are two forms of JSA: contribution-based and income-based.
u Contribution-based JSA depends on having paid sufficient Class 1 NICs
and is payable for a maximum of six months. It is paid at a fixed rate
irrespective of savings or partner’s earnings, but no additional benefits are
paid for dependants. Contribution-based JSA is paid gross but is taxable.
u People who do not qualify for contributions-based JSA may be able to get
income-based JSA, which is, to all intents and purposes, Income Support under
another name.
Claimants for JSA must satisfy a number of strict requirements. Claimants are
usually credited with NICs for every week when they receive JSA.
11.3 Support for bringing up children

Benefits related to bringing up children fall into two categories: benefits payable
during pregnancy and benefits payable as the children are growing up.
11.3.1 Statutory Maternity Pay (SMP)

Women who become pregnant while they are in employment may be able to get
Statutory Maternity Pay (SMP) from their employer. The requirements that a woman
must meet in order to receive SMP are as follows.
u She must have worked for the same employer, without a break, for at least
26 weeks including (and ending with) the 15th week before the baby is due −
known as the ‘qualifying week’.
u Her average weekly earnings in the eight weeks up to the qualifying week must
not be less than the ‘lower earnings limit’ (LEL).

SMP is payable for a maximum of 39 weeks. The earliest it can begin is 11 weeks
before the baby is due and the latest is when the baby is born.
There are two rates of SMP: for the first six weeks the amount paid is equal to
90 per cent of the employee’s average weekly earnings; after that, the remaining
payments are at a flat rate of £139.58 (2016/17) or 90 per cent of the employee’s
average weekly earnings, whichever is the lower.
SMP is taxable and NICs are due on the amount paid.
11.3.2 Maternity Allowance

Some working mothers who become pregnant are not able to claim SMP. These
include those who are self-employed or who have recently changed jobs. They may
be able to claim an alternative benefit called Maternity Allowance. This is paid by
the Department for Work and Pensions (DWP) and not by employers.
Maternity Allowance is paid at a lower rate than SMP but, unlike SMP, it is not
subject to tax or NICs on the amount paid.
A standard rate of Maternity Allowance is payable to those whose earnings exceed

the lower earnings limit. For those who earn less than the limit but above the
minimum threshold for a claim to be made, an amount equal to 90 per cent of
average earnings will be paid.
Contrary to popular belief, Maternity Allowance is not a benefit available to all
women who become pregnant, whether or not they have been working. There are
restrictions on who can claim.
Like SMP, Maternity Allowance is payable for a maximum of 39 weeks. The earliest
it can begin is 11 weeks before the baby is due and the latest is when the baby is
born.
11.3.3 Child Benefit

Child Benefit is a benefit available to parents and others who are responsible for
bringing up a child. It does not depend on having paid NICs. It is not affected by
receipt of any other benefits.
Child Benefit is available for each child under the age of 16. It can continue up to
and including the age of 19 if the child is in full-time education or on an approved
training programme. A higher rate is paid in respect of the eldest child and a lower
rate in respect of every other child.
Child Benefit is means-tested in the form of an income tax charge. The charge will
be applied to taxpayers whose income exceeds £50,000 in a tax year and who are
in receipt of Child Benefit and to taxpayers whose income exceeds £50,000 and
whose partner is in receipt of Child Benefit. In the event that both partners have
an income that exceeds £50,000, the charge will apply only to the partner with the
highest income. An income tax charge will apply to those taxpayers affected by
this measure to reduce or remove the financial benefit of receiving Child Benefit.
For taxpayers with income above £50,000 and up to £60,000, the amount of the
charge will be 1 per cent of the amount of Child Benefit for every £100 of income
that exceeds £50,000. The measure of income used is the individual’s adjusted
net income. For taxpayers with income above £60,000, the amount of the charge

Support for people who are ill or disabled
will equal the amount of Child Benefit received, ie the charge will cancel out the
benefit.
11.3.4 Child Tax Credit

Child Tax Credit is designed mainly to help parents on low incomes but people
earning as much as £26,000 per year can be eligible. It is payable in addition to
the entitlement to Child Benefit. The parent does not have to be working to claim.
Child Tax Credit is paid directly to the person who is mainly responsible for caring
for the child. Payment is made in respect of each child until 1 September following
their sixteenth birthday or up to the twentieth birthday if the child is:
u in full-time education or on an approved training programme;
u not claiming Income Support or any tax credit;

u not serving a custodial sentence of four months or more.
11.4 Support for people who are ill or disabled

There is a wide range of benefits for people who are sick, injured or disabled, or
who need constant care.
11.4.1 Statutory Sick Pay (SSP)

Statutory Sick Pay (SSP) is paid by employers to employees who are off work due to
sickness or disability for four days or longer.
To qualify, claimants must earn more than the lower earnings limit (LEL).
SSP is paid for a maximum of 28 weeks in any spell of sickness. Spells of sickness
with less than eight weeks between them count as one spell. It is payable to
employed people whose average weekly earnings are above the level at which
NICs are payable.
Amounts paid as SSP are subject to tax and to NI deductions, just as normal
earnings would be.
People who are still sick after 28 weeks may be able to claim short-term
Employment and Support Allowance (see section 11.4.3).
11.4.2 Incapacity Benefit

Incapacity Benefit is a benefit for people who are unable to work due to illness
or disability. Before October 2008 it could be claimed by those ineligible for SSP
because they were self-employed or because the SSP payment period had expired;
from 2008 it was replaced fornew claimants by Employment and Support Allowance
(ESA) (see section 11.4.3) and existing claimants are being moved onto ESA.

11.4.3 Employment and Support Allowance

Employment and Support Allowance (ESA) replaced Incapacity Benefit from
October 2008, for new claimants. The focus of ESA is on what work a person
is capable of doing, rather than the previous approach of paying benefits on the
basis that a person was incapable of working.
A ‘work capability assessment’ is applied to all claimants. The assessment looks at
people’s physical and mental abilities, taking account of learning disabilities and
similar conditions. Following the assessment, most people are given support and
employment advice to enable them, if possible, to return to work.
During the 13-week assessment period a benefit rate of up to £73.10 per week
(2016/17) is payable for over 25s (under-25s receive £57.90). After this period,
those who can carry out a work-related activity will be placed into a work-related
activity group and receive up to £102.15 per week (2016/17). The aim is to help
people back into work. People whose condition causes very severe limitation of
their ability, who are not able to engage in any work-related activity, are placed
into a support group and will get a higher rate of benefit (£109.30 per week in
2016/17).
11.4.4 Attendance Allowance

This is a benefit for people aged 65 or above needing help with personal care as a
result of sickness or disability.
Attendance Allowance is not means-tested and it does not depend on having paid
NICs.
There are two levels of benefit: a lower rate for people who need help with personal
care by day or by night, and a higher rate for those who need help both by day and
by night.
11.4.5 Disability Living Allowance and Personal

Independence Payment
Disability Living Allowance (DLA) is a tax-free benefit for people who need help with
personal care and / or need help getting around. It can only be received by people
whose disability claim began before age 65 but, once granted, it can continue
beyond age 65. Since April 2013, new claims for DLA can only be made in respect
of a child under the age of 16 who is suffering from a severe disability; new adult
claimants and some existing claimants whose circumstances have changed must
apply for Personal Independence Payments (PIP). To be eligible for PIP, claimants
must have a long-term health condition or disability that affects their mobility or
their ability to carry out daily tasks such as washing, dressing, using the toilet
or cooking a meal. They must have needed help for a qualifying period of three
months and must be expected to need help for a further six months. The qualifying
period is waived for people who are not expected to live for six months.
There are two components to PIP and claimants may receive either or both:
u care component: this is for people who need help in carrying out daily tasks;
u mobility component: this applies if a person has difficulty in walking or cannot
walk at all.

Support for people in hospital or receiving residential/nursing care
For each component there are ‘standard’ and ‘enhanced’ rates.

The provisions for DLA are similar.
11.4.6 Carer’s Allowance

The government recognises that support is also needed for carers, ie people who
give up a large part of their time − and possibly their jobs − in order to look
after someone who is seriously ill or severely disabled. Carer’s Allowance (CA) is a
benefit for people who are caring for a severely disabled person; they do not have
to be a relative of the patient in order to qualify.
The right to receive CA does not depend on having paid NICs. The benefit is a flat
rate, with possible additions for a partner or children. It is taxable and must be
declared on tax returns.
The following criteria must be met.

u The carer must:
− be aged over 16;
− spend at least 35 hours per week as a carer;

− be earning no more than a certain amount each week;
− not be in full-time education (defined as 21 hours or more a week of

supervised study).
u The person being cared for must:
− be receiving Disability Living Allowance / Personal Independence Payment or

Attendance Allowance or Constant Attendance Allowance;
− not be in hospital or in residential care.
11.5 Support for people in hospital or receiving

residential/nursing care
When people are in hospital, some of the needs normally met by benefits or
pensions are instead met by the National Health Service. In the past, therefore,
some benefits were reduced or suspended while a claimant was in hospital. In the
2005 Budget, however, it was announced that these reductions will no longer be
made.
For those in a residential care or nursing home provided by a local council, who
cannot afford the minimum charges, Income Support may be available. For those
in residential or nursing care in a private establishment, Income Support may be
available provided that savings do not exceed £16,000. Income Support amounts
are worked out by adding together the fees for the home and any meals that have
to be paid for separately, subject to a maximum benefit amount depending on the
type of care received.

11.6 Support for people in retirement

There is a system of state pensions which pay benefits from state pension age.
The system has evolved over many years and before reforms were made in
2016 comprised a basic state pension, various additional elements (including the
state earnings-related pension scheme, state second pension and graduated state
pension) and a Pension Credit that guarantees a minimum level of state provided
income in retirement.
The system had become extremely complex and, in an attempt to simplify it, a new
single-tier state pension was introduced in April 2016. Those who reached state
pension age before 6 April 2016 receive their state pension benefits based on the
system of basic and additional state pension, and those who reach state pension
age on or after 6 April 2016 receive the single-tier state pension − single tier as
there are no additional elements.
Entitlement to the single-tier state pension is based on NICs with some entitlement
once NICs (Class 1, 2 or 3) have been paid for at least 10 years and maximum
benefit after 35 years. Upon reaching state pension age a comparison is done
to see whether a person would receive more pension based on the entitlement
to the basic / additional state pension they had built up (to 5 April 2016) or if
the single-tier state pension had existed throughout their whole working life; the
higher amount is awarded as their starting amount under the new state pension.
The benefit levels for 2016/17 are as follows (per person per week):
u Full basic state pension − £119.30.

u Pension Credit − £155.60 (£237.00 for a couple).
u New state pension − £155.60 (where individual entitled to maximum pension).
More details on the operation of state pensions can be found in section 15.2.
11.7 Universal Credit

In an effort to simplify the benefit system and improve work incentives, Universal
Credit is beginning to replace the present benefit structure. The changes were
implemented following the passing of the Welfare Reform Act 2012; the process of
moving claimants onto Universal Credit began in 2013 and is due to continue on
a phased basis until 2017, although problems with implementation have created
delays.
Universal Credit is an integrated means-tested benefit primarily aimed at people
of working age. The benefit is not specifically limited to people who are in work or
out of work and should therefore make the process of transition into and out of
work easier.
The new system aims to:

u simplify the system, making it easier for people to understand, and easier and
cheaper for staff to administer;
u improve work incentives;

u smooth the transitions into and out of work;

The benefit cap
u reduce in-work poverty; and

u cut back on fraud and error.
Universal Credit will eventually replace:
u income-based Jobseeker’s Allowance;

u income-related Employment and Support Allowance;
u Income support;
u Child Tax Credits;
u Working Tax Credits; and
u Housing Benefit.
Universal Credit consists of a basic allowance with different rates payable for single
people / couples and younger people.
There are also additional payments for claimants who have:
u responsibilities as a carer;
u children / disabled children;
u housing costs;
u childcare costs;
u limited capability for work.
The payment is a single payment made on a monthly basis, to mirror the frequency
of payment of a salary to those who work.
11.8 The benefit cap

There is a limit on the total amount of benefit that most people of working age,
aged 16−64, can receive. The cap applies to the total amount that people in the
same household can get from the following benefits:
u Bereavement Allowance;
u Carer’s Allowance;
u Child Benefit;
u Child Tax Credit;
u Employment and Support Allowance (unless it is just the support element);
u Guardian’s Allowance;
u Housing Benefit;
u Incapacity Benefit;
u Maternity Allowance;

u Severe Disablement Allowance; and

u Widowed Parent’s Allowance.
The level of the cap is:
u £500 a week for couples (with or without children living with them);
u £500 a week for single parents whose children live with them;
u £350 a week for single adults who do not have children, or whose children do
not live with them.
This may mean the amount people receive for certain benefits will go down to
ensure that the total amount received isn’t more than the cap level.
People won’t be affected if anyone in the household qualifies for Working Tax
Credit or receives any of the following benefits:
u Disability Living Allowance;
u Personal Independence Payment;
u Attendance Allowance;
u Industrial Injuries Benefits;
u Employment and Support Allowance (if it is just the support component);
u War widow’s or widower’s pension;
u War pensions;
u Armed forces compensation scheme;
u Armed forces independence payment.
Individuals might be affected by the cap if they have any grown-up children who
still live with them and they qualify for one of these benefits. This is because they
will not normally count as part of the household. Source: www.gov.uk/benefit-cap.
11.9 Benefits and financial advice

There is a wide range of state benefits covering many different circumstances.
Many of them, however, are small in amount and can do little more than prevent
people from suffering extreme poverty.
There are a number of reasons for the relatively small size of benefits, and two of
the main ones are as follows.
u In order to keep down the costs of providing the benefits, it is necessary to
encourage people to end their benefit claims as soon as is genuinely possible.
The government makes the reasonable assumption that, if a person can receive
a higher income when sick or unemployed than they would in employment, that
person will not be in a hurry to end their claim. Sadly, the complexity of the
benefit structure sometimes leads to the existence of the so-called ‘benefits
trap’, in which a person can be worse off if they return to work.
u State benefits are funded on a pay-as-you-go basis, which means that current
benefits are paid for by current taxes and NICs. All governments have to juggle
the equation between how high they can make the tax rates and how small

Benefits and financial advice
they can make the benefit levels. The situation is worse in times of economic
downturn, because there are fewer people working (and therefore contributing
taxes and NICs) and more people claiming benefits.
State benefits can affect financial planning in two main ways.
u State benefits can affect the need for protection − the amount of additional
cover needed by a client can be quantified as the difference between the level
of income or capital required and the level of cover already existing. Existing
provision includes any private insurance that the client already has, any benefits
that might be paid by their employer and also any state benefits to which they
or their dependants would be entitled.
Employer benefits will depend on the type of employment contract they have.
Often those with salaried employment have more benefits that those on
waged or hourly paid jobs. Benefits could include death-in-service benefit for
dependants, salary paid in the event of ill health (within certain time limits), a
private healthcare scheme, and maternity payments.
The financial adviser or planner would need to ascertain the details of these
types of benefit and take them into consideration, alongside their knowledge
of the main state benefits and the circumstances in which they are payable.
u Financial circumstances can affect entitlement to benefits − certain benefits are
means-tested, meaning that the amount of benefit is reduced if the individual’s
(or sometimes the family’s) income or savings exceed specified levels. This
might mean, for example, that a financial plan that increases a person’s income
might be less attractive than it seems at first sight, if it also has the effect of
reducing entitlement to Income Support, for example.
11.9.1 Determining the shortfall

It is important to consider a number of factors when deciding how much protection
cover is required. There is no single rule for calculating the amount of cover
required but it is usually based on quantifying the shortfall in income that the
dependants would suffer. The shortfall can be expressed as the difference between:
u how much protection would actually be needed if the risk event happened; and
u how much protection the client currently has, in terms of existing provisions
and any state benefits that would be payable.
In calculating the shortfall, the amount needed is often based on the breadwinner’s
current income because this is what will be lost if death occurs or if they become
unable to work through illness. Strictly speaking, it may be better to base it on the
dependants’ projected expenditure because this is what will be required and is a
more accurate reflection of protection need.
Within this process, it may be helpful to consider:
u current income levels;
u changes to income on death or illness (allowance should be made for any state
benefits or existing provision that will form part of the dependants’ income);
u current outgoings/cost of living;
u changes to outgoings on death or illness (they might either increase or
decrease);

u expected changes in outgoings in the future (such as end of mortgage, or

children leaving home or entering private education);
u the cost of known future plans that are still to be implemented;
u the standard of living aspired to in the future.

The client’s current protection includes any policies held, as well as any benefits
provided by employers. It will also be necessary to consider any savings they hold
and, as discussed above, any state benefits.
It is important to ascertain what protection policies clients already have because
these may reduce the need for new policies. It is not appropriate to recommend
additional policies where clients have needs that are already adequately covered. It
is also not normally appropriate to recommend the cancellation of existing policies
in order to replace them with similar ones. This is known as churning and the
regulator rightly takes a dim view of this practice.
If it can be shown conclusively that the same cover can now be obtained at a
reduced cost, however, it may be appropriate to recommend the cancellation of an
existing policy and its replacement with a new one.
Review questions
1. What is the purpose of Working Tax Credit?
2. What state support is available for those people bringing up children?

3. Explain the rules relating to Statutory Sick Pay.
4. What benefit has replaced Incapacity Benefit for most claimants?
5. Who might be eligible for Personal Independence Payment?
6. Which individuals in residential care are not eligible for any state support?
7. What is the main drawback of relying only on state pension benefits in
retirement?
8. How is the amount of new single-tier state pension a person is entitled to

worked out?
9. Why are state benefits relatively small in size?
10. How do state benefits affect financial planning?

11. How should the level of protection for a client be calculated?
12. What is ‘churning’?

Topic 12
Financial protection products
Learning objectives
u explain the purpose and considerations of life protection products;
u explain the purpose and considerations of income and health protection;
u summarise the purpose and considerations of business protection.
12.1 Introduction
Very few aspects of life are entirely free from some element of risk and most
people have some form of insurance to protect them against the financial effects
of adversity. Most families need protection against unforeseen events that would
deprive them of their sources of income, such as the untimely death or serious
illness of a main breadwinner. In this topic we will consider the main areas of
protection that are available to retail financial services consumers.
12.2 Life assurance protection
12.2.1 Whole-of-life assurance

A whole-of-life assurance is, as the name implies, designed to cover the life assured
for the whole of that lifetime. It will pay out the amount of the life cover in the
event of the death of the life assured, whenever that death occurs, provided that
the policy remains in force.
Premiums may be:
u payable throughout life (ie for the full term of the policy, whatever that turns
out to be); or
u limited to a fixed term (eg 20 years) or to a specified age (such as 60 or 65).
If limited premiums are chosen, the minimum term is normally ten years.
Because a whole-of-life assurance (unlike a term assurance) will definitely pay out
sooner or later, life companies build up a reserve to enable them to pay out
when the life assured dies. This enables companies to offer surrender values on

12: Financial protection products
whole-of-life policies that are cancelled by the client before death has occurred.
These surrender values are, however, generally small in relation to the sum
assured. In fact, in the early years of a policy, the surrender value will be less
than the premiums paid. This emphasises the fact that whole-of-life policies are
protection policies and not investment plans.
Whole-of-life policies can be taken out on a number of different bases:
u non-profit;
u with-profit;
u unit-linked;
u unitised with-profit;
u low-cost;
u flexible;
u universal.
12.2.1.1 Non-profit
This policy has a fixed sum assured, which is payable on maturity (ie at the end of
the policy term) or on earlier death. Because the return is fixed and guaranteed,
the investor is shielded from losses due to adverse stock market movements; on
the other hand, they are equally unable to share in any profits the company might
make over and above those allowed for in calculating the premium rate (hence the
name: ‘non-profit’). For that reason, non-profit policies are rarely used today.
12.2.1.2 With-profit
Like its non-profit equivalent, a with-profit policy has a fixed basic sum assured
and a fixed regular premium. The premium, however, is greater than that for a
non-profit policy of the same sum assured, and the additional premium (sometimes
called a ‘bonus loading’) entitles the policyholder to share in the profits of the life
assurance company.
The company distributes its profits among policyholders by annually declaring
bonuses that become part of the policy benefits and are payable at the same time
and in the same circumstances as the sum assured. There are two types of bonus.
u Reversionary bonuses: these are normally declared each year and, once
they have been allocated to a policy they cannot be removed by the company,
provided that the policy is held until the end of the term or earlier death. Some
companies declare a simple bonus, where each annual bonus is calculated as
a percentage of the sum assured; others declare a compound bonus, with the
new bonus being based on the total of the sum assured and previously declared
bonuses. Most companies set their reversionary bonuses at a level that they
hope to be able to maintain for some time, in order to smooth out the short-term
variations of the stock markets, but with the low level of interest rates and the
volatility of stock market returns in the years following the 2007/08 credit crisis,
bonus rates fell and are now at much lower levels than they were in the 1980s
and 1990s.

Life assurance protection
u Terminal bonuses: these are bonuses that may be added to a with-profit policy
at the end of its life, when it terminates, typically when a death or maturity
claim becomes payable. Unlike reversionary bonuses, a terminal bonus does
not become part of the policy benefits until the moment of a death or maturity
claim, thus allowing the company to change the terminal bonus rate − or even
remove the terminal bonus altogether. Terminal bonuses are intended to reflect
the level of investment gains that the company has made over the term of the
policy, so the rate of bonus often varies according to the length of time that the
policy has been in force. In the current climate of reduced stock market values,
many companies have reduced the level of their terminal bonuses.
12.2.1.3 Unit-linked
The first unit-linked policies were issued in the late 1950s and represented a
revolutionary change in the way in which policies were designed. The development
reflected the desire of many policyholders to link investment returns more directly
to the stock market, or even to specific sectors of the market.
Unit-linked policies work on the basis that, when a premium is paid, the amount
of the premium − less any deductions for expenses − is applied to the purchase
of units in a fund or funds selected by the policyholder. A pool of units gradually
builds up and, at the maturity date, the policyholder receives an amount equal to
the total value of all units then allocated to the policy. Most unit-linked policies also
provide a fixed benefit on death before the end of the term. The cost of providing
this life cover is taken from the policy each month by cashing in sufficient units
from the pool of units.
Unit-linked policies have the potential to produce better returns than with-profit
policies, albeit without the guarantees that with-profit policies provide.
12.2.1.4 Unitised with-profit

Unitised with-profit endowments have been available since the late 1980s, when
they were introduced in an attempt to combine the security of the with-profit policy
with the greater potential for reward offered by the unit-linked approach. As with
unit-linking, premiums are used to purchase units in a fund and the benefits paid
out on a claim depend on the number of units allocated and the then-current price
of units.
The difference from a standard unit-linked policy lies in the fact that unit prices
increase by the addition of bonuses which cannot be taken away once they have
been added. This means that unit prices cannot fall and the value of the policy,
if it is held until death or maturity, is guaranteed. If the policy is surrendered (ie
cashed in before its maturity date), however, a deduction is made from the value
of the units. This deduction, the size of which depends on market conditions at
the time of the surrender, is known as a market value adjustment (MVA).
12.2.1.5 Low-cost whole-of-life

A low-cost or minimum-cost whole-of-life policy has a sum assured that is
payable on death whenever it occurs. It is, however, made up of two elements:
a whole-of-life with-profits plus a decreasing term assurance.
The basic whole-of-life with-profits sum assured is lower than the overall level of
cover required, with bonuses being added as the policy continues. A guaranteed
death benefit is offered and, while the whole-life with-profits increases with the

addition of bonuses, the shortfall is made up by a decreasing term assurance.

Once the basic sum assured plus bonuses increases beyond the guaranteed death
benefit, the decreasing term assurance element ceases.
This policy is suitable for anyone seeking maximum life cover on a permanent
basis at minimum cost.
12.2.1.6 Flexible whole-of-life

When whole-of-life policies are issued on the unit-linked basis, they are generally
referred to as flexible whole-of-life.
The flexibility to which the name refers lies in the fact that these policies can offer
a variable mix between their life cover and investment content. This means that
the structure of the plan can be adjusted as the balance of a person’s needs for
protection and investment change throughout life. The key to this flexibility is the
method of paying for the life cover by cashing in units at the bid price.
u The policyholder pays premiums of an amount that they wish to pay − or feel
that they can afford to pay.
u The premiums are used to buy units in the chosen fund or funds, and these
units are allocated to the policy.
u The policyholder selects the level of benefits that they wish to have.
− If a high level of life cover is required, a larger number of units will be cashed
each month, and a correspondingly lower number will remain attaching to
the policy. This means that the investment element of the policy (which
depends on the number of units) is also lower.
− Conversely, a low level of life cover means fewer units cancelled and hence
a higher level of investment.
The flexibility of the system, under which benefits are paid for by cashing units,
means that other options are often available. These include an option to take
income, indexation of benefits (for automatic adjustment of death benefits) and
the ability to add another life assured.
Although it can have a high level of investment, a flexible whole-of-life assurance
should never be thought of primarily as a savings vehicle, but rather as a protection
plan that could be adapted to investment if circumstances changed.
The initial life cover is guaranteed for a certain period, often ten years. Beyond
that point, the company reserves the right to increase the premiums or to reduce
the cover − to take account of increases in costs or to allow for the fact that unit
prices have not grown as quickly as had been assumed. The death benefit is then
guaranteed until the next review.
Further reviews are usually undertaken at five-yearly intervals, or even annually
with older lives assured, and adjustments may again be made. The need for such
reviews is the price that clients have to pay for the flexibility of the system. In fact,
the reviews are beneficial to the client because they reveal possible shortfalls at
any early stage, when they can be rectified before the cost becomes prohibitive.

12.2.1.7 Universal whole-of-life assurance

The flexibility of unit-linked whole-of-life is sometimes extended further by adding
a range of other benefits and options to the policy. When that is done, the policy
is usually referred to as universal whole-of-life. Benefits and options that may be
added include:
u income protection insurance;
u critical illness cover;

u accidental death benefit;
u total and permanent disability cover;
u hospital benefits or other medical cover;

u guaranteed insurability (to increase cover);
u indexation of benefits;
u flexibility of premium levels;
u waiver of premium during periods of inability to pay due to, for instance,
disability or unemployment.
Most of the additional benefits will be at extra cost, the additional cost being met
by cashing more units.
12.2.1.8 Uses and benefits

Whole-of-life policies are appropriate to those circumstances where the need is for
a sum of money to be paid on the death of an individual, whenever that death
may occur. Like all protection policies, therefore, their overall benefit is that they
provide peace of mind. They can be used in personal and business situations, and
for certain taxation purposes.
The uses of whole-of-life policies include the following:
u to protect dependants against loss of financial support in the event of the death
of a breadwinner;
u to provide a tax-free legacy;
u to cover expenses on death;
u to provide funds for the payment of inheritance tax.
12.2.1.9 Joint-life second-death policies

When a whole-of-life policy is used to provide the funds likely to be needed to pay
inheritance tax (IHT), it is normal to use a whole-of-life policy that will pay out
on the death of the survivor of the husband and the wife (known as a joint-life
second-death policy or a last survivor policy).
The reason for this is that, in most families, the estate of the first spouse to die
passes to the surviving spouse (free of IHT), and the IHT becomes due only when
the surviving spouse dies and the estate passes to the family or to others. It is usual
to put these policies into ‘trust’ (see section 20.2 ) to ensure that the proceeds of

the policy are used to meet the IHT liability and do not pass into the value of the
estate.
12.2.2 Term assurance

A wide variety of term assurances are available, but they all share one common
characteristic: that the sum assured is payable only if the death of the life assured
occurs within a specified period of time (the term). As a pure protection plan,
nothing is paid if the insured survives to the end of the term.
Term assurance is the most basic form of life assurance − pure protection for
a limited period with no element of investment. For this reason, it is also the
cheapest.
Term assurance can be used for personal and family protection and also for a
wide range of business situations. Business use includes the provision of key
person insurance, to protect against the loss of profits resulting from the death
of an important employee, and partnership insurance schemes, to enable surviving
partners to buy out the share of a partner who has died.
Other characteristics shared by term assurances are as follows.
u The term can be anything from a few months to, say, 40 years or more (for terms
that end after age 65, it may be worth considering taking out a whole-of-life
policy instead).
u If the life assured survives the term, the cover ceases and there is no return of
premiums.
u There is no cash value or surrender value at any time.
u If premiums are not paid within a certain period after the due date (normally
30 days), cover ceases and the policy lapses with no value. Most companies will
allow reinstatement within 12 months provided all outstanding premiums are
paid and evidence of continued good health is provided.
u Premiums are normally paid monthly or annually, although single premiums
(one payment to cover the whole term) are also allowed.
u Premiums are normally level (the same amount each month or year), even if the
sum assured varies from year to year.
There are a number of types of term assurance and a number of options that can
be included if the policyholder wishes. These are described below.
12.2.2.1 Level term assurance

With level term assurance, the sum assured remains constant throughout the term.
Premiums are normally paid monthly or annually throughout the term, although
single premiums can be paid.
Level term assurance is often used when a fixed amount would be needed on
death to repay a constant fixed-term debt such as a bank loan or an interest-only
mortgage.
It can also be used to provide family protection, for instance, against the loss
suffered by the death of a wage earner until the children leave home. If it is used

for that purpose, the policyholder should bear in mind that the amount of cover in
real terms would be eroded by the effect of inflation.
12.2.2.2 Decreasing term assurance

The sum assured reduces to nothing over the term of the policy. Premiums may
be payable throughout the term, or may be limited to a shorter period such as
two-thirds of the term.
This policy could be used to cover the outstanding capital on a decreasing debt.
The following are two particular types of decreasing term assurance.
u Mortgage protection assurance: the most common use of decreasing term
assurance is to cover the amount outstanding on a repayment mortgage. It
is usually known as a mortgage protection policy (not to be confused with
short-term sickness and redundancy cover for mortgage repayments, which
is sometimes also called mortgage protection insurance). The sum assured on
mortgage protection assurance is calculated in such a way that it is always equal
to the amount outstanding on a repayment mortgage of the same term, based
on a specified rate of interest. The sum assured (like the mortgage) decreases
more slowly at the start of the term than towards the end.
u Gift inter vivos cover: decreasing term assurances can be arranged to cover
special requirements, such as ‘gifts inter vivos’, which are gifts made during
a person’s lifetime, as opposed to on death. Gift inter vivos cover is a term
assurance policy designed to provide an amount sufficient to pay the inheritance
tax due should the donor die within seven years of making the gift. To achieve
this, the sum assured under the policy is set at the start of the policy as the
amount of tax that is due. It remains level for three years and then reduces in
year 4 to 80 per cent of the tax due, 60 per cent in year 5, 40 per cent in year
6 and 20 per cent in year 7, after which time the cover ceases as the gift will be
exempt. Additional cover should also be arranged to protect the remainder of
the estate.
12.2.2.3 Increasing term assurance

Some companies offer increasing term assurance policies where the sum assured
increases each year by a fixed amount or a percentage of the original sum assured.
This type of policy can be used where temporary cover of a fixed amount is required
but where the cover needs to increase to take some account of the effects of
inflation on purchasing power.
12.2.2.4 Convertible term assurance

A convertible term assurance is a term assurance that includes an option to convert
the policy into a whole-of-life or endowment assurance without further evidence of
health (or indeed any additional underwriting). This guaranteed insurability means
that no medical or other evidence is required and the conversion is carried out at
normal premium rates whatever the state of health of the life assured.
The cost of this option is an addition of, typically, around 10 per cent of the
premium.
The option is normally included only on level term assurance policies but there is
no technical reason why it should not be included on decreasing term assurances
and others.

Certain rules and restrictions apply to the conversion option.
12.2.2.5 Renewable term assurance

A renewable term assurance policy includes an option, which can be exercised at
the end of the term, to renew the policy for the same sum assured without the
need for further medical evidence.
The new term is the same as the previous term and the new policy itself includes
a further renewal option, except that there is a maximum age, usually around 65,
after which the option is no longer available.
The premium for the new policy is based on the life assured’s age at the date when
the renewal option is exercised, not their age when the policy was first taken out.
Renewable and increasable term assurance is similar to the renewable policy,
with the added option on renewal to increase the sum assured by a specified
amount − often either 50 per cent or 100 per cent of the previous sum assured,
again without evidence of health.
Some companies offer renewable, increasable and convertible term

assurance, combining all three of the options described above.
12.2.3 Family income benefit

The aim of family protection is often to replace income lost on the death of the
breadwinner. A family income benefit (FIB) policy is a type of decreasing term
assurance designed to meet this need by providing income rather than a lump
sum.
The policy pays out a tax-free regular income (monthly or quarterly) from the date
of death of the life assured until the end of the chosen term. Since the cover
reduces as time passes, this policy can be described as a form of decreasing term
assurance.
As an alternative to regular income payments, beneficiaries may choose to receive a
lump sum payment that will be calculated as a discounted value of the outstanding
instalments.
Policies can be arranged with escalating instalments, to combat the effects of

inflation. Since these provide higher levels of cover than ordinary FIBs, the
premiums are also higher.
12.2.4 Pensions term assurance

Prior to A-Day (6 April 2006) it had been possible for people with personal pension
plans and stakeholder pension plans to take out (within specified limits) term
assurance policies for which they could obtain tax relief on the premiums at
their highest rate. The new pension regime introduced by A-Day appeared to
open the availability of such policies to virtually everyone, whatever their pension
arrangements. However, the government at the time quickly closed this benefit
and since December 2006 no new pension term assurances have been issued.

Ill-health and accident insurance
12.3 Ill-health and accident insurance
12.3.1 Critical illness cover

Critical illness cover (CIC) will provide a tax-free lump sum payment on diagnosis
of one of a range of specified illnesses. The illness need not be terminal and one
significant purpose of critical illness cover is to provide a lump sum to meet the
additional costs that someone may face if they are diagnosed with a serious illness.
The range of illnesses and conditions covered varies from one insurer to another
but would typically include the following:
u most forms of cancer;

u heart attack;
u stroke;
u coronary artery disease requiring surgery;
u major organ transplant;
u multiple sclerosis;
u kidney failure.
Other conditions that are sometimes covered are:

u paralysis;
u blindness;
u loss of limb(s).
Many policies also make provision for payment of the sum assured in the event
of total and permanent disability. Again, the definition of total and permanent
disability varies between companies. Some take it as being a total and permanent
disability that prevents the policyholder from doing any job to which they are
suited by virtue of status, education or experience. Other companies employ a
tighter definition that requires that the disability prevents the person from doing
any job at all.
Typical uses of critical illness cover are:
u provision of long-term care, either in hospital or in the home;
u alterations to living accommodation;

u purchase of specialised medical equipment, eg a kidney dialysis machine;
u mortgage repayment;
u improving the quality of life of a terminally ill person.

12.3.2 Income protection insurance

Income protection insurance (IPI) (also known as permanent health insurance −
PHI) pays an income when accident/illness prevents someone from earning a living
by carrying out their normal occupation. It is designed to protect people who are
working and who would lose part or all of their income if they were unable to
work due to illness or accident. For that reason, PHI is often referred to as income
protection.
Many companies also offer IPI to parents/carers who are not in paid employment.
This is because, although they may not actually earn an income, there is usually a
clear need to provide income in the event of their illness. The income could then
be used to pay for housekeeping or childminding fees if they are unable to fulfil
their usual roles due to illness or accident.
12.3.2.1 Premium rates

A major factor in determining the premium to be charged is the occupation of the
life insured. An IPI provider might typically classify occupations in the following
way.
u Class 1: the lowest risk covering those in clerical, professional or administrative
roles. Examples would include accountants and civil servants.
u Class 2: occupations carrying a low risk of an accident. Examples would include
hairdressers and pharmacists.
u Class 3: occupations carrying a moderate risk of accident or health problems.
Examples would be farmers or electricians.
u Class 4: occupations with the highest risk of a claim. There will be a substantial
risk of health problems or the risk of accident arising from the occupation.
Examples would include coal miners and industrial chemists.
Certain occupations will be excluded from IPI cover on the basis that they represent
too great a risk.
The occupation class that a person is deemed to fall within will determine the level
of premium (Class 1 occupations get the cheapest rates) and may also influence
the terms on which cover is offered. Other factors that will influence the premium
rate are:
u the age of the life insured;
u the amount of benefit;
u current state of health;
u past medical history;
u the length of the deferred period (see the next section).
12.3.2.2 Types of income protection premiums

There are three types of income protection premiums available − ‘reviewable,
‘renewable’ and ‘guaranteed’.
u Reviewable premiums: a reviewable premium means that premiums may start
off relatively low, but will be reviewed in the future and may go up every few

years or so. In some cases, the premium may be reviewable every year, or every
five years, to take into account changing circumstances.
u Renewable premiums: renewable premiums are similar to reviewable
premiums, but every time the policy comes up for renewal, the premium is
reviewed and the amount paid to the insurer may change.
u Guaranteed premiums: the nature of guaranteed premiums means that these

tend to be more expensive than the other two options, but the premiums are
guaranteed for the life of the policy, which may be as long as 25 years.
A waiver of premium option may also be provided whereby premiums for the IPI
policy are not required while benefits are being paid from the policy, but the policy
cover continues as normal.
12.3.2.3 Payment of benefit

The payment of benefits commences after a deferred period. This is the amount
of time that elapses between the onset of the illness/injury and the point at which
benefits payments commence. Typical deferred periods are 4, 13, 26, 52 and
104 weeks. The minimum four-week deferred period is to prevent multiple claims
for minor ailments such as colds.
A self-employed person, who typically would suffer a loss of income after a very
short period of illness, should opt for a short deferred period. Conversely, an
employed person may wish to opt for a long deferred period if they have sickness
benefits paid by their employer. If this is the case, the deferred period should be
set to match the date at which the employer’s sick pay ceases. The longer the
deferred period chosen, the cheaper the premium will be.
Benefit levels are set so that the claimant is unable to receive a higher income
when not working than they could from working. Typical maximum IPI benefits
are 60−65 per cent of gross pre disability earnings. State benefits − benefits are
payable in addition to this so in effect claimants cannot receive more than 75 per
cent of gross pre-disability earnings. These limits apply to total benefits from all
IPI contracts held by the individual.
Benefits are paid pro-rata if illness means that a person can work but only part-time.
Cover is ‘permanent’ in the sense that the insurer cannot cancel the cover simply
because the policyholder makes numerous claims. The policy could be cancelled,
however, if the customer fails to keep up their premium payments or takes up a
hazardous job or pastime.
Some policies will allow benefits to be indexed either before or during a claim. The
rate of increase may be at a fixed rate, perhaps 3 per cent to 7 per cent, or based
on a published measure of inflation.
Benefit is normally paid until death, return to work or retirement, whichever event
occurs first.
IPI is available as a standalone policy, either as a pure protection plan or on a
unit-linked basis. Additionally, IPI can be available as an option on a universal
whole-of-life plan.

12.3.2.4 Taxation of IPI benefits

Where IPI is taken out on an individual basis the benefits are tax-free.
IPI can be arranged by an employer on a group basis and in this case the income
will be taxable as earned income. The employer pays the premium, which is a
tax-deductible business expense; the premium paid by the employer is not taxable
as a benefit in kind on the employee/scheme member, ie no tax or National
Insurance is payable by the member on the premium paid, provided that the
employer has discretion as to whether to pay the proceeds to the employee. In
practice, the employer has such discretion and then pays the proceeds on to the
member concerned. The scheme member pays income tax and National Insurance
on the proceeds.
12.3.3 Accident, sickness and unemployment

insurance
Accident, sickness and unemployment (ASU) insurance plans are a type of general
insurance that may be considered as an alternative to IPI.
ASU insurance is typically used to cover mortgage repayments in the event that
illness, accident or loss of employment prevents the policyholder from earning
a living. If used in this way it can be known as mortgage payment protection
insurance. A level of income equal to monthly mortgage repayments is paid for a
limited period, usually a maximum of two years.
Additional cover can sometimes be included to cover other essential outgoings.
ASU cover taken out with personal loans is known as ‘payment protection
insurance’ (PPI). Benefits cover the loan payments for the remainder of the loan
term. These policies have been mis-sold to some consumers, mainly due to
eligibility under the terms of the policy not being checked.
As with income protection insurance, there will be a deferred period, normally one
month, which must elapse before benefit payments can commence. Lump sums
may be paid on certain events (death, disablement and loss of a limb).
In contrast to IPI, these plans should be viewed as short term to protect mortgage
payments rather than as providing total protection of earned income.
It would be more accurate to describe these policies as accident, sickness and
redundancy insurance, as they do not offer protection from unemployment when
the insured is sacked, or resigns voluntarily. The policy will often include the
following restrictions.
u The proposer must have been actively and continuously employed for a
specified minimum period prior to effecting the plan.
u Any redundancy that the proposer had reason to believe was pending when they
took out the policy will be excluded.
u No benefit will be payable if redundancy occurs within a specified period of the
cover starting.
A person may have to have been employed for a minimum period either before
they can take out this type of plan or before the unemployment element of the
plan becomes valid.

ASU policies are annually renewable at the discretion of the insurer. This means
that the insurer could increase premiums in light of poor claims’ experience or
may even withdraw the cover offered. This is a major difference from IPI.
12.3.3.1 Taxation of ASU policies

All benefits are tax-free but there is no tax relief on contributions to an ASU plan,
regardless of whether it is arranged on a group or personal basis.
If the scheme is set up on a group basis, any employer contribution will be allowed
as an expense against corporation tax. Any employer contribution will be classed
as a benefit in kind.
12.3.4 Private medical insurance

Private medical insurance (PMI) is a pure protection plan designed to provide cover
for the cost of private medical treatment, thus eliminating the need to be totally
dependent on the NHS.
Plans can be arranged on an individual basis or as part of a group scheme
established by an employer. Employer-sponsored schemes currently account for
the vast majority of PMI provision in the UK.
In a non-emergency situation, PMI can offer the following benefits:
u avoidance of NHS waiting lists;
u choice of hospital where the treatment will take place;
u choice of timing of the treatment (to fit in with work demands, for example);
u high-quality accommodation;
u choice of medical consultant.
The range of cover normally provided includes reimbursement of:
u inpatient charges including nursing fees, accommodation, operating fees,
drugs and the cost of a private ambulance;
u surgical and medical fees including surgeon’s fees, anaesthetist’s fees,
pathology and radiology;
u outpatient charges including consultations, pathology, radiology and home
nursing fees.
Some policies offer additional benefits such as the payment of a daily rate if
treatment is delivered within an NHS hospital and involves an overnight stay.
The way in which benefits are paid varies between providers. Some will offer a
full refund of charges with payment direct to the healthcare provider. Other plans
impose an upper limit on the amount that can be reclaimed in any one year.
Premium rates depend on a number of factors, including:
u location − this is mainly because the cost of medical care varies throughout the
country (costs are particularly high in London);
u type of hospital to which the individual is allowed access under the terms of
the plan − again, treatment in the postgraduate teaching hospitals in London
is more expensive and will be reflected in higher premiums;
u standard of accommodation available to the patient under the terms of the plan.

A major factor will be the type of scheme that is taken out. For example, many
providers offer a budget scheme, which may limit the patient’s choice of hospital
or require treatment on the NHS if the waiting list does not exceed a maximum
period, eg six weeks. Any limit on the range of cover provided will reduce the
premium payable. The limit may take the form of a financial limit on the amount
of benefit that is provided or limits on the range of treatment covered.
One other significant factor is the age of the person applying for cover. The
morbidity risk increases with age and consequently so does the probability of
a claim being made under the terms of the plan.
12.3.4.1 Underwriting
Certain events will be excluded from cover under the scheme. Cover will not be
provided for any pre-existing medical conditions, and other general exclusions are
the costs of:
u routine optical care (such as provision of spectacles or lenses);
u routine dental treatment;
u routine maternity care;
u chiropody;
u the treatment of ailments that are self-inflicted, eg the consequences of drug
and alcohol abuse;
u cosmetic surgery;
u alternative medicine.
12.3.4.2 Taxation
Premiums are subject to insurance premium tax but the benefits are paid out
tax-free.
Employers who contribute to PMI on behalf of their employees are able to claim
the cost as an allowable deduction against corporation tax.
Contributions paid by an employer are regarded as a benefit in kind as far as the
employee is concerned and will be taxable as if they had been paid as income.
12.3.5 Long-term care insurance

The purpose of long-term care (LTC) insurance is to provide the funds to meet
the costs of care that arise at a point in later life when a person is no longer
able to perform competently some of the basic activities involved in looking after
themselves each day and consequently requires assistance.
The need for this type of protection has increased because families are more spread
out than in earlier generations and less able to take care of elderly relatives. The
problem has also been exacerbated by the fact that life expectancy has increased
and people’s expectations for their quality of life in later years are higher than
ever. There has been growing concern over the standard of care that state support
and the NHS can realistically be relied upon to provide.

12.3.5.1 Benefits
The amount of benefit paid from an LTC plan will depend on the degree of care
required by the insured. This will be established by ascertaining the person’s ability
to carry out a number of activities of daily living (ADLs). Typical ADLs would
be:
u washing;
u dressing;
u feeding;
u using the toilet;
u moving from room to room;
u preparing food.
Each LTC insurer will have its own definitions of what constitutes an inability to
carry out an ADL. Many follow the definitions laid down by the Association of British
Insurers.
The greater the number of ADLs that cannot be performed without assistance,
the greater the amount of care required and, therefore, the higher the level of
benefit that will be paid. It is normal for insurers to require that the person must
be incapable of performing at least two or three of the ADLs before a claim can
be accepted. A person need not be confined to a nursing home to receive LTC
benefits: for example, a person may be unable to dress themselves in the morning
and prepare and eat food without assistance. Therefore, the range of support they
would need may be limited to a person coming in at certain points during the day
to help with those specific activities.
12.3.5.2 Taxation of benefits

If an annuity is purchased for immediate long-term care needs, it must be an
‘immediate needs annuity’ in order for the benefits to be tax-free. An immediate
needs annuity is one where the benefits are payable directly to the care provider
for the care of the person protected under the policy. Furthermore, the annuity
must have qualified as an immediate needs annuity when it was taken out. In other
words, the benefits from an ordinary ‘purchased life annuity’ cannot be paid as
tax-free just because they are being used to fund long-term care.
If an annuity does not qualify as an ‘immediate needs annuity’ − ie if its benefits
can be paid to the policyholder − it is taxable, but only the interest element (20 per
cent tax will be deducted at source, higher-rate taxpayers having a further liability
of 20 per cent; additional-rate taxpayers have a further liability of 25 per cent).
Where an ‘immediate needs annuity’ is established on a ‘life of another’ basis, the
benefits can still be paid tax free, provided that they are paid direct to the care
provider and are used solely for the care of the person protected under the policy.
If any part of the annuity benefits are paid to anyone other than the care provider,
or for any purpose other than for the care of the person protected under the policy
(including payments that may be due on the death of the protected person), that
portion of the benefits is taxable, but only the interest element.
Benefits are also tax free if the long-term care policy is ‘pre-funded’, ie where
there is no annuity but, instead, premiums are paid to an insurance company
(out of tax-paid income) to insure against a possible future event. For pre-funded

long-term care policies, it doesn’t matter whether the benefits are paid direct to
the care provider or to the protected person.
12.4 Protection needs for businesses

We covered protection needs for businesses in section 6.4.2, which you should
take some time to review now. The solutions are the same as for personal needs
− for example, life cover through term and whole-of-life insurance, critical illness
cover and income protection insurance.
To summarise, the main areas were:
u protection for key employees;

u death of a business partner;
u partnership protection schemes;
u death of a small business shareholder;

u sickness of a sole trader;
u sickness of a business partner;

u sickness of self-employed.
Review questions
1. What is a whole-of-life assurance policy?

2. When are reversionary bonuses declared on with-profit policies?
3. What are the possible additional features of a universal whole-of-life-policy?
4. What is the cash surrender value of a term assurance policy?
5. Which illnesses are typically covered by critical illness policies?
6. What factors affect premium rates for income protection insurance?

7. What is the typical deferment period for ASU policies?
8. List the fees that are covered by PMI.
9. Explain the taxation rules relating to PMI.
10. Why is there a need for long-term care insurance?

Topic 13
Investment products
Learning objectives
u classify the range of asset classes and their key features;

u explain cash deposits;
u explain individual savings accounts (ISAs);

u summarise government securities, corporate bonds and Eurobonds;
u explain equities;
u summarise property as an investment.
13.1 Introduction
This topic will focus on the various asset classes and their key features to enable
an understanding of the types of investment product available for investors to
acquire, either directly or through collective investments. Collective investments
will be considered in Topic 14.
13.2 Asset classes

Asset classes can be categorised broadly as follows.
u Cash − bank or building society deposits and some National Savings
investments. An emergency fund should hold between three and six months’
income. The amount held in cash will increase the more risk-averse the investor.
u Fixed-interest securities (eg gilts and bonds); these are low- to medium-risk
investments aimed at medium- to long-term growth.
u Equities (eg shares in companies); these present higher risk to the investor
and may be UK and international equities. They may be held in some form of
collective investment (see Topic 14) to help spread the risk.
u Property − some investors choose to hold property and we will consider this
in section 13.11.

13: Investment products
Investment professionals usually drill down into the broad asset classes shown
above, often working with between 9 and 15 asset classes. For example
equities can be divided into additional ‘sub classes’ including shares in different
indices (FTSE 100/250/All-Share), shares by market capitalisation (large and small
companies), shares in different countries and so on.
The client’s objectives and attitudes to risk will dictate which of the classes are
appropriate for them. For example, if the client needs income, they may meet
this objective by holding cash and fixed-interest securities; however, there are
other alternatives that can be considered. Some of the portfolio should be held in
income-producing shares or collectives in order to provide the potential for capital
growth. If an income portfolio does not benefit from capital growth, the income
will remain static and inflation will reduce its value. Allocating assets in the right
proportion will help the client to meet their objectives.
At the opposite end of the spectrum, a client with a capital growth objective will
hold very little in cash and fixed-interest securities − they do not provide significant
capital growth.
When allocating assets within a portfolio, it is also important to look at the types of
vehicle within each class. A client wanting capital growth should consider investing
in overseas, as well as UK, equities, because at certain times overseas markets may
outperform those in the UK, and vice versa. The exact allocation of each will depend
on their precise objective, their timescale and their attitude to risk.
The remainder of this topic looks at these classes in more detail.
13.3 Cash deposits

Deposit-based investments are those in which the capital element is fixed but the
income from the investment may vary. We looked at these in outline in section 8.2.
Investors place money in deposit-based savings accounts for a number of reasons.
Some consider their capital to be secure. In one respect this is true, ie the amount
of capital invested remains intact, but inflation reduces the value of capital and, in
times of high inflation, the value of deposits can quickly be eroded in real terms.
There is also the risk of loss of capital if the institution becomes insolvent. This
is rare with banks and building societies, but is not unknown. In the event of
insolvency, investors may be able to reclaim some of their funds through the
Financial Services Compensation Scheme.
The convenience of the ready accessibility of banks and building societies is a
strong reason for investors to deposit money with them; it is believed that, to
some extent, inertia inhibits an investor’s search for a more rewarding home for
their deposits.
If the reason for saving or investing money is for a short-term purpose (next
year’s holiday or a new car, perhaps) then few would argue that a deposit-based
savings account is a sensible place in which to invest the money. It is prudent to
have a part of an investment portfolio that is easily accessible in, for example, a
no-notice deposit account; this is often referred to as money put by for a ‘rainy
day’. Institutional investors (eg pension funds) maintain a part of each of their
funds in readily accessible form.

Cash deposits
13.3.1 Deposit accounts

These are among the most straightforward types of account that financial services
providers offer. Depositors (whether individuals or corporate bodies) can invest
from as little as £1 with no maximum, and receive a return on their investment in
the form of interest.
Interest is normally variable and is usually linked to the bank’s base lending rate.
It is calculated daily and added to the account on a periodic basis (eg quarterly,
half-yearly or yearly).
Some deposit accounts offer higher interest rates provided that a certain minimum
investment is made. Deposits can be subject to notice of withdrawal, with the
typical notice period being seven days. Often the requirement for notice will be
waived subject to a penalty, which is normally equal to the amount of interest that
could be earned over the notice period.
Deposit accounts may be considered as an investment of funds kept for an
emergency or otherwise in case of need. Over the longer term, however, they
have proved to be unattractive when compared with asset-backed investments.
13.3.2 Building society accounts

Building society accounts pay interest on various types of account such as ordinary
savings accounts, high-interest accounts and term accounts. The main difference
between a bank and a building society is in their legal structure. Building societies
are mutual organisations and are owned by their members (investors with share
accounts and borrowers), whereas banks are limited companies owned by their
shareholders.
13.3.3 Money market deposit accounts

The money market is a market for short-term debt securities, commercial paper,
negotiable certificates of deposit, and Treasury bills with a maturity of one year
or less and often 30 days or less (see section 14.8.3 for examples). Money market
securities are generally very safe investments returning a relatively low interest rate
that is most appropriate for temporary cash storage or short-term time horizons.
Deposit accounts based on this market (the money is invested there) usually attract
a higher rate of interest than ordinary deposit accounts. The rate of interest
reflects current money market interest rates and may vary according to the amount
invested. There are two basic types of money market account: fixed accounts and
notice accounts.
u Fixed accounts are term deposit accounts, where a sum of money is invested
for a fixed period during which time it cannot normally be withdrawn. This
period can vary from overnight to five years. The rate of interest is normally
fixed for the whole period.
u Notice accounts have no fixed term but, as the name implies, there is a
requirement on the investor to give an agreed period of notice of withdrawal.
Similarly, the bank must normally give the investor the same period of notice
of a change in interest rate. A typical period of notice could be anything from
seven days to six months, although 12-month notice periods are available.

Money market deposit accounts may be suitable for individuals with very large
amounts of cash to place on short-term deposit until they commit the cash to
other purposes.
13.3.4 Taxation
The system of taxing interest changed from 6 April 2016. Interest is paid gross,
without deduction of tax. Where the interest payment falls into the first £5,000
of an individual’s taxable income or where it falls within an individual’s personal
savings allowance (£1,000 for basic-rate taxpayers, £500 for higher-rate taxpayers)
then no tax is paid on the interest. Otherwise income tax is payable at:
u 20 per cent for basic-rate taxpayers;
u 40 per cent for higher-rate taxpayers;
u 45 per cent for additional-rate taxpayers.
13.3.5 Offshore investments

The term ‘offshore’ is usually applied to any investment medium, whether bank
or building society account or any other form of investment, based outside the
UK. Such offshore investments are usually provided in a country that offers more
advantageous taxation of investments. Such countries, sometimes referred to as
‘tax havens’, include the Channel Islands, Luxembourg and the Cayman Islands.
Offshore investment can potentially expose the investor to greater risk than a
similar onshore investment. Firstly, the account may not be denominated in sterling
and will therefore be at risk of adverse currency movements if the investment
is to be converted back to sterling at some point. Secondly, not all offshore
accounts are protected by investor protection schemes like the UK Financial
Services Compensation Scheme (FSCS). Investors should confirm what protection
is available by the relevant local regulatory regime.
Offshore investments may be useful to an investor who needs money to be available

outside the UK − eg someone who works abroad, owns a property abroad or who
plans to move abroad in the future.
The interest on an offshore deposit will be paid gross. A UK resident must declare
the income to HM Revenue & Customs (HMRC). Overseas interest is taxable in the
hands of UK residents (unless they are not ordinarily resident or domiciled in the
UK). They may, however, be able to obtain relief from some or all of this tax under
a double taxation agreement if the interest has been taxed overseas.
There are specific rules governing whether or not an individual is resident or

non-resident as far as their liability to UK taxation is concerned. Care should be
taken to determine an investor’s residential status.
The Foreign Account Tax Compliance Act (FATCA) is a US federal law and forms
part of the US Hiring Incentives to Restore Employment Act of 2010. The Act aims to
combat tax evasion by US tax residents using foreign accounts. It includes certain
provisions on withholding taxes and requires financial institutions outside the US
to pass information about their US customers to the US tax authorities, the Internal

Cash deposits
Revenue Services (IRS). Failure to meet these reporting obligations would result in
a 30 per cent withholding tax on the financial institutions.
The FATCA provisions imposed new and substantial burdens on UK businesses
in identifying US taxpayers, and reporting information to the IRS. Significantly for
UK institutions the Data Protection Act precludes UK businesses from passing the
required information to the US.
The UK government (along with France, Germany, Italy, and Spain) with the
support of the European Commission, took part in joint discussions with the US
government to explore an intergovernmental approach (IGA) to FATCA, supporting
the overall aim to combat tax evasion, while reducing risks and burdens on financial
institutions.
The UK and the US subsequently signed an IGA in September 2012 agreeing to
implement the provisions of the FATCA, subject to a reduction in some of the
administrative burden of complying with the US regulations. The IGA provides a
mechanism for UK financial institutions to comply with their obligations without
breaching the data protection laws. Under the IGA, financial institutions pass
information to HMRC who will then exchange this information with the IRS.
The IGA has changed since it was signed, in that Annex II was updated and the
changes resulted in a wider scope of institutions and products exempt from the
FATCA requirements.
13.3.6 National Savings and Investments

National Savings and Investments (NS&I) offers a range of saving and investment
products on behalf of the government. The risk associated with the products is
very low because all products guarantee the return of any capital invested. There
are NS&I products to suit most types of investor, with different terms, interest rates
and taxation. Full details of the range of deposit-based savings and investments
offered can be obtained from the Post Office or by visiting the National Savings
and Investments website at www.nsandi.com. The tax treatment of NS&I accounts
is the same as for bank / building society accounts − unless interest is tax-free, it
is paid gross and is taxable where falling outside of an individual’s first £5,000 of
taxable income and personal savings allowance of a basic- / higher-rate taxpayer.
A brief summary of the products available as at January 2016 is included below.
From time to time NS&I varies its product offerings and sometimes withdraws
certain products (eg National Savings Certificates). Students should review the
website (www.nsandi.com) periodically to check current offerings.
13.3.6.1 Direct Saver

Managed online or by phone, this account offers instant access, and a minimum
investment of £1 up to to £2m. It is available to anyone aged 16 or over.
13.3.6.2 Investment account

An investment account may be opened by anyone over the age of 16 and, for those
under this age, a parent, grandparent or legal guardian may open the account. The
account pays a variable rate of interest deposits from £20 to £1m. The account is
postal only.

13.3.6.3 Income bonds

Income bonds offer regular monthly income and are available to anyone over age
16. The income bond is available to those who want to invest between £500 and
£1m; the account has no term and capital can be withdrawn at any time. Interest
is paid up to, but not including, the day it is withdrawn. The interest rates are
variable.
13.3.6.4 Premium Bonds

Premium Bonds are available to anyone over 16, and can be bought for those under
16 by parents, grandparents, great-grandparents and guardians. They provide
investors with a regular draw for tax-free prizes, while they retain the right to cash
in the bond. The minimum purchase is £100 and the maximum is £50,000. Prizes
are drawn each month and can be worth up to £1m. Winnings from Premium Bonds
are tax-free. The bonds can be encashed at any time, subject to eight working days’
notice.
13.3.6.5 Children’s Bonds

The Children’s Bond is a lump sum investment intended to be retained for at least
five years. It can be bought by parents, grandparents, great-grandparents and
guardians for those under 16. Investments are from £25 to £3,000 per issue. The
bond will mature once it reaches its first 5-year anniversary on or after the child’s
16th birthday. The interest rate is fixed for the term of the bond. They can be
cashed in early with a penalty equivalent to 90 days’ interest.
13.3.6.6 Direct ISA

A Direct ISA is available to anyone who is UK resident and aged 16 or over. The
minimum opening balance is £1. As with all ISAs, the investment limit for 2016/17
is £15,240.
13.4 Individual savings accounts

In 1997 the government decided that the existing tax-free savings schemes were
not sufficiently accessible to a large proportion of the population. It was estimated
that 50 per cent of the population of the UK had less than £200 in savings,
with about 25 per cent having no savings at all. The government subsequently
introduced, from 6 April 1999, the individual savings account (ISA). Its stated
objectives were to develop the savings habit and to ensure that tax relief on savings
is fairly distributed. In the 2014 Budget the government announced that from 1 July
2014 ISAs would be reformed making them simpler and more flexible. An ISA is
simply a ‘tax wrapper’ which is placed around other forms of investment to confer
more favourable tax treatment than the underlying investment would otherwise
enjoy, so encouraging saving.
There are three main types of ISA:
u Stocks and shares − this component can include:

Individual savings accounts
− shares and corporate bonds issued by companies listed on stock exchanges

anywhere in the world;
− gilt-edged securities and similar stocks issued by governments of countries
in the EEA;
− UK-authorised unit trusts that invest in shares and securities;
− UK open-ended investment companies (OEICs);
− UK-listed investment trusts;
− corporate bonds listed on a recognised stock exchange;
− life assurance policies;
− cash.
u Cash − this component includes:
− bank and building society deposit accounts;
− certain taxable NS&I accounts − excluding the investment account. NS&I also
offers a deposit account-type ISA.
u Innovative finance − this type of ISA has been available since April 2016. It
includes investments made via peer-to-peer lending websites such as Zoopla
and Funding Circle.
Peer-to-peer lenders operate by taking in investments from those who have
funds to invest and then lending these funds out to businesses who wish to
raise funds to finance their business activities. The peer-to-peer lender will
pay interest to the investors and charge (a higher rate of) interest to those
companies who borrow funds.
Investing money via a peer-to-peer lender can be done outside of an ISA but
investing using an ISA means that interest is tax-free.
The interest is not guaranteed; as the money invested is lent out, there is a
risk of the business(es) it is lent to going out of business and defaulting on
their loan repayments. The peer-to-peer lender will carry out due diligence to
minimise this risk, but potential investors should understand the risk.
Importantly, unlike cash deposits, peer-to-peer lenders are not covered under
the Financial Services Compensation Scheme.
A ‘Help to Buy’ ISA was introduced from December 2015. The purpose of the Help
to Buy ISA is to encourage first-time buyers to save for a home by rewarding them
with a bonus on their savings. An initial deposit of £1,200 and monthly savings of
up to £200 can be made. Each £200 attracts a bonus of £50 (25 per cent), subject
to a minimum overall investment of £1,600, with a maximum bonus of £3,000
on savings of £12,000. The bonus is payable on purchases of up to £450,000 in
London and £250,000 elsewhere in the UK, and is payable upon completion of the
purchase.
ISAs have an overall limit for 2016/17 of £15,240. There is the option of using
the whole allowance in a single component or splitting the investment across the
different types of ISA.
The minimum age for investing into a cash or Help to Buy ISA is 16 years, and for
stocks and shares and the innovative finance ISAs, the minimum age is 18 years.
An ISA investor must be resident in the UK for tax purposes, and an ISA can only

be held in a single name, ie joint accounts are not permitted, although husbands
and wives can have one each.
Investors are exempt from income and capital gains tax on their ISA investments.
Fund managers are exempt from tax on other income and gains received for the
benefit of ISA investors.
Many ISAs allow no-notice withdrawals to be made, although there are some
fixed-rate cash ISAs available that do not permit withdrawals during the fixed-rate
period. Withdrawals from the innovative finance ISA are subject to notice. It is
now possible to replenish withdrawals made during a particular tax year. For
example, if an investor aged 40 paid in £15,240 cash to open an ISA on
20 November 2016 and then withdrew £2,000 on 25 January 2017, they could
reinvest the £2,000 withdrawn during the remainder of the 2016/17 tax year to
top the investment back up to the maximum level of £15,240.
Since December 2014 it has been possible for ISAs to be transferred to a spouse
/ civil partner where the account holder dies. Under the previous system, the ISA
had to be encashed and its tax privileges were lost. Now, the spouse / civil partner
of the deceased gains an additional ISA allowance equivalent to the ISA holdings
of the deceased, referred to as an additional permitted subscription. This enables
the ISA savings to be transferred into another ISA.
ISAs can be transferred between providers on a like-for-like basis.
13.4.1 Lifetime ISA

A new Lifetime ISA is to be introduced from April 2017. This new ISA will be
available to those aged between 18 and 40 and is aimed at encouraging people to
save for their first home and / or to provide an income in retirement.
Maximum contributions are £4,000 per year, and the government will provide a £1
bonus for each £4 saved (25 per cent). As long as the savings are used to purchase
a first home with a value of up to £450,000 or to provide an income in retirement
from age 60, the bonus is retained. The monies are otherwise accessible but the
bonus would be lost and any withdrawal subject to a 5 per cent charge.
13.4.2 Help to Save

The Help to Save scheme was announced in March 2016 and will be available from
April 2018. The scheme is designed to encourage people with low incomes to set
money aside through regular saving.
To be eligible for the scheme an individual must be claiming Universal Credit or
tax credits. Eligible individuals will be able to save up to £50 per month into the
scheme, which runs for an initial two-year period. At the end of the initial two years
a bonus of 50 per cent of the amount saved is paid, up to £600. The scheme can
then continue for a further two years, after which time a further bonus of 50 per
cent of the amount saved during that period is paid.
Withdrawals can be made at any time.

Government securities
13.5 Government securities

Gilt-edged securities (commonly known as gilts) are UK government securities
and represent borrowing by the government. Borrowing is necessary to fund the
shortfall in tax revenues and government spending on costs such as the welfare
state. Gilts are safe investments because the government will not default on interest
or capital repayments.
A gilt is categorised primarily according to the length of time left to run until its
redemption. The redemption date is the date on which the government must buy
back the gilt at its original issue value or par value, normally quoted as a nominal
£100. Each gilt pays interest on the par value at a fixed interest rate known as the
coupon.
Most gilts have a specific redemption date, although some have two dates between
which there will be redemption on a date selected by the government, at its
discretion. The categories are as follows.
u Short-dated gilts: also known as ‘shorts’, these are gilts with less than five
years to run before redemption.
u Medium-dated gilts: also known as ‘mediums’, these are gilts with between
5 and 15 years to run before redemption.
u Long-dated gilts: also known as ‘longs’, these are gilts with over 15 years to
run before redemption.
u Undated gilts: gilts with no redemption date at all are redeemable at any time
subject to the government’s discretion. The government is, however, under no
obligation ever to redeem them.
The above definitions are based on categorisations in the financial press. The UK
Debt Management Office, which issues gilts, defines short and medium gilts as
follows:
u short-dated gilts: 0−7 years;
u medium-dated gilts: 7−15 years.
Index-linked gilts are gilts where the interest payments and the capital value move
in line with inflation. The redemption value and the interest paid are therefore
index-linked. For the investor this means that the purchasing power of their capital
and interest received will remain constant, unlike all other fixed-interest stock
where inflation erodes the purchasing power of fixed-interest payments.
A gilt-edged stock with a coupon of 5 per cent and a redemption date in 2021
might be designated as ‘Treasury 5 per cent 2021’.
Interest on gilts is normally paid half-yearly, so the holder of £10,000 nominal
of Treasury 5 per cent 2021 would receive £250 in interest every six months.
The interest is paid gross, but is subject to income tax unless it falls within the
first £5,000 of an individual’s taxable income or their personal savings allowance
(£1,000 for basic-rate taxpayers, £500 for higher-rate taxpayers).
Gilts are bought ‘below par’ at the time of issue. Gilts cannot be redeemed by
investors prior to the redemption date but can be sold to other investors. The
price at which they are sold depends on a number of factors, including the level of
market rates of interest, nearness to the redemption date, and supply and demand.
Gilt prices are quoted either cum dividend or ex dividend. If a stock is bought
cum dividend, the buyer acquires the stock itself and the entitlement to the next

interest payment. If, however, the stock is bought ex dividend, then while the
buyer acquires the stock itself, the forthcoming interest payment will be payable
to the previous owner of the stock (ie the seller).
Any capital gains made on the sale of gilts are free of capital gains tax (CGT).
Example
Andrew, a higher-rate taxpayer, buys £100,000 par value of Treasury 5 per
cent 2019 at a price of 80.0, ie he pays £80,000 for the stock.
He receives annual interest of £5,000 (actually £2,500 per half year), which
represents a yield of 6.25 per cent on his investment of £80,000.
The interest is paid gross and, assuming that he has no other savings income,
the first £500 is tax-free with the balance of £4,500 taxed at 40 per cent
(£1,800).
Later he sells the stock for £90,000. There is no capital gains tax to pay on his
gain of £10,000.
13.6 Local authority stocks

Like the government, local authorities can borrow money by issuing stocks or
bonds, which are fixed-term, fixed-interest securities. They are secured on local
authority assets and offer a guaranteed rate of interest, paid half-yearly. The
interest is paid gross and taxed in the same way as savings interest and income
from gilts in the hands of an investor. The bonds are not negotiable and have a
fixed return at maturity.
Return of capital on maturity is guaranteed but these instruments are not quite as
secure as gilts because there is no government guarantee.
13.7 Permanent interest-bearing shares

Permanent interest-bearing shares (PIBS) are issued by building societies to raise
capital. They are termed ‘permanent’ as they have no redemption date. They pay
a fixed rate of interest on a half-yearly basis. Interest is paid gross, although it is
taxable as savings income according to the investor’s tax status.
Investors should also note that PIBS rank below ordinary accounts in priority of
payment, should a society become insolvent.
13.8 Corporate bonds

Corporate bonds are similar in nature to gilt-edged stocks, but they represent loans
to commercial organisations rather than to the government. They normally have a
fixed redemption date, a specified redemption value and a fixed interest rate, and
− like gilts − they can be bought and sold at prices that reflect market rates of
interest.
They are considered higher risk than gilts because they do not have government
backing, and they therefore tend to offer higher yields. The returns on corporate

Equities and other company finance
bonds are related to risk and to help investors they are given gradings by ratings
agencies (such as Standard and Poor’s). As an example, a ‘AAA’ rating would be
considered very low risk.
13.9 Eurobonds
A Eurobond is a bond issued or traded in a country using a currency other than the
one in which the bond is denominated. This means that the bond uses a currency,
but operates outside the jurisdiction of the central bank that issues that currency.
Eurobonds are issued by multinational organisations and governments.
For example, a UK company may issue a Eurobond in Germany, denominating it in
US dollars. It is important to note that the term has nothing to do with the euro
currency, and the prefix ‘euro’ is used more generally to refer to deposits outside
the jurisdiction of the domestic central bank.
13.10 Equities and other company finance

When companies need to raise money in order to commence or to expand their
business, there are various ways in which this can be done. Mention was made
in section 13.8 of corporate bonds, which represent one way of borrowing money
for a fixed period at a fixed rate of interest. Other types of loan, either secured
or unsecured, can also be used, but the most common way for companies to be
funded is through the issue of shares, described in the following sections.
13.10.1 Ordinary shares

Ordinary shares, also known as equities, are the most important type of security
that UK companies issue. They can be, and are, bought by private investors, but
most transactions in equities are made by institutions and by life and pension
funds.
Holders of ordinary shares (shareholders) are in effect the owners of the company.
The two main rights that they have are:
u to receive a share of the distributed profits of the company in the form of
dividends;
u to participate in decisions about how the company is run, by voting at
shareholders’ meetings.
The rights attaching to shares of the same class can sometimes differ from
company to company, even though the shares normally have the same major
characteristics. It is therefore prudent for investors to find out precisely what rights
attach to a particular share. These rights are set out in the company’s articles of
association, which is a public document and can be examined at the registered
office of the company or at Companies House.
Direct investment in shares is considered to be high risk because the failure of the
company can result in the loss of all the capital invested. This risk can be mitigated
by investing across a range of shares, and the products available to facilitate this
(such as unit trusts and investment trusts) are described in Topic 14.

The prices at which shares are traded depend on a range of factors, including:
u the profitability of the individual company;
u the strength of the market sector in which it operates;
u the strength of the UK and worldwide economies;
u supply and demand for shares and other investments.
In the short term, share prices can fluctuate both up and down − sometimes quite
spectacularly − but in the long term, investment in equities and equity-linked
markets has outpaced inflation and has provided higher growth than deposit-type
investments.
13.10.2 Buying and selling shares

The London Stock Exchange and AIM are the markets in which equities are traded
and were described in section 1.3.5. Investors can buy shares on these markets
through a stockbroker. Many large financial service providers have a stockbroking
department with access to brokers for their clients, with most offering online or
telephone services. There are other independent stockbrokers who also offer these
types of services.
13.10.3 Returns from shares
13.10.3.1 Risk and reward

Shareholders in a limited liability company do not have a liability for the debts of
the company. The company has a separate legal identity and is itself liable for its
debts. Shareholders do, however, run the risk that the value of their investment in
the company could go down or even, in the event of a liquidation, be lost altogether.
In line with the broad rules of risk and return, therefore, it might be expected that
the potential for high returns would also be a feature of the share market. It is
certainly true that, on average and over the longer term, equity markets have far
outpaced the returns available on secure deposit-based investments.
13.10.3.2 Assessment of financial returns

The financial returns that shareholders hope to receive from their shares take two
forms:
u the growth in the share price (capital growth); and
u the dividends they receive as their share of the company’s distributable profits
(income).
There are a number of measures that can be used to assess the success of
investment in a company’s shares and to predict future performance.
u Earnings per share: this is equal to the company’s net profit divided by the
number of shares, but it is not normally the amount of dividend to which a
shareholder is entitled on each of their shares. This is because a company may
choose not to distribute all of its profits: some profits may be retained in the

Equities and other company finance
business to finance expansion, for instance. This in turn leads to the concept
of dividend cover.
u Dividend cover: this factor indicates how much of a company’s profits are
paid out as dividends in a particular distribution. If, for example, 50 per cent of
the profits are paid in dividends, the dividend is said to be covered twice. Cover
of 2.0 or more is generally considered to be acceptable by investors, whereas a
figure below 1.0 indicates that a company is paying part of its dividend out of
retained surpluses from previous years.
u Price/earnings ratio: as its name suggests, the P/E ratio, as it is commonly
known, is calculated as the share price divided by the earnings per share. It is
generally considered to be a useful guide to a share’s growth prospects: a ratio
of 20 or more, for example, indicates that a share is doing well and can be
expected to increase in value in the future. Such a share is likely, as a result, to
be relatively more expensive than others within the same market sector. A low
ratio − less than about 4 − indicates that the market feels that the share has
poor prospects of growth.
13.10.4 Taxation of shares

Dividends are received by shareholders without deduction of tax. Each individual
has a dividend allowance of £5,000 per tax year: dividends within this allowance
are free of tax. Dividends in excess of this amount are subject to tax as follows:
u 7.5 per cent where received by a basic-rate taxpayer;
u 32.5 per cent where received by a higher-rate taxpayer;
u 38.1 per cent where received by an additional-rate taxpayer.
Example
An investor who is a higher-rate taxpayer receives a dividend of £1,000 from
shares in a UK company.
If the investor has not used their dividend allowance, the payment is tax-free. If
the dividend allowance has already been used, tax at 32.5 per cent is charged
(£325).
Gains realised on the sale of shares are subject to capital gains tax (CGT), although
investors may be able to offset the gain against their annual CGT exemption
allowance.
13.10.5 Ex dividend
Dividends are usually paid half-yearly. Because of the administration involved in
ensuring that all shareholders receive their dividends on time, the payment process
has to begin some weeks before the dividend dates. A ‘snapshot’ of the list of
shareholders is made at that point, and anyone who purchases shares between
then and the dividend date will not receive the next dividend (which will be paid
to the previous owner of the shares). During that period, the shares are said to
be ex dividend (or xd). The share price would normally be expected to fall by
approximately the dividend amount on the day it becomes xd.

13.10.6 Share indices

The Stock Exchange Daily Official List gives the closing prices of all listed securities
on the previous day. The Financial Times and other newspapers produce daily lists
of the share prices of most companies, making it easy to check up-to-date share
prices.
It is possible to measure the overall performance of shares by using one or more
of the various indices that are produced. These include the following.
u Financial Times 30 Share Index (FT 30): this is an index of 30 major
industrial companies’ shares, which represent around one-quarter of the market
value of UK equities.
u FTSE 100 Index (commonly known as the ‘Footsie’): this is an index of the top
100 companies in capitalisation terms. Each company is weighted according to
its market value.
u FTSE All-Share Index: this is an index of around 900 shares, split into sectors.
It measures price movements and shows a variety of yields and ratios as well as
a total return on the shares.
13.10.7 Rights issues and scrip issues

u Rights issue: London Stock Exchange rules require that, when an existing
company that already has shareholders wishes to raise further capital by issuing
more shares, those shares must first be offered to the existing shareholders.
This is done by means of a rights issue offering, for example, one new share
per three shares already held, generally at a discount to the price at which
the new shares are expected to commence trading. Shareholders who do not
wish to take up this right can sell the right to someone else, in which case the
sale proceeds from selling the rights compensate for any fall in value of their
existing shares (due to the dilution of their holding as a proportion of the total
shareholding).
u Scrip issue: also known as a ‘bonus issue’ or a ‘capitalisation issue’, this
is an issue of additional shares, free of charge, to existing shareholders. No
additional capital is raised by this action − it is achieved by transferring reserves
into the company’s share account. The effect is to increase the number of shares
and to reduce the share price proportionately.
13.10.8 Preference shares and other shares

u Preference shares: as with ordinary shares, holders of preference shares are
entitled to dividends payable from the company’s profits. Preference dividends
are generally at a fixed rate; in the payment hierarchy, they rank after loan
interest but ahead of ordinary share dividends. Many preference shares are
cumulative preference shares, which means that if dividends are not paid,
entitlement to dividends is accumulated until such a time as they can be paid.
Preference shares do not normally carry voting rights but, in some cases,
holders may acquire voting rights if their dividends have been delayed. In the
event of a company being wound up, preference shares rank behind loans but
ahead of ordinary shareholders’ claims.
u Convertibles: these are securities, issued by companies to raise capital, which
carry the right to be converted at some later date into ordinary shares of the

Property
issuing company. Traditionally they were issued in a form that effectively made
them a loan (with a lower rate of interest than conventional debt because of
the right to convert to equity) but, in recent years, they have been increasingly
issued as convertible preference shares.
13.11 Property
In broad terms, investment in property (or real estate) falls into three categories:
u residential property;
u agricultural property;
u commercial and industrial property.
The vast majority of investors will only ever be involved in residential property. For
most people this does not extend beyond the purchase of their own home, although
an increasing number of people are buying residential properties specifically as an
investment. The significant fall in property values in 2008 was a timely reminder
that property can prove to be a risky investment in the short term.
Property investment has a number of benefits and advantages.

u Property is a very acceptable form of security for borrowing purposes.
u The UK property market is highly developed and operates efficiently and

professionally.
u Rents (and therefore capital values) tend to move with money values and
consequently provide a good hedge against inflation.
u Professional property management services are readily available.
On the other hand, there are a number of pitfalls and disadvantages of which
inexperienced investors in particular should be made aware.
u There is the risk of being unable to find suitable tenants or that tenants will
prove to be unsuitable.
u Location is of paramount importance and a badly sited development may prove
a problem.
u The property market is affected by overall economic conditions − in times of
recession, lettings may be difficult and property prices may fall.
u Property is less readily marketable than most other forms of investment.
u Investment costs tend to be high and can include management fees, legal
charges and stamp duty. As with direct investment in shares, direct investment
in property can be a risky business for the small investor, although the
advent of buy-to-let mortgages has made it easier. For smaller amounts of
capital and for those who wish to spread the risk, there are property bonds
where the underlying fund is invested in a range of properties and shares in
property companies. Another alternative is real estate investment trusts (see
section 14.4.3).

13.11.1 Taxation
Income from property, after deduction of allowable expenses, is subject to income
tax. It is treated as earned income for tax purposes. On the disposal of investment
property, any gain will be liable to capital gains tax (CGT), but any capital
expenditure on enhancement of the property’s value can be offset against taxable
gains.
13.11.2 Buy-to-let
Despite some dramatic falls from time to time, the overall trend in UK house prices
over the last 30 years has been strongly upwards. The early 2000s saw dramatic
rises in the price of property in the UK. One unfortunate consequence of this is that
young people and other first-time buyers now find it difficult to afford to purchase
a property, especially in the south-east of England, which has seen significant
increases. In times of economic downturn, this effect is worsened by an uncertain
job market that makes it difficult for people to commit to large mortgages.
The situation can be eased if there is a reasonable supply of good-quality properties
to rent but traditionally the UK has had a shortage of private rental property,
particularly compared with most other European countries, for instance. There are
a number of reasons for this, including the following.
u Historically, lenders viewed loans to buy property to let as being commercial
rather than residential loans − even if the property was to be let for residential
purposes. This meant higher rates of interest than for standard mortgage loans
on owner-occupied property.
u Rental income was traditionally excluded from a borrower’s income when
assessing their ability to make the mortgage repayments.
Buy-to-let is an initiative designed to stimulate growth in the private sector of the
rental market. The aim is to encourage private investors to borrow at competitive
interest rates with a view to investing in rental property that should give them a
reasonable expectation of sustained income and capital growth. Lenders involved
in this scheme will now take potential rental income into account and will charge
interest rates broadly in line with those for owner-occupation mortgages.
The scheme is the result of a joint initiative by the Association of Residential
Letting Agents (ARLA) and mortgage lenders. Alliance and Leicester (now part of
Santander), Halifax and NatWest were instrumental in the early stages, although
many more banks and building societies now offer buy-to-let mortgages.
This change in policy results from the knowledge that a buy-to-let scheme will be
professionally managed. For many schemes, it is a requirement that an agent who
is a member of ARLA should be involved in:
u selecting suitable properties;
u selecting suitable tenants;
u arranging appropriate tenancy agreements (normally assured shorthold
tenancies);
u managing the properties.
Gross rents for buy-to-let properties are typically 125−150 per cent of the
monthly mortgage payments. There are of course other costs, such as agents’
commission/fees, insurance and maintenance costs.

Property
The government has become increasingly concerned about the buy-to-let market
and its effect on the ability of first-time buyers to enter the property market. As a
result it introduced a number of measures to reduce the attractiveness of buy-to-let
ownership, as follows:
u Stamp duty on the purchase of additional properties is subject to a 3 per cent
surcharge.
u The ability of landlords to deduct mortgage finance costs from income before
tax, and therefore gain tax relief at the highest rate paid, is in the process of
being replaced by a basic-rate tax credit. This change will be phased in between
April 2017 and April 2021.
u The previous ‘wear and tear’ allowance for furnishings has been replaced with
a one-off capital allowance in respect of expenditure on furnishings.
13.11.3 Commercial property

Investment in commercial property covers almost anything that is not defined as
wholly ‘residential’. This includes:
u individual retail shops;
u shopping arcades and shopping centres;
u offices;
u industrial units, ie factories, workshops and storage units;
u hotels and leisure resorts;
u mixed-use property − shops/offices, perhaps including a residential element.
Commercial property aims to provide reasonably high rental income together with,
in general, steady growth in capital value, although in recent years commercial
property prices have fallen.
The main advantages are:
u regular rent reviews, with typically no more than five years between each;
u longer leases than for residential property;
u more stable and longer-term tenants;
u typically lower initial refurbishment costs.
Drawbacks may include the following.
u The higher average value means that spreading the risk is more difficult.
u Commercial property does not generally show the spectacular growth in value
that can sometimes be achieved in residential property.
u If the investment is to be funded by borrowing, interest rates may be higher
than for residential loans.
Lenders often carry out detailed investigations before lending for the purchase of
commercial property, checking on:
u the quality of the land and property;
u the reputation of builders, architects and other professionals involved;
u the suitability of likely tenants.

Review questions
1. What are the four investment product asset classes?
2. What type of client might use a money market deposit account?

3. What is the value of the personal savings allowance for a higher-rate taxpayer?
4. What are the risks associated with investing in offshore deposit accounts?
5. Explain the purpose of a ‘tax wrapper’.

6. What is the ‘par value’ of a gilt?
7. Explain the terms ‘cum dividend’ and ‘ex dividend’ in relation to gilts.
8. What are the two main rights that shareholders of a company have?
9. How can the financial returns on shares be measured?
10. Where can a shareholder check the values of their holdings?

11. What is a ‘rights issue’?
12. Why might a client be attracted to property as an investment?

Topic 14
Indirect investments and other
investment types
Learning objectives
u explain unit trust and OEICs;

u explain investment trusts;
u explain UK and offshore life assurance company products;
u summarise other investment types.
14.1 Introduction
In this topic we will be focusing on indirect investments as a way of spreading
risk. Such investments are referred to as ‘indirect’ as the investor doesn’t own the
underlying investments directly but rather the underlying investments are selected
by and owned by the fund provider, the investor owning a share in the fund. These
types of investment are also known as ‘collective funds’, examples of which are
unit trusts, open-ended investment companies and investment trusts; the term
‘collective’ derives from the fact that smaller investments from a large number
of individual investors are gathered together. We looked at these in overview
in section 8.6. Collective investments have proved very popular in the UK, with
total funds under management of the order of £950bn as at November 2015 (The
Investment Association, 2016). Collective funds can be managed in two ways.
u Active management is a system by which the fund manager actively manages

the assets, by researching appropriate stocks, buying and selling to create gains
and generally making day-to-day decisions about the investments. The manager
will make decisions in line with the fund’s aims and objectives. An example
would be a UK equity fund.
u Passive management is a system by which the fund’s objective is to track the

performance of a benchmark or index, which means that the manager’s role
is to mirror the composition of the index or benchmark as opposed to making
investment decisions. An example would be a FTSE tracker fund.
In general, management charges on passive funds are lower, reflecting the reduced
involvement of the manager.

14: Indirect investments and other investment types
Finally in this topic we will consider a selection of other types of investment option
that are available to investors. These are:
u commodities;
u foreign exchange; and
u money market instruments.
14.2 Unit trusts

A unit trust is a pooled (or collective) investment created under trust deed.
An investor may contribute to a unit trust by way of a lump sum or regular
contributions, or a combination of both.
The unit trust is divided into units, with each unit representing a fraction of the
trust’s total assets. A unit trust is open-ended in the sense that a manager can,
in response to demand, create more units. Unit trusts can invest funds in shares
(both UK and overseas), corporate bonds, gilts and cash, and investors can choose
the type of fund or sector they want to invest in, such as emerging markets.
The trust deed places obligations on both the manager and the trustees.
14.2.1 The role of the unit trust manager

The manager is responsible for:
u managing the trust fund;
u valuing the assets of the fund;
u fixing the price of units;
u offering units for sale;
u buying back units from unit holders.
The manager is obliged, under the terms of the trust deed, to buy back units
from investors who wish to sell them, and will generate profit from charging
management fees and dealing in the units.
14.2.2 The trustees

The trustees have an overall responsibility to ensure investor protection. To enable
this to happen they:
u set out the trust’s investment directives;
u hold and control the trust’s assets;
u ensure that adequate investor protection procedures are in place;
u approve proposed advertisements and marketing material;
u collect and distribute income from the trust’s assets;

Unit trusts
u issue unit certificates to investors;

u supervise the maintenance of the register of unit holders.
The trustees have a policing role to ensure that the manager complies with the
terms of the trust deed. The role of trustee is often carried out by an institution
such as a clearing bank or life company.
14.2.3 Authorisation of unit trusts

Unit trusts are primarily regulated in the UK under the terms of the Financial
Services and Markets Act 2000, and have to be authorised by the FCA.
14.2.4 Pricing of units

To price the fund, the manager will calculate the total value of trust assets, allowing
for an appropriate level of costs, and then divide this by the number of units that
have been issued. The prices at which units are bought and sold are calculated by
the managers on a daily basis using a method specified in the trust deed. The unit
prices are directly related to the value of the underlying securities that make up
the fund.
There are three important prices in relation to unit trust transactions.
u The offer price is the price at which investors buy units from the managers.
u The bid price is the price at which the managers will buy back units from
investors who wish to cash in all, or part, of their holding.
u The cancellation price is the minimum permitted bid price, taking into
account the full costs of buying and selling. At times when there are both
buyers and sellers of units, the bid price is generally above this minimum level,
since costs are reduced because underlying assets do not need to be traded.
Many unit trusts still use bid and offer prices, with the difference between them
(known as the bid−offer spread) being of the order of 5−6 per cent. Some unit
trust managers, however, are moving to a single-price system because they believe
that this is better understood by investors. In this case, they may impose an exit
charge if units are sold within, say, three or five years of purchase.
14.2.4.1 Historic and forward pricing

A significant change in the pricing of units took place in 1988. Prior to that time,
clients bought or sold at prices determined before the start of the dealing period
− typically the previous day’s valuation. (If a fund’s daily valuation takes place, for
example, at noon, the dealing period is from midday on one day to midday on the
following working day.) This system, known as historic pricing, is now considered
unacceptable because prices clearly do not reflect what is happening in the market:
an investor might telephone for a price and complete a purchase, just before the
newly calculated daily price is published, knowing that the market has risen in the
meantime.
Concern about historic pricing led to the introduction of the system known as
forward pricing, which is now standard practice for unitised funds. Under forward
pricing, clients buy or sell in a given dealing period at the prices that will be

determined at the end of the dealing period. The prices published in the financial
press are therefore only a guide to investors, who do not know the actual price at
which their deal will be made.
Fund managers are still permitted to use historic pricing if they wish, subject to the
proviso that they must switch to forward pricing if an underlying market in which
the trust is invested has moved by more than 2 per cent in either direction since
the last valuation.
14.2.4.2 Buying and selling units

Unit trust managers are obliged to buy back units when investors wish to sell them.
There is consequently no need for a secondary market in units and they are not
traded on the stock exchange. This adds to the appeal of unit trusts to the ordinary
investor, for whom the buying and selling of units is a relatively simple process.
u Units can be bought direct from the managers or through intermediaries. They
can be purchased in writing or by telephone: all calls to the managers’ dealing
desks are recorded as confirmation that a contract has been established.
u Purchasers receive two important documents from the managers:
− the contract note: this specifies the fund, the number of units, the unit
price and the amount paid. It is important because it gives the purchase
price, which will be needed for capital gains tax (CGT) purposes when the
units are sold;
− the unit certificate: this specifies the fund and the number of units held,
and is the proof of ownership of the units.
u In order to sell some or all of the units, the unit holder signs the form of
renunciation on the reverse of the unit certificate and returns it to the managers.
If only part of the holding is to be sold, a new certificate for the remaining units
is issued.
14.2.5 Charges
There are two main types of charge applied to unit trusts.
u The initial charge covers the costs of purchasing fund assets and the costs
involved in setting up the plan. The initial charge is typically covered by the
bid−offer spread, the difference, on any given day, between the (higher) offer
price at which the manager offers units for sale and the (lower) bid price at
which they will buy units back.
u The annual management charge, as its name suggests, is the fee paid for the
use of the professional investment manager. The charge varies but is typically
0.5−2 per cent of fund value depending on the degree of active management
required. Although an annual fee, it is commonly deducted on a monthly or
daily basis.

Unit trusts
14.2.6 Types of unit

Unit trusts may offer the following units.
u Accumulation units, which automatically reinvest any income generated by
the underlying assets. This would suit someone looking for capital growth.
u Distribution or income units, which split off any income received and
distribute it to unit holders. The units may also increase in value in line with the
value of the underlying assets.
14.2.7 Taxation of unit trusts
14.2.7.1 Income tax

Authorised unit trusts are categorised as either equity trusts, where they have less
than 60 per cent of their assets invested in cash or fixed-interest securities, or
fixed-interest where they have 60 per cent or more of their assets invested in cash
or fixed-interest securities. Equity-based unit trusts pay income as a dividend to
investors.
Dividends are paid out without deduction of tax. Each individual has a dividend
allowance of £5,000 and where total dividend income received by an individual
each tax year falls within the dividend allowance, it is free of tax. Where dividend
income exceeds the £5,000 dividend allowance, the excess will be taxed according
to the tax status of the individual.
u Basic-rate taxpayers pay tax at 7.5 per cent.
u Higher-rate taxpayers pay tax at 32.5 per cent.

u Additional-rate taxpayers pay tax at 38.1 per cent.
Income from a fixed-interest trust is paid as interest, and tax at 20 per cent is
deducted at source. As the income is paid as interest and is classed as savings
income it counts towards an individual’s personal savings allowance, £1,000 for
basic-rate taxpayers and £500 for higher-rate taxpayers.
u Non-taxpayers can reclaim the tax that has been deducted.
u Where the income falls within the personal savings allowance of a basic-rate
taxpayer they can reclaim the tax deducted, otherwise they have no further tax
liability.
u Where the income falls within the personal savings allowance of a higher-rate
taxpayer they can reclaim the tax deducted, otherwise they have a further
tax liability of 20 per cent on the income in excess of their personal savings
allowance.
u Additional-rate taxpayers have no personal savings allowance and would pay a

further 25 per cent of the gross interest payment in tax.
A distribution of £40 net received by a unit holder is equivalent to gross income of

£50. If the unit holder is a higher-rate taxpayer who has exceeded their personal
savings allowance, a further £10 tax will be payable through self-assessment. A
non-taxpayer, a basic-rate taxpayer with savings income of less than £1,000 or a

higher-rate taxpayer with savings income of less than £500, can reclaim the £10
deducted.
14.2.7.2 Capital gains tax

No capital gains tax is levied within the unit trust, but the investor may be liable to
capital gains tax on any gain made when units are encashed. The annual exemption
allowance can be used to reduce any liability to capital gains tax.
14.2.8 Risks of unit trusts

A unit trust is an investment that carries risk both in terms of the level of income
provided and in respect of the value of capital invested; neither are guaranteed.
The legal constitution of a unit trust helps to mitigate risk of fraud because the
trustees have a responsibility to ensure there is proper management.
Given the nature of a unit trust as a pooled investment, the risk will be lower than
that of an individual investing directly into equities on their own behalf. Unit trust
funds will typically invest in a spread of between 30 and 150 different shares.
The actual risk will depend on the type of unit trust selected. The wide range of
choice means that there are unit trusts to match most investors’ risk profiles. A
cash fund will carry similar risks to a deposit account, while specialist funds such
as emerging markets are high risk by their very nature and overseas funds carry
the added risk of currency fluctuations.
Unit trusts provide no guarantee that the initial capital investment will be returned
in full or that a particular level of income will be paid.
14.3 Open-ended investment companies

(OEICs)
Open-ended investment companies (OEICs) have been popular in mainland Europe
for many years and have been available in the UK since 1997. They share a number
of characteristics with unit trusts and investment trusts. The similarity with unit
trusts is not surprising, and there is a high degree of commonality between the
regulations on OEICs and unit trusts.
OEICs are a pooled investment offered by a company that buys and sell the shares
of other companies and deals in other investments. The OEIC will issue shares −
typically participating redeemable preference shares − that can be bought and sold
by investors.
Although operating as a company, an OEIC cannot borrow money to finance its
activities other than for short-term purposes, unlike an investment trust.

Open-ended investment companies (OEICs)
14.3.1 Legal constitution of an OEIC

An OEIC is established under company law, not under trust. OEICs must be
authorised by the FCA.
The role of overseeing the operation of the company and of ensuring that
it complies with the requirements for investor protection is carried out by a
depositary, who will be authorised by the FCA. The role of the depositary is
much the same as the trustee of a unit trust.
An authorised corporate director, whose role is much the same as the manager
of a unit trust, manages the OEIC. The role of the corporate director is to:
u manage the investments;
u buy and sell OEIC shares as required by investors;
u ensure that the share price reflects the underlying net asset value of the OEIC’s
investments.
The range of OEICs is similar to that of unit trusts. OEICs are available that
offer: income; capital growth; fixed interest; access to overseas markets; access to
specialist markets (eg commodities, technology or healthcare); index tracking.
14.3.2 Investing in an OEIC

As with unit trusts and investment trusts, investments can be made either by lump
sum, regular contribution or a combination of both.
Investors buy shares in the OEIC. The number of shares that are available is
unlimited so the OEIC is, as the name would suggest, open-ended like a unit trust,
rather than closed-ended like an investment trust. The value of the shares varies
according to the market value of the company’s underlying investments.
An OEIC may be structured as an ‘umbrella’ company that is made up of several
sub-funds. Different types of share can be made available within each sub-fund.
14.3.3 Pricing of OEIC shares

The basic procedure for establishing the share price is the same as that for
determining the unit price in a unit trust: the total value of OEIC assets is
established and then divided by the number of shares currently in issue.
There are, however, some differences in pricing when OEICs are compared to unit
trusts. OEIC shares have only one price, not a separate bid and offer price as for
units in a unit trust.
14.3.4 Charges
u Initial charge: as already mentioned, OEIC shares are single-priced so there is
no bid−offer spread. An OEIC will levy an initial charge, however, normally in
the region of 3−6 per cent of the value of the individual’s investment.
u Annual management charge: annual management charges based on the
value of the fund are deducted, normally from the income that the OEIC

generates. The range of annual management charges is typically between

0.5 per cent for indexed funds and 2 per cent for more actively managed
funds. Other administration costs may also be deducted from the income that
is generated.
14.3.5 Taxation of OEICs

The tax treatment of OEICs is similar to that for unit trusts, with OEICs being
categorised as equity-based or fixed-interest and the tax treatment of income
depending on the categorisation.
The fund managers are not subject to tax on capital gains, although a liability to
CGT may arise for the investor when the OEIC is encashed. The amount of any CGT
liability can be mitigated by use of the annual exemption.
14.3.6 Risks
The risks associated with investing in an OEIC are similar to those of investing
in a unit trust. As a pooled investment employing the services of professional
investment managers, the degree of risk is lower than direct equity investment.
Risk is also mitigated by the spread that can be achieved for a relatively small
investment. There is, however, no guarantee of the maintenance of the original
capital invested or the level of income that will be generated.
14.4 Investment trusts

Investment trusts are collective investments but, unlike unit trusts, they are not
unitised funds. Furthermore − despite their name − they are not even trusts. They
are in fact public limited companies whose business is investing (in most cases)
in the stocks and shares of other companies. Investing in an investment trust
is achieved by purchasing shares of the investment trust company on the stock
exchange; similarly, in order to cash in the investment, it is necessary to sell these
shares to another investor. As with all companies, the number of shares available
remains constant, so an investment trust is said to be closed-ended (in contrast
to the open-ended nature of unit trusts).
The share price of an investment trust obviously depends to some extent on the
value of the underlying investments, but not so directly as in the case of a unit trust.
The price can depend on a number of other factors that affect supply and demand.
In many cases, the share price of an investment trust is less than the net asset
value (NAV) per share; the NAV per share is the total value of the investment fund
divided by the number of shares issued. This situation − referred to as being at
a discount − means that an investor should achieve greater income and growth
levels than would be obtained by investing directly in the same underlying shares.
One advantage of being constituted as a company is that an investment trust can
benefit from gearing: this means that, like all companies, it can borrow money
in order to take advantage of business opportunities (in their case, investment
opportunities). This avenue is not open to unit trusts, which are not permitted to
borrow. Gearing enables investment trusts to enhance the growth potential of a
rising market, but investors should be aware that it can equally accentuate losses

Investment trusts
in a falling market. This factor led to some high-profile difficulties for certain
investment trusts in the volatile stock market of the early 2000s.
14.4.1 Taxation of investment trusts

The taxation situation is similar to that described for equity unit trusts. At least
85 per cent of the income received by investment trust fund managers must be
distributed as dividends to shareholders. Dividends are paid without deduction
of tax and there is no tax liability where the dividend falls within the dividend
allowance of the investor. If the dividend income exceeds the dividend allowance
there is an additional liability of 7.5 per cent, 32.5 per cent or 38.1 per cent for
basic, higher and additional-rate taxpayers.
There is no capital gains tax whilst monies are held within an investment trust.
Upon encashment there may be personal capital gains tax if the gain, when added
to other gains realised by the investor during the current tax year, exceeds the
annual CGT exemption.
14.4.2 Split-capital investment trusts

Sometimes known as split-level trusts or simply as splits, split-capital investment
trusts are fixed-term investment trusts offering two or more different types of
share. The most common forms of share offered by split-level investment trusts
are:
u income shares, which receive the whole of the income generated by the
portfolio but no capital growth;
u capital shares, which receive no income but which − when the trust is wound
up at the end of the fixed term − share all the capital growth remaining after
fixed capital requirements have been met.
Recent innovations have seen the introduction of intermediate types of shares,

offering different balances of capital and income.
14.4.3 Real estate investment trusts

Real estate investment trusts (REITs − pronounced ‘reets’ to avoid confusion with
rights) are tax-efficient property investment vehicles that allow private investors
to invest in property while avoiding many of the disadvantages of direct property
investment (see section 13.11).
REITs became available in the UK from January 2007. Similar schemes operate in a
number of other countries, particularly the USA and Australia.

14.5 Investment products based on life

assurance
14.5.1 Endowments
The most common form of savings contract offered by life assurance companies
is endowment assurance, which is, broadly speaking, a policy on which the sum
assured is paid out at the end of a specified term or on the earlier death of the life
assured (although some policies are open-ended and allow policyholders to choose
when to receive the proceeds of their investment). The client’s investment is made
in the form of regular premiums to the life assurance company throughout the
term of the policy. There are a number of variations, the most common of which
are as follows.
14.5.1.1 Non-profit endowment

This policy has a fixed sum assured, which is payable on maturity (ie at the end of
the policy term) or on earlier death. Because the return is fixed and guaranteed,
the investor is shielded from losses due to adverse stock market movements; on
the other hand, they are equally unable to share in any profits the company might
make over and above those allowed for in calculating the premium rate (hence the
name, ‘non-profit’). For that reason, non-profit policies are rarely used today.
14.5.1.2 With-profits endowment

Like its non-profit equivalent, a with-profits endowment has a fixed basic sum
assured and a fixed regular premium. The premium, however, is greater than
that for a non-profit policy of the same sum assured, and the additional premium
(sometimes called a ‘bonus loading’) entitles the policyholder to share in the profits
of the life assurance company.
The company distributes its profits among policyholders by annually declaring
bonuses that become part of the policy benefits and are payable at the same time
and in the same circumstances as the sum assured. There are two types of bonus.
u Reversionary bonuses: these are normally declared each year and once they
have been allocated to a policy they cannot be removed by the company,
provided that the policy is held until the end of the term or earlier death.
Some companies declare a simple bonus, where each annual bonus is calculated
as a percentage of the sum assured; others declare a compound bonus, with
the new bonus being based on the total of the sum assured and previously
declared bonuses. Most companies set their reversionary bonuses at a level
that they hope to be able to maintain for some time, in order to smooth out the
short-term variations of the stock markets, but with the level of interest rates
and other investment yields falling in recent years, bonus rates were reduced
and stand at much lower levels than in the 1980s and early 1990s. In spite of
this, with-profit policies have produced much better returns in the long run than
non-profit policies.
u Terminal bonuses: these are bonuses that may be added to a with-profit
policy when a death or maturity claim becomes payable. Unlike reversionary
bonuses, a terminal bonus does not become part of the policy benefits until the
moment of a death or maturity claim, thus allowing the company to change the
terminal bonus rate − or even remove the terminal bonus altogether. Terminal

Investment products based on life assurance
bonuses are intended to reflect the level of investment gains that the company
has made over the term of the policy, so the rate of bonus often varies according
to the length of time that the policy has been in force. In the current climate of
reduced stock market values, many companies have reduced the level of their
terminal bonuses.
14.5.1.3 Unit-linked endowment

The first unit-linked policies were issued in the late 1950s and represented a
revolutionary change in the way in which policies were designed. The development
reflected the desire of many policyholders to link investment returns more directly
to the stock market, or even to specific sectors of the market.
Unit-linked endowments work on the basis that, when a premium is paid, the
amount of the premium − less any deductions for expenses − is applied to the
purchase of units in a chosen fund. A pool of units gradually builds up and, at
the maturity date, the policyholder receives an amount equal to the total value of
all units then allocated to the policy. Most unit-linked endowments also provide a
fixed benefit on death before the end of the term. The cost of providing this life
cover is taken from the policy each month by cashing in sufficient units from the
pool of units.
Over the longer term, the most successful unit-linked endowments have shown
better returns than with-profit endowments. Unlike with-profit endowments,
however, unit-linked policies do not provide any guaranteed minimum return at
maturity; they are, therefore, a good illustration of the maxim that greater potential
return generally goes hand-in-hand with the acceptance of greater risk.
The FCA requires life companies that carry on with-profits business to publish
a document (called the Principles and Practices of Financial Management −
PPFM) that sets out how a firm manages its with-profits business. Each year the
insurance company has to certify to the FCA that their with-profits funds have
been managed in accordance with the PPFM. With-profits companies must also
produce a customer-friendly version of the PPFM (‘CFPPFM’) explaining the main
PPFM document in clear and non-technical language.
14.5.1.4 Unitised with-profits endowments

Unitised with-profits endowments have been available since the late 1980s, when
they were introduced in an attempt to combine the security of the with-profits
policy with the greater potential for reward offered by the unit-linked approach. As
with unit-linking, premiums are used to purchase units in a fund and the benefits
paid out on a claim depend on the number of units allocated and the then-current
price of units.
The difference from a standard unit-linked policy lies in the fact that unit prices
increase by the addition of bonuses which, like the reversionary bonuses on a
with-profit policy, cannot be taken away once they have been added. This means
that unit prices cannot fall and the value of the policy, if it is held until death or
maturity, is guaranteed. If the policy is surrendered (ie cashed in before its maturity
date), however, a deduction is made from the value of the units. This deduction,
the size of which depends on market conditions at the time of the surrender, is
known as a market value adjustment (MVA).

14.6 Investment bonds

Investment bonds are collective investment vehicles based on unitised funds.
Because of the unitised structure of their funds, they may appear similar to unit
trusts, but they are actually very different.
Investment bonds are available from life assurance companies and are set up as
single-premium unit-linked whole-of-life assurance policies. Investing in a bond
is achieved by paying the single (lump sum) premium to the life company.
The investor then receives a policy document that shows that the premium has
purchased (at the offer price) a certain number of units in a chosen fund and that
those units have been allocated to the policy. In order to cash in the investment, the
policyholder accepts the surrender value of the policy, which is equal to the value
of all the units allocated, based on the bid price on the day when it is surrendered.
Investors are attracted by the relative ease of investment and surrender, by the
simplicity of the documentation and also by the ease of switching from one fund
to another: companies generally permit switches between their own funds without
charging the difference between bid and offer prices.
The range of available funds is similar to those offered by unit trusts and
investment trusts. In addition, some companies offer with-profits investment
bonds, in which premiums are invested in a unitised with-profits fund. If a
with-profits bond is cashed in within a specified period after commencement
(typically five years), the amount received is likely to be less than the value of
the units.
On the death of the life assured, the policy ceases and a slightly enhanced value
(often 101 per cent of the bid value on the date of death) is paid out.
14.6.1 Taxation
The funds in which the premiums are invested are internal life company funds and
their tax treatment is different from that of unit trusts. In particular, they attract
tax at 20 per cent on capital gains (whereas unit trust funds are exempt) and
this tax is not recoverable by investors even if they themselves have a personal
exemption from capital gains tax. The taxation system for policy proceeds in the
hands of the policyholder is complex but, broadly speaking, because gains have
been taxed at 20 per cent within the fund, tax on the gain is payable only by
higher-rate taxpayers, and then only at 20 per cent − the excess of the higher rate
over the 20 per cent already deemed to have been paid within the fund. This is
because investment bonds are non-qualifying policies.
Unlike investment trusts and unit trusts, investment bonds do not normally provide
income in the form of dividends or distributions, but it is possible to derive a form
of ‘income’ from them by making small regular withdrawals of capital (by cashing
in some of the units allocated to the policy). These do not attract additional tax for
basic-rate taxpayers, and even higher-rate taxpayers can withdraw up to 5 per cent
of the original investment each year without incurring an immediate tax liability.
This 5 per cent allowance can, if not used, be carried forward and accumulated up
to an amount of 100 per cent of the original investment.
These withdrawals are tax-deferred and on maturity, death or encashment of the
bond, a tax liability may arise and this is determined by top slicing. Top slicing is
a term that refers to the way of determining what tax is due for UK residents by
calculating the average return over the term of the bond so that the whole gain is
not taken into consideration in one year.

Offshore life assurance company bonds
If the planholder is a higher rate or additional rate taxpayer in the tax year a plan is
surrendered, the gain (ie the surrender value + withdrawals, less original purchase
money) will be subject to tax.
1. The gain on the policy (surrender value + withdrawals less original investment)
is calculated.
2. This gain is divided by the number of complete years the investment has been
in force.
3. This gives what is termed the ‘average gain’.
4. The average gain is added to the planholder’s taxable income in the year of
surrender
5. There is a tax liability if the combined taxable income and average gain (after
personal allowance) takes the planholder from a 20 per cent taxpayer into the
40 per cent rate. In this instance 20 per cent tax would be payable on the income
in excess of the higher rate tax band.
If the taxable income plus average gain straddles the additional rate tax band
then 20 per cent tax will be payable on the income that falls within the 40 per
cent band and a further 25 per cent on the income in excess of the additional
rate band.
6. The proportion of any gain above the preceding tax band is the investment
bond’s taxable slice − referred to as the ‘Top Slice’.
7. The ‘top slice’ is multiplied by the complete years the investment has been in
force to give the taxable gain.
14.7 Offshore life assurance company bonds

Offshore life assurance bonds usually involve paying a single premium, which buys
a portfolio of cash, investment funds and other investments. Life cover is minimal,
as the purpose of the bond is to shelter investments. Usually the bond invests in
a menu of investment funds, and in cash. If bonds directly invest in property or
stocks and shares, the UK’s HMRC regards them as ‘personalised’ and subjects
them to a less favourable tax regime.
Most offshore life offices offer funds from a variety of investment managers, rather
than offer their own in-house funds. This open approach helps investors choose
from the best-performing funds in a particular sector. During the lifetime of the
bond, investors can switch between funds and investment sectors.
14.7.1 Taxation
Investments within an offshore bond can grow gross of any tax. Any income drawn
from the bond is liable to tax in the country where the investor lives. In the UK,
any income and proceeds are liable to income tax, but this can be deferred if the
withdrawal is less than five per cent of the original investment.
This means that offshore bonds can be a good investment for someone who is
planning to move overseas at a later date and will be able to benefit from the
gross roll-up of income within the wrapper. They may also be suitable for overseas

workers who may be able to take an income when not subject to UK tax, although
local taxes may apply.
Offshore bonds can also help mitigate inheritance tax liabilities. Many UK
expatriates may live outside the UK income tax net but, unless they change their
domicile, their estate is still liable to IHT.
14.7.2 Risks
When the investment is outside the jurisdiction of the FCA, it would be a wise
move for investors to consult only those advisers who are regulated in reputable
jurisdictions, where there is a formal regulatory system to protect investors. This
system should ideally include redress for poor advice including a mechanism for
complaints and compensation in the event of default. Investors should also bear
in mind that there could be currency and exchange rate risks and that the returns
may be affected by different economic factors to those driving the UK economy.
14.8 Other types of investment
14.8.1 Commodities
Commodities have been traded for thousands of years, particularly metals (such as
silver and gold) and foodstuffs (including wheat and other grain crops). In modern
times the concept of a commodity has been broadened considerably and now
includes, for instance, electricity, timber and even future royalties on music and
other artistic work.
For the modern investor, commodities offer a number of opportunities, both
directly and indirectly.
u Investment in precious metals, particularly gold, is available even to small
investors through the sale, by various governments, of gold coins such as South
African krugerrands.
u A lot of trade in commodities is carried out through the medium of ‘forward
contracts’, ie binding agreements made now under which one party must sell
and the other party must buy a specified amount of a commodity at a specified
price on a particular date in the future. Other, more sophisticated, commodity
derivatives have also been developed, primarily to enable farmers and other
producers to hedge their risks (for instance the risk of a crop failure). The
majority of trading in the commodity derivatives markets is now done by people
who have no need of the commodity itself: they make a profit by speculating
on the price movements of the commodities through the purchase and sale of
derivatives.

Other types of investment
14.8.2 Foreign exchange

We saw in section 9.5.3.5 how the foreign exchange market works and how it
can benefit trading between countries. The amount of money being transferred
for investment purposes is even greater than that being transferred for trading
purposes. International investment can be split into short term and long term.
u Short-term investment − a company that has a temporary surplus needs to
invest it, if only for a short period, in order to earn a return. It will invest money
in a country that currently has the highest interest rates.
u Long-term investment − individuals and companies buy shares and make
longer-term loans to borrowers in other countries. A company may wish to
invest in overseas expansion by opening a branch in another country.
Currency speculators trade in the currency markets on their own account. They
aim to make profits by anticipating changes in exchange rates and buying/selling
at the appropriate time. A speculator might spend £1m on buying US dollars at
an exchange rate of 55p and then exchange the resulting $1,818,182 back into
sterling when the rate changed to 57p, making a profit of £36,364.
George Soros, perhaps the world’s most renowned currency speculator, caused
a sensation in September 1992 when he sold around $10bn worth of sterling in
anticipation of the UK’s devaluation of sterling. The devaluation happened as the
UK withdrew from the European Exchange Rate Mechanism (ERM), and it is believed
that Soros made over a billion dollars in one day’s trading.
14.8.3 Money market instruments

Money market instruments is a generic term used to describe a number of forms
of short-term debt. Interest is not normally paid during the term of the transaction,
the rate of interest being determined by the difference between the amount
invested/borrowed and the amount repaid.
In order to illustrate the nature of these instruments, we will describe three of

them: Treasury bills, certificates of deposit and commercial paper.
14.8.3.1 Treasury bills

Treasury bills are short-term redeemable securities issued by the Debt Management
Office (DMO) of the Treasury. Like gilt-edged stocks they are fundraising
instruments used by the UK government, but they differ from gilts in a number
of ways. Two major differences are set out as follows.
u Treasury bills are short term, normally being issued for a period of 91 days,
whereas gilts can be long term or even undated.
u Treasury bills are ‘zero-coupon’ securities, ie they do not pay interest. Instead,
they are issued at a discount to their face value or par value (the amount that
will be repaid on their redemption date).
As with gilts, Treasury bills are considered to be very low-risk securities, the risk
of default by the borrower (the UK government) being so low as to be effectively
zero.

Because they are such short-term securities, changes in market rates of interest
have little impact on the day-to-day prices of Treasury bills unless the changes are
significantly large.
Throughout their term, Treasury bills can be bought and sold, and there is a
strong secondary market, provided mainly by banking organisations as there is
no centralised marketplace. The price tends to rise steadily from the issue price
to the redemption value over the 91-day period, but prices can also be affected by
significant interest rate changes, or by supply and demand.
Treasury bills are purchased in large amounts, and they are not, therefore,
generally of interest to small private investors. They are held in the main by
large organisations (particularly financial institutions) seeking secure short-term
investment for cash that is temporarily surplus to requirements.
14.8.3.2 Certificates of deposit

Certificates of deposits (often known as CDs) are a method of facilitating short-term
larger-scale lending − typically for periods of three months or six months, and for
amounts of £50,000 or more. Depositors who require a longer term can often
obtain CDs that can be ‘rolled over’ for a further three or six months on specified
terms.
They are issued by banks and building societies, and are in effect a receipt to
confirm that a deposit has been made with the institution for a specified period at
a fixed rate of interest. The interest is paid with the return of the capital at the end
of the term.
Certificates of deposit are bearer securities, which means that repayment on the
specified terms will be made to the bearer of the certificate on the maturity date.
So, if the depositor needs money before the end of the term, the certificate can be
sold to a third party.
Banks may also hold CDs issued by other banks, and they can issue and hold CDs to
balance their liquidity positions. For example, a bank would issue CDs maturing at
a time of expected liquidity surplus, and hold CDs maturing at a time of expected
deficit.
14.8.3.3 Commercial paper

Businesses need to borrow for a variety of purposes. When they need funds for
investment in their longer-term business plans, they may issue corporate bonds.
When they wish to borrow for working capital purposes, however, they can issue
commercial paper, which is an unsecured promissory note (ie a promise to repay
the funds that have been received in exchange for the paper). The transactions are
for very large amounts, with most purchasers being institutions such as pension
funds and insurance companies. Commercial paper can be placed directly with
investors, or through intermediaries.
References
The Investment Association (2016) Funds under management [online]. Available at:
http://www.theinvestmentassociation.org/investment-industry-information/fund-statistics/funds-
under-management.html [Accessed: 24 May 2016].

Review questions
Review questions
1. What does the term ‘open-ended’ mean in relation to unit trusts?
2. What is the bid−offer spread?

3. What is the tax position for a basic-rate taxpayer receiving dividend income
from an equity unit trust?
4. What does an OEIC invest money in?

5. When do CGT liabilities arise with OEICs?
6. Why is an investment trust closed-ended?

7. If a policyholder wishes to surrender a unitised with-profit policy before its
maturity how would this be treated by the insurance company?
8. What are the potential risks of taking out an offshore life assurance company
bond?
9. How can an investor make an indirect investment in commodities?
10. What are examples of money market instruments?

Topic 15
Pensions
Learning objectives
u summarise state pension provision;

u explain occupational pensions;
u explain personal pensions;

u explain pension death benefits;
u evaluate options at retirement.
15.1 Introduction
We overviewed pension products in section 8.7 and support from the state for
people in retirement in section 11.6. In this topic we consider in some detail the
various options available to people to provide for their retirement.
The major consideration in retirement is usually the reduction in income.
Irrespective of other changes that occur in retirement, the loss of such income
can have enormous effect on the lifestyle of the retired person. It is earned
income that usually allows people to maintain a reasonable standard of living.
On retirement, there are many expenses and costs that do not decrease and some
that may even increase. Lighting and heating of the house, for example, may
increase because more time is spent at home. Most other costs of accommodation
or property maintenance will probably remain constant, apart from inflationary
effects. Individuals will also have increased leisure time and may require more
income to enable them to enjoy it. One can now begin to understand the difficulty
in maintaining a standard of living after retirement.
Income lost can only be replaced as a result of carefully considered financial
planning. If no provision is made, the consequences are severe.
There are a number of other factors affecting retirement that are beyond our
control:
u life expectancy and population change;

u state of health and associated care needs;

15: Pensions
u retirement ages;
u legislation.
You need to be aware of these factors in considering retirement planning, in order
to present an accurate picture and to give yourself a better appreciation of some
of the potential financial problems at retirement.
A pension − whether this is provided via the state, employer or the individual − is
a fund built up by contributions that are invested until the beneficiary retires. At
this point decisions need to be made about whether to receive all the benefits as
an income or to take part of the benefit as cash with a reduced income.
15.2 State pension provision

State pensions are payable from state pension age (SPA), this is currently age 65
for men and in the process of increasing to age 65 for women, by 2018. There
are plans to further increase SPA for both men and women. A system of regular
reviews has been introduced which will, in future, see SPA linked to trends in
life expectancy. The guiding principle will be that people should expect to spend
around one third of their adult life receiving state pension benefits. The first review
is to take place by May 2017.
Entitlement to state pensions is based on National Insurance contributions (NICs),
with maximum benefits paid once NICs have been paid / credited for at least
35 years (NICs are covered in section 10.3 and Appendix A). It should be noted
that, as a state benefit, state pensions are designed to enable only a threshold
standard of living to be maintained; at best, benefits will be a maximum of
25 per cent of average earnings. Anyone planning to rely solely on state pension
benefits in retirement will probably find a marked reduction in their income levels,
as compared to that during their working life.
Whilst state pensions are funded by NICs, there is no individual pension fund
building up for each person. The system operates on what is referred to as a ‘pay
as you go’ basis.This means that contributions collected from today’s contributors
pay today’s pensioners. There is no element of advance funding to guarantee the
payment of future benefits − for that, there is a dependence on people paying
NICs in the future. This has become a serious problem given that the proportion
of people of working age paying NICs, compared to those above state pension age
and drawing a state pension, has reduced and will continue to do so. This issue
gives context for the changes to SPA.
State pension provision underwent large scale change from April 2016, with the
introduction of the new ‘single-tier’ state pension. The state pension system had
evolved over many years and consisted of several elements including a basic state
pension and several additional, earnings-related elements. As a consequence of
the sheer number of elements involved, the state pension system had become
extremely complex and difficult to understand. The introduction of the new state
pension is an attempt to simplify arrangements.
The introduction of the new state pension means that the pensioner population
of the UK is effectively split into two groups, depending on whether an individual
reached state pension age before or on / after 6 April 2016; those in the former
group are entitled to state pension benefits based on the system of basic state
pension / additional state pension, those who reached SPA on / after 6 April 2016
are entitled to the new single-tier state pension with an allowance made to ensure
they are no worse off than if they had been paid basic / additional state pension.

State pension provision
15.2.1 State pension for those who reached SPA before 6

April 2016
Those who reached SPA before 6 April 2016 potentially have their state pension
benefits made up of the following different elements of state pension provision:
u Basic state pension − all individuals employed and self-employed will benefit
from a basic state pension, provided that sufficient NICs have been paid or
credited.
u Graduated pension scheme − all employed individuals who paid
contributions to the scheme while it was in operation between 6 April 1961
and 5 April 1975 will benefit under the graduated pension scheme.
u Additional state pension − in addition to the basic state pension, employees

who earn in excess of the lower earnings limit and pay Class 1 NICs are eligible
to receive an additional state pension. Up to 5 April 2002, this additional state
pension was the state earnings-related pension scheme (SERPS) but this was
replaced by the state second pension (S2P) from 6 April 2002. SERPS remains
significant because many people will be entitled to SERPS benefits they have
built up in the past.
The self-employed and business partners are ineligible for the additional state
pension as they would not have paid Class 1 NICs whilst self-employed.
Employees had a choice regarding SERPS and S2P. They could, if they wished,
‘contract out’ of these benefits. Where an individual ‘contracted out’ the NICs
that would have been used to pay for additional state pension benefits would
instead have been directed to another form of pension, such as a personal
pension or an occupational pension scheme. There was no option to contract
out of the basic state pension. Where an individual did contract out, their
state pension benefits would be reduced but would hopefully be replaced by
additional benefits accrued from the NICs directed to an alternative source of
pension.
Anyone who is uncertain about their entitlement to state pension benefits can
request a state pension benefits statement from the Department of Work and
Pensions (DWP).
15.2.2 State pension for those who reached SPA on / after

6 April 2016
Those who reach state pension age on or after 6 April 2016 will receive the new
‘single-tier’ state pension; single tier as there is only one element to it as compared
with the previous system of basic / additional state pension.
The main features are as follows:

u Eligibility is based on payment of National Insurance contributions (NICs).
u To qualify, NICs must have been paid / credited for at least 10 years, with
maximum benefits where NICs have been paid for 35 years.
u Entitlement is based on Class 1, 2 and 3 NICs.

15: Pensions
u The maximum level of new state pension is £155.60 per week (2016/17).
u Each claimant is awarded a starting amount based on what their NIC record
would give them under the previous system of basic / additional state pensions
as compared with what it would have entitled them to had the new state pension
been in place throughout their working life − the higher amount is awarded as
a starting amount.
A person’s entitlement to the new state pension may be reduced where they had
periods of being ‘contracted out’ of the additional state pension during their
working life.
15.2.3 Pension Credit

Pension Credit is a benefit designed to ensure that all people of state pension
age have a total income of a specified minimum amount. In 2016/17, Pension
Credit guarantees a minimum income of £155.60 per week to a single person and
£237.55 to a couple. Like the state pensions, this amount is expected to increase
each year to take account of inflation
15.3 Occupational pensions

The amount of money involved in occupational pensions is huge. Larger employers
will usually have their own ‘in house’ pension department and appoint specialist
investment managers to look after the investment of monies held within their
pension fund. This will not be possible for a smaller employer who may rely on an
insurance company’s pension funds. Generally, a pension contribution is invested
in a mixture of assets such as cash deposits, gilts, equities and property, via various
routes depending upon the type of provider.
Generally, expert fund managers usually make the investment decisions, although
it is possible, in some circumstances, for the members to be involved.
Occupational pension schemes have been in existence for many years and many
people simply become members as a result of joining a particular employer,
particularly as there is now an element of compulsion through the workplace
pension / auto-enrolment rules. Many clients will be members of occupational
schemes and advisers and planners need to understand the mechanics of
occupational schemes and assess the level of benefits that they will provide.
15.3.1 Types of occupational pension scheme

Occupational pension schemes are normally established under an irrevocable trust.
This separates the assets of the pension scheme from the employers and so offers
a degree of security for scheme members.
Schemes may be either funded in advance or unfunded.
u Unfunded schemes are known as pay-as-you-go schemes. An example of
an unfunded scheme in the public sector is the civil service pension fund.
Neither the government (the employer) nor civil servants (employees) make
contributions. The money required to provide benefits to those members who

Occupational pensions
have retired is taken from general tax revenue as required, rather than invested
into assets to provide funds at a later time.
u Funded schemes rely on the payment of regular contributions, by the
employer and usually also by the member, and the investment of those
contributions to provide a fund which will be the source of future benefits for
scheme members. The majority of occupational schemes are funded schemes.
In turn, these funded schemes are either contributory or non-contributory.
− A pension scheme is non-contributory if only the employer pays
contributions.
− Contributory schemes are those into which both employers and employees
make contributions.
15.3.2 Scheme design

Perhaps the most important decision in the design of a pension scheme concerns
the method used to calculate the retirement benefits that the scheme will pay its
members. This is called the benefit base. Broadly speaking, there are two options:
u defined-benefit (final salary) schemes − these are based on a formula; or
u money-purchase (defined-contribution) schemes − benefits are based on the
size of the fund.
Defined-benefit schemes promise to pay a defined level of benefit relating to
a set formula rather than relying on investment returns. Generally, the pension
benefits are built up as a proportion of a member’s final salary and related to the
number of years an individual has been a member of a scheme, for example a
scheme with an ‘accrual rate’ rate of 1/60th would see a member accrue pension
benefits of 1/60th of their final salary as pension for each year they are a member
of the scheme.
HMRC sets rules around the way the concept of final salary can be defined, and
different schemes will use different rules within the broader HMRC rules. For
example, scheme A may base final salary on the average salary paid over the
last three years of employment, scheme B may use total remuneration averaged
over the final five years of employment.
The benefits received will be affected by the employee’s length of service, the
accrual rate and the employee’s salary: an employee with 30 years’ service in a
scheme with an accrual rate of 1/60th would, for example, retire on a pension of
30/60, ie 50 per cent of final salary. The most common accrual rates are 60ths and
80ths. Generally, scheme members have the option to exchange a portion of the
pension income they have built for a tax-free lump sum at retirement, a process
referred to as commutation.
Normally, a spouse / civil partner / dependant’s pension will be included so that a
percentage of the pension income will continue to be paid upon the death of the
scheme member, typically this could be 50 per cent of the member’s pension.
Most final salary schemes also provide lump sum death benefits in the event that
a member dies before or after they have started drawing their pension. The scale
of such benefits will be dependent upon the rules of the individual scheme and,
in terms of pre-retirement benefits, may vary between one and four times annual
salary.

15: Pensions
The employer decides on the level of benefit that will be payable, guarantees this
in the scheme rules and is required to ensure that sufficient contributions are paid
into the fund to meet the commitment.
Naturally, the employer is unable to forecast accurately the cost of the scheme
because a member’s ‘final earnings’, investment returns and the level of death
benefits that must be paid will be very difficult to predict. Nonetheless, since
benefits are defined, the employer must ensure that the pension fund is sufficient
at all times to meet the benefit promises made. It might be said that the employer
is bearing the risk in this sort of scheme − if there is a shortfall, it must make it up.
There have been problems in recent years with employers facing difficulties with
the investment performance of the pension fund. In light of such problems, many
employers have closed final salary schemes, either to new members or in respect
of all future benefit accrual, or changed the benefit structure.
A public sector scheme, such as the civil service pension, is normally structured
with a 1/80th accrual rate. The main difference to other occupational pension
schemes is that public sector schemes combine accrual of pension income benefits,
at a rate of 1/80th, and lump sum tax-free cash benefits, at a rate of 3/80ths, for
each year of scheme membership. For example, an individual with 30 years’ service
in the scheme, retiring on a salary of £40,000 per annum, will receive a pension of
£15,000 per annum (30/80 × £40,000) plus tax-free cash of £45,000 (30 × 3/80
× £40,000).
Where the scheme accrues pension benefits in this way, the member has no choice
− both parts must be taken, even if there is no particular need for a lump sum
or if the member would like to draw a lump sum only and defer their income.
The individual cannot forgo the tax-free cash in order to receive a larger pension.
Public sector pensions are fully inflation protected and will therefore increase in
payment. Another benefit is that if the individual moves to a different public sector
occupation, they will be given full credit for existing years’ service (under what is
known as the ‘transfer club’).
A money-purchase, also referred to as a defined-contribution, scheme is
more straightforward in that individual contributions are identifiable. An agreed (or
defined) contribution is paid by the member and employer and invested for each
individual member or for entire funds. On retirement, the accumulated fund is then
used to purchase whatever benefits it can. With a money-purchase arrangement,
benefits depend on the amounts paid in, which the member has control over, and
investment returns / investment conditions when benefits are taken, which the
member has little control over.
Money-purchase schemes can be contrasted to defined-benefit schemes. They are
not open-ended commitments for the employer, who can decide how much to put
in without being bound by a predetermined commitment to provide a certain level
of benefits.
This gives the employer the advantage of knowing how much the pension scheme
will cost, which helps, especially for smaller firms, to predict outgoings. It might
be said that the member bears the risk associated with a money-purchase scheme.
An occupational money-purchase scheme is obliged to provide an annual pension
statement that includes a statutory money purchase illustration. This includes
an estimate of future fund growth and income. The income is then discounted at
a specified inflation rate percentage per annum to show how much it would be
in today’s terms (ie if the member were to retire today). This will hopefully give
the member an idea of their current level of provision and whether they need to
increase their contributions.

Occupational pensions
15.3.3 Workplace pensions and auto-enrolment

Workplace pensions are being introduced as a result of the Pensions Act 2008.
These duties require employers to automatically enrol (make a member of) some or
all of their workers into a workplace pension scheme that meets certain minimum
standards as a qualifying workplace pension scheme. Most employers will be
subject to the automatic enrolment requirements and must enrol certain employees
where they are not already members of a pension scheme that meets certain
minimum standards. The roll-out of automatic enrolment began in 2012 for large
businesses, and most businesses will be part of the scheme by 2018.
Whilst certain employees are automatically enrolled into a qualifying workplace
pension, they may opt out if they wish. Where an employee does opt out, they
will be automatically re-enrolled every three years. Employers are required to make
a minimum level of contributions for certain employees, depending on their age
and earnings. Employers can use a scheme such as National Employment Savings
Trust (NEST), either on its own or alongside an existing scheme they have in place;
perhaps using their own occupational pension for longer serving employees, and
NEST or an alternative workplace pension for newer employees who would then
gain membership of the main occupational scheme at a later date.
Schemes such as this make it easier for employers to fulfil their duties under the
legislation and help people to save for their retirement. The legal minimum for
contributions is, until April 2018, a total of 2 per cent of an employee’s qualifying
earnings, of which the employer must contribute 1 per cent. Qualifying earnings
are defined as earnings between £5,824 and £43,000 a year for the 2016/17 tax
year. Qualifying earnings include an employee’s salary, wages, overtime, bonuses
and commission, as well as statutory sick, maternity, paternity or adoption pay.
By 2019 the minimum contribution level will have risen gradually to 8 per cent, of
which employees will need to pay at least 3 per cent.
There are some perceived advantages and disadvantages of money-purchase

(defined-contribution) pension arrangements. The advantages include that they
are:
u easy for members to understand in terms of benefits and contribution rates;

u usually better value for short-service members who leave the scheme before
reaching retirement (for example by moving to a new job);
u able to offer a known outlay for the employer who can then control scheme
costs directly.
The disadvantages include that:

u there is no underlying benefit promise for members;
u the member ends up taking the risk of investments within the scheme
underperforming because the employer has no commitment other than to pay
the agreed contributions;
u ultimately, members’ benefits will be affected by underlying interest and annuity

rates on the day of retirement.

15: Pensions
15.3.4 Improving benefits from occupational pensions

schemes
There are three ways in which a member can make pension contributions to
enhance the benefits from a company scheme:

u stakeholder/personal pensions.
15.3.4.1 Additional voluntary contributions (AVCs)

Additional voluntary contributions (AVCs) are controlled by employers and, in some
instances, are simply an extension of the main scheme. They offer the employee
little independence from the employer.
The following points apply to employer-sponsored AVCs.
u Scheme trustees may require 12 months’ notice of the intention to pay or to

vary the rate of payment of AVCs.
u AVCs need not be paid on a regular basis and, provided scheme rules permit,
can be varied in amount and regularity.
u Contributions to the AVC scheme will be deducted from gross salary during
payroll calculations. This means that gross contributions are made immediately
to the scheme and the employee receives full tax relief at the same time.
u The employee is unlikely to be offered much choice of investment fund. Many
companies use insurance companies to administer the scheme but the employee
has no control or choice over the provider.
u AVC benefits can be taken independently from the main scheme.
u AVCs can be cost-effective, despite the restrictions, because the main scheme
usually covers some, or all, of the costs.
Some schemes offer AVCs in the form of added years. This means that the AVC
provides additional years of service as if the member had actually worked them.
The benefits will include all of the standard scheme benefits, such as pension,
cash and dependant’s benefits. The scheme actuaries will work out how much the
member needs to pay to gain one year’s additional service and it is up to the
member how many years they fund, within the overall limits allowed. Added years
provide certainty regarding benefits but can be much more expensive than other
forms of top-up. The benefits earned in this way must be taken with the main
scheme.
The advantages of AVCs include that they are low cost, that all of the pension is
held with one source, that there is immediate tax relief at the highest marginal
rate and that added years can provide guarantees. The disadvantages of AVCs are,
however, that there is often limited investment choice, that an employer will know
the individual’s funding level and that the AVCs are tied to the main scheme.

Non-occupational pension provision
15.3.4.2 Free-standing additional voluntary contributions

(FSAVCs)
Free-standing additional voluntary contributions (FSAVCs) are initiated by the
employee and need not involve the employer at all. The employee selects the
provider and the investment funds. Providers include life offices, approved friendly
societies, unit trust managers, building societies and banks.
Contributions to an FSAVC scheme are made from taxed income and receive
20 per cent tax relief at source; a higher-rate taxpayer can reclaim an additional
20 per cent; an additional-rate taxpayer can reclaim an additional 25 per cent.
The advantages of FSAVCs include independence, portability, a wider choice of

investment and no employer involvement.
The disadvantages are higher costs, that the employer will not bear the charges
and that higher-rate tax relief must be claimed separately.
15.3.4.3 Stakeholder pensions (SHPs) and personal pension

plans (PPPs)
Since 6 April 2006, occupational scheme members can contribute to any number
of registered schemes, including stakeholder or personal pension plans.
The advantages of these are that they are normally cheaper than FSAVCs, they are
portable, there is fund choice and flexibility, and they are independent.
The disadvantages are that they may be more expensive than an AVC because the
individual bears all of the charges and that higher-rate tax relief must be claimed
separately.
As all employees can now contribute to stakeholder/personal pensions, FSAVCs,

which are generally more expensive, are expected to become obsolete.
15.4 Non-occupational pension provision

For individuals who are not members of occupational pension schemes, or who
are self-employed, there is a gap in retirement provision that leaves only state
pensions, with the associated modest levels of benefits, to rely on.
For individuals in these categories and for those who wish to make contributions
in addition to their occupational schemes, there is a facility to contribute through
personal pension plans (PPPs). These contracts were introduced by the Finance Act
1986 and have been available since 1 July 1988 as a means by which individuals
can accumulate their own pension funds independently.
A personal pension is always set up on a money-purchase basis, the member

(and possibly other parties) makes contributions, and the eventual size of pension
benefits depends on how much has been paid in and how the investments
underlying the pension fund have performed.
In allowing PPPs, the government was anxious that as wide a range of institutions
as possible participate in providing plans, so that there would be increased choice
and competition. Individuals can choose from a wide range of personal pension
schemes available from banks, building societies, unit trust companies, friendly
societies and life assurance companies.

15: Pensions
Stakeholder pensions (SHPs) were first introduced on 6 April 2001. They are a
flexible, low-cost form of personal pension provision, which we will look at later
in this section, although most of the rules and regulations governing personal
pension plans also apply to SHPs. In general terms, a stakeholder pension is a type
of personal pension plan that meets certain minimum standards.
15.4.1 Stakeholder pensions

The stakeholder pension (SHP) is a type of personal pension. As such, it is subject to
the same rules that apply to all other personal pension schemes. The stakeholder
pension receives exactly the same tax treatment as any other personal pension
scheme.
What distinguishes the stakeholder pension from others are its additional rules
and standards, exclusive to the stakeholder pension and introduced to ensure that
it offers value for money, flexibility and security.
Providers are not precluded from making extra services available at a cost to those
who have taken out stakeholder pensions; neither are they prevented from levying
additional charges. In both cases, however, they may only do so with the express
agreement of the pension holder. Any additional charges must be clear and be
distinguished from the charges allowed by law.
For safety, stakeholder pension schemes must be run either by authorised
managers or trustees. Their legal duty and responsibility is to ensure that the
particular scheme for which they are responsible meets the legal requirements
15.4.1.1 Minimum standards for stakeholder pensions

The following minimum standards apply to pension schemes designated as
stakeholder.
u Each scheme must nominate a default investment option for customers who do
not want to choose how their payments are invested.
u Charges must not exceed 1 per cent per annum for members who joined before
April 2005. For those who joined after 5 April 2005, the maximum charge is
1.5 per cent for the first 10 years, reducing after that time to 1 per cent per
annum.
u Transfers to and from SHPs are unrestricted provided they are between
registered pension arrangements.
u There must be no restrictions on scheme membership.
u All payment methods must be accepted, except payment via cash, debit and
credit card.
u The minimum contribution must be no more than £20, excluding tax relief.
u Annual statements must be provided that give a breakdown of all payments

made, the fund value and what this will be worth at retirement.
Schemes must also provide access to low-risk investment media that investors can
use to reduce the risk of loss as they approach retirement age.

Tax rules
15.4.2 Self-invested personal pensions

A self-invested personal pension plan (SIPP) is a personal pension arrangement
that allows the individual to make direct investment choices from a wider range of
investments than normally offered by pension providers.
A list of allowable investments for inclusion within a SIPP would be:
u unit-linked or unitised with-profits insurance funds;
u unit trusts, OEICs, investment trusts;

u deposit accounts;
u equities (quoted on a recognised stock exchange);

u bonds;
u commercial property;
u derivatives.
Residential property is not an appropriate direct investment since it will class as
a prohibited asset and will be subject to punitive tax charges. For prohibited
assets, there is an unauthorised payment charge of 40 per cent on the member
and a surcharge of 15 per cent on the scheme. If such assets represent 25 per cent
or more of fund value, there are further tax charges and the risk that the scheme
will be deregistered.
Indirect investment (such as real estate investment trusts), however, will be
acceptable.
A SIPP can borrow up to a maximum of 50 per cent of the net fund value (to
purchase commercial property, for example).
The contribution and benefit rules are the same as for personal pensions. A SIPP
can accept transfers from other contracts if the product provider offers this facility.
15.5 Tax rules

Pensions offer generous tax reliefs, not least on the contributions paid in.
Consequently, HMRC rules are designed to ensure that pensions are structured
so as to enable people to achieve a primary aim of providing for their financial
security in retirement, rather than being used simply as a means of tax avoidance.
15.5.1 Contributions
There is a limit of £40,000 per year on the maximum tax-relieved pension
contribution that an individual can pay into a pension during a tax year. Where
a person earns less than £40,000 per year this limit is set at the level of their
earnings. This is referred to as the annual allowance.
For those who are ‘high earners’, those earning £150,000 or more per year,
the annual allowance is reduced by £1 for every £2 of earnings over £150,000,
reducing to a minimum level of £10,000.

15: Pensions
Those who flexibly access their pension using flexi-access drawdown or by taking
an uncrystallised funds lump sum (see section 15.6.1) are also subject to a special
‘money purchase annual allowance’ of £10,000.
UK residents without earnings can contribute up to £3,600 gross per annum to
registered pension schemes. This means that minors (those under the age of 18) or
those who look after the home and family can have stakeholder or personal pension
plans. The legal guardian must enter into the contract on behalf of the minor; to
ensure that the ownership of the pension reverts to the minor, the guardian will
sign a declaration. The declaration will indicate that the pension is for the benefit
of a specific minor and that the guardian acknowledges that ownership of the
pension will revert to the minor when they reach the age of 18.
15.5.2 Third-party contributions

Third parties (ie neither the individual nor their employer) may make payments on
behalf of the individual who has a stakeholder or personal pension plan. Third-party
payments will count towards the plan-holder’s annual allowance. Tax relief will be
given at the rate applicable to the owner of the plan. This means that a higher-rate
taxpayer making a contribution for a basic-rate taxpayer (or non-taxpayer) will not
receive higher-rate tax relief.
15.5.3 Tax relief

Tax relief is available at the individual’s highest rate(s) of income tax.
Where contributions are made to a personal or stakeholder pension, all
individual payments are made net of basic-rate income tax. This also applies to
non-taxpayers. Any higher-rate tax relief due will need to be claimed back via
annual self-assessment / personal tax returns. For those higher-rate taxpayers
who make payments on account, a contribution to a personal pension will reduce
the income tax payable as a balancing payment by 31 January following the end of
the tax year.
Higher-rate taxpayers, and in some cases additional-rate taxpayers, will receive
higher-rate tax relief by adding their gross contribution to the basic-rate tax band
when calculating their tax liability.
Contributions to occupational pensions usually operate on a different basis. The
sponsoring employer will usually deduct the pension contribution from gross
(pre-tax) earnings. This means that all tax relief, basic and, if applicable, higher
and additional-rate, is granted immediately at the point the contribution is paid.
There is also a lifetime allowance (£1m in 2016/17) that sets the maximum level of
tax advantaged pension savings an individual can build up during their life. Where
pension benefits exceed this level, any excess is subject to a punitive tax charge.
15.5.4 Previous pension scheme membership

It is possible that a person will build up a number of different pension pots
during their working life. This often happens where a person changes jobs
and becomes a member of different occupational pensions or arranges different
personal pensions.

Pension benefits
Personal and stakeholder pensions have the flexibility to receive transfer payments
from previous pension schemes of which an individual was a member. These
transfer payments will generally not affect the full value of pension rights built
up or the amount of contributions that the individual has made in respect of the
particular scheme. Anyone considering transferring their pension rights from one
scheme to another should take professional financial advice on the matter.
15.6 Pension benefits

The pension benefit rules apply to whatever type of pension a person holds.
Benefits are not available until an individual has reached normal minimum pension
age, currently 55. It is not necessary to take all the benefits at the same time.
The exceptions to this age ruling are armed forces personnel, police force and fire
service schemes and some sports people.
Benefits from a scheme may be taken before the normal minimum pension age if
the member is in ill health. To pay benefits in these circumstances, the scheme will
need a written opinion from a registered medical practitioner that the member is
incapable of continuing their current occupation because of ill health.
An individual need not actually retire or cease work to take their pension benefits.
15.6.1 Options on retirement

When deciding to crystallise a registered pension benefit, the first decision a
scheme member faces is how much pension commencement lump sum (if any)
to take from the fund.
The maximum tax-free cash lump sum that may be taken at the start of retirement
(known as a pension commencement lump sum) is 25 per cent of the fund
value. This must be payable when the scheme member first crystallizes the pension
arrangement (or within three months of crystallisation).
The pension commencement lump sum is normally subject to a maximum of

25 per cent of the lifetime allowance, ie £250,000 for 2016/17. It may, however,
be higher if the fund is covered by transitional protection; transitional protection
enables those individuals to protect their pension benefits where they had built up
benefits in excess of the lifetime allowance under previous tax regimes when the
lifetime allowance was set a higher level.
A registered pension scheme is only authorised to pay out benefits to, or in respect
of, a member in two forms: either as an income or as a lump sum.
These pension benefits must also comply with HMRC rules; if a pension benefit
does not comply with these rules, it is deemed an unauthorised member payment
and will be taxed accordingly.
There is no maximum pension that can be paid from a registered scheme,
the maximum benefit is informally limited by the annual allowance on
maximum contributions and the lifetime allowance. Beyond the tax-free pension
commencement lump sum, pension benefits are taxable as pension income under
the pay-as-you-earn (PAYE) tax system.

15: Pensions
Once any pension commencement lump sum has been taken, the remaining
pension benefits may be taken in a number of ways.
u Scheme pension − the pension income is provided from the registered scheme
or from an insurance company selected by the scheme administrator. This is
the only option available to members of defined-benefit schemes.
u Members of money-purchase pension schemes potentially have more choice

and, as long as the scheme they are a member of offers the option, can choose
to take benefits as follows:
− Lifetime annuity − an insurance contract whereby the member converts

their pension fund into an income for life, either with the company that they
have used to build up their pension fund or by moving the fund to another
provider. The provider will quote an annuity rate which sets the level of
income that will be provided by the fund. The member has the choice to
take a level income that will cease on their death or add more options such
as an increasing (indexed) income or spouses’ / dependents’ benefits to
allow for a continuing income or payment of a lump sum on death. Where
such options are added, the initial rate of income will be reduced.
− Drawdown pension − whilst an annuity offers a guaranteed income, a

potential disadvantage is that the entire pension fund is withdrawn, meaning
there is no prospect of future investment growth. Drawdown pension enables
the pension fund to remain invested with income drawn directly from the
fund. If the member wishes, they can then buy an annuity at a later date.
This is done through flexi-access drawdown which enables the member to
draw as much or as little from their pension fund. Income is subject to tax
as pension income.
Prior to the introduction of flexi-access drawdown in April 2015, there

were two other forms of drawdown pension: flexible drawdown and capped
drawdown. All flexible drawdown arrangements have been converted to
flexi-access drawdown. Capped drawdown, as the name suggests, limited
income withdrawals to 150 per cent of an assumed annuity rate set by the
Government Actuaries Department (the GAD rate). Whilst no new capped
drawdown arrangements could be set up after 5 April 2015, existing
arrangements can stay in place and further pension funds can be added.
Alternatively, an individual who is already in capped drawdown can convert
the arrangement to flexi-access drawdown.
− A final option is uncrystallised funds pension lump sum (UFPLS). This
has been available since 6 April 2015 and enables an individual to draw some
or all of their uncrystallised pension funds as a lump sum payment or as a
series of lump sums; uncrystallised funds are those that are not currently
being used to provide pension benefits. Twenty-five per cent of each UFPLS
payment is tax-free with the balance taxed as pension income.

Review questions
15.6.2 Death benefits

Where a member of a pension scheme dies, death benefits can be paid in the
following ways.
u A lump sum, which is payable at the discretion of the scheme administrator /
trustees to the member’s dependants or legal personal representatives.
u A dependants’ pension / beneficiary’s annuity to one or more dependants
or beneficiaries as nominated by the member.
u A beneficiary’s flexi-access drawdown pension to enable named

beneficiaries to continue to draw income direct from the pension.
Where a member of a pension scheme dies before the age of 75, their pension
benefits are separated into two parts: crystallised funds that are already being
used to provide pension benefits and uncrystallised funds that remain invested
within the fund.
Any death benefits paid from uncrystallised funds are tested against the member’s
lifetime allowance, with any excess taxed at 55 per cent where taken as a lump
sum or 25 per cent if taken as an income.
Crystallised funds will already have been tested against the lifetime allowance, so
no lifetime allowance check is triggered by the member’s death.
Death benefits paid from crystallised funds, from uncrystallised funds within the
annual allowance and for those benefits remaining after any lifetime allowance
charge has been paid are free of income tax.
A member’s pension benefits are tested against the lifetime allowance at age 75,
so where a member dies at age 75 or older there is no lifetime allowance check.
Where the member dies at age 75 or older, death benefits, whether lump sum and
or income, are added to the income of the recipient, in the year of receipt, and
subject to income tax.
Review questions
1. Where an individual was ‘contracted out’ for periods during their working life,
what will the effect on their entitlement to the new state pension be?
2. Explain ‘unfunded’ pension schemes.

3. Why have employers closed defined-benefit schemes to new employees in
recent years?
4. How can employees improve benefits from occupational pension schemes?

5. Why are FSAVCs expected to become obsolete?

15: Pensions
6. What is the maximum amount that UK residents without earnings can

contribute to a registered pension scheme?
7. How can a higher-rate taxpayer claim back tax on personal pension
contributions?
8. What type of investments are allocated within a SIPP?
9. How much is the maximum allowed for a pension commencement lump sum?
10. What are the main ways of taking pension benefits after the pension
commencement lump sum has been taken?

Topic 16
Mortgage loans and associated
products
Learning objectives
u summarise the range of mortgage solutions;
u explain the purpose of equity release.
16.1 Introduction
We looked at mortgage loans in overview in section 8.4.1 and we are now going
to consider mortgage products in more detail. There is a vast array of different
schemes available to customers, and advisers need to be sure that they are
recommending the most suitable for customers’ needs, circumstances and income.
We will also consider equity release schemes. In section 8.4 we covered further
advances and second mortgages, but there are other ways in which a customer
can free up value from their property.
16.2 Interest-only mortgage repayment

options
As we saw in section 8.4.1, one type of mortgage is the interest-only option.
The borrower has to have some means of repaying the capital at the end of the
mortgage term.
Note: FCA MCOB rules permit lenders to advance a mortgage on an interest-only
basis only if the borrower has a credible repayment strategy in place. The options
outlined in this section would generally not be classed as credible repayment
strategies if being set up today to fund a new mortgage, as they lack the necessary
guarantees. They remain relevant as many existing borrowers use these methods
and, where one of these plans has been running for a number of years and
accumulated an investment value, it may then be deemed as being a credible
repayment option.
16.2.1 Endowment assurances

Both with-profit and unit-linked endowments can be used for mortgage purposes.
In each case, special adaptations have been developed to take account of the
particular needs of mortgage repayment.

16: Mortgage loans and associated products
One feature of life policies is that they can be legally assigned to a third party, who
effectively becomes the owner of the policy and is entitled to receive the benefits in
the event of a claim. Some lenders require the endowment to be assigned to them
as part of the mortgage deal; others may simply require that the policy document
be passed into their possession, without a formal assignment.
16.2.1.1 Low-cost endowment

Borrowers prefer to use with-profit policies rather than non-profit because of the
potentially better returns. The problem is, however, that the premiums are higher
− an important consideration for most borrowers, who are seeking to minimise
their mortgage costs.
The low-cost endowment provides a suitable compromise by basing premiums on
a sum assured that is lower than the mortgage loan amount but which, including
the bonuses that are expected to be declared over the policy term, should become
sufficient to repay the loan. Since bonuses are not guaranteed, the basic sum
assured is calculated using a conservative estimate of future bonus rates − often
around 75 per cent of the company’s current reversionary bonus rate. Terminal
bonuses are not taken into account. These policies have not performed well in the
last few years and many mortgage providers no longer accept them as repayment
vehicles for mortgage loans.
16.2.1.2 Unit-linked endowment

When used for mortgage purposes, the premium required to fund a unit-linked
endowment is calculated as the amount that will provide sufficient to repay the
loan at the end of the term if unit prices increase at a specified conservative rate of
growth. Policyholders can choose which fund or funds to use for their investment,
but it is usually recommended that premiums be invested in a managed fund: it
would certainly not be wise to use a very speculative fund for mortgage repayment
purposes.
The growth rate is not guaranteed, and it is the borrower’s responsibility to ensure
that the policy will provide sufficient funds to repay the loan. Regular reviews
by the life company of the policy’s progress enable the borrower to increase the
premiums (or make other provisions) if the policy is not on target. Most companies
also provide the facility to switch to a cash fund, or similar, in order to protect the
policy value from sudden market falls towards the end of the term.
One advantage of the unit-linked policy as a repayment vehicle is that, in a strongly
rising market, the value of the policy may reach the required amount before the
end of the term. In that event, the policy can be surrendered and the loan repaid
early − thus saving on future interest, and freeing the repayment amounts for the
client to use for other purposes. This has to be balanced with the possibility that
the value could fall near to maturity and not provide the funds expected.
16.2.2 Pension mortgages

One of the benefits of a pension is that a lump sum(s) can be taken from the fund
once the member has reached normal minimum pension age, currently age 55.
Up to 25 per cent of the accumulated fund can be taken as a tax-free cash sum,
a pension commencement lump sum (PCLS); if the scheme is a money-purchase
arrangement, such as a personal pension or a stakeholder pension, it is possible
that the member can take further, taxable, lump sums in addition to the PCLS.

Interest-only mortgage repayment options
This means that pensions have the potential to be used as mortgage repayment
vehicles, with the loan being repaid out of the cash lump sum(s).
The plans have other financial benefits.
u Pension contributions qualify for tax relief at a person’s highest rate of tax.
The practical effect of this for a higher-rate taxpayer, for instance, is that each
£100 of contribution costs them only £60. (There is no tax relief on endowment
policy premiums.)
u The fund in which the contributions are invested is not subject to tax on capital
gains, meaning that it should grow faster than a comparable endowment policy
fund, which is taxed on both income and capital gains.
On the other hand, there are a number of factors a borrower might feel are possible
drawbacks to the use of a pension plan for mortgage repayment purposes.
u As benefits cannot be taken until normal minimum pension age, the term of the
mortgage must run until at least age 55. The pension cannot be used to repay
the mortgage any earlier, even if the fund has grown to a sufficient value.
u If the tax-free PCLS is to be used to repay the mortgage then the pension fund
must be worth four times the value of the mortgage (as the PCLS is limited to
25 per cent of fund value). As there is a lifetime allowance that limits the total
value of lifetime tax-relieved pension holdings, the maximum mortgage that
can be repaid from the PCLS is £250,000 (the lifetime allowance for 2016/17
is £1m). It may be possible to draw additional taxed lump sums to pay off a
mortgage but this option is limited to money-purchase pensions and, even then,
not all providers offer this facility.
u If a lump sum is drawn from the pension to repay a mortgage then the value
available to provide benefits in retirement will be reduced.
u A personal pension or stakeholder pension, unlike an endowment assurance,
does not automatically carry any built in life assurance. A separate policy will
be required to cover the repayment of the loan in the event of premature death.
There is a further characteristic of the use of a pension plan that might be
considered a disadvantage by the lender: pension contracts cannot be assigned
to a third party as security for a loan or for any other purpose. The lender cannot,
therefore, take possession of the plan or become entitled to receive benefits
directly from it. This fact has not, in practice, prevented many lenders from being
willing to accept pensions as a means of funding a mortgage.
16.2.3 Individual saving account (ISA) mortgages

ISAs have long been recognised as a popular means of repaying an interest-only
mortgage.
All managers allow investments to be made on a regular monthly basis, provided,
of course, that the overall annual limits are not exceeded.
The amount of regular investment that would be required to produce the necessary
lump sum at the end of the mortgage term can be calculated, based on an assumed
growth rate and on specified levels of costs and charges.

The main benefits of using an ISA as a repayment vehicle are:

u the funds grow free of tax on capital gains, thus reducing the cost of repaying
the mortgage;
u if the fund’s rate of growth exceeds that assumed in the initial calculations, the
mortgage can be repaid early.
Drawbacks associated with the use of ISAs (and other similar investment schemes)
are as follows:
u If growth rates do not match the initial assumptions, the final lump sum will
fall short of the mortgage amount − unless additional investments have been
made.
u In the event of premature death, the value of the ISA investment is unlikely to
be sufficient to repay the loan. Additional life assurance cover is required to
meet this eventuality, meaning there is an additional cost to the customer.
u The limits on annual contributions can make it difficult to pay back a loan
quickly or to fund a large loan. This is less of an issue for couples, as they are
each allowed to invest their individual maximum but it is not normally possible
for these funds to be held together in order to accumulate at a faster rate.
16.3 Mortgage interest options and other

schemes
Regardless of whether a customer chooses a capital-and-interest repayment
mortgage or an interest-only mortgage with some kind of a repayment vehicle,
there are often a number of different types of mortgage product available. The
main variations are described below, but remember that these are not necessarily
specific products in themselves; they are characteristics of products. Some of these
characteristics can be combined within a single product, for example a fixed-rate
mortgage with a cashback.
Remember also that how interest is charged will vary from one lender to another:
some charge interest on an annual basis, some on a monthly basis, and some on
a daily basis.
16.3.1 Variable rate

A variable rate is the basic method of charging interest, with monthly payments
going up or down without limit as interest rates change. One disadvantage is that
borrowers cannot easily predict the level of future payments, which can cause
budgeting problems.
16.3.2 Discounted mortgage

A discounted mortgage takes the form of a genuine discount off the normal variable
rate (for example, 2 per cent off for three years). It is not a deferment of capital or
interest payments. There is usually a restriction on how soon the mortgage can be
repaid, or a penalty for repaying within a certain period.

Mortgage interest options and other schemes
16.3.3 Fixed rate

With a fixed-rate mortgage, the borrower is able to ‘lock in’ to a fixed interest
payment for a specified period, usually between one and five years. At the end of
the period, the rate reverts to the lender’s prevailing variable rate. This scheme
is popular with first-time buyers and others who want to be able to budget
precisely. There is often a substantial arrangement fee, however, and there may be
restrictions or penalties on changing to another lender.
16.3.4 Capped rate

An interest rate might have an upper fixed limit, known as the ‘cap’. The lender’s
normal variable rate will apply to this type of mortgage, but it will be subject to
the capped rate. Should the variable rate exceed the cap, the borrower will still pay
not more than the capped rate. If there is also a fixed lower limit, it is known as a
‘cap and collar’ mortgage.
16.3.5 Base rate tracker mortgages

As the name suggests, base rate tracker mortgages are linked to the base rate set
by the Bank of England. The base rate is reviewed once a month and reflects the
cost of borrowing money from the Bank of England. Base rate tracker mortgages
give the borrower the certainty that their payments will rise and fall in line with base
rate changes. It should be noted that most lenders offering this type of mortgage
do charge a premium above the base rate. A typical example would be a borrower
being charged interest at 0.95 per cent above the base rate.
16.3.6 Flexible mortgages

The flexible mortgage is a scheme that gives the borrower some scope to alter
their monthly payments to suit their ability to pay, as well as the opportunity to
pay off the loan more quickly. Although there is no precise definition of a flexible
mortgage, it is generally considered that such a product should offer the following
basic features:
u interest calculated on a daily basis;

u the facility to make overpayments at any time without incurring an early
repayment charge;
u the facility to underpay, but only within certain parameters set out by the lender
when the mortgage was arranged;
u the facility to take a payment holiday, again within certain parameters laid down
at the outset.
The combination of a daily interest calculation and occasional, or regular,

overpayments will result in considerably less interest being paid overall and the
mortgage term being reduced.
The ability to reduce monthly payments, or suspend them entirely, for a

limited period will benefit the borrower who is experiencing temporary financial

difficulties. Such a situation can be further relieved by the borrower being able to
‘borrow back’ previous overpayments.
Most flexible mortgages allow the borrower to draw down further funds as and
when required, although the lender will have set a limit on total borrowing at the
outset. Some lenders provide borrowers with a cheque book to enable additional
funds to be drawn. Flexible mortgages involve a much easier administrative
process than is usual when dealing with further advances. The wording of the
mortgage deed generally used for flexible mortgages is such that all additional
funds withdrawn, within the limit on total borrowing, will automatically take priority
over any other subsequent charges registered against the property.
16.3.7 Current account mortgage

An increasingly popular version of the flexible mortgage is the current account
mortgage. This scheme enables the borrower to carry out all of their personal
financial transactions within the single account. The account is able to receive
salary credits and pay standing orders and direct debits in exactly the same way as
a conventional current bank account. The borrower will be provided with a cheque
book and a debit/credit guarantee card.
The combination of salary credits and the calculation of interest on a daily basis
considerably reduces the amount of interest payable and consequently also the
mortgage term.
16.3.8 Offset mortgage

A more recent development is the offset mortgage. This scheme requires the
borrower to have savings or other accounts with the lender and enables the interest
payable on such accounts to be offset against the mortgage interest charged.
For example, if a borrower has an offset interest-only mortgage for £80,000 and
£25,000 in a savings account with the lender, they can opt to waive payment of
interest on their savings; enabling interest to be charged on a net loan of £55,000.
This calculation is repeated on a daily basis.
Even more complex offset mortgages are becoming available that enable the
borrower to offset interest payable on various savings accounts against interest
charged on their mortgage and on any other secured or unsecured loans held with
the lender.
Many lenders now offer flexible mortgages with a fixed, discounted or capped
rate for an initial period. Early repayment charges do not normally apply to these
products but an arrangement fee may be payable and, in some cases, it may be
a condition of the loan that a particular insurance product is purchased from the
lender.
16.3.9 Cashbacks
A cashback is a relatively common incentive offered by many lenders. A lump sum
is paid to the borrower immediately after completion of their mortgage, either as
a fixed amount or as a percentage of the advance. Generally, lower loan-to-value
ratios will result in higher cashbacks. For example, the cashback may be 3 per cent

Mortgage interest options and other schemes
of the advance for a loan-to-value ratio of up to 80 per cent, and 2 per cent for a
higher loan-to-value ratio.
It is usually a condition of the mortgage that some or all of the cashback must be
repaid if the loan is redeemed within a specified period.
Discounted rates and cashbacks are sometimes used by lenders either to tempt
borrowers away from competitors or as a loyalty bonus to persuade them to
stay. Payment of legal fees is another offer that is commonly made to encourage
switching of the loan between lenders while incurring minimum costs.
16.3.10 Low-start mortgage

The low-start mortgage is a repayment mortgage designed to assist borrowers who
want to keep down costs in the early years. The low initial repayments are achieved
by deferring the capital instalments for the first few years. Borrowers need to be
aware that payments will increase at the end of the initial period and that no capital
will have been repaid.
16.3.11 Deferred interest

In the early years of a deferred-interest mortgage, some of the interest is not paid
but is added to the outstanding capital. This is a useful method for those who
expect an increasing income, and who wish to maximise the loan while minimising
the costs in the early years.
This type of mortgage is not suitable for people who borrow a high proportion
of the property price − especially at a time when prices may be falling − because
there is an increased danger of negative equity.
16.3.12 CAT-standard mortgages

In 2001, the government introduced specified CAT (charges, access and terms)
standards that can be applied to mortgage products to avoid confusing marketing
and hidden charges. Lenders do not have to offer CAT-standard mortgages, and
there is no guarantee by either the government or the lender that a CAT-standard
mortgage will be the most suitable product for a particular borrower.
CAT-standard mortgages are likely to appeal to borrowers who wish to have clearly
stated limits on charges. Examples of the limits set on charges and other costs are
the following.
u The variable interest rate must be no more than 2 per cent above Bank of
England base rate and must be adjusted within one calendar month when the
base rate is reduced.
u Interest must be calculated on a daily basis.
u No arrangement fees can be charged on variable-rate loans and no more than

£150 can be charged for fixed-rate or capped-rate loans.
u Maximum early redemption charges apply to fixed-rate and capped-rate loans.

u No separate charge can be made for mortgage indemnity guarantees.

u All other fees must be disclosed in cash terms before the customer makes any
commitment.
Other rules relating to access and terms include the following.

u Normal lending criteria must apply.
u The customer can choose on which day of the month to pay.

u All advertising and paperwork must be clear and straightforward.
u Purchase of related products cannot be made a condition of the offer.
16.4 Methods of releasing equity

Equity in a mortgage loan context is the excess of the market value of a property
over the outstanding amount of any loan or loans secured against it. There are a
number of ways to release the equity in a property. Releasing equity means using
the excess value to obtain capital or income; this can then be used for another
purpose. Individuals may release this value to repay debts or to finance large
purchases such as a home extension. Typically, on retirement individuals may
wish to top up their pension income or release capital to buy a car, for example,
without having to downsize their property.
16.4.1 Lifetime mortgages

A lifetime mortgage is, as the name suggests, a mortgage that potentially runs over
the remainder of a borrower’s life. The lender will usually be prepared to lend up
to a maximum of 55 per cent of the property value, depending on the borrower’s
age. Lifetime mortgages may be arranged in different ways depending on whether:
u interest is rolled up with no need for interest payments;
u only interest payments are made;
u both capital repayments and interest payments are made.

The majority of lifetime mortgages are on a fixed-rate basis with interest rolled up,
and take into account the fact that, unlike with a standard mortgage product, the
term of the loan is unknown.
Interest is charged at the lender’s lifetime mortgage rate, but no regular payments
of capital or interest are made. Instead, the interest is added to the loan. The
context for there being no need to make payments on the loan is that the issue the
borrower is trying to address is to increase income, any requirement to make
interest payments and loan repayments would reduce the effectiveness of the
arrangement.
When the borrower dies or moves (perhaps into residential care), the property
is sold and the mortgage loan, plus rolled-up interest is repaid to the lender. If
any of the sale proceeds remain once the loan has been repaid, the borrower, or
their estate, receives the balance. If the property is owned jointly, the mortgage
continues until the second death or vacation of the property.

Shared-ownership mortgages
Most lenders provide a ‘no-negative-equity’ promise, which means that the

borrower cannot owe more than the value of the property when the loan is due to
be repaid.
A lifetime mortgage can be arranged on a drawdown basis. The lender agrees

a maximum lending limit and the borrower can borrow an initial minimum loan
and subsequently draw down lump sums as they wish, subject to a minimum
withdrawal, typically £2,000 to £5,000. Interest is charged on the amount
outstanding, but is rolled up rather than paid each month. The benefit of this
type of loan over a standard lifetime mortgage is that interest only accrues on the
amount actually borrowed, so the borrower has a degree of control and the debt
will not increase as rapidly. It will allow the borrower to provide an annual ‘income’
while maintaining control over the speed at which the debt builds up.
A variation on a lifetime mortgage is a home income plan, which involves the use
of an annuity. Funds are raised through a lifetime mortgage and invested in full
or in part into an annuity. An annuity is an investment plan that provides regular
income in return for a lump sum. The use of an annuity means that any needs
for an increased income can be met within a single arrangement. Income from the
annuity is used to make payments of interest on the loan with the balance paid to
the individual who has arranged the plan.
The main providers of equity release plans have formed a trade association called
the Equity Release Council, formerly known as Safe Home Income Plans (SHIP). This
has established a code of practice designed to safeguard the interests of borrowers.
Since 2004, additional protection for customers taking out equity release plans has
been provided through the regulation of such plans by the FCA (and formerly the
FSA) through MCOB.
16.4.2 Home reversion schemes

Home reversion schemes are an alternative to home income plans and involve the
homeowner selling all or part of their property to the company in return for an
income for life. The customer(s) retains the right to live in the house until their
death(s), after which the company sells the property and retains the percentage of
the proceeds they are entitled to.
The FCA regulates these schemes even though they do not involve a mortgage
loan.
16.5 Shared-ownership mortgages

Shared-ownership mortgages combine owner-occupation with rental. They enable
the borrower to buy a stake in the property and rent the remainder. For example,
the borrower can purchase a 25 per cent stake in the property, funded by a
mortgage, with the option of buying subsequent 25 per cent shares in the future. As
the borrower increases their share in the property, the mortgage element increases
and the rented element reduces. This process of increasing one’s share in the
property is sometimes called ‘staircasing’.
This type of scheme (usually arranged by housing associations) enables those on
relatively low incomes to become owner-occupiers, even though they cannot afford
a conventional mortgage.

16.6 Related property insurance

A lender’s security depends on the property being maintained in an acceptable
condition. For that reason, borrowers have to covenant (ie promise under the terms
of the mortgage deed) to maintain the property in good condition.
They also have to covenant to insure the property adequately. A lender is permitted
by law to:
u insist that a property, but not the owner’s contents, is continuously insured by
means of a policy that is acceptable to the lender;
u have its interest as mortgagee noted on the policy;
u secure a right over the proceeds of any claim and to insist that the proceeds be
applied to remedy the subject of the claim or to reduce the mortgage debt.

Review questions
Review questions
1. Why do most mortgage providers no longer accept low-cost endowment

policies as repayment vehicles for interest-only mortgage loans?
2. What are the benefits of using a pension fund as a mortgage loan repayment
vehicle?
3. What are the potential drawbacks of using an ISA as a mortgage loan repayment
vehicle?
4. Explain a fixed-rate mortgage interest option.
5. What types of customer would benefit from an offset mortgage?
6. Who might benefit from a low-start mortgage?
7. What is the purpose of CAT-standard mortgages?

8. Explain the difference between a lifetime mortgage and home reversion
schemes.
9. Why might a shared-ownership mortgage be attractive to someone on a low

income?
10. What rights does a lender have in relation to the insurance of a property that
it has as security for a mortgage loan?

Topic 17
Interacting ethically with clients
Learning objectives
u explain regulatory requirements for financial advice;

u summarise the regulatory requirement for ethical behaviour;
u summarise the regulatory requirements for training and competence;

u summarise the appropriate conduct of a client relationship.
17.1 Introduction
Topic 2 covered regulations as they apply to organisations and the senior
management. This topic looks more closely at what is required of people who
are in contact with the customer and who provide information on which product
recommendations are based.
Advising on investments is defined by the FCA in its Handbook as ‘the regulated
activity specified in article 53 of the Regulated Activities Order’ (see section 2.2),
which is, in summary: advising a person if the advice is: (a) given to the person in
his capacity as an investor or potential investor, or in his capacity as agent for an
investor or a potential investor; and (b) advice on the merits of his doing any of
the following (whether as principal or agent):
1. buying, selling, subscribing for or underwriting a particular investment which
is a security or relevant investment (that is, any designated investment, funeral
plan contract, pure protection contract, general insurance contract or rights to
or interests in a funeral plan contract); or
2. exercising any right conferred by such an investment to buy, sell, subscribe for
or underwrite such an investment.
Advising on a home finance transaction is defined by the FCA as: ‘any of the
regulated activities of advising on regulated mortgage contracts, advising on a
home purchase plan, advising on a home reversion plan or advising on a regulated
sale and rent back agreement’.
We looked at who can give advice in section 2.2. These employees have to pass the
PRA’s/FCA’s ‘fit and proper test’ and also maintain necessary ongoing competence
to undertake their roles. This will mean passing the required examinations,

17: Interacting ethically with clients
completing continuous professional development and completing sales calls under

the regular observation of their line managers.
17.2 Regulatory requirements for financial

advice
A number of factors have resulted in legislation to regulate the financial services
industry.
u Scandals or crises: for example, the events surrounding the collapse of
Northern Rock and the credit crisis of the late 2000s. These have shown up
the need for prudential control and for protection against mismanagement and
fraud.
u An increase in consumers’ financial awareness and a demand for a more
customer-focused business approach. Also, demands for a ‘one-stop shop’
approach to financial services sales have been instrumental in the deregulation
of banks and building societies over the past 25 years.
u The need to respond to changes in lifestyle: more relaxed attitudes to
marriage and divorce in recent years have led to a strengthening of the rights
of divorcees to share in former spouses’ pension benefits; the introduction of
civil partnerships for same-sex couples has extended the scope of some tax
benefits and other financial and social benefits.
u Developments in business methods: technological advances, in particular,
have fuelled many recent changes. This is particularly true for banks and
building societies, whose customers now carry out many of their transactions
electronically.
u Innovation in product design: rapid expansion has been seen in the ranges
of certain products, particularly in mortgage business. This has made it more
important than ever that a consumer should be provided with sufficient clear
information about the features and benefits of the products they are buying.
u The increase in the number and complexity of financial products: this
has made it necessary to provide customers with more information and advice.
When considering financial advice, mis-selling is probably the biggest issue that
consumers, advisers and planners face. Services where there is a significant
financial risk to the customer − mortgages, for example, and investment services
such as life policies, managed portfolios and pensions − are examples of where it
can occur.
Mis-selling involves advisers recommending services that are not suitable or
making exaggerated claims about the likely performance of a service. Some
advisers can be tempted to do this in order to meet sales targets, and customers,
with little knowledge, tend to go along with recommendations on the basis of trust.
For example, poor advice around the sales of payment protection insurance led to
an investigation by the Office of Fair Trading. As a result the rules relating to the
sale of this product changed to allow consumers time to look at other providers
in the marketplace. Of all the complaints dealt with by the Financial Ombudsman
Service, sales and advice still account for the largest proportion.
The need for regulation to protect consumers is obvious; they need to feel that they
can trust the advice they are being given and the person giving it. If they do not

Regulatory requirements for ethical behaviour
receive advice then potentially they may suffer financial hardship because a need
has gone unprotected at a time when they would value it most. Advice should be
given based on the expertise of the financial adviser and based on full disclosure
of customer information, matched to the products available. In cases where there
is no suitable product the adviser is obliged to say so.
To the adviser, regulation may seem onerous at first but it is there to protect them
and their organisation. Advisers should seek to have long-term relationships with
their clients and this should be based on mutual trust. Advisers and planners need
to be professional in dealing with their clients and the regulation gives them a
framework within which to work.
As we have seen, any person working in an authorised firm who carries out a
controlled function must be approved by the FCA. The FCA is responsible for
approving individuals who have conduct-focused roles. Approved persons are
approved to carry out a specific controlled function or functions. Advisers and
planners are classed as having customer functions and these cover client-facing
roles such as:
u an investment adviser;
u a trainee investment adviser;

u a corporate finance adviser;
u a pension transfer specialist;

u an adviser on syndicate participation at Lloyd’s;
u customer trading;
u investment management.
17.3 Regulatory requirements for ethical

behaviour
Regulation of advisers should drive ethical behaviour in giving advice and dealing
with customers. Before becoming an approved person, advisers have to pass the
FCA’s ‘fit and proper test’ which is a benchmark used to assess an individual’s
suitability to perform a controlled function. The most important considerations
are the individual’s:
u honesty, integrity and reputation;
u competence and capability;

u financial soundness;
u approach to the fair treatment of customers.
We will consider the sales process in Topic 18 and Topic 19. However, there are
other activities of advisers and planners that should be considered.

17.3.1 Advertising and financial promotion rules

Before meeting a customer, advisers and planners may be involved in financial
promotions. A financial promotion is defined as an ‘invitation or inducement to
engage in investment activity’. This includes:
u advertisements in all forms of media;

u telephone calls;
u marketing during personal visits to clients;

u presentations to groups.
Financial promotions can be ‘communicated’ only if they have been prepared, or

approved, by an authorised person.
There is a distinction between:
u real-time financial promotions, such as personal visits and telephone

conversations; and
u non-real-time financial promotions, such as newspaper advertisements and

those on internet sites.
The overall principle is that financial promotions to retail clients and professional
clients must be fair, clear and not misleading. In the case of retail clients, this
means specifically that information supplied must:
u be accurate, including the requirement not to emphasise potential benefits
without giving a fair and prominent indication of the risks;
u be understandable by an ‘average’ member of the group it is aimed at;
u not disguise or obscure important terms or warnings.

Direct offer advertisements should contain the name of the regulator (PRA and /
or FCA).
17.3.1.1 Comparisons
Comparisons with other products must be meaningful, and presented in a fair and
balanced way. Markets in Financial Instruments Directive (MiFID) firms are subject
to additional requirements to detail the source of information and the assumptions
made in the comparison. MiFID aims to be part of a plan to make a single market
in financial services across the EU and, among other things, increases the range of
core investment services and activities that firms can provide in other EU countries.
17.3.1.2 Past performance

Past performance information must not be the most prominent part of a promotion.
It must be made clear that it refers to the past, and it must contain a warning
that past performance is not necessarily a reliable indicator of future results. Past
performance data must be based on at least five years (or the period since the
investment commenced, if less, but not less than one year).

17.3.1.3 Unsolicited promotions − cold calling

Cold calling can expose consumers to high pressure sales tactics leading to the
sale of inappropriate or over-expensive products or services. Cold calling is where
the consumer did not initiate the contact with the provider. Customers can be
approached if they expressly request it, however failing to tick a box to say that
they do not want to be contacted, or relying on standard terms that allow contact
with the customer again, is not sufficient to allow a cold call.
Cold calling is banned for investment and mortgage sales unless certain conditions
are met.
u Specific rules for investment business

Investment rules allow for three scenarios where cold calls could be made,
where the promotion:
− is to an existing customer who anticipates receiving a cold call;
− relates to packaged products that do not contain higher volatility funds, or

to life policies not connected to higher volatility funds; or
− only relates to readily realisable securities (but not warrants) or generally
marketable non-geared packaged products.
In addition the caller must:
− only make contact at an appropriate time of day, for example between 9am
and 9pm Monday to Saturday and not on Sundays;
− identify themselves and the firm they represent at the start and make clear
why they are calling;
− ask whether the client would like to continue or terminate the call, ending
the call if asked to do so; and
− give a contact point to any customer who they arrange an appointment with.
u Specific rules for mortgage business

A firm cannot make a cold call unless it is to an existing customer who
anticipates receiving a cold call. The only exception is to limit the information
to the name of the firm, a contact point and / or a brief factual statement of the
firm’s main business.
u General insurance and banking business
There are no cold calling restrictions for general insurance or banking business,
although firms must consider the need to be fair, clear and not misleading in
all communications.

17.3.2 Status of advisers and disclosure of status

Advisers are classed as independent or restricted. To be considered
independent, advisers must base any personal recommendation on a comprehensive
and fair analysis of the relevant market, and the advice must be unbiased and
unrestricted. The definitions are:
u Comprehensive and fair analysis − means advisers must take into account
all retail investment products capable of meeting the needs and objectives of
their customers.
u Relevant market − means advisers must consider the whole market for the
area in which they provide advice. This is based on the needs of their customer
base. For example, certain products, such as risky or structured products, may
have been assessed as unsuitable for their customer base. If the firm decides not
to advise on these products, the firm will not need to carry out a comprehensive
review of the market for these products for each of their customers.
u Unbiased − means advisers must be free from any restrictions that may limit
their ability to recommend suitable products, such as holding agreements
binding the firm to a particular product provider.
u Unrestricted − means advisers must also consider other relevant products that
meet the needs of the client, but fall outside the definition of retail investment
products, ie cash deposit ISAs.
Note that any advice which does not meet the requirements to be classed as
independent advice is defined as restricted advice.
The adviser must clearly inform clients whether services are provided
independently or under any limitation or restriction. The disclosure is generally
made at the start of a client meeting and must be made before the adviser
recommends a product. There is no prescribed wording for the disclosure. It is
the firm’s responsibility to describe what restricted advice means (ie advice is
limited to a range of products) in regard to the firm’s particular service.
To raise professional standards of all advisers, minimum qualifications are
mandatory; an individual advising on packaged investment products must, as a
minimum, achieve an approved qualification in financial services at RQF Level 4. In
addition the following is important:
u All approved persons within the firm must adhere to the approved persons
sourcebook (which sets out several high-level principles).
u How customers are treated is just as important as having the required
qualifications.
u Training and competence schemes must be used to include keys skills.
u Supervisors must have sufficient knowledge and skill to monitor advisers. Firms
should continually assess and monitor its supervision and development plans
for this range of skills and attributes.
u Supervisors should actively monitor what individuals do in practice and review
their performance.
To modernise the way in which advice is paid for and to address the potential
for adviser remuneration to distort the outcome for the customer, changes
have been made to the way in which advisers receive income. Advisers will no
longer receive commission from providers. Instead when advisers make product

recommendations they should clearly disclose the nature of their service and set
the level of their charges related to the amount of work done. This should prevent
motivation based upon the level of fee associated with a particular product type or
product provider.
The consultation fee for any financial advice given will be subject to VAT if it does
not result in a sale, ie if it is advice only. If the advice does result in the adviser
arranging with a provider to make a sale then VAT is not chargeable (even though
the sale may not be concluded). Ongoing reviews to ensure that the product is still
suitable are also free of VAT (Professional Adviser, 2012).
17.3.3 ‘Know your customer’

‘Know your customer’ (KYC) is a key regulatory theme as it helps in the prevention
of financial crime and in ensuring that information collected about customers is
accurate, timely and up to date, thus enabling suitable recommendations to be
made.
All customers should be correctly identified when accounts are opened or products
taken. In the UK there has been a long-standing obligation to have effective
procedures in place to detect and prevent money laundering that could be hiding
the proceeds of financial crime or funding terrorism. Advisers and planners are well
placed to spot money laundering, and the following are indications of potential
cause for concern:
u evasiveness at interview, particularly if the customer is unwilling to provide
all the information required or unwilling to meet in person, or if they appear
anxious to complete a transaction quickly;
u large sums of cash to pay into investment products, or where large sums of
cash do not seem to fit with the customer’s employment profile;
u where the country of origin of the customer or their cash is suspected to be
where, say, drugs manufacture or trafficking is prevalent.
KYC also concerns the need to take reasonable steps to find out and record
all details of the customer that relate to products and services offered. The
information must be collected before any recommendation is made and we will
consider the information required in section 18.4. Unless an adviser or planner
has all the relevant information about a customer it is impossible for them to
understand their goals, needs and objectives and so recommend the most suitable
products.
17.3.4 Treating Customers Fairly (TCF)

We looked at TCF in section 2.3.6, but it is worth revisiting it here briefly as it
is a key component of an adviser’s or planner’s activity. Customers should be
clear about the services they are being offered and the true costs being levied.
All information provided should be clear, fair and not misleading, and should
enable customers to make comparisons with other products on the market. This
means that product literature should be clear and appropriate to the needs of the
customer.
Importantly, any advice given should be of sufficiently high quality to reduce the
risk of mis-selling. The products themselves should perform as customers have
been led to expect and associated services should be of an acceptable standard.

17.3.5 Record-keeping
The maintenance of clear and readily accessible records is vital at all stages of the
relationship between financial services professionals, their clients and the FCA,
from details of advertisements to information collected in factfinds, to the reasons
for advice given and beyond. Record-keeping requirements for the different stages
can be found in appropriate sections of the Conduct of Business Sourcebook,
including details of what must be kept and the minimum period for which it must
be retained.
There are many business reasons for maintaining good records. From a regulatory
point of view, the most important reason is to be able to demonstrate compliance
with the regulations. Records can be kept in any appropriate format, which includes
storage on computer, although the rules say that records stored on computer must
be ‘capable of being reproduced on paper in English’.
Firms are expected to take reasonable steps to protect their records from
destruction, unauthorised access and alteration.
17.4 Regulatory requirements for training and

competence
The FCA has published a Training and Competence Sourcebook that requires
firms to make certain commitments regarding the competence of all persons
who are employed in controlled functions that relate to conduct-focused roles.
It is particularly prescriptive and aims to ensure that customers in the regulated
financial services markets deal with employees who are competent. The regime
consists of:
u a high-level competence requirement (the ‘competent employees rule’) which
applies to individuals engaged in the regulated activity in all UK authorised firms
(including wholesale firms) as set out in the Senior Management Arrangements,
Systems and Controls sourcebook (SYSC); and
u more detailed requirements for certain retail activities, including the need to
attain a qualification where relevant, as set out in the Training & Competence
sourcebook (TC).
The Training and Competence rules (TC) do not apply, for example, if a firm only
carries out wholesale activities.
There are three key areas of training and competence that all providers need to
consider. They are:
u assessing competence;
u maintaining competence; and
u record keeping.
17.4.1 Training
Firms must, at appropriate intervals, determine each employee’s training needs
and must organise training that is both appropriate and timely. The success of the
training in achieving its objectives must be evaluated.

Regulatory requirements for training and competence
17.4.1.1 Assessing competence

It is up to providers to decide what methods they want to use to assess their
employee’s competence. The FCA defines competence as ‘having the skills,
knowledge and expertise needed to discharge the responsibilities of an employee’s
role’. This includes achieving a good standard of ethical behaviour. It is not
sufficient to just obtain the right appropriate qualification and / or read the
Statements of Principle for Approved Persons (APER).
Providers need procedures in place with clear criteria for individuals to be assessed
as competent, so that all parties involved understand when competence has been
reached (FCA, 2015).
Employees must not be allowed to engage in carrying out any of the activities
covered by these rules until the employer is satisfied that the employee has:
u achieved an adequate level of knowledge and skill to operate when supervised;
and
u passed the regulatory examination relevant to their activity. Some activities
such as advising on pension transfers and pensions opt-outs and advising on
long-term care insurance require additional qualifications.
Supervisors should have coaching and assessment skills as well as technical
knowledge.
Remember that those individuals performing a ‘significant harm’ function are
subject to the certification regime and must have their competence assessed and
confirmed by their employer on an ongoing basis.
17.4.1.2 Appropriate examinations

Approved persons who carry out certain controlled functions are required
to achieve a pass in an ‘appropriate examination’ as demonstration of their
competence. Lists of appropriate examinations for different functions are held
by the Financial Skills Partnership (FSP). The FSP sets the standards for appropriate
examinations: awarding bodies submit proposals for particular examinations;
when these are accredited, they are added to the lists.
Any financial adviser working in retail investments needs to hold a relevant
qualification at RQF Level 4 or above and undertake at least 35 hours of continuing
professional development (CPD) every year to ensure that their knowledge is up to
date. Certain activities are considered by the FCA to be specialist, such as pension
transfers and equity release. Advisers who give advice in another area, for example
mortgage products, need to hold a qualification that is relevant to that area and
undertake separate CPD activity.
Advisers have thirty months, from being appointed to role, in which to attain the
relevant qualification (FCA, 2011).
17.4.1.3 Maintaining competence

Firms are required to assess the competence of their employees on a regular basis,
as well as continue to assess employees’ training needs.
Firms must not only consider changes in the marketplace and in products,
regulation and legislation, but also consider the skills, expertise, technical

knowledge and behaviour of their employee, and their ability to apply these in
practice.
There are specific continuing professional developments (CPD) requirements
for firms undertaking retail investment activities. Of the 35 hours minimum
requirement, at least 21 hours must be structured activity (eg some sort of
formal training). Retail investment advisers are also required to make an annual
declaration that they are meeting standards and, as evidence, hold a Statement
of Professional Standing (SPS) from an accredited body such as the Institute of
Financial Services ( FCA, 2016).
17.4.1.4 Record-keeping
Firms should keep records on anything that relates to the firm complying with
the TC Sourcebook. They will need to keep appropriate records relating to staff
recruitment, training, assessment of competence, supervision of staff and details
of appropriate qualifications for any activity within the scope of TC.
Typical records might include some, or all, of the following:
u details of prior competence;
u initial assessments;
u training courses, etc, attended;
u assessment by written examination or by observation;

u success in appropriate examinations;
u summary of meetings / discussions with supervisor.
How long records should be kept depends on which type of business the records
relate to. For MiFID business, records must be kept for at least 5 years after an
individual has stopped carrying on an activity within the scope of TC, for non-MiFID
business it is 3 years after stopping the activity and for a pension transfer specialist
the records must be kept indefinitely.
17.5 Conduct of the client relationship

The relationship between the adviser and the client is formally defined by a number
of legal elements, such as the law of agency and data protection legislation.
It is also essential that the client should understand the terms on which any
business will be transacted, and advisers are required to have a written agreement
with the client, setting out the terms of business.
It is, however, vital that the relationship should also be one of mutual trust. This
will be much more easily achieved if the adviser can show an understanding not
only of the products that they sell, but of human nature and of the situations in
which people find themselves − and both the perceived and real needs that they
consequently have.
Part of this relationship of trust will be the confidentiality with which the adviser
treats the customer’s personal and financial information. Some confidentiality
requirements are specified by legislation − for example the Data Protection
Act 1998; however, an adviser should make it clear that all of the customer’s

Conduct of the client relationship
information will be kept confidential at all times unless there is a legal requirement
for it to be revealed.
An adviser must also be aware of the consumer protection legislation that regulates
the relationship with the client. As we have seen, there are also specific rules set
down by the FCA that should be followed.
17.5.1 Rules about the process of advising clients
17.5.1.1 Types of client

There are three defined categories of client, which can be broadly described as
follows.
u Eligible counterparty: this category provides the lowest level of investor
protection. It includes large financial institutions such as banks, insurance
companies, investment firms, collective investment funds and governments,
where the counterparty requires a limited service, such as straightforward
execution of transactions.
u Professional client: this category includes all the bodies that would otherwise
be eligible counterparties, except for the fact that they require a higher
level of service than would apply to ‘eligible counterparty business’, eg they
require advice, in addition to execution of transactions. This category also
includes other types of large clients, particularly ‘other institutional investors
whose main activity is to invest in financial instruments’. When dealing with
professional clients, advisers can assume an adequate level of experience and
knowledge and an ability to accept financial risks.
u Retail client: this category provides the highest level of investor protection and
comprises customers who do not fall into either of the previous two categories
− especially, customers who might be described as ‘the person in the street’
and who cannot be expected to have anything more than a simple general
understanding of financial services. It is expected that most customers will fall
into this category.

References
FCA (2011) Calculation of time limits for attaining an appropriate qualification [online]. Available
at: https://www.handbook.fca.org.uk/handbook/TC/2/2A.html [Accessed: 13 June 2016].
FCA (2015) Training and competence [online]. Available at:
https://www.the-fca.org.uk/training-and-competence [Accessed: 13 May 2016].
FCA (2016) Professional standards: advisers [online]. Available at:
https://www.the-fca.org.uk/professional-standards-advisers [Accessed: 13 May 2016].
Professional Adviser (2012) HMRC’s final VAT guidance in full [online]. Available at:
http://www.ifaonline.co.uk/ifaonline/feature/2156211/hmrcs-final-vat-guidance [Accessed: 13
May 2016].
Review questions
1. What is the biggest issue that consumers, advisers and planners face when
giving financial advice?
2. What are the four Statements of Principle that apply directly to advisers and
planners?
3. Explain the difference between ‘real-time’ and ‘non-real-time’ promotions.

4. Explain the ‘cold calling’ rules that apply to mortgage contracts.
5. Why is KYC important to financial advisers and planners?

6. How can an employer assess the competence of its advisers?
7. What are the three types of client in relation to giving advice?

Review questions
Case study 1
Geri is employed by a high street bank as an independent adviser giving advice

to clients on investments, insurance and pensions. The bank also employs IFAs
to advise high-net-worth clients (those with sole income of over £75,000 per
annum or with over £150,000 to invest). If Geri sees clients who meet these
criteria she must refer them to these IFAs.
Geri is able to explain income tax and capital gains treatment of investments.
She is not allowed to calculate annual income tax or capital gains tax for clients;
however, the bank does offer a separate tax service for an annual fee.
The bank sets quarterly targets for all its advisers and points are awarded for
products sold. Advisers can earn bonuses of up to 30 per cent of their annual
salary if they exceed their targets, and these bonuses are paid quarterly.
How would you advise Geri to proceed in the situations described in

questions 1−4?
1 Geri has a meeting with Lucy and her civil partner Lindsey. Lindsey has received
an inheritance of £180,000 which she would like to invest in their joint names.
They have no existing investments and plan to buy a new car costing £15,000
and a new kitchen for their house. Geri thinks that there is probably a need for
retirement planning and this would be good as it would help with her quarterly
target. What would be a reasonable course of action for Geri to take?
a. Refer Lucy and Lindsey to an IFA as the amount available is above her
threshold.
b. Suggest to the couple that after the car and the kitchen refit it is likely
that she will be able to give them advice as the amount will be below her
threshold.
c. Find out how much they intend to spend on the kitchen and car and then
decide whether she needs to refer them to an IFA.
d. Suggest that they make lump sum contributions to stakeholder pensions
bringing the amount that each invest below her threshold.
2 Geri has an annual review with her client David. During the interview David
mentions that he feels he has been far more successful at investing since he
started using the bank’s products. He says that he used to invest directly in
shares but suffered a number of losses. Geri knows that past losses can be
offset against gains to reduce capital gains tax. What should Geri advise David
to do?
a. As these were not bank products she should not give any advice and she is
not qualified to give detailed tax advice.
b. She should ask David to bring the details into the branch so she can work
out how much he could claim back.
c. She could tell David that he will be able to make significant savings if he
signs up for the bank’s tax service.
d. She can mention in general terms that losses may be used to reduce capital
gains tax and recommend that David takes advice from an accountant or
takes up the bank’s tax service.

3 Tom has £75,000 to invest, and in conversation with Geri it seems that indirect
investment would be the best option for him. Geri feels that an OEIC might be
the best option for Tom but isn’t too confident in explaining how they work.
She is much more confident explaining investment bonds as they are the main
form of investment that she deals with and she will receive more sales points
for this product. Geri thinks that she has more chance of gaining the business
for the bank if she talks about investment bonds. What should Geri do?
a. Recommend investment bonds; she is more likely to gain the business for
the bank.
b. Make a second appointment with Tom to give her a chance to research the
products and how they work and decide on suitability.
c. Refer Tom to the IFA as she knows that he will be able to explain both
products more clearly.
d. Consider another product, as this may be a better way to deal with her
problem.
4 Geri is completing a factfind with Joanne who is reviewing her finances as she
is expecting her first child in four months. Joanne seems very interested in
protecting herself from financial hardship due to illness, but Geri feels there
is more need for protection in the event of her death. When Geri broaches the
subject with Joanne, she brushes it off , saying, ‘My husband has a good job,
so why would he worry?’ What would be the best course of action?
a. Go along with what the customer wants; it is up to her in the end anyway.
b. Suggest that a joint meeting with Joanne’s husband to discuss their joint
finances would be advisable.
c. Ask the customer if everything is all right with her marriage and the fact she
is pregnant.
d. Steer Joanne away from the subject and talk about saving for the child (Geri
knows that a stakeholder pension would be useful here).
Case study 2
Ben is a paraplanner for a small firm of independent financial advisers. He

has recently been teamed up with Greg who is new to the firm. Greg was very
successful with his previous employer and has made no secret of the fact that
he intends to do well so he can gain a partnership in the firm. Ben has been out
on interview with Greg a few times and has observed the following situations,
described in questions 5−8.
5 Greg omitted to obtain a client’s signature on a proposal form for an investment

of £50,000. What should Ben do?
a. File the form; the client gave Greg a cheque anyway, so it must be okay.
b. Accept Greg’s signature on the form in place of the client’s.
c. Ask Greg to contact the client immediately to arrange for a signature.

d. Report the omission to the senior partner.

Review questions
6 Greg is discussing retirement planning with a customer who is on a relatively low

income, with few savings and aged 49. Greg advises that a stakeholder pension
will be the most appropriate solution for them. Why might Ben be concerned
about this advice?
a. There is no need to be concerned as anything could happen in the next 16
years before this person retires.
b. This is clearly mis-selling and should be reported to the senior partner.

c. The stakeholder pension won’t be tax-efficient for this particular customer
as he isn’t paying a lot of tax.
d. There may be other forms of investment that would be better suited to this
person’s circumstances.
7 Greg is talking to a client about their attitude to risk and investing in the stock
market. He asks the client to say where he sees himself on the ‘traffic light’
system the firm uses to gauge clients’ attitude to risk. Ben doesn’t feel that the
customer really understands the risks involved with investments of this sort.
What is the potential problem this may bring later?
a. There won’t be a problem as the traffic light system is an acceptable way of
gauging risk.
b. It may lead to another appointment which will cost the firm money.
c. Ben might have to give evidence against his colleague in an FCA

investigation.
d. The client may be sold an investment that is actually too risky for them,
leading to a loss they weren’t expecting.
8 Greg is also authorised to undertake mortgage advice. Ben takes the opportunity
to sit in on a factfind interview with a new client to see how the process differs
from investment and protection factfind interviews. In the interview Greg finds
out that the client is self-employed and hasn’t brought all of the information
relevant to income and expenditure with her. What should Greg not do in this
instance?
a. Ask the client for a copy of her last tax return to HMRC.
b. Ask the client to give him copies of her last six months’ bank statements
and credit card bills.
c. Indicate to the client that she will be offered a loan by the mortgage company.
d. Indicate to the client what type of mortgage will be the most suitable for her.

Topic 18
The sales process: Part 1
Learning objectives
u explain the sales process in the context of financial services;

u identify client information required for review and how this can be obtained.
18.1 Introduction
In this topic we will consider the first part of the sales process from the adviser and
planner perspective. Depending on the organisation, planners may or may not have
face-to-face contact with clients. Planners are however responsible for supporting
the adviser and ensuring that the client’s relationship with the organisation runs
smoothly.
Retirement planning and investment advice are, in the main, delivered though
face-to-face meetings, with a combination of such meetings and telesales for the
sale of protection, mortgages and general insurance. We will focus mainly on
face-to-face meetings as these tend to be for full reviews rather than the sale
of single products. We will, however, touch on some of the issues around telesales
calls (which are also discussed in section 19.7).
Sales processes differ from organisation to organisation, depending on the

technology and communications available. There are however a number of
common steps that have to be followed and standard documentation that has
to be produced in order for the seller to be compliant with FCA regulations. We
will consider the sales process as a seven-step model (see Figure 18.1), and in this
topic will concern ourselves with steps one and two. It is possible for both advisers
and planners to be involved in the whole process, although it must be remembered
that it is the adviser who makes final recommendations to the client.

18: The sales process: Part 1
Figure 18.1 The sales process
18.2 The sales process
18.2.1 Lead generation

Leads can be generated from a number of sources depending on the organisation
and how it generates business for advisers and planners to deal with. For example,
a retail bank may rely on branch staff and account managers spotting opportunities
from conversations with customers and provide leads to financial advisers to
follow up on. In this example the adviser may then contact the customer and
make the appointment themselves. In a smaller whole-of-market firm, planners
may undertake prospecting (cold calling) exercises and contact customers with a
view to making appointments or telephone interviews for the adviser. It must be
remembered that cold calling cannot by undertaken for mortgage business.
In any prospecting or appointment-making exercise it is important that nothing

should be said to the customer that might be construed as advice. The focus
should be on the benefits of having financial advice without making claims about
products that could be offered. Prospecting telephone calls should also follow the
rules for unsolicited calls (see section 17.3.1.3) and calls to existing customers
should follow similar guidelines.
When making appointments it is important to remind the customer to bring any
necessary information with them that will enable a client review to be fully and
accurately completed. This saves time and unnecessary chasing of customers at a
later point. The ‘know your customer’ rules have to be observed here and the need
to be vigilant for potential financial crime.

Introductions and initial disclosure
18.2.2 Execution only

The FCA defines execution-only business as:
a transaction executed by a firm upon the specific instructions of a client

where the firm does not give advice on investments relating to the merits
of the transaction and in relation to which the rules on the assessment of
appropriateness do not apply (FCA, no date).
This can be contrasted with investment advice, where an adviser makes a
recommendation based on a full analysis of a customer’s needs and circumstances;
and simplified advice, where a streamlined and / or automated process is used to
gather the personal and financial information on which advice is given.
Where investment business is undertaken on an execution-only basis, rather than

asking for a specific recommendation, the customer instructs the adviser to effect
a specific transaction on their behalf, detailing in full the nature of the product
required.
For an execution-only transaction, the adviser’s duty of care to fully explain the
nature of the transaction and the risks involved does not apply. The customer acts
entirely of their own volition.
The Financial Ombudsman Service (FOS) has highlighted that complaints relating
to execution-only business often result from the customer not realising they have
taken out an investment on an execution-only basis. The FOS has indicated that it
expects firms to be able to provide ‘clear and credible’ evidence that a transaction
was conducted on an execution-only basis. Such evidence would be a signed
statement from the customer confirming that:
u they are aware that business was transacted on an execution-only basis;

u they have not asked for or received advice;
u it is their decision alone to take out the investment; and
u the business takes no responsibility for the suitability of the investment.

Where a non-execution-only client wishes to effect a transaction that contravenes
any advice given, the adviser should require the client to sign to this effect. It
is expected that a very small proportion of any adviser’s cases will be on an
execution-only basis.
18.3 Introductions and initial disclosure

Prior to the first meeting it is important to prepare any documentation required
so everything is to hand when the customer arrives. This includes researching
any links the client already has and establishing details of existing holdings and
products. Arrangements should be made to make the client feel welcome. This can
be as simple as asking what their journey was like and the offer of tea or coffee.
When first meeting a customer it is important to put the customer at ease and
make a good first impression. There are also certain formalities to be observed,
this will mean introducing yourself, giving a business card and finding out what
the customer prefers to be called. If both the adviser and planner are attending the
meeting then both roles will be need to be explained clearly and who is responsible
for what going forward.

It is important to build rapport at these early stages (and throughout the

conversation) by a certain amount of small talk and finding common areas of
interest. Some customers may feel the prospect of talking to a financial adviser
daunting, particularly if they have never done so before, and may feel happier if
they understand a little of the process at the outset. This may give a good lead into
the need for initial disclosure and what it means for them.
In this first meeting with a client, advisers are required to give information about
the products and services they provide and about possible costs to the client. This
information will be in a combined initial disclosure document and includes:
u the nature of the services they provide and the types of products offered;
u from where products are sourced − independent advice or restricted advice;
u what type of service is offered;

u details of ownership and regulation of the firm;
u how to complain to the company and, if not satisfied, to the Financial

Ombudsman Service;
u how to obtain compensation from the Financial Services Compensation Scheme;
u the fact that different firms offer clients different options for meeting the cost
of advice;
u charging arrangements for advice and options for payment.
The FCA requires that the information is provided in a ‘durable medium’ and
provides a format for supplying the required information via a services and costs
disclosure document (SCDD).
Firms are not obliged to use the templates provided by the FCA; they can if they
wish develop their own disclosure material, provided that it satisfies the FCA’s
disclosure requirements.
Note: at the time of updating for 2016, the FCA is consulting on changing the
format of the initial disclosure documentation, as it believes the current approach
leads to the duplication of information and causes confusion. The FCA is proposing
that the SCDD template it currently provides will be removed.
18.3.1 Client agreements

A client agreement is required where a firm is going to provide higher-risk
investment business. Examples include discretionary investment management
services and transactions in instruments such as futures and options. It would
not usually be required for packaged investments, pensions and life policies.
The agreement recognises the fact that the services provided put an additional
reliance on the adviser’s advice and general service. The agreement should contain
the terms, information about the firm and its services relating to the agreement,
and include information on communications, conflicts of interest and authorised
status.

Establish client needs
18.3.2 Discretionary investment management

agreement
This form of customer agreement would be used when an adviser is given discretion
over a client’s investment portfolio and is able to make investment decisions
without reference to the client each time. It would be much like a normal client
agreement, with additional sections, the most important of which would relate to:
u information on the method and frequency of valuation of the investments in the
client portfolio;
u details of any delegation of the discretionary management of all or part of the

investments or funds in the client portfolio;
u a specification of any benchmark against which the performance of the client

portfolio will be compared;
u the types of designated investments that may be included in the client
portfolio and types of transaction that may be carried out in those designated
investments, including any limits;
u management objectives, the level of risk to be reflected in the manager’s
exercise of discretion, and any specific constraints on that discretion;
u costs and charges including the total price including all related fees,
commissions, charges and expenses, and all taxes payable via the firm or,
if an exact price cannot be indicated, the basis for the calculation of the total
price so that the client can verify it. The commissions charged by the firm must
be itemised separately in every case;
u notice of the possibility that other costs that are not paid via the firm or imposed
by it; and the arrangements for payment or other performance.
18.4 Establish client needs

An adviser must not give advice to a client unless they have fully ascertained
the client’s personal and financial circumstances, their objectives and preferences
relevant to the services that the adviser has agreed to provide. In this way they can
establish the client’s needs by gathering the right information.
This process is carried out by the completion of a confidential client information

questionnaire, commonly known as a factfind. There is no prescribed format for
this document, but it usually takes the form of a confidential questionnaire, either
on paper or on computer, which is then retained as part of the client’s records. It
will include details of the following:
u personal information;
u employment;
u income;
u expenditure;
u assets;
u liabilities;

u objectives and attitudes;

u existing and future needs;
u ability to provide for them;
u attitude towards providing for them;

u knowledge and experience of investment;
u attitude to risk − where relevant to the service the adviser will provide.
We can look at each of these areas in more detail.
18.4.1 Personal and family details

Current personal and family situation information includes the details of all of the
people who may need to be included in the planning exercise, together with any
constraints that may apply. The following basic information will be needed.
u Name and address: full name of the client, along with their contact address
and telephone number.
u Date and place of birth: dates of birth for all those included in the factfind.
The client’s place of birth may be important for underwriting or taxation
reasons, but any hint of racial discrimination must be avoided.
u Domicile and residence for tax purposes: domicile and tax residence have
significant tax implications for many clients and must be considered in relation
to any financial advice given. If the client (or any of their immediate family) is
domiciled outside the UK, and/or is not resident for tax purposes, great care
should be taken, because the wrong advice could have serious adverse tax
implications. In addition to establishing the client’s domicile and residence, it
is important to establish how long that status has applied.
u Marital status: the use of the word ‘marital’ in this context now carries
a wider meaning than in earlier generations, and may include those who
are single, married, civil partners, cohabiting, divorced, widowed, etc. It is
usually preferable to have both partners of a relationship involved in the
financial planning process, since the decisions made will often affect both
partners. Some clients, however, prefer to keep their financial affairs separate.
If the client is divorced or separated it is important to understand the
terms of any maintenance arrangement, property arrangements and pension
splitting/sharing arrangements.
u Family details: the client’s family details are important for a number of
reasons.
− There may be family members who are, or who will be, financially dependent
on the client. This may be children or older family.
− The client may become the beneficiary of gifts or trusts.
− The client may wish to become a donor, now or in the future.

− From a marketing viewpoint, there may be an opportunity for referrals to
family members.

− The most important group of family members is usually the children, and
this may include children from previous relationships. In order to give
appropriate advice about protection against death and disability, as well
as about planning for school or university fees, for example, it is necessary
to know how old the children are and the parents’ ambitions/objectives for
them.
− Minor children may have income of their own, from investments, trust
settlements and so on; it is important to establish the level of the income
and the source. Where the income exceeds £100 a year and is generated
from investments funded by the parents, it will be subject to income tax as
if it were the parents’ income. Where the parents are not the source of the
funds, the income is treated as the child’s.
u Wills: have the client and partner made wills? If so, the adviser should establish
the broad outline of the terms of the wills and when they were last reviewed.
If no wills are in place, at the very least the adviser should recommend that
the clients address the situation as a matter of urgency, explaining why it is
important.
u Trusts: has the client established any trusts? If so, details should be recorded.
18.4.2 Employment details

Is the client employed, self-employed, unemployed or retired? If the client is a
director or a partner, it may be necessary to delve deeper and establish information
about their business arrangements. It also helps to know whether they are part-time
or full-time, temporary or permanent, as well as gaining details of the client’s
profession or trade.
Details of the client’s income and benefits package (or net profit, if self-employed)
will need to be established. It is often useful to ascertain an exact breakdown
of income by its component parts − basic, commission, bonus and overtime −
together with the average level of overall earnings. Similarly, an adviser must
establish the exact nature of benefits provided − private medical insurance,
company cars, pension and/or death-in-service details, subsidised loans, etc. If
the client is self-employed, information that should be gathered includes:
u ownership of the business;
u when it was established;
u the accounting year-end date;
u financial information over two or three years, including:
− balance sheet;
− profit-and-loss account;
− net profit;
u future short- and longer-term plans for the business.
Additional information would include details of share-option schemes or
profit-related pay schemes and details of additional employment or self-employment.
It may be helpful to obtain copies of payslips, P60s, tax returns and notices of tax
coding.

18.4.3 Income and expenditure

By analysing a client’s income and expenditure, it is possible to identify more easily
the implications of, say, premature death on the family income and spending
patterns. It is also possible to identify any ‘surplus’ income that could be used
to fund the purchase of any additional products recommended or to assess
affordability of any products to be recommended.
To calculate a household’s income is usually relatively straightforward. The client

may be in receipt of other income from pensions, investments, maintenance, trust
settlements and so on. Issues to consider and record include:
u the source of the income;

u who receives the income;
u the regularity and consistency of the income;
u the tax status of the income − taxable or tax-free;

u the purpose of the income, where appropriate.
An analysis of the client’s expenditure can be more difficult: certain items are easily
determined, for example those paid by standing order such as rent or mortgage
and some household bills. Other items will cause a degree of difficulty − or even
embarrassment: trying to pin down how much is spent on, for example, food and
drink, holidays or motoring.
Many firms split expenditure into two categories:
1. Fixed/essential: expenditure that must be met every month, such as food,

heating, insurance, council tax and so on. The client must pay these costs.
2. Discretionary: spending that could be stopped or reduced if necessary, or

part of the money could be diverted to other things. Although holidays are
important, a family would not lose their house or starve if they chose not to
fund a holiday, whereas missing a mortgage payment could lead to serious
problems.
It is a regulatory requirement that the adviser is able to demonstrate that any
recommendation accepted by the client is affordable. The income and expenditure
record is the main way to demonstrate that affordability has been considered. In
addition, the breakdown will enable an analysis of the likely level of income needed
in the event of death, incapacity or unemployment.
18.4.4 Assets
When discussing assets and investments with clients the following key information
should be obtained:
u ownership − single ownership or jointly owned;
u purpose of the investment;

u type of investment − property, deposit in a bank account, pension policy or
fund;
u size of original investment and date;

u current value and/or projected future value;

u rate of return (if any);
u type of return, eg capital growth or income, and whether that return is fixed,
guaranteed or variable;
u tax status of the investment or other asset − exemptions, reliefs, etc;
u options available and/or penalties;
u sum assured and/or lives assured and maturity dates;
u name of the institution providing the asset.
If the client owns, or has an interest in, a business, the details should be recorded
in the same way, with any available exemptions or reliefs noted.
18.4.5 Liabilities
The relevant information with regard to certain borrowing liabilities includes the
following:
u lender;
u amount of loan;
u balance outstanding;
u original term and term remaining;
u type of loan, eg secured, unsecured (and if secured, on what);
u amount of monthly or other periodic payment;
u rate of interest; repayment method;
u protection of capital or payments.
Clients are often unaware of the details of any arrangements that they have. It is
an adviser’s responsibility to try to obtain this information and clients should be
asked, wherever possible, to bring all relevant details with them.
18.4.6 Existing provision

In many cases the client will already have some provision in place to address some
of the needs identified; it is important that the details are recorded so that the
plans can be taken into account, where appropriate. For example, they might have
life assurance, pension or investment products.
18.4.6.1 Life assurance, critical illness and income protection

The adviser needs to establish the following in relation to these products:
u why the policy was arranged;
u lives assured and basis − own life; joint-life first or second death; life of another;

u type of policy − term, renewable; convertible; whole-of-life, etc;

u sum assured − amount; increasing/decreasing;
u term; start and end dates;
u premium − amount; level/increasing; guaranteed/reviewable; rating/loading;
u provider;
u investment basis (if appropriate); surrender value;
u assigned or in trust − details;
u underwriting conditions/restrictions.
18.4.6.2 Pension policies

The following information is needed:
u type of provision − occupational, personal, etc, and provider;
u defined-benefit schemes − the scheme booklet will provide much of the general
detail; member statements should provide the specific detail;
u premium/contribution;
u age at which benefits are available;
u projected benefits − income/tax-free cash; index-linking;
u current fund value/benefits earned;
u current fund links (defined-contribution schemes);
u death in service or life assurance linked to the scheme.
18.4.6.3 Investment
The adviser should seek the following information:
u type of investment − shares, deposits, unit trusts, investment bonds, etc;
u the purpose of the investment − income; capital growth; future target, etc;
u the tax status of the investment;
u the date and value of the initial investment;
u current value;
u fund selection; surrender penalties, tie-ins, etc;
u views on how the investment has performed to date;
u details of any investments that have been cancelled and why;
u ethical and socially responsible perspectives.
It may be necessary to ask the client to sign letters of authority to existing product
providers to obtain up-to-date information on policy benefits and investment
details. This will then enable analysis of the client’s existing policies to meet their

goals, needs and objectives. At this point it will be possible to decide whether
any further information is necessary to completely understand the client’s existing
financial circumstances.
18.4.7 Plans and objectives

This part of the factfind is substantially different from the other two parts: the
personal and family details and the financial situation are concerned with the
gathering of hard facts − facts about tangible items and people. The client’s
plans and objectives tend to be more intangible in nature: here the aim is to find
out ‘why?’, ‘how?’ or ‘do you feel that?’ − in other words, to discover the client’s
feelings about what they have, what they want and where they want to go from a
financial point of view. These are known as soft facts. For example a hard fact is
how many children a person has; a soft fact would be the parents’ aspirations for
those children.
Advisers need to know the following:

u the income, capital and general provisions the client wants in any given situation
− the death of the breadwinner, retirement, and so on;
u how the client feels about their current arrangements (or lack of them) in each
area − for example, how they would feel if their family had insufficient income
if the breadwinner died (this can be difficult for a client to think through and
requires careful questioning and listening on behalf of the adviser);
u their attitudes and objectives within each area, now and in the future;
u why they have certain arrangements, or goals or views;

u their willingness to take action in each area;
u the likelihood of change in their situation;
u the client’s ethical stance on investments, if they have one.

Knowing their client’s feelings about their situation and their existing
arrangements will help the adviser to build their understanding of the client in
a number of ways:
u by discovering the reasons behind the client’s existing arrangements, which
may in turn indicate the client’s level of understanding of their finances;
u by determining the level of the client’s interest in their situation, their level of
motivation towards improving their situation and the likelihood of their taking
action;
u by ascertaining the client’s views on a number of possible alternative solutions,
which will help in constructing acceptable recommendations.
It is also important to prioritise with the client any needs or objectives identified. It
is unlikely that they can all be addressed in full, and in many cases some may need
to be addressed at a later stage as part of the ongoing review process. The adviser
must make sure they understand the priority order from the client’s perspective
and address the issues accordingly when making recommendations.

18.4.8 Attitude to risk (risk profiling/risk tolerance)

Part of this needs analysis requires advisers/planners to take all reasonable steps
to ensure that the client understands the nature of any risks implicit in the product
proposed. This is governed specifically by the suitability rules. This means they
will have to take great care to establish the client’s objectives and attitude to risk
before making the recommendation.
This is particularly important when advising on investments, and it is necessary

to establish the client’s attitude to risk, both generally and towards the specific
investment under consideration. For example, a client who already holds a number
of investments might be willing to take a higher-risk approach with their new
investments. On the other hand, if it is their only capital, they are likely to prefer
a more safety-conscious approach. All of this means explaining the relationship
between risk and reward, and identifying the client’s feelings about the capital −
are they prepared to take a degree of risk to achieve their target, or is safety the
most important factor for them? The client’s attitude to risk could also vary from
objective to objective − retirement, school fees and so on.
General considerations would include the following.
u Does the client want income or capital growth?

u How much of their available capital do they wish to invest and how much should
be left in easy access accounts for other needs?
u What is their attitude towards tying up money for the medium to long term
versus having access to it in the short term?
u In the case of income, does the client want the income now or at a point in the
future? Can the client accept a fluctuating income?
u Is there a specific time and purpose for the investment? How important is it to
achieve the objective?
u Sensible investors will want to make the most gain from their investments while
taking the lowest risk. The adviser’s role is to find out what they want the
investments to achieve and then the level of risk the client is prepared to take
to achieve those objectives. In most cases, the client will only achieve objectives
by taking a degree of risk.
There are two main factors in the equation.
u The client’s objectives and how much money they have available to
meet them: if the client has sufficient resources it may be possible to achieve
their objectives without taking any risks, although that is unlikely. For example,
if the client wished to provide a lump sum of £39,000 in 10 years’ time, they
would need to invest £33,780 in a deposit account earning interest of 1.5 per
cent a year (ignoring tax). This would provide a virtually no-risk investment,
as long as the interest rate averaged 1.5 per cent over the term, which is not
unrealistic given that interest rates do not vary widely in a stable economy. In
contrast, a share-based investment growing at 5 per cent a year would be more
volatile, less reliable and possibly outside the client’s ‘comfort zone’.
u The degree of risk the client is prepared to take: this needs to be

considered objectively and subjectively. In the example above, unless the client
has the initial capital to fund the deposit option, they will probably accept that
the share option is the logical option from an objective perspective. However,
on an emotional level they may be reluctant to take the required level of risk

with their money. They will have to weigh up the probability of missing the
target by taking a safe approach against the possibility of reaching the target
but risking their capital by taking the more adventurous option. The key is to
balance the objectives against the risk the client is prepared to take. It is also
important to realise that a couple may each have a different attitude to risk; this
needs to be taken into account when formulating any advice.
18.4.9 Risk categories

Client attitudes to risk can be broadly categorised as follows.
u No risk/risk-averse − not prepared to take any risk at all.
u Low risk/cautious − may be prepared to take a very small element of risk if

convinced that it is necessary.
u Medium risk/balanced − accepts that some risk may be necessary with some
of their available money but would prefer any risk to be controlled.
u Medium to high risk − relatively happy to gamble with a larger part of their
capital if the potential reward is attractive, and accept losses as part of the
bigger picture.
u High risk/adventurous/speculative − prepared to take a high level of risk
in order to achieve growth.
Risk categories with relatively broad definitions should be supported by brief
sub-sections within each definition to aid customer understanding. This can
include:
u a short summary description that is fair and balanced;
u bullet points to provide more detail of the risk of capital loss and the nature of
typical investments in each category; and
u a simple chart showing the ‘shape’ and variability of annual returns over a
period that helps the customer to understand that they need to be comfortable
to accept the gains and losses associated with a particular level of risk.
This approach explains the risk in a number of different ways. Descriptions that
include text and a visual representation give different elements to engage different
customers.
Some firms use fewer categories, while others extend the categories further. It
is very likely that the client’s investment experience will be reflected in their risk
acceptance; the more experience, the more adventurous the investor.
18.4.10 Establishing the client’s attitude to risk

When establishing the client’s attitude to risk, it is likely that the adviser will need
to explain the types of risk to ensure that the client makes an informed decision.
In general they would be the:
u risk to capital;
u risk to income produced;

u way in which different investments work and the risk involved − deposits
versus shares, for example;
u effect of time on an investment − secure investment is sensible for
short-term investment, while asset-backed investment (ie based on stocks and
shares) is prudent for medium- to long-term investment;
u risk of not achieving the objective by being too cautious or too adventurous;
u risk of shares or single investments compared with pooled investment.

There are a number of ways to establish the amount of risk a client is willing and
able to take.
18.4.10.1 Interview approach

The adviser asks the client a number of questions about their feelings towards
their money and the risk of losing some or all of it.
Questions would include the following.
u What investments does the client already have (or what investments have they
had in the past)?
u How do they feel about these investments?
u How have their investments performed?

u Is there anything that concerns them about those investments?
u How would they feel if the value of their investment went down?
u How do they feel about the risk−reward relationship?
u How important is security of capital?
u How would they feel if their investment missed the target?

u What level of understanding do they have about the different investment
vehicles?
The answers to these questions will allow the adviser to draw an informed but
unscientific conclusion about the client’s attitude to risk, in conjunction with the
client’s objectives and the timescale.
In the past this was the standard process for most advisers but it is flawed, because
the result will always be very subjective and reliant on the quality of the questions,
the adviser’s explanations and the client’s understanding of the process and the
questions.
18.4.10.2 Menu approach

The adviser describes the categories of risk tolerance and then asks the client
where they feel they fit in. As with the ‘interview’ approach, the result is heavily
dependent on the skill of the adviser and the client’s understanding of the
categories. The adviser may, unwittingly, influence the client through intonation
or emphasis, or the client may be eager to answer in the way they think the adviser
would expect or like.

18.4.10.3 Psychometric approach

The adviser uses tools to assess the client’s psychological attitude to risk in
general rather than their objective ability to cope with financial risk. Psychometrics
assesses the client’s knowledge, experience, attitudes and personality rather than
considering how much they are prepared to risk. The tests are validated statistically
by using a large sample of the population. The questions will consider a number
of aspects of the client’s approach, including:
u their own feelings on their attitude to, and tolerance of, risk;
u past financial decisions they have made;
u how they would feel and react in a number of ‘what if’ financial scenarios
containing positive and negative outcomes;
u how they would feel about a number of hypothetical events and outcomes in
relation to their finances.
The results should not be relied upon in isolation and need validating against other
information from the customer.
18.4.10.4 Portfolio approach

The adviser shows the client a number of hypothetical portfolios, each comprising
different ratios of investments described merely as low risk, low return; medium
risk, medium return; and high risk, high return, together with examples of
investments that would be in each category. The client’s chosen portfolio provides
an indication of their attitude to risk and will provide a basis on which the adviser
can plan asset allocation.
18.4.11 Capacity for loss

A client’s attitude to risk can be viewed as their psychological tolerance of uncertain
returns, fluctuating capital values and variable income. Capacity for loss is a
separate, but equally important consideration. A client’s capacity for loss is the
extent to which their financial arrangements permit them to be able to absorb
falls in investment values. In simple terms, if a client has no capacity for loss they
should not consider risk based investments, regardless of their attitude to risk.
References
FCA (no date) Execution-only transaction [online]. Available at:
https://www.handbook.fca.org.uk/handbook/glossary/G395.html

Review questions
1. When generating leads, what is it important to remember not to do?
2. If a client wants to make an execution-only transaction, what should the adviser

ensure that they do?
3. What two pieces of documentation should an adviser give to a client at the
start of their first face-to-face meeting?
4. What is another name for the confidential client information questionnaire?
5. Why is knowing whether a client is divorced or separated important?
6. Explain the difference between fixed expenditure and discretionary expenditure

in terms of a client’s budget.
7. Determining how a client feels about retirement is an example of what?
8. What does an adviser or planner need to do so that they can obtain details of
a client’s existing policies or investments?
9. What is the main drawback of the interview approach to assessing a client’s

attitude to risk?
10. What are the five risk categories generally used by financial service providers?

Topic 19
The sales process: Part 2
Learning objectives
u demonstrate how to collate and interpret client information;

u evaluate affordability and suitability;
u match appropriate solutions with customer needs;

u perform clear presentation of solutions to clients;
u explain the importance of ongoing reviews.
19.1 Introduction
In this topic we will continue our discussion of the sales process begun in Topic 18,
here focusing on steps 3 to 7 in Figure 18.1. We will also consider some of the skills
that advisers and planners need in order to undertake their roles effectively.
19.2 Collating and interpreting client

information
Having collected all the relevant details, the adviser (or planner) will then conduct a
customer needs analysis by collating and interpreting the client information. In this
exercise the adviser will need to assess the clients’ goals, needs and objectives,
and look at their current and future circumstances.
An analysis will be required of what opportunities are available to the customer and
what perhaps might constrain them in the future. In financial terms, an opportunity
may be the maturing of an investment or inheritance, a constraint could be a spouse
giving up work to look after children, so affecting monthly income.
It may be that more information is required before a recommendation can be made,

and both advisers and planners would have to make arrangements to collect this
information.
Advisers should be aware that ‘churning’ (the practice of cancelling an existing

policy which is suitable and replacing it with a new policy which is equally suitable
and in the advisers interests rather than the clients) is not permitted.

19.3 Evaluating affordability and suitability

After the factfind the adviser/planner will evaluate affordability and suitability
through researching appropriate products. This means that an accurate picture
of the client’s financial situation will first need to be completed, which will involve
preparing the following from information collected:
u a draft net worth statement using information about the client’s assets and
liabilities (net worth is arrived at by subtracting outstanding liabilities from the
value of assets held; it will also be necessary to undertake a valuation of any
existing investments);
u a detailed income and expenditure statement;
u a cash flow forecast covering an agreed timescale to check affordability; and

u any relevant tax calculations.
Once the above has been completed a draft financial strategy can be prepared. A
financial strategy is a plan that will enable the client to achieve their goals and
objectives and it entails a number of steps. These are to:
u prioritise areas for research;
u undertake this research;

u evaluate the products in terms of suitability for the client;
u consider the costs of the products; and

u consider the products in terms of the client’s risk profiles.
At this point the adviser and planner can move on to the next step.
19.4 Matching appropriate solutions to

customer needs
Advisers and planners must recommend the products that are most suitable for
the client, based on data supplied by the client and on any further information
concerning the client about which the adviser should reasonably be aware. The
recommendation must be solely in the best interests of the client and no account
should ever be taken of the commission that might be payable to the adviser.
A suitability report should be prepared that explains why the particular product
recommended is suitable for the client based on their particular personal and
financial circumstances, their needs and priorities as identified through the
fact-finding process and their attitude to risk (both in general terms and in
relation to the specific recommendations made). The report should also identify
any potential disadvantages of the transaction for the client, such as any ‘lock-in’
period. It should be clear, concise and written in plain English.
Suitability reports are required for:
u life policies;
u pension policies;

Presenting solutions
u unit trusts and OEICs, and investment trusts (where acquired through an
investment trust savings scheme);
u pension transfers and opt-outs.
They are not required for mortgage advice, although many mortgage providers will
prepare one to help the customer understand the mortgage being recommended.
For a life policy the report must be sent before the contract is concluded unless
the necessary information is provided orally or immediate cover is necessary. For
a pension plan, where a cooling off notice is required, the report must be sent
no later than the fourteenth day after the contract is concluded. For investment
business the report must be issued or as soon as possible after the transaction is
effected or executed.
There is a range of other information that will need to be presented and this should
be prepared in advance of the next meeting.
19.5 Presenting solutions

This may involve another meeting or a telephone call with the client to go through
the products identified. At this meeting or prior to the call the client should have
the relevant information available to enable them to understand what is being
offered and whether they are then able to make a decision. The following sections
detail what the adviser should consider at this point.
19.5.1 Charges and commission

The FCA regulations require a firm to ‘pay due regard to the needs of its clients and
communicate information to them in a way that is clear, fair and not misleading’.
This includes the need to ensure that a private customer is made aware of the
direct or indirect costs of any financial products or services they may purchase, so
that they are better able to make informed choices.
19.5.1.1 Disclosure of charges

When an adviser transacts designated investment business for a client, the amount
of the charges must be disclosed in writing before the business is transacted. The
firm’s charging basis, for the advice given / services provided, will be explained
in the initial disclosure documents and / or client agreement. Charges relating to
the specific packaged products recommended will be set out in the key features
document (see section 19.5.2).
Where the client wishes to deal with the firm, and prior written disclosure would
delay the transaction (for example, when the business is being arranged by
telephone), the firm can make the disclosure verbally before the transaction is
executed and provide written confirmation immediately thereafter.
19.5.2 Product disclosure

Advisers who advise on or sell packaged products (eg life policies, pension policies,
unit trusts and investment trust saving schemes) must provide clients with written
details of the key features of a product before the sale is concluded. Although

it is the adviser’s responsibility to provide the documents, the product providers

usually prepare the papers. It is a requirement that key features documents
should be of the same quality as the materials used for marketing purposes.
The format for supplying the information is specified by the FCA and cannot
normally be changed by the firm. The rules on what must be included are very
detailed, but, as a broad guide, a key features document will cover the following
issues:
u the essential elements of the product;
u details of risk factors related to the product;
u whether the levels of income or capital might vary;
u the consequences of making the product paid-up;
u client-specific information relating to charges and their impact on what the
customer may receive from the product (this includes projected maturity values
both in gross terms and net of charges);
u any commission or equivalent that will be paid;
u details of where additional information can be obtained;
u information on any taxation implications on the encashment of the product
either at its maturity date or before.
In respect of mortgage contracts, a lender must provide a prospective borrower
with an illustration, setting out the key features of the mortgage contract, before
the borrower applies for a mortgage.
19.5.2.1 Changes to product disclosure requirements from 31

December 2016
From 31 December 2016 it will be necessary to provide a key information
document (KID) where a customer is arranging packaged retail and insurance-based
investment products (PRIIPs). The purpose of introducing this requirement is to
ensure that:
u there is consistency between the information that different providers make
available to their customers;
u the information provided covers certain key relevant areas;
u the information is presented in an easy to understand manner;
u it is easier for investment customers to make meaningful comparisons between
providers.
The KID must be no longer than three sides of A4 and the language used must
be plain, concise and easy to understand. It must contain certain key information
about the investment including:
u product name;
u name of the provider;
u main features;
u risks and reward profile;

Presenting solutions
u past performance data;

u costs and charges;
u details of any applicable investor protection.
Products defined as PRIIPs, and thus subject to the requirement to provide a KID,
include:
u investment funds;
u life assurance based investments such as endowments;

u retail structured securities;
u structured products and structured deposits;

u derivatives.
19.5.3 Risk disclosure
The FCA frequently highlights the risks that customers face when taking out
financial products.
For example its business plan for 2016/17 (incorporating a Risk Outlook)
highlighted the following:
u inflation and interest rates are expected to remain low − this can encourage
and sustain high levels of indebtedness and fuel the search for higher returns
from investments, encouraging riskier investments;
u changing market conditions create and increase volatility and uncertainty, which
can lead to capital losses for investors who may not fully understand the risks
associated with their investments;
u the referendum on EU membership;
u government policies which increasingly transfer responsibility to consumers

and bring a greater need for advice, bringing greater opportunities and risks;
u technology transforming the way consumers access financial services (FCA,

2016).
The regulator requires that the risks associated with all financial products must
be ‘adequately’ disclosed. The product provider is left to decide what risks are
sufficiently significant to be disclosed for its own particular products. These ‘most
significant’ risks should be covered in the documentation provided in such a way
that they are easily accessed and understood by the customer.
19.5.4 Cooling off and cancellation

When a client buys a regulated packaged or insurance product, they have the right
to change their mind and withdraw from the contract within a specified period. The
provider is required to send a statutory cancellation notice, known as the cooling

off-notice, which explains the process. This time period is either 14 or 30 days
depending on the product type.
u Life and pensions and contracts of insurance which are, or have elements of, a
pure protection contract or payment protection contract the period is 30 days.
u For investments, deposits and other insurance contracts the period is 14 days.
The notice must be sent by post direct from the product provider to the client.
The notice runs either from the date when the contract begins or from the date on
which the client receives the contractual terms and conditions if this is later.
The client can withdraw from the contract at any time during the cooling-off
period, without any commitment or loss, by returning the signed cancellation
notice to the product provider. Generally the client will receive a full refund of
any premiums paid if they cancel the contract during this period. The exception
to this is where the client cancels a lump-sum unit-linked investment (a unit trust,
open-ended investment company (OEIC) or investment bond, for example). Where
the money has been invested and the value of the investment has fallen. Under
these circumstances, the client is entitled to a refund of the reduced investment:
no charges can be taken but an adjustment can be made to reflect the fact that
the value of the lump sum has fallen. This is to prevent people cancelling due to
falls in the market. This risk should be explained to the client before the contract
is effected.
For mortgages the situation is slightly different. Once the mortgage offer has been
issued, the borrower(s) has a seven-day period of reflection and can accept the
terms of the offer at any stage.
19.5.5 Implementation of solutions

If the client is in agreement then the application or proposal forms will need to be
completed. Any changes to existing products or investments will need to be made
and confirmation that these changes have been implemented accurately should be
obtained.
Checks will need to be made to ensure that the product or investment is set up
correctly and the relevant documentation goes out on time. Direct debits or other
payments should be checked to make sure they go through as agreed and that a
courtesy call to the client is made to ensure that they are happy with the process
they have experienced.
19.6 Ongoing review and relationship

management
There are a number of factors to be considered post-sale. The information obtained
through the factfind must be retained for a specified period of time, depending on
the nature of the product recommended. These periods are:
u indefinitely for pension transfers/opt-outs and free-standing additional
voluntary contributions;
u five years for life policies, pension contracts and MiFID business;
u three years for all other products.

Telesales
In practice, advisers will wish to retain the information in all cases for as long
as they believe they may be required to justify the advice and recommendations
given.
It may be useful to agree a time for review of the customer’s financial situation
in, say, 12 months’ time, perhaps linked to an annual pay review or if there
is a significant life event pending, such as marriage or having children, which
would warrant a meeting to discuss arrangements. Being able to approach existing
customers as part of ongoing relationship management is much easier and less
time-consuming than trying to prospect for new customers. Part of the initial
interview process could be to flag with the client times when financial advice would
be appropriate as it may be something that the client was unaware of. For example,
a change in employment may require advice, as benefits with a new employer may
be curtailed and cash given instead. For each client it may therefore be necessary to
record and review certain future events that the adviser has been made aware of to
enable them to make contact with the client and resume their dialogue. However,
in doing so they must be aware of their obligations under the Data Protection Act
not to retain information longer than necessary (see section 5.8.2).
It is also useful for advisers and planners to review client files and client holdings
to determine how well the products or investments sold are performing. It may be
necessary to revisit the client’s attitude to risk and rebalance investment portfolios
or products. This may give opportunities for future meetings to discuss client
requirements.
It is important to ensure that any queries from the client are dealt with effectively
and efficiently and that service standards are maintained. Once a client has been
gained, ongoing good service is one of the main ways of ensuring their loyalty.
19.7 Telesales
While protection, mortgages and general insurance can be sold on a face-to-face
basis, these products can also be sold over the telephone. With the increased use
of technology to provide information to the adviser it is possible to provide clients
with quotes immediately and also to record conversations in case a query arises
later. This method is more suitable for the sales of single products rather than a
more in-depth review of the client’s financial situation.
The process is essentially the same, although steps four (evaluating affordability
and suitability) and five (matching appropriate solutions to client needs) will be
completed by a computer program based on the information given by the client.
After the call has been concluded the documentation will be printed off and sent
directly to them for review and, if they wish to go ahead, for signature.
Many organisations require advisers to work to a script, which follows the input
of information into the electronic factfind. This ensures that what is said to the
client is compliant with regulations and that all the necessary data is collected.
For example, ICOBS rules state that firms must take ‘reasonable steps to ensure
a customer is given appropriate information about a policy in good time and
in a comprehensible form so that the customer can make an informed decision
about the arrangements proposed’. Complaints that telesales advisers have not
followed compliance procedures (especially in the case of pure protection and PPI
policies) led to scripts being developed. Following poor results from a ‘mystery
shopper’ exercise undertaken by the FSA in 2009 in relation to critical illness
sales, a checklist of points and sample sales script was approved for use by the
Association of British Insurers.

It is important for telesales advisers to remember that they need to:

u make appropriate verbal disclosures when selling products to a consumer over
the phone;
u provide product information in a way that is clear, fair and not misleading;
u be clear about the status and scope of service the firm is providing; and
u ensure that advice given is suitable.
19.8 The skills required

We have looked so far at the information an adviser needs in order to provide
suitable advice. However, the process is not just about information. The adviser
requires a range of skills to gather the information, ensure they understand the
client and their needs, and to match products to the client’s goals, needs and
objectives. We will consider these skills briefly now.
19.8.1 Communication skills

It should go without saying that general communication skills are vital. The
ability to ‘talk the client’s language’, to empathise with their situation and explain
complex technical issues in ways that the client can understand are all skills a good
adviser will demonstrate on a regular basis, as is avoiding jargon, ‘management
speak’ and over-technical language. In addition, the adviser should be able to
communicate well in writing, again pitched at the level the client is comfortable
with. The two main components of good communication skills, questioning and
listening, are discussed below.
19.8.1.1 Questioning skills

Fact-finding is only partly about asking the set questions in the factfind
questionnaire. One of the essential skills is to ask additional or supplementary
questions when the client provides an important item of information. The key
to this is usually to know why the question is important and the implications of
possible different answers. The types of question and the way they are asked will
influence the quality and quantity of information gathered. There are two broad
categories of question.
u Closed questions: these are usually questions that require a ‘yes’ or ‘no’
answer, or require a fact or figure. Examples would be ‘how much do you earn?’;
‘how many children do you have?’; ‘what is your date of birth?’. These questions
are short and to the point, and do not ask for an opinion or explore the client’s
attitudes and feelings. They are good for gathering factual information or for
summarising, but their over-use can lead to a feeling of interrogation, does not
help to build rapport, and can seem to be part of a ‘box-ticking’ exercise.
u Open questions: in simple terms, these are questions that cannot be answered
with a ‘yes’ or ‘no’, or by stating a simple fact. They are good for exploring
client attitudes and feelings, or for expanding on information. Examples could
include:
− ‘How would you feel if . . .?’
− ‘What would happen if . . .?’

The skills required
− ‘What would you want . . .?’

− ‘What would that mean to . . .?’
It is vital for the adviser to really understand what makes the client ‘tick’ and
establish their attitudes and feelings, which means that good use of open questions
is essential.
19.8.1.2 Listening skills

An adviser needs good listening skills, which could be said to consist of two
elements.
u Listening to client responses: there is a distinct difference between hearing
and listening. We can hear a client’s response without actually understanding or
really taking in what they are saying. Listening means focusing on what they are
saying and the meaning behind it, making sure the message is understood and
reacting appropriately. If the adviser constantly asks for the same information,
the client will soon realise that they are not really listening. It is easy to
become distracted or to think ahead during a conversation and miss important
information.
u Acknowledging: part of the listening process is to make it clear that the
message has been received and understood. Indications can be given verbally or
non-verbally but it is important that they are given. One of the great frustrations
is not to be listened to; many domestic arguments start with the phrase, ‘You’re
not listening to me’. Acknowledgement can be given non-verbally by nodding,
smiling, putting the pen down and leaning back, leaning forward and other
subtle gestures. It can also be given verbally by agreeing, asking follow-up
questions, summarising and so on.
19.8.2 Analytical skills

Advisers and planners need analytical skills to help them evaluate customer
information, and the affordability and suitability of solutions to match customer
needs. This will include the ability to:
u show attention to technical details;
u find solutions to client problems;
u consider what further information may be needed;
u compare policy costs and benefits, matching them to client’s goals, needs and
objectives.
19.8.3 Organisational skills

Often advisers and planners will be working to tight deadlines to meet client
expectations so it is important they can organise themselves sufficiently well to
provide good levels of service. This will involve the ability to:
u prioritise work objectives and manage their time;
u respond quickly to potential problems;

u communicate with colleagues to ensure that tasks are completed;

u follow organisational and regulatory procedures to ensure that standards of
professional behaviour are adhered to.
References
FCA (2016) Business plan 2016/17 [pdf]. Available at:
http://www.fca.org.uk/static/documents/corporate/business-plan-2016-17.pdf
Review questions
1. How would an adviser or planner establish a client’s net worth?

2. What is a suitability report?
3. What are the rules relating to disclosure of charges when business is being
arranged by telephone?
4. When should written details of packaged products be given to clients?
5. What is a ‘cooling-off’ period?

6. If a customer cancels a contract during the cooling-off period what happens to
the premiums that may have been paid?
7. How long must factfind information be retained post-sale?
8. Why have scripts been developed for telesales calls?

9. How are open questions useful when talking with clients?
10. How can you acknowledge what a client has said?

Topic 20
Key legal concepts
Learning objectives
u explain the concept of legal persons;

u summarise the concept of ownership of assets;
u summarise the concept of capacity to contract;

u summarise powers of attorney;
u explain wills and intestacy;
u summarise insolvency and bankruptcy.
20.1 Introduction
In this final topic we will consider some of the underlying legal considerations in
the relationship between the customer and their provider of financial services. It is
important for financial advisers and planners to have this underpinning knowledge,
as although it will not be at the forefront of their dealings with clients, it is very
relevant to their dealings with them.
20.2 Legal persons

‘Legal persons’ in the context of financial services refers to those who have a
separate legal existence and can, therefore, enter into contracts or be sued in
a court of law. It is important to remember that this includes individuals in a
personal/private capacity and those individuals acting in a formal capacity such
as executors of wills (see section 20.6) or those holding powers of attorney (see
section 20.5) as well as groups of individuals such as trustees.
Trustees administer ‘trusts’. A trust (also known as a settlement) is a method by
which the owner of an asset (the settlor) can distribute or use that asset for the
benefit of another person or persons (the beneficiaries) without allowing them
to exert control over the asset while it remains in trust. Depending on the nature
of the trust, the beneficiaries may eventually become the absolute owners of the
asset. Trusts were typically set up to allow parents (or grandparents) to pass assets
on to children, particularly in the event of the settlor’s death while the children were

20: Key legal concepts
relatively young. There also used to be some tax advantages of setting up a trust,
but the rules on this have been tightened in recent times.
Legal persons also includes organisations such as limited companies.
20.3 Ownership of assets

The law of England and Wales defines two distinct types of property (in this context,
the word ‘property’ is used to refer to all types of assets, rather than its more
narrow reference to land and buildings).
u Realty: property is deemed to be ‘real’ if a court will restore it to a dispossessed

owner and not merely provide compensation for loss. Real property tends to be
distinguished by being immovable, eg land and what is attached to it, also
known as real estate.
u Personalty: all other property is called personalty.
20.3.1 Joint ownership

There are two types of joint ownership, both of which are described in terms of
tenancy (but the meaning of tenancy here does not relate to the letting of property).
These phrases refer to the joint ownership of any form of asset (or liability).
u Joint tenants: the whole property is deemed to be owned by each of the
owners, so that if one owner dies, the property automatically transfers into
the ownership of the other. The transfer on death to the surviving owner is
automatic and cannot be overridden by any provision in the deceased person’s
will.
u Tenants in common: each owner has an identifiable share of the property;
if one owner dies, their share of the property passes to whoever is entitled to
inherit it under the terms of the will or under the rules of intestacy.
The concept of joint tenants or tenants in common can apply equally to debts,
such as mortgages. In the former case, all borrowers are equally liable for the
whole debt, while in the latter each is responsible for a portion of the debt. Banks,
building societies and other commercial lenders always insist that joint mortgages
are written on a joint tenancy basis.
20.4 Law of contract

Most business agreements, particularly in the world of financial services, are
established as legally binding contracts. Some are made orally, some in writing
and some by deed. Not all contracts can be made orally but all contracts generally
are subject to certain basic requirements for them to be binding.
The basic requirements for contracts to be binding on the parties involved are as
follows.
u Offer and acceptance: there must be an offer made by one party (the offeror)
and there must be an unqualified acceptance by the other. This acceptance

Power of attorney
must be communicated to the other party. In practice there may be a number

of counter-offers before agreement is reached.
u Consideration: the subject of the contract (often a promise to do something
or supply something) must be matched by consideration (which is frequently,
but not necessarily, the payment of money). This is given by one of the parties
(the promisee) to the person making the promise − that is, the other party to
the contract (the promisor). A promise to pay is valid consideration.
u Capacity to contract: each of the parties to the contract must have the legal
capacity, or power, to enter into the contract. Certain parties have only limited
powers to enter into a contract − for example, minors (persons under the age
of 18) and those of unsound mind. For financial institutions such as insurance
companies, capacity to contract depends on being authorised by the PRA (or
FCA).
u The terms of the contract must be certain, complete and free from
doubt.
u There must be an intention to create a legal relationship, as distinct from
a merely informal arrangement.
u Legality of object: contracts cannot be made for illegal or immoral purposes.
u The contract must not have been entered into as a result of
misrepresentation, or under duress or undue influence.
Some contracts have to be recorded in a specific legal form: all agreements for the
sale of land must be made in writing and conveyances of land (the actual transfer
of ownership) must be performed by deed.
Generally, there is no duty of disclosure between parties to a contract; most
contracts are based on the principle of caveat emptor (‘let the buyer beware’).
However, there are exceptions: for example, someone making a proposal to enter
an insurance contract must take reasonable care not to make a misrepresentation
when completing the application or providing details to the insurer. If information
is misrepresented in a careless or reckless manner, the insurer has the right to
apply certain ‘remedies’ which, at the extreme, can include cancellation of the
policy.
If a party fails to perform their side of the contract and does not have a legal
excuse for doing so, then this is a breach of contract. Several court remedies are
available in these circumstances. The main ones are to seek damages, an order for
‘specific performance’ or an injunction. Of these, by far the most frequently sought
is damages, whereby the injured party seeks to obtain financial compensation for
their loss. The intention is to put them in the position they would have been in
had the contract not been breached by the other party, in so far as it is possible to
do so with money. In certain circumstances, an order for specific performance can
be obtained to compel the other party to complete the contract. Alternatively, an
injunction can be sought − this is a court order preventing someone from doing
something.
20.5 Power of attorney

An attorney is a person who is given the legal responsibility to act on behalf of
another person. This may be necessary in the cases, for example, of an elderly
person who is incapable of managing their own finances or of someone living

abroad. The person who makes a power of attorney is called the donor and the
person who acts for them is called the donee, or simply the attorney.
A person who does not have the legal capacity to enter into a contract (eg a minor
or a mentally incapacitated person) cannot appoint someone else as their attorney.
In fact, an ordinary power of attorney would automatically cease if a person were to
become mentally incapacitated. The Enduring Powers of Attorney Act 1985 created
a new type of power, called an enduring power of attorney, which does continue
if the donor becomes mentally incapacitated. Enduring powers of attorney have to
be registered with the Public Guardianship Office if the attorney believes that the
donor is becoming mentally incapacitated. Once the enduring power has been
registered, the attorney can continue to act despite the donor’s mental capacity.
An enduring power of attorney can be revoked only with the consent of the Court
of Protection.
As of October 2007, when the Mental Capacity Act 2005 came into force, enduring
powers of attorney have been replaced by lasting powers of attorney (LPAs)
under which attorneys are able to make decisions not only about financial matters,
but also about personal and health matters. An LPA is established while a person
still has a mental capacity, but only comes into force when they have become
incapacitated. Following the implementing of the Mental Capacity Act, the Public
Guardianship Office has been renamed the Office of the Public Guardian. Existing
enduring powers of attorney can remain in force, but all new arrangements must
be LPAs.
20.6 Wills and intestacy

The people who carry out the procedures necessary to distribute the estate
of someone who has died are known as the deceased person’s personal
representatives.
The exact procedure to be carried out in order to distribute a deceased person’s
estate depends on whether or not there is a valid will. The following comments
apply to the law of England and Wales (Scottish law differs both in the procedures
involved and in the terminology used).
If there is a valid will, the executor(s) apply for a grant of probate. The executors
are appointed (ie named in the will) by the testator (the person making the will)
to ensure that the actions specified in the will are carried out. The grant of probate
gives the executors legal authority to carry out the testator’s instructions, as set
out in the will. An executor can also be a beneficiary of the will. The duties of
an executor can be time-consuming and onerous and it is not uncommon for
executors to appoint a solicitor to carry out all or part of their duties.
If there is no will (or the will is invalid), a grant of letters of administration
is issued to an appropriate person, who is known as the administrator. This
will often be the surviving spouse or another close relative. The administrator’s
responsibility is to deal with the estate as prescribed by the rules of intestacy.
A will is a written declaration of an individual’s wishes regarding what they want
to happen after they have died. Although primarily concerned with how the person
wishes to dispose of their assets, a will can also deal with other matters, such as
giving instructions about burial.
The terms of a will only take effect on the death of the testator, the person who
made the will. Before then, the testator can revoke (cancel) or modify the will at
any time. Modifications are recorded in a document known as a codicil.

Wills and intestacy
To make a valid will, two formalities must be followed.

u The will must be in writing.
u The will must be properly executed.
The minimum age for making a valid will under English law is 18.
The will should be a clear and unambiguous statement of the deceased’s wishes
in respect of their estate, and must be signed by the testator in the presence of
two witnesses, who must not be beneficiaries under the will (or the spouses of
beneficiaries).
In the event of marriage or remarriage or entering into a civil partnership, a will is
automatically revoked, unless specifically written in contemplation of the change
of status.
In the UK, approximately seven out of ten people die intestate, without leaving a
valid will. Writing a will is the first step in gaining control over an estate and is,
therefore, a vital part of financial planning.
The cost of writing a will is quite reasonable and should not be viewed as a barrier
to making a will. A financial adviser’s role should not involve the writing of a will
but it is important that clients understand the benefits of a valid will and the risks
of not having one. If the client has no will, the financial adviser should recommend
that they seek professional advice from a solicitor.
In certain circumstances it may be advantageous, following the death of the
testator, for the beneficiaries under a will to vary the way the estate has been
allocated. This can be achieved by executing a deed of variation. All those who
would have benefited from the provisions of the will must be over 18 years of
age and be in agreement on the terms of such a variation. A deed of variation is
often executed for tax purposes: a change in beneficiaries or in the relative shares
received could reduce the inheritance tax liability, for example. In order to be
effective for tax purposes, the deed of variation must be executed within two years
of the death and HM Revenue & Customs must be informed within six months of its
execution. The variation must not be entered into for any consideration of money
or money’s worth.
20.6.1 Intestacy
A person who has died without having made a valid will is said to have died
intestate. This includes the situation where the deceased has left a will but where
the will turns out to be invalid.
If a will makes valid provision for the distribution of some of the assets of the
estate, but not of others, this is referred to as partial intestacy.
The distribution of the estate of a person who has died intestate is determined
by a complex set of rules known as the rules of intestacy. They are very specific
and there is no flexibility or discretion for their variation by the person dealing
with the estate. The destination of property under the intestacy rules depends on
the size of the estate and the deceased’s family circumstances. In many cases −
especially if the estate is a large one − the distribution of the assets may not be
as the deceased would have wished. In particular, it is not necessarily true − as
many people believe − that a surviving spouse or civil partner will receive the whole
estate.

The main rules are as follows. Please note that for the purpose of these rules, the
word ‘spouse’ includes civil partner.
u If the deceased leaves a spouse but no children: the spouse inherits the
estate of the deceased, in full.
u If there is both spouse and children: the spouse gets all of the deceased’s
personal chattels plus the first £250,000 plus half the balance of the residue
in excess of £250,000, absolutely; the other half of the balance in excess of
£250,000 goes to the children.
u If there are children but no spouse: the estate is shared equally among the
children.
u If there is neither spouse nor children: the estate goes to the deceased’s
parents or (if they are dead) to the deceased’s brothers and sisters (or their
children), if there are no brothers or sisters then the estate goes to half-brothers
/ half-sisters.
This is just a summary of the main rules and ultimately, if no blood relative can be
found, the estate will pass the Crown.
20.7 Insolvency and bankruptcy

Insolvency arises when:
u a person’s liabilities exceed their assets; or
u a person cannot meet their financial obligations within a reasonable time of
their falling due.
Bankruptcy takes the position a stage further and arises when a person’s state of
being insolvent is formalised under the terms of a county court order. A person can
petition to have themselves declared bankrupt or a creditor may petition to have
someone else declared bankrupt. The bankruptcy level, ie the amount of money
owed for which a person can be made bankrupt, is £5,000 (since 1 October 2015,
£750 before then).
The primary UK legislation on insolvency is the Insolvency Act 1986, but this
has been subject to amendments over the years. In 2000, an EU Regulation on
Insolvency Proceedings was adopted and it came into force in 2002.
As a result of the Enterprise Act 2002, which came fully into force in April 2004,
most bankruptcy orders now remain in force for 12 months, during which time the
person is said to be an undischarged bankrupt. During this time, a bankrupt
person’s possessions are, in effect, surrendered to an official receiver, who can
dispose of them and use the cash to pay off the creditors. The only exceptions
are clothing and household items, and work-related items. Although bankruptcy
cancels most kinds of debt and allows people to make a fresh financial start, it
comes at a price: it normally makes it more difficult to obtain credit in the future
and it can affect employment prospects.
One practical effect of bankruptcy is that a person will be unable to borrow, other
than nominal amounts, during the period that the order is in force. Even after the
end of the period, the person must, by law, disclose the existence of a previous
bankruptcy when applying for a mortgage. This may mean that it will be more
difficult for them to obtain a loan or that they may be charged a higher rate of
interest to cover the greater perceived risk.

Insolvency and bankruptcy
20.7.1 Individual voluntary arrangements

An individual voluntary arrangement (IVA) is an alternative to bankruptcy, under
which the debtor arranges with the creditors to reschedule the repayment of the
debts over a specified period. An IVA can be set up only if creditors who represent
at least 75 per cent of the debt agree to the arrangement. The scheme must be
supervised by an insolvency practitioner.
There are now a large number of firms that assist individuals with significant
personal debts to enter into IVAs. In most cases they are able to arrange for interest
to be frozen, for a reduction in the amount of the debt, and for legal protection
from creditors if the terms of the IVA are met. The firms are generally able to
persuade the bank or other lender to write off part of the debt in exchange for
a reasonable guarantee of receiving repayment of the remainder. In many cases
this is better for the bank than simply writing off the debt or selling it to a debt
recovery firm.
An individual with an IVA will find it difficult to obtain credit while the IVA is in place,
and creditworthiness is likely to be impaired even after the end of the arrangement.
20.7.2 Debt relief orders (DROs)

Debt relief orders (DROs) help people who are insolvent and on a low income. They
are a much cheaper alternative to bankruptcy as the cost for a DRO is around £90.
They can be arranged through approved organisations such as third-party debt
advisers.
To be considered for a DRO the debtor must fit the following criteria:
u owe less than £20,000 in unsecured credit debts;
u must not be a homeowner;

u have no more than £1,000 assets (although one car up to the value of £1,000
will be exempt); and
u have less than £50 a month income left over after they have paid all of their
living expenses.
The person’s debts are frozen for a period of twelve months. During this time
creditors agree not to pursue the debtor for the outstanding debt, nor add further
interest on the balances. If, after the twelve months, the debtor’s circumstances
have not improved, the debts are written off.
DROs became available in April 2009 and have proved a popular way out of
problems for insolvent people on a low income with few assets.

Review questions
1. What is a legal person?
2. Explain the two types of property.

3. What does ‘capacity to contract’ mean?
4. Explain the principle of caveat emptor.
5. What is a lasting power of attorney?

6. Who are personal representatives?
7. What happens to the estate of someone who has died without making a will?
8. How can a will be altered after the death of the testator?
9. Define insolvency.
10. What is an IVA?

Appendix A
UK taxation figures for the tax
year 2016/17
Please read this Appendix in conjunction with Topic 10, to which the section
numbering here relates.
10.2 Income tax

Income assessable to tax includes:
u the value of benefits in kind, such as company cars or medical insurance; and
u redundancy payments and other compensation for loss of office (where in
excess of £30,000).
10.2.2 Allowances and tax rates 1

The personal allowance for 2016/17 is £11,000.
If income is above £100,000
If your income is over £100,000, the personal allowance is reduced by half of

the amount − £1 for every £2 − over that limit. If income is £122,000 or more
(2016/17), the personal allowance will be reduced to nil. This £100,000 limit
applies irrespective of age.
The Blind Person’s Allowance is £2,290 in 2016/17.
Income tax on bands of taxable income (2016/17)

Income tax on Income tax rate Income tax rate
Income tax band earned income on savings on dividends
above £5,000
£0−£5,000 (starting rate) N/A 0% 7.5%
Up to £32,000 (basic rate) 20% 20% 7.5%
£32,001−£150,000 40% 40% 32.5%
(higher rate)
Over £150,000 (additional 45% 45% 38.1%
rate)

UK taxation figures for the tax year 2016/17
For savings income such as interest from bank, building society and National
Savings and Investments accounts, there is a starting-rate band at 0 per cent
for savings income up to £5,000. This starting-rate band is available where
an individual’s taxable non-savings income is below £5,000, ie total income
including savings income is below £16,000 (£11,000 personal allowance plus
£5,000 starting-rate band).
For those whose taxable non-savings income exceeds £5,000, there is a personal
savings allowance (PSA) of £1,000 for basic-rate taxpayers, and £500 for
higher-rate taxpayers; there is no PSA for additional-rate taxpayers. Where an
individual is entitled to the PSA they pay no tax on the first £1,000 / £500 of
savings income. In calculating entitlement to the PSA, income, including that from
savings interest, is taken into account.
For dividend income, each individual has a tax-free dividend allowance of £5,000
per tax year, which means that no tax is paid on the first £5,000 of dividend
income, regardless of an individual’s personal tax status, and the amount of
non-dividend income a person receives. Dividend income in excess of the £5,000
dividend allowance is taxed as follows:
u 7.5 per cent on dividend income within the basic-rate tax band;
u 32.5 per cent on dividend income within the higher-rate tax band;
u 38.1 per cent on dividend income within the additional-rate tax band.
Example 1
A married man aged 30 receives £10,000 as employment income and interest
of £2,500 from a building society account in the 2016/17 tax year. He has a
personal allowance of £11,000.
Gross income £12,500

Personal allowance (£11,000)
Taxable income £1,500
No income tax is payable, as the £1,500 of taxable income is interest and falls
within the starting-rate band of £5,000, subject to 0% tax.
Example 2
A single woman aged 30 receives £11,400 as employment income and interest
of £5,000 from a building society account in the 2016/17 tax year. She has a

Taxable employment income is £400 (£11,400 − £11,000) x 20% = £80

As there is £400 of taxable non-savings income, £400 of the starting rate for
savings income is used up, meaning that £4,600 of the savings income falls
within the starting-rate band (£5,000) and no tax is charged on this.

10.2.2 Allowances and tax rates
The remaining £400 of savings income falls within the personal savings
allowance of £1,000 (for a basic-rate taxpayer).
Total income tax is £80.
Example 3
A married man aged 40 receives £50,000 as employment income and interest

of £2,500 from a building society account in the 2016/17 tax year. He has a

In respect of employment income:

Taxable employment income is £39,000 (£50,000 − £11,000).
£32,000 of taxable employment income falls in the basic-rate tax band.

Tax of £6,400 (£32,000 x 20%).
£7,000 falls into the higher-rate tax band (£39,000 − £32,000).

Tax of £2,800 (£7,000 x 40%).
In respect of the savings interest:
There is entitlement to a personal savings allowance of £500 as the individual

is a higher-rate taxpayer.
The first £500 of the savings interest is free of tax.
The balance is taxed at 40% (£2,000 x 40% = £800).
Total income tax is: £6,400 + £2,800 + £800 = £10,000.

Example 4
A married man aged 30 receives £25,000 as employment income and dividend
income of £7,500 from shares in the 2016/17 tax year. He has a personal
allowance of £11,000.

Dividend allowance (£5,000)
In respect of employment income:

Taxable employment income is £14,000 (£25,000 − £11,000).
All of the taxable employment income falls in the basic-rate tax band.
Tax of £2,800 (£14,000 x 20%).
In respect of the dividend income:
There is entitlement to a dividend allowance of £5,000.

The first £5,000 of the dividend income is free of tax.
The balance is taxed at 7.5% as the individual is a basic-rate taxpayer (£2,500

x 7.5% = £187.50).
Total income tax is: £2,800 + £187.50 = £2,987.10.
Example 5
A single woman aged 40 earns £50,000 (gross) in the 2016/17 tax year.
She has no other income. She is employed and has a personal allowance of
£11,000.

Personal allowance £11,000
Income tax due
£32,000 at 20% = £6,400
£7,000 at 40% = £2,800
Total tax due £9,200

10.3 National Insurance

u Class 1: these are paid by employees at 12 per cent on earnings between
certain levels known as the ‘primary threshold’ (£155 per week in 2016/17)
and the ‘upper earnings limit’ (£827 per week in 2016/17), with a reduced level
of 2 per cent payable on earnings above the upper limit. They are also paid by
employers at 13.8 per cent on employees’ earnings above a lower limit called
the ‘secondary threshold’ (£156 per week in 2016/17), but with no upper limit.
u Class 2: these are flat-rate contributions paid by the self-employed if their
annual profits exceed a specified lower threshold (£5,965 pa for 2016/17). They
are quoted as a weekly amount (£2.80 per week in 2016/17). The self-employed
will often also pay Class 4 National Insurance contributions. Whilst quoted
as a weekly amount, Class 2 contributions are paid twice a year, under the
self-assessment system, along with income tax and Class 4 NICs.
u Class 3: these are voluntary contributions that can be paid by people who would
not otherwise be entitled to the full state pension or state sickness benefits.
This can occur because a person has, for instance, taken a career break or
spent some time working overseas. They are flat-rate contributions (£14.10 per
week in 2016/17).
u Class 3A: these are another class of voluntary National Insurance contributions.
They can be paid by those who reached state pension age before 6 April
2016, and are used to boost entitlement to additional state pension. Class
3A contributions can be made until 5 April 2017.
u Class 4: these are additional contributions payable by self-employed persons

on their annual profits between specified minimum and maximum levels, with
a reduced rate payable above the upper limit, as for Class 1. They are paid to
HMRC in half-yearly instalments along with income tax. The rate for 2016/17
is 9 per cent of profits between £8,069 and £43,000, plus 2 per cent of profits
above £43,000.

Customer group and allowances for 2016/17 are as follows:
u Individuals, personal representatives and trustees for disabled people: £11,100.
u Other trustees: £5,550.

For 2016/17, the following CGT rates apply:
u 10 per cent for basic-rate taxpayers and 20 per cent for higher-rate and
additional-rate taxpayers (the rate used will depend on the amount of their
total taxable income and gains).
u An 8 per cent surcharge applies on the above rates where the disposal is of
residential property that is not eligible for private residence relief, giving rates
of 18 per cent and 28 per cent.
u 20 per cent for trustees or personal representatives; 28 per cent where the
disposal is of residential property that is not eligible for private residence relief.

Example
Vanessa, a basic-rate taxpayer, bought units in a unit trust for £50,000 in May
2005 and sold them for £80,000 in June 2016. At the same time she sold some
shares for £10,000 that she had bought for £12,000. What capital gains tax
will she pay?
Gain on unit trust £30,000

Deduct annual allowance (£11,100)
Deduct loss on shares (£2,000)
Taxable gain £16,900
Tax @ 10% £1,690
10.5 Inheritance tax

The inheritance tax (IHT) threshold (or ‘nil-rate band’) is the amount up to which
an estate will have no inheritance tax to pay, as the rate is set at zero. For the
tax year 2016/17 this is £325,000. Any portion of the nil-rate band that remains
unused on death can be transferred to the spouse / civil partner of the deceased so
that it may be used on their later death. The amount transferred is the percentage,
rather than the value, of the band that is unused; this can then be used in respect
of future increases in the level of the nil-rate band.
Example 1
If on the first death an estate of £200,000 was left entirely to the deceased’s
son when the nil-rate band was £300,000, the unused proportion is 33.33
per cent. If the wife then died when the nil-rate band was £325,000, this
could be increased by 33.33 per cent to £433,333. If, on the first death, the
estate of £200,000 was left entirely to the deceased’s wife (with or without a
will), the unused proportion of the husband’s nil-rate band is 100 per cent,
since transfers between spouses and civil partners on death are exempt from
inheritance tax. If the wife then died when the nil-rate band was £325,000,
this would have increased by 100 per cent to £650,000.
If the estate − including any assets held in trust and gifts made within seven years
of death − is more than the threshold, inheritance tax will be due at 40 per cent
on the amount over the nil-rate band.
For deaths after April 2012, a lower rate of IHT of 36 per cent is applicable where
10 per cent or more of the deceased person’s net estate is left to charity.
Taper relief reductions

Time between the date the gift Taper relief percentage
was made and the date of death applied to the tax due
3 to 4 years 20%
4 to 5 years 40%
5 to 6 years 60%
6 to 7 years 80%

Example 2
Joe made a gift of £350,000 on 15 January 2013. He died on 15 April 2016.
The IHT threshold for the year he died is £325,000. Follow the steps below to
work out the inheritance tax due.
u Step one: take away the threshold from the value of the gift: £350,000 −
£325,000 = £25,000. So IHT is due on £25,000.
u Step two: work out the IHT at the full rate of 40 per cent: £25,000 × 40
per cent = £10,000.
u Step three: the gift was made within three to four years of death. So taper
relief at 20 per cent is allowed: £10,000 × 20 per cent = £2,000.
u Step four: take away the taper relief from the full tax charge:
£10,000 − £2,000 = £8,000.
In this example, taper relief reduces the amount of tax payable from £10,000 to
£8,000. 2
Chargeable lifetime transfer tax rate = 20 per cent.
Exemptions from inheritance tax:
u Transfers between spouses and between same-sex couples registered under the
Civil Partnership Act both during their lifetime and on death.
u Small gifts of up to £250 (cash or value) per recipient in each tax year.
u Donations to charity, to political parties and to the nation.

u Wedding gifts of up to £1,000 (increased to £5,000 for gifts from parents or
£2,500 from grandparents).
u Gifts that are made on a regular basis out of income and which do not affect
the donor’s standard of living.
u Up to £3,000 per tax year for gifts not covered by other exemptions. Any part
of this £3,000 that is not used in a given tax year can be carried forward for
one year, but no further.
A reduced rate of 36 per cent applies where at least 10 per cent of an estate is
left to charity.

Value added tax (VAT) was set at 20 per cent from 4 January 2011.
Domestic heating VAT rate is 5 per cent.

Annual turnover of a business for VAT registration is £83,000.

10.6.2 Stamp duty

u Stamp duty reserve tax: the rate of stamp duty on securities is 1.5 per
cent of the market value for bearer instruments and 0.5 per cent of market
value for shares. From 13 March 2008, transactions that result in a stamp duty
reserve tax charge of £5 or less are exempt. Bearer instruments are financial
instruments, such as bonds, on which the name of the owner is not recorded.
Possession of the certificate is the only proof of ownership, and title passes by
physical delivery to a new owner.
u The system of stamp duty land tax (SDLT) has changed. Under the previous
system SDLT was taxed at a single rate according to the price paid for the
property. Under the new system, in place since 4 December 2014, different
rates of SDLT are allocated to different portions of the purchase price.
− There is no SDLT on the portion of the purchase price up to £125,000.
− On the portion of the purchase price between £125,001 and £250,000, SDLT
is charged at 2 per cent.
− On the portion of the purchase price between £250,001 and £925,000, SDLT
is charged at 5 per cent.
− On the portion of the purchase price between £925,001 and £1.5m, SDLT is
charged at 10 per cent.
− On the portion of the purchase price above £1.5m, SDLT is charged at

12 per cent.
Where the purchase price exceeds £500,000, the rate of SDLT is 15 per cent of
the whole purchase price for certain types of purchasers, including corporate
bodies.
Where property is purchased but will not be the main residence of the buyer,
a buy-to-let property or second home for example, a 3 per cent stamp duty is
payable in addition to the rates above.
In Scotland, stamp duty land tax was replaced by land and buildings transaction
tax (LBTT) from 1 April 2015. It operates in a similar way to SDLT but the
thresholds and rates are different.

Endnotes
10.6.3 Corporation tax
Corporation tax 2016/17

Profits Rate
All profits 20%
For companies with profits up to £1.5m, corporation tax is normally due nine
months after the end of the relevant accounting period. For those with profits over
£1.5m, corporation tax is due in quarterly instalments beginning approximately
halfway through the accounting period.
10.6.4 Withholding tax

20 per cent for the tax year 2016/17.
Endnotes
1 Source: www.direct.gov.uk
2 Source: www.direct.gov.uk

Appendix B
Answers to review questions
Topic 1 Key influences in the UK financial services industry 293

Topic 2 The Prudential Regulation Authority and the Financial
Conduct Authority 294
Topic 3 Conduct of business rules 296
Topic 4 Complaints and compensation 297
Topic 5 Other rules and regulations relevant to advising financial
services clients 297
Topic 6 Clients’ needs and managing money 300
Topic 7 Customer needs for future income 300
Topic 8 Overview of financial services products 302
Topic 9 Economic factors 303
Topic 10 UK taxation and state benefits 305
Topic 11 Principles of financial protection: Existing provision 306
Topic 12 Financial protection products 307
Topic 13 Investment products 309
Topic 14 Indirect investments and other investment types 310
Topic 15 Pensions 311
Topic 16 Mortgage loans and associated products 312
Topic 17 Interacting ethically with clients 314
Topic 18 The sales process: Part 1 315
Topic 19 The sales process: Part 2 316
Topic 20 Key legal concepts 318
Topic 1 Key influences in the UK financial

services industry
1. The financial services industry exists largely to facilitate the use of money.
It ‘oils the wheels’ of commerce and government by channelling money from
those who have a surplus, and wish to lend it for a profit, to those who wish
to borrow it, and are willing to pay for the privilege.
2. Financial intermediation is where an organisation borrows money from the
surplus sector of the economy and lends it to the deficit sector, paying a
lower rate of interest to the person with the surplus and charging a higher
rate of interest to the person with the deficit. Banks and building societies are
the best-known examples. An intermediary’s profit margin is the difference
between the two interest rates.
3. The central bank (the Bank of England), banks (retail and wholesale) and mutual
organisations (building societies, insurance companies and credit unions).
4. To set interest rates and manage the rate of inflation.

5. A mutual organisation is not constituted as a company and does not, therefore,

have shareholders. It is, in effect, owned by its members, who can determine
how the organisation is managed through general meetings similar to those
attended by shareholders of a company. In the case of a building society, the
members comprise its depositors and borrowers; for a life company they are
the with-profit policyholders.
6. Traditionally credit unions operated in the poorer sections of the community,

providing savings and reasonably priced short- and medium-term loans to their
members. In more recent years it has been recognised that credit unions have
a strong role to play in combating financial exclusion and delivering financial
services to those outside the mainstream.
7. The London Stock Exchange has been London’s market for stocks and shares
for hundreds of years. Government stock, share capital and loan capital,
overseas shares and options are all traded on this market.
8. In spite of the UK retaining its own currency and control over its own monetary
policy, the financial services industry is hugely influenced by the European
Union’s policies and laws. Large portions of the UK’s financial regulatory
regime for consumers and companies are determined by European laws. This
includes regulation relating to banking, investment, life assurance, general
insurance, operating as a financial adviser, compensation for losses, money
laundering, data protection and many other areas.
9. Regulations have general application, are binding in their entirety and

directly applicable in all member states (unless particular states have specific
dispensation). Directives are binding as to the result to be achieved upon each
member state to which they are addressed. In other words, the objectives of
the Directive must be achieved within a specified timescale (typically two years)
but exactly how they are achieved is left to national authorities in each state.
10. Clearing in the banking context refers to the process, at the end of each
business day, of settling between banks the transfers of money outstanding
as a result of the use by customers of cheques, direct debits, debit cards and
other means of money transfer. At the end of any particular day, for instance,
NatWest will need to pay to Barclays a total sum in relation to cheques written
by its customers and banked by Barclays’ customers − and of course exactly
the same will be true in reverse. As a result, a net figure will be due from one
of the banks to the other, and this is settled through accounts that the banks
hold at the Bank of England.
Topic 2 The Prudential Regulation Authority

and the Financial Conduct Authority
1. The three operational objectives of the FCA are:
u facilitating efficiency and choice in the market for financial services;

u protecting and enhancing the integrity of the UK financial system;
u securing an appropriate level of protection for consumers.

2. The PRA promotes the safety and soundness of deposit takers, insurers and
major investment firms seeking to minimise the adverse effects that they could
have on the stability of the financial system.

Topic 2 The Prudential Regulation Authority and the Financial Conduct Authority
3. Consumer protection can be achieved by:

u product governance and intervention;
u banning misleading financial promotions;
u publicising enforcement action.

4. The behaviour of firms and individuals relating to:
u customers’ interests: a firm must pay due regard to the interests of its
customers, and treat them fairly;
u communications with clients: a firm must pay due regard to the information
needs of its clients and communicate information to them in a way that is
clear, fair and not misleading;
u conflicts of interest: the way in which a firm must manage conflicts of

interest fairly, both between itself and its customers and between one
customer and another;
u customers’ relationship of trust: a firm must take reasonable care to ensure

the suitability of its advice and discretionary decisions for any customer who
is entitled to rely on its judgment; and
u clients’ assets: the adequate protection that a firm must arrange for clients’
assets when it is responsible for them.
5. To pass the ‘fit and proper test’ an individual must show their:
u honesty, integrity and reputation;

u competence or capability; and
u financial soundness.
6. The FCA expect that all firms must be able to show consistently that the fair
treatment of consumers is at the heart of their business. Firms are required to
provide management information as evidence.
7. Capital adequacy is a bank’s own funds (from shareholders), not money
deposited by investors, and should be sufficient so as to make it very unlikely
that customers’ deposits would be placed at risk.
8. Financial crime includes market abuse (insider dealing and market
manipulation) and money laundering.
9. A person who is appointed to carry out an investigation on the FCA’s behalf

has the power to demand that:
u the person being investigated or anyone connected with them:
− answer questions;
− provide information;
u any person (whether or not they are being investigated or are connected
with the person under investigation) provide documents. In the case of a
specific investigation, any person can also be required to answer questions
or provide information.
10. The main enforcement powers of the FCA are:

u variation of a firm’s permissions;

u withdrawal of approval;
u injunction;
u restitution;
u redress;
u disciplinary action;
u bring criminal prosecutions; and
u enhanced supervision.
Topic 3 Conduct of business rules

1. A new Conduct of Business Sourcebook was introduced to give firms increased
flexibility to decide how best to achieve regulatory outcomes in a way that
is suitable for their particular businesses. It also placed stronger emphasis
on senior management responsibility because the regulator considered that
senior managers are best placed to decide how to achieve the outcomes
required.
2. Retail client, professional client and an eligible counterparty.
3. The property must be in the UK and it must be residential to the extent that
the borrower or their immediate family must occupy at least 40 per cent of the
property. There is an exemption to the 40 per cent occupancy requirement in
respect of ‘consumer’ buy-to-let mortgages, which are regulated under MCOB.
4. Under MCOB 3, a distinction is drawn between real-time promotions (by
personal visit or telephone call) and non-real-time (by letter, email, or advert
in newspapers, magazines or on television, radio or the internet). Unsolicited
real-time promotions are not permitted. Customers must not be contacted
during ‘unsocial’ hours (9 pm to 9 am, and all day Sunday) with allowance made
for religious beliefs and working patterns. Non-real-time promotions must
include the name and contact details of the firm. They must be clear, fair and
not misleading, and if comparisons are used they must be with products that
meet the same needs. They must state that ‘your home may be repossessed if
you do not keep up repayments on your mortgage’. Records of non-real-time
promotions must be retained for one year after their last use.
5. Insurance Conduct of Business (ICOB).
6. ICOB 6 sets out the cancellation rights of retail customers. The cancellation
rights themselves are offered by the product provider but intermediaries must
be aware of them because it is their responsibility to inform customers of
their cancellation rights. For general insurance, the cancellation period is
14 days, while for pure protection contracts (eg critical illness cover) the period
is 30 days. If a customer cancels, the insurance company must return any sums
paid to it within 30 days of cancellation. For general insurance contracts, the
company can deduct any reasonable and genuinely incurred costs, including
a charge for time on risk, but the company must not make a profit and the
amount retained must not be capable of being interpreted as a penalty.
7. The Standards of Lending Practice.

Topic 5 Other rules and regulations relevant to advising financial services clients
8. Under BCOBS 5 a firm must provide a service in relation to a retail banking

service that is prompt, efficient and fair to a banking customer and which has
regard to any communications or financial promotion made by the firm to the
banking customer from time to time. This includes dealing with customers
in financial difficulty, those who wish to move bank accounts, and lost and
dormant accounts.
9. Banks, building societies, e-money issuers, money remitters, non-bank
payment card issuers and non-bank merchant acquirers.
10. Accounts where access to funds is restricted, for example, in fixed-term
deposits.
Topic 4 Complaints and compensation

1. The FCA defines a complaint as ‘any expression of dissatisfaction, whether
oral or written, and whether justified or not, from or on behalf of an eligible
complainant about the firm’s provision of, or failure to provide, a financial
service’.
2. It must ‘adequately address the subject matter of the complaint’. It must
also inform the complainant that if they are not satisfied, they can refer their
complaint to the FOS within six months of the date of the letter.
3. All complaints must be reported, even where resolved quickly.
4. (a) Banking and loans; (b) insurance; c) investment.
5. The FOS can make awards of up to £150,000, plus the complainant’s
reasonable costs. Awards are binding on the firm but not on the complainant,
who is free to pursue the matter further in the courts if they wish. An award is
not intended to punish the firm, but to put the complainant back into the same
financial position in which they would have been had the event complained
about not taken place.
6. Complaints are related to cases of maladministration, and it must be shown
that this has led to injustice (financial loss, distress, delay or inconvenience).
Disputes are disagreements about facts or about law.
7. Decisions are binding on all parties and can be enforced in the courts.
8. Retail consumers and small businesses.
9. It provides compensation arrangements for customers who have lost money
through the insolvency of an authorised firm causing the firm to fail.
10. Claims cannot be made for other losses due to say negligence, poor advice or
simply a fall in stock market values.
Topic 5 Other rules and regulations relevant

to advising financial services clients
1. It will need to apply to the FCA who assesses if a business and the persons
involved in it are fit to hold a licence before granting one. All licensees are
monitored by the FCA to ensure they are operating responsibly.

2. The APR represents a measure of the total cost of borrowing and its aim is
to allow a fair comparison, between different lenders, of the overall cost of
borrowing. The calculation of APR is specified under the terms of the Consumer
Credit Act 1974 and it takes account of two main factors:
u the interest rate − whether it is charged on a daily, monthly or annual basis;
u the additional costs and fees charged when arranging the loan, eg an
application fee.
The result is that the APR is higher than the actual rate being charged on
the loan; however it gives consumers the opportunity to make comparison
between different providers with the ability to compare ‘like with like’ on the
basis of total cost rather than simply headline rates, which are often used to
attract customers.
3. The aim was to make improvements in three broad areas.
u To enhance consumer rights and redress. Consumers are able to challenge
unfair lending and will have access to more effective options for resolving
disputes.
u To improve the regulation of consumer credit businesses by ensuring fair
practices and through ‘targeted action to drive out rogues’.
u To make regulation more appropriate for all kinds of consumer credit
transaction. Protection is being extended to all consumer credit and to
create a fairer regime for business.
4. The role of TPR is to regulate occupational pensions schemes − ie schemes that
employees join that are run by their employers. It has a number of statutory
objectives that include:
u to protect the benefits and rights of members of occupational pension
schemes;
u to protect members of personal and stakeholder pension schemes where
employees have direct payment arrangements;
u to promote, and improve understanding of, the good administration of
work-based pension schemes;
u to reduce the risk of situations arising that may lead to claims for
compensation from the Pension Protection Fund;
u to maximise employer compliance with employer duties and safeguards
under the Pensions Act 2008 (including the requirements in respect of
auto-enrolment);
u (in carrying out its duties) to minimise any adverse impact on the
sustainable growth of an employer.
5. The Consumer Rights Act 2015 covers:

u what to do when goods are faulty;
u how services should match up to what has been agreed, and what should
happen when they do not;
u what should happen when goods and services are not provided with
reasonable care and skill;

Topic 5 Other rules and regulations relevant to advising financial services clients
u unfair terms in a contract;

u the greater flexibility for public enforcers, such as the FCA or Trading
Standards, to respond to breaches of consumer law.
6. All advertisements should be:
u legal, ie containing nothing that breaks the law, or incites anyone to do so,
and omitting nothing that the law requires;
u decent, ie containing nothing that is likely to cause serious or widespread
offence, judged by current prevailing standards of decency (account is
taken of the context of the advertisement, the medium used and the likely
audience; particular care should be taken with sensitive issues such as race,
religion, sex or disability);
u honest, ie not exploiting the credulity, lack of knowledge or inexperience
of consumers;
u truthful, ie not misleading by inaccuracy, ambiguity, exaggeration,
omission or any other means.
7. The areas covered by the Standards of Lending Practice are:
u financial promotions and communications;

u product sale;
u account maintenance and servicing;

u money management;
u financial difficulty; and
u consumer vulnerability.
8. Mortgage lending (this is covered by MCOB).

9. ‘Processing’ has a very broad meaning, covering all aspects of owning data,
including:
u obtaining the data in the first place;
u recording of the data;
u organisation or alteration of the data;

u disclosure of the data by whatever means;
u erasure or destruction of the data.

10. The data must be adequate but not excessive, it must be kept accurate and
up to date, it must not be kept longer than is necessary, and it must be kept
secure from accidental or deliberate misuse, damage or destruction.

Topic 6 Clients’ needs and managing money

1. Goals are a client’s non-financial future aspirations; needs are the financial
requirements that help them achieve those goals; and objectives are the
actions a client needs to take to help them achieve their goals.
2. It can help to categorise customers into ‘market segments’ for marketing and
promotional purposes.
3. A budget is required as affordability is one of the key factors a lender will take
into account when assessing a mortgage loan application.
4. The financial impact due to death, illness or unemployment.
5. In the event of their death, the normal earner may have to give up work to look
after the children or may have to meet the cost of full-time childcare.
6. On the death of one of the partners, the beneficiaries of that partner’s estate
(often their spouse and/or family) may wish to withdraw their share of the
partnership’s value. This can cause problems for the remaining partners
because it might mean that they will have to sell partnership assets to
pay the deceased partner’s family. Since much of the value may be in the
form of ‘goodwill’, it may not be possible to realise it except by selling the
whole business. ‘Goodwill’ is that intangible and yet real portion of the value
of a business that relates to the firm’s good name or reputation. In such
circumstances, the need for partnerships to insure against the death of each
partner − in order to buy out their share − is clear.
7. ‘Over-indebtedness’ broadly means that a borrower has taken on too much
debt, often from a variety of different sources, and for some reason starts
to have difficulty in repaying. As soon as the borrower is late paying loan
repayments (arrears) or goes over overdraft limits (excesses) their credit-rating
is downgraded and they will have problems borrowing further to ‘catch up’.
8. Before the recent credit crunch, homeowners with equity in their property
were able to extend their mortgage loans, using the increasing value of
their properties to fund their spending habit and clearing their outstanding
overdrafts and credit cards, only to start again. However, this ‘easy way out’ of
debt was closed following the credit crunch, as property prices fell and it was
more difficult to obtain mortgage loan borrowing.
Topic 7 Customer needs for future income

1. Generally, deposit accounts provide a more secure investment because interest
is added to the investment and the capital is not put at risk at any point. Even if
the provider were to pay no interest, the capital would be secure − but deposit
accounts pay interest at low rates, often not even equal to the rate of inflation.
Because of this the value of the deposit is eroded over time.
2. A ‘low-risk’ investment is likely to fluctuate less widely than a ‘higher-risk’

investment. A ‘high-risk’ investment has the potential for making larger gains
but also has the potential for suffering larger losses. This is commonly known
as the concept of ‘risk versus reward’. In general, the higher the risk, the higher
the potential reward or loss.

Topic 7 Customer needs for future income
3. Interest rate risk can show itself in four main ways.

u Borrowers with a variable-rate mortgage loan run the risk that the interest
rate will rise and increase their costs.
u Savers in variable-rate accounts run the risk that the interest rate will reduce.
This is a particular risk for those who have retired and who depend on
income from savings.
u Those on a fixed-rate mortgage run the risk that a reduction in variable rates
will leave them paying more than they would in the current market. Many
borrowers will take comfort in the security of knowing that their mortgage
will not increase over the fixed term and may be prepared to accept the
downside.
u Those saving in fixed-rate savings accounts may receive a lower rate relative
to the market if rates increase, but will be unable to withdraw their money
without penalty.
4. The considerations are: the timescale of the investment; the client’s age and
life stage; the client’s current and future financial circumstances; and the
customer’s objectives.
5. The customer’s attitude to risk can be established by asking:
u what investments they might already have (or have had);
u how they feel about these investments;
u how the investment has performed;
u whether there is anything that concerns them about the investments;
u how they would feel if the value of their investment were to go down;
u how they feel about the risk−reward relationship;
u what they need the proposed investments to achieve;
u how important it is to achieve that objective;
u how important is the security of capital.
The answers to these questions should be considered together with the
customer’s objectives and timescale.
6. There are two broad purposes behind why people invest, which are to provide
income − either now or in the future − or a capital lump sum. There may be
an underlying reason or sometimes there is no specific purpose in mind.
7. Low inflation and low interest rates tend to go together, and one effect of this
is that people tend to suffer from the so-called money illusion − ie they tend to
think of interest rates in their nominal sense and not to adjust their thinking
to allow for inflation. Both savers and borrowers can be affected.
8. Pensions can be provided by the state, employers or from a client’s own
personal pension plan.
9. Clients should be encouraged to make their own pension provision as the
state scheme is in what could be called a ‘crisis’. The extent of the problem
is illustrated by the fact that recent estimates of the total shortfall in pension
provision, popularly known as the ‘savings gap’, have varied between £27bn

and £33bn. Statistics show that 90 per cent of people now live to the age at
which they receive their state pension, compared with 66 per cent of people
only 50 years ago, and those who do collect their pension receive it on average
for eight years longer than did pensioners in the early 1950s.
10. Income tax, capital gains tax and inheritance tax.
Topic 8 Overview of financial services

products
1. The convenience of the readily accessibility of the funds and to some extent
the inertia of looking for other forms of investment. Investors perceive banks
and building societies to be safe places to keep their money as the risk of
insolvency and failure of these organisations is low. In any event it is protected
(within certain limits) by the FSCS.
2. Peace of mind, control over the availability of funds and value for money.
3.
u Whole-of-life policies do exactly as their name suggests − provide a lump
sum of money, upon death, whenever that death occurs.
u Term assurances, again, do as the name suggests − if a death occurs during
the specified term of the plan, a sum of money agreed at the start of the
plan will be paid out. This is usually a lump sum, but one version of term
assurance, called a family income benefit, will pay out an income upon
death during the term.
4. Critical illness cover provides a lump sum in the event of diagnosis of one of a
range of predetermined serious conditions or if the insured suffers a serious
and permanent disability.
5. The parties involved in a mortgage are:
u the mortgagor: the individual borrower who transfers their property to the
lender for the duration of the loan;
u the mortgagee: the lender (bank, building society or other institution) who
has an interest in the property for the duration of the loan.
6. With a repayment mortgage, the borrower makes monthly repayments to the
lender and each monthly amount consists partly of interest and partly of
capital repayment: the higher the interest rate (for any given mortgage amount
and term), the higher the monthly repayment.In the case of an interest-only
mortgage loan, the monthly payments made to the lender are solely to pay
interest on the loan. No capital repayments are made to the lender during
the term of the loan and the capital amount outstanding therefore does not
reduce at all. The borrower still has the responsibility of repaying the amount
borrowed at the end of the term, and this is normally achieved through
the borrower making regular payments to an appropriate savings scheme,
although the loan might be repaid out of other resources, eg from the proceeds
of a legacy.
7. A second mortgage is one that is created when the borrower offers the property
for a second time as security while the first lender still has a mortgage secured
on the property. The new lender takes a ‘second legal charge’ on the property.
The original lender’s first charge takes precedence over this second mortgage

Topic 9 Economic factors
and any subsequent charges. This means that, in the event of a sale due to
default, the original lender’s claim will be met first in full (if possible) and, if
sufficient surplus then remains, the second mortgagee’s charge will be met.
8. Personal loans, overdrafts and revolving credit (via credit cards).
9. Ordinary shares, also known as equities, are the most important type of
security that UK companies issue. They can be, and are, bought by private
investors, but most transactions in equities are made by institutions and by life
and pension funds. Loan stocks and debentures are also issued by companies
to raise finance. These types of borrowing are usually over the longer term,
which helps the company to make long-term business plans.
10. Collective investments help to spread risk and costs, and use the expertise
of professional fund managers. There is a wide choice of investment funds
catering for all investment strategies, preferences and risk profiles.
11.
u Defined-benefit (final salary) − the employee will receive a pension that is
calculated using a set formula. The scheme will provide benefits on the
basis of an accrual rate, such as 1/60th, and benefits are accrued or earned
in line with the accrual rate for each year the individual is a member of the
scheme. The longer the employee has been a member of the scheme, the
higher the percentage of their final salary they will receive as pension. For
example, an individual who has been a member of a scheme with an accrual
rate of 1/54th for 36 years would be entitled to a pension of two thirds of
final salary upon retirement.
u Money-purchase (defined-contribution) − an agreed contribution is invested

for each member. On retirement, the accumulated fund is used to purchase
benefits. The level of benefits is not guaranteed by the employer.
12. A SIPP is a self-invested personal pension. It allows investment in a broader
range of investments that are not permitted in normal personal pensions.
SIPPs are primarily intended for people with more complicated arrangements
and larger pension funds.
Topic 9 Economic factors

1. Disinflation is the term for falling inflation. It should not be confused with
deflation, because, with disinflation, prices still rise, but not at the previous
rate.
2. The Retail Price Index (RPI) is an index based on a ‘basket of goods and services’
selected to reflect the expenditure of an average household. The rate of RPI will
increase or decrease in line with changes in the prices of the goods and services
included in the basket. The RPI is used to calculate increases in pensions,
benefits and index-linked gilts.
3. Those who save in any interest-bearing savings scheme such as deposit
accounts and gilts.
4. Mortgage loans secured on property tend to charge relatively low rates of

interest. Secured borrowing is less risky because there is an asset that can be
sold to repay the debt if necessary. Credit cards generally charge high rates of
interest. The borrowing is not secured, the term is open-ended and providers
must cover the cost of fraud protection and other requirements.

5. A number of economic factors will influence interest rates. These are the level
of government borrowing, higher levels of individual borrowing, monetary and
fiscal policy and foreign interest rates.
6. The ageing population.
7. Most UK income is generated by economic activity in the UK, and this is known
as the domestic product. The gross domestic product (GDP) is the term used for
the total of income from UK economic activity and is the measure of economic
growth.
8. The interest rate cycle.
9. The government’s fiscal policy comprises its approach to spending in the

public sector, borrowing and tax. Monetary policy covers the use of the money
supply and interest rates to control inflation and the economy.
10. The balance of payments is the record of one country’s trade with the rest of
the world; in the case of the UK, it is calculated in sterling. Money coming in
to the country is known as a credit and money going out is known as a debit.

Topic 10 UK taxation and state benefits
Topic 10 UK taxation and state benefits

1. Income assessable to tax includes:
u salary/wages from employment, including bonuses and commissions, and

taxable benefits in kind;
u pensions and retirement annuities, including state pension benefits;
u profits from a trade or profession;

u inventor’s income from a copyright or patent;
u tips;
u interest on bank and building society deposits;

u dividends from companies;
u income from government stocks and local authority stocks;

u income from trusts;
u rents and other income from land and property;
u the value of benefits in kind, such as company cars or medical insurance.

2. Form P60, issued each year to the employee by the employer.
3. No − dividends are not subject to the deduction of income tax and are dealt
with by the use of tax credits, but the result to the taxpayer is the same.
4.
Earned income £43,775

No tax is due on John’s £300 gross interest
as it falls within his £500 personal savings
allowance.
Less personal allowance (£11,000)
£32,775 Tax
payable
20% tax on first £32,000 £32,000 £6,400
40% tax on amount remaining £775 £310
Tax due £6,710
5. Julie is a higher-rate taxpayer as her taxable income is £91,000 − £11,000 =

£80,000. No tax is due on the dividend income as it falls within the dividend
allowance of £5,000. As a higher-rate taxpayer Julie is entitled to a personal
savings allowance of £500; tax at 40% is payable on £400 (£900 − £500) x
40% = £160.
6. Assets that are exempt from CGT include:
u main private residence;

u ordinary private motor vehicles;

u personal belongings, antiques, jewellery and other tangible movable

objects (referred to as ‘chattels’), provided each object is valued at £6,000
or less;
u gifts to the nation of items of national, historic or scientific interest;

u foreign currency for personal expenditure;
u UK government stocks (gilts);
u NS&I Savings Certificates and Save As You Earn schemes;

u Premium Bond winnings and lottery winnings;
u gains on qualifying life assurance policies disposed of by the original

owners;
u individual savings accounts (ISAs).
7. Potentially exempt transfers (PETs) are gifts made during a person’s lifetime
that are not subject to tax at the time of the transfer. If the donor survives for
seven years after making the gift, these transactions become fully exempt and
no tax is payable. If the donor dies within seven years of making the gift, and
the value of the estate (including the value of any gifts made in the preceding
seven years) exceeds the nil-rate band, inheritance tax becomes due.
8. The supply of financial advice is not exempt from VAT and advisers who charge
a fee for their service are subject to VAT in the same way as solicitors or
accountants.
9. Stamp duty is payable by the purchaser in respect of certain transactions,

notably purchases of securities and of land. It is a tax imposed on the
documents that give effect to the transaction (eg conveyances of property or
stock transfer forms) and is calculated as a percentage of the purchase price.
10. Corporation tax is paid by limited companies, clubs, societies and associations,
by trade associations and housing associations, and by co-operatives.
Topic 11 Principles of financial protection:

Existing provision
1. Working Tax Credit is designed to top up the earnings of employed or
self-employed people who are on low incomes; this includes those who do
not have children. There are extra amounts for:
u working households in which someone has a disability; and
u the costs of qualifying childcare.
2. Statutory Maternity Pay, Maternity Allowance, Child Benefit and Child Tax
Credit.
3. Statutory Sick Pay (SSP) is paid by employers to employees who are off work
due to sickness or disability for four days or longer. To qualify, claimants must
earn more than the lower earnings limit (LEL). SSP is paid for a maximum of
28 weeks in any spell of sickness. Spells of sickness with less than eight weeks
between them count as one spell.

Topic 12 Financial protection products
SSP is payable to employed people whose average weekly earnings are above
the level at which NICs are payable. Amounts paid as SSP are subject to tax
and to NI deductions, just as normal earnings would be. People who are still
sick after 28 weeks may be able to claim short-term Employment and Support
Allowance.
4. Employment and Support Allowance.
5. People who need help with personal care and/or need help getting around.
6. Those people in residential or nursing care whose savings exceed £16,000.
7. State pensions are designed to provide little more than a subsistence-level
living standard.
8. Entitlement to new state pension is based on NICs with some entitlement once
NICs (Class 1, 2 or 3) have been paid for at least 10 years and maximum benefit
after 35 years. Upon reaching state pension age a comparison is done to see
whether a person would receive more pension based on entitlement to basic
/ additional state pension or if the new state pension had existed throughout
their whole working life; the higher amount is awarded as their starting amount
under the new state pension.
9. To keep down the costs of providing benefits and to encourage people to get
back to work as soon as possible.
10. State benefits affect the need for protection and financial circumstances can
affect entitlement to benefits through means-testing.
11. There are a number of factors when deciding how much protection cover
is required. There is no single rule for calculating the amount of cover
required but it is usually based on quantifying the shortfall in income that
the dependants would suffer. The shortfall can be expressed as the difference
between:
u how much protection would actually be needed if the risk event happened;
and
u how much protection the client currently has.
12. The cancellation of existing policies and their replacement with similar ones.
The regulator takes a dim view of this practice.
Topic 12 Financial protection products

1. A whole-of-life assurance policy is designed to cover the life assured for the
whole of their lifetime. It will pay out the amount of the life cover in the event
of the death of the life assured, whenever that death occurs, provided that the
policy remains in force.
2. Reversionary bonuses are normally declared each year; once they have been
allocated to a policy they cannot be removed by the company, provided that
the policy is held until the end of the term or earlier death.
3. Benefits and options that may be added include:
u permanent health insurance;
u critical illness cover;

u accidental death benefit;

u total and permanent disability cover;
u hospital benefits or other medical cover;
u guaranteed insurability (to increase cover);

u indexation of benefits;
u flexibility of premium levels;

u waiver of premium during periods of inability to pay due to, for instance,
disability or unemployment.
Most of the additional benefits will be at extra cost, the additional cost being
met by cashing more units.
4. There is no cash surrender value for this type of policy.
5. The range of illnesses and conditions covered varies from one insurer to
another but would typically include the following:
u most forms of cancer;

u heart attack;
u stroke;
u coronary artery disease requiring surgery;
u major organ transplant;
u multiple sclerosis;
u kidney failure.
Other conditions that are sometimes covered are:

u paralysis;
u blindness;
u loss of limb(s).
6. The type of occupation of the life insured, plus:
u the age of the life insured;

u the amount of benefit;
u current state of health;
u past medical history;
u the length of the deferred period.
7. Normally one month.

8. The range of cover normally provided by PMI includes reimbursement of:

Topic 13 Investment products
u inpatient charges including nursing fees, accommodation, operating fees,

drugs and the cost of a private ambulance;
u surgical and medical fees including surgeon’s fees, anaesthetist’s fees,
pathology and radiology;
u outpatient charges including consultations, pathology, radiology and home
nursing fees.
9. Premiums are subject to insurance premium tax but the benefits are paid out
tax-free.
Employers who contribute to PMI on behalf of their employees are able to claim
the cost as an allowable deduction against corporation tax.
Contributions paid by an employer are regarded as a benefit in kind as far as
the employee is concerned and may be taxable.
10. The need for this cover has increased because families are more spread out
than in earlier generations and less able to take care of elderly relatives.
The problem has also been exacerbated by the fact that life expectancy has
increased and people’s expectations for their quality of life in later years are
higher than ever. There has been growing concern over the standard of care
that state support and the NHS can realistically be relied upon to provide.
Topic 13 Investment products

1. Cash, fixed-interest securities, equities and property.
2. Individuals who have very large amounts of cash to invest in short-term
deposits until they commit these sums to other purposes.
3. A higher-rate taxpayer receives a personal savings allowance of £500; total
savings income within this allowance is free of tax with any excess taxed at
40 per cent.
4. Offshore investment can potentially expose the investor to greater risk than
a similar onshore investment. Firstly, the account may not be denominated
in sterling and will therefore be at risk of adverse currency movements if the
investment is to be converted back to sterling at some point. Secondly, not
all offshore accounts are protected by investor protection schemes. Investors
should check what protection is available through local regulatory regimes.
5. A ‘tax wrapper’ is a scheme (recognised by HMRC) placed around other forms
of investment to grant them favourable tax treatment, so encouraging saving.
6. Par value is the issue value of the gilt, normally quoted as a nominal £100.
7. Gilt prices are quoted either cum dividend or ex dividend. If a stock is bought
cum dividend, the buyer acquires the stock itself and the entitlement to the
next interest payment. If, however, the stock is bought ex dividend, then while
the buyer acquires the stock itself, the forthcoming interest payment will be
payable to the previous owner of the stock (ie the seller).
8. Holders of ordinary shares (shareholders) are in effect the owners of the
company. The two main rights that they have are: (a) to receive a share of the
distributed profits of the company in the form of dividends; (b) to participate in
decisions about how the company is run, by voting at shareholders’ meetings.

9. The financial returns that shareholders hope to receive from their shares take
two forms: the growth in the share price (capital growth) and the dividends
they receive as their share of the company’s distributable profits (income).
There are a number of measures that can be used to assess the success of
investment in a company’s shares and to predict future performance; these
include earnings per share, dividend cover and the price/earnings ratio.
10. The Stock Exchange Daily Official List gives the closing prices of all listed
securities on the previous day. The Financial Times and other newspapers
produce daily lists of the share prices of most companies, making it easy to
check up-to-date share prices.
11. London Stock Exchange rules require that, when an existing company that
already has shareholders wishes to raise further capital by issuing more shares,
those shares must first be offered to the existing shareholders. This is done by
means of a rights issue offering, for example, one new share per three shares
already held, generally at a discount to the price at which the new shares are
expected to commence trading. Shareholders who do not wish to take up this
right can sell the right to someone else, in which case the sale proceeds from
selling the rights compensate for any fall in value of their existing shares (due
to the dilution of their holding as a proportion of the total shareholding).
12. Property investment has a number of benefits and advantages:
u Property is a very acceptable form of security for borrowing purposes.
u The UK property market is highly developed and operates efficiently and
professionally.
u Rents (and therefore capital values) tend to move with money values and
consequently provide a good hedge against inflation.
u Professional property management services are readily available.
The significant fall in property values in 2008 was a timely reminder that
property can prove to be a risky investment in the short term.
Topic 14 Indirect investments and other

investment types
1. A unit trust is divided into units, with each unit representing a fraction of the
trust’s total assets. A unit trust is open-ended in the sense that a manager can,
in response to demand, create more units.
2. Many unit trusts use bid and offer prices, with the difference between them
(known as the bid−offer spread) being of the order of 5−6 per cent.
3. When income is paid by an equity unit trust, it is classed as dividend income.
A basic-rate taxpayer has no tax liability on the income as long as the dividend
falls within their dividend allowance of £1,000. If the dividend is above £1,000
(either on its own or when added to other dividend income) then it is taxed at
7.5 per cent.
4. OEICs buy and sell the shares of other companies and deal in other
investments.
5. A liability to CGT may arise for the investor when the OEIC is encashed.

Topic 15 Pensions
6. Investment trusts are public limited companies whose business is investing

(in most cases) in the stocks and shares of other companies. The number of
shares in the investment company remains the same (as with other companies)
so for this reason an investment trust is said to be closed-ended.
7. If the policy is surrendered (ie cashed in before its maturity date), however,
a deduction is made from the value of the units. This deduction, the size of
which depends on market conditions at the time of the surrender, is known as
a market value adjustment (MVA).
8. With the investment being outside the jurisdiction of the FCA it would be a
wise move for investors to consult only those advisers who are regulated in
reputable jurisdictions, where there is proper regulation, and some kind of
redress for poor advice.
9. Indirect investment in commodities is carried out through the medium of

‘forward contracts’, ie binding agreements made now under which one party
must sell and the other party must buy a specified amount of a commodity at
a specified price on a particular date in the future.
10. Treasury bills, certificates of deposit and commercial paper.
Topic 15 Pensions
1. Contracting out, now abolished, enabled scheme members to forgo their rights
to the additional state pension. In return they would pay a lower level of
National Insurance contributions (NICs) with the reduced NICs rebated into
an alternative pension arrangement. As those who contracted out had their
NICs redirected, their entitlement to the new ‘single-tier’ state pension will be
reduced when they reach state pension age.
2. Unfunded schemes are known as pay-as-you-go schemes. An example of an
unfunded scheme in the public sector is the civil service pension fund. The
government (the employer) and the civil servants (employees) do not make
contributions. The money required to provide benefits on retirement is simply
taken from the public purse as required rather than invested into assets to
provide funds at a later time.
3. The employer is unable to forecast accurately the cost of the scheme because
a member’s ‘final earnings’ will be very difficult to predict. Nonetheless, since
benefits are defined, the employer must ensure that the pension fund is
sufficient at all times to meet the benefit promises made. It might be said
that the employer is bearing the risk in this sort of scheme − if there is a
shortfall, it must make it up. There have been problems in recent years with
employers facing difficulties with the investment performance of the pension
fund and the closure of final salary schemes (to new members) or changing
the benefit structure as a result.
4. There are three ways in which a member can make pension contributions to
enhance the benefits from a company scheme:
u stakeholder/personal pensions.

5. All employees can now contribute to stakeholder/personal pensions. FSAVCs,

which are generally more expensive, are therefore expected to become
obsolete.
6. The maximum level of tax-relieved pension contribution an individual can
make during a tax year is limited by a person’s earnings and also by the annual
allowance (£40,000 in 2016/17). The annual allowance is reduced to £10,000
where a scheme member flexibly accesses their pension benefits through
flexi-access drawdown or UFPLS. It can also be reduced where someone earns
in excess of £150,000 per year. Where someone has no earnings they can
contribute £3,600 (gross) to a pension.
7. Any higher-rate tax relief due will need to be claimed back via annual
self-assessment/personal tax returns. For those higher-rate taxpayers who
make payments on account, a contribution to a personal pension will reduce
the income tax payable as a balancing payment by 31 January following the
end of the tax year.
8. A list of allowable investments for inclusion within a SIPP would be:

u unit-linked or unitised with-profits insurance funds;
u unit trusts, OEICs, investment trusts;
u deposit accounts;
u equities (quoted on a recognised stock exchange);
u bonds;
u commercial property;
u derivatives.
9. The maximum tax-free pension commencement lump sum that may be taken
is 25 per cent of the value of pension benefits. This must be payable when the
scheme member first crystallises all / some of the benefits payable under the
pension arrangement (or within three months of crystallisation).
10. Scheme pension (the only option in a defined-benefit scheme), lifetime annuity,
drawdown pension (through flexi-access drawdown or by using a pre-6 April
flexible drawdown arrangement) or uncrystallised funds pension lump sum
(UFPLS) drawdown.
Topic 16 Mortgage loans and associated

products
1. These policies have not performed well in the last few years and as a result
many mortgage providers no longer accept them as repayment vehicles for
mortgage loans because they tend not to reach a sufficient value to repay the
loan.
2. There are three main benefits.

Topic 16 Mortgage loans and associated products
u A tax-free lump sum is allowable from a pension on retirement and this can
be used to repay the mortgage loan. If the scheme is a money-purchase
arrangement it is possible that further, taxable, lump sums may be drawn.
u Pension contributions qualify for tax relief at a person’s highest rates of
tax, making it a tax-efficient way of saving.
u The fund in which the contributions are invested is not subject to tax on
capitals gains (in the same way as an endowment policy for example), which
means it should grow at a faster rate.
3. The potential drawbacks are as follows.
u The limits on annual contributions can make it difficult to pay back a loan
quickly or to fund a large loan. This is less of an issue for couples, as they
are each allowed to invest their individual maximum, but it is not normally
possible for these funds to be held together in order to accumulate at a
faster rate.
u If growth rates do not match the initial assumptions, the final lump sum
will fall short of the mortgage amount − unless additional investments have
been made.
u In the event of premature death, the value of the ISA investment is unlikely
to be sufficient to repay the loan. Additional life assurance cover is required
to meet this eventuality, meaning there is an additional cost.
4. A fixed-rate mortgage option allows the borrower to ‘lock in’ to a fixed interest
payment for a specified period, usually between one and five years. At the end
of the period, the rate reverts to the lender’s prevailing variable rate. There is
often a substantial arrangement fee, however, and there may be restrictions
or penalties on changing to another lender.
5. This would suit a borrower who had large cash balances on their accounts. They
might be unwilling to tie these into other forms of investment or, for example,
might receive payment for large expenses claims from their employers that
create large balances for a couple of weeks each month.
6. This type of mortgage will suit borrowers who want to keep the costs down in
the early years. Examples might be young professionals or others who are just
starting out in the world of work.
7. CAT-standard mortgages are those that meet specific standards in relation to
charges, access and terms; the intention behind their introduction was to avoid
confusing marketing and hidden charges.
8.
u Lifetime mortgages are designed mainly to enable elderly homeowners who
do not have a mortgage on their property to release some of the equity
in order to supplement their retirement income. The customer takes an
interest-only loan, secured on their property, which is mortgaged in the
normal way. Interest is allowed to roll up and is repaid, along with the
original loan, when the property is sold on the death of the borrower (or
second borrower, if a couple).
u Home reversion schemes involve the homeowner selling all or part of their
property to the company in return for an income for life. The customer(s)
retains the right to live in the house until their death(s), after which the
company sells the property and retains all the proceeds. The FCA regulates
these schemes even though they do not involve a mortgage loan.

9. This type of scheme (usually arranged by housing associations) enables those

on relatively low incomes to become owner-occupiers, even though they cannot
afford a conventional mortgage. As the borrower increases their share in the
property, the mortgage element increases and the rented element reduces.
This process of increasing one’s share in the property is sometimes called
‘staircasing’.
10. A lender is permitted by law to:

u insist that a property subject to a mortgage is continuously insured by
means of a policy that is acceptable to the lender;
u have its interest as mortgagee noted on the policy;

u secure a right over the proceeds of any claim and to insist that the proceeds
be applied to remedy the subject of the claim or to reduce the mortgage
debt.
Topic 17 Interacting ethically with clients

1. Mis-selling − it involves advisers recommending services that are not suitable
or making exaggerated claims about the likely performance of the service.
Some advisers can be tempted to do this in order to meet sales targets and
customers, with little knowledge, tend to go along with recommendations on
the basis of trust.
2. An adviser or planner (approved person) must:

u act with integrity in carrying out their controlled function;
u act with due skill, care and diligence in carrying out their controlled
function;
u observe proper standards of market conduct in carrying out their controlled
function;
u deal with the FCA and with other regulators in an open and cooperative
way and disclose appropriately any information of which the FCA would
reasonably expect notice.
3. Real-time financial promotions cover, for example, personal visits and
telephone conversations. Non-real-time financial promotions cover, for
example, newspaper advertisements and those on internet sites.
4. Cold calls are not permitted in relation to mortgage contracts.
5. ‘Know your customer’ relates to the need to take reasonable steps to find
out and record all details of the customer that relate to products and services
offered. Unless an adviser or planner has all the relevant information about
a customer it is impossible for them to understand their goals, needs and
objectives and so recommend the most suitable products.
6. Competence can be assessed by the adviser achieving an adequate level
of knowledge and skill to operate when being supervised and passing the
relevant regulatory module of an appropriate examination. Individuals must
work under close supervision until they have been assessed as competent.
Individuals must not be assessed as competent until they have passed all

Topic 18 The sales process: Part 1
modules of an appropriate examination and demonstrated a consistent ability

to act competently under minimum supervision.
7. Eligible counterparty, professional client and retail client.
Case study 1
1 Answer c) is the best course of action. Answer a) is incorrect because the amount
available is not actually known; b) is incorrect because Geri cannot make this
decision for the client in order to help her meet targets; d) is incorrect because
the investment required is to be in joint names and pensions have to be in sole
names.
2 Answer d) is the best course of action. Answer a) is incorrect because she can
discuss the issue in general terms; b) is incorrect because she is not qualified
to talk in this level of detail; and c) is incorrect because at this point she cannot
know what savings can be made.
3 Answer b) is the best course of action, although this highlights the need to
ensure that advisers are fully competent. Answer a) is incorrect as this is not
the most suitable advice for the client and Geri must put his needs before
the needs of the bank; c) is incorrect because the amount is below the IFA’s
threshold and Geri does not need to pass up this opportunity; d) is incorrect as
this is not acting in the best interests of the client.
4 Answer b) is the best course of action as Geri really needs to see the complete
picture. Answer a) is incorrect, although the customer will make the final
choice; c) may not be appropriate at this point and may be considered by some
customers to be a little forward; and d) is incorrect as it is avoiding the issue
entirely.
Case study 2
5 Answer c) is correct. Answers a) and b) are unacceptable courses of action.
Answer d) may be a little hasty as this could have been a genuine oversight and
not worth souring a working relationship for.
6 Answer d) is correct. This person may be in need of savings for an emergency
and putting funds into a stakeholder pension ties them up until retirement.
Answer a) is true up to a point; however, advisers need to find out about
customers’ circumstances and aspirations and help them to make decisions
based on these facts. Answer c) is untrue as stakeholder pensions are
tax-efficient for those with even no income.
7 Answer d) is the correct answer. While the other answers may be true, d) is the
one that will affect the customer most.
8 Answer c) is the correct answer − without having income and expenditure details
confirmed it is unwise to indicate that a mortgage offer can be made because
proving affordability is very important in mortgage advice. It is acceptable to
ask for the information in mentioned in answers a) and b) and it is also possible
to discuss what type of mortgage product is likely to be most suitable.

1. In any prospecting exercise, to remain compliant with regulations it is
important that nothing should be said to the customer that might be construed

as advice. It is important to talk about the benefits of having financial advice

without making claims about products that could be offered.
2. Execution-only transactions should be confirmed by obtaining the client’s
signature to the effect that the transaction is execution-only. Similarly, where
a non-execution-only client wishes to effect a transaction that disregards any
advice given, the adviser should require the client to sign to that effect.
3. A business card and a services and costs disclosure document.
4. Factfind.
5. If the client is divorced or separated it is important to understand the
terms of any maintenance arrangement, property arrangements and pension
splitting/sharing arrangements.
6. Fixed (or essential) expenditure is that expenditure that must be met every
month, such as food, heating, insurance, council tax and so on. The client
must pay these costs. Discretionary expenditure is spending that could be
stopped or reduced if necessary, or part of the money could be diverted to
other things. Although holidays are important, a family would not lose their
house or starve if they chose not to fund a holiday, whereas missing a mortgage
payment could lead to serious problems.
7. Establishing a ‘soft fact’.
8. They need to ask the client to sign letters of authority to existing product
providers to obtain up-to-date information on policy benefits and investment
details.
9. It is flawed because the result will always be subjective and reliant on
the quality of the questions, the adviser’s explanations and the client’s
understanding of the process and the questions.
10. Client attitudes to risk can be broadly categorised as follows.
u No risk/risk averse − not prepared to take any risk at all.
u Low risk/cautious − may be prepared to take a very small element of risk
if convinced that it is necessary.
u Medium risk/balanced − accepts that some risk may be necessary with
some of their available money but would prefer any risk to be controlled.
u Medium to high risk − relatively happy to gamble with a larger part of their
capital if the potential reward is attractive, and accept losses as part of the
bigger picture.
u High risk/adventurous/speculative − prepared to take a high level of risk
in order to achieve growth.

1. Net worth can be established by subtracting outstanding liabilities from the
value of assets held. Part of this will involve undertaking a valuation of any
existing investments.
2. A suitability report explains why the particular product recommended is
suitable for the client based on their particular personal and financial

circumstances, their needs and priorities as identified through the fact-finding

process and their attitude to risk (both in general terms and in relation to the
specific recommendations made). The report should also identify any potential
disadvantages of the transaction for the client, such as any ‘lock-in’ period. It
should be clear and concise and written in plain English.
3. Where the client wishes to deal with the firm, and prior written disclosure
would delay the transaction (for example, when the business is being arranged
by telephone), the firm can make the disclosure verbally before the transaction
is executed and provide written confirmation immediately thereafter.
4. Written details of the products’ key features must be provided to clients before
the sale is concluded.
5. Clients have the right to withdraw from contracts. The time period is most
commonly 14 days (30 days for protection policies) and runs either from the
date when the contract begins or from the date on which the client receives
the contractual terms and conditions if this is later. The notice must be sent
by post direct from the product provider to the client.
6. The customer can withdraw from the contract at any time during the cooling-off
period, without any commitment or loss, by returning the signed cancellation
notice to the product provider. Generally the customer will receive a full
refund of any premiums paid if they cancel the contract during this period.
The exception to this is where the customer cancels a lump-sum unit-linked
investment where the money has been invested and the value of the investment
has fallen. Under these circumstances, the customer is entitled to a refund of
the reduced investment: no charges can be taken but an adjustment can be
made to reflect the fact that the value of the lump sum has fallen. This risk
should be explained to the customer before the contract is effected.
7. The information obtained through the factfind must be retained for a specified
period of time, depending on the nature of the product recommended. These
periods are:
u indefinitely for pension transfers/opt-outs and free-standing additional

voluntary contributions;
u five years for life policies, pension contracts and MiFID business;
u three years for all other products.

8. Many organisations require advisers to work to a script, which follows the
input of information into the electronic factfind. This ensures that what is
said to the client is compliant with regulations and all the necessary data
is collected. There have been complaints that telesales advisers have not
followed compliance procedures (especially in the case of pure protection and
PPI policies) which have led to scripts being developed.
9. They are good for exploring client attitudes and feelings and for expanding on
information.
10. Acknowledgement can be given non-verbally by nodding, smiling, putting the

pen down and leaning back, leaning forward and other subtle gestures. It can
also be given verbally by agreeing, asking follow-up questions, summarising
and so on.

Topic 20 Key legal concepts

1. Legal persons in the context of financial services refers to those who have a
separate legal existence and can, therefore, enter into contracts or be sued
in a court of law. It is important to remember that this includes individuals in
a personal/private capacity and those individuals acting in a formal capacity
such as executors, as well as groups of individuals such as trustees.
2.
i. Realty: property is deemed to be ‘real’ if a court will restore it to a
dispossessed owner and not merely provide compensation for loss. Real
property tends to be distinguished by being immovable, eg land and what
is attached to it, also known as real estate.
ii. Personalty: all other property is called personalty.
3. Capacity to contract means that each of the parties to the contract must have
the legal capacity, or power, to enter into the contract. Certain parties have
only limited powers to enter into a contract − for example, minors (persons
under the age of 18) and those of unsound mind.
4. Caveat emptor (‘let the buyer beware’) means that there is no duty of disclosure
between parties to a contract.
5. An attorney is a person who is given the legal responsibility to act on behalf of
another person. This may be necessary in the cases, for example, of an elderly
person who is incapable of managing their own finances or of someone living
abroad. Lasting powers of attorney enable attorneys to make decisions about
financial matters and also about personal and health matters.
6. Personal representatives are the people who carry out the procedures
necessary to distribute the estate of someone who has died.
7. If there is no will (or the will is invalid), a grant of letters of administration is
issued to an appropriate person, who is known as the administrator. This will
often be the surviving spouse or another close relative. The administrator’s
responsibility is to deal with the estate as prescribed by the rules of intestacy.
8. This can be achieved by executing a deed of variation. All those who would
have benefited from the provisions of the will must be over 18 years of age
and be in agreement on the terms of such a variation. A deed of variation is
often executed for tax purposes: a change in beneficiaries or in the relative
shares received could reduce the inheritance tax liability, for example. In order
to be effective for tax purposes, the deed of variation must be executed within
two years of the death and HM Revenue & Customs must be informed within
six months of its execution. The variation must not be entered into for any
consideration of money or money’s worth.
9. Insolvency arises when:
u a person’s liabilities exceed their assets; or
u a person cannot meet their financial obligations within a reasonable time
of their falling due.
10. An individual voluntary arrangement (IVA) is an alternative to bankruptcy,
under which the debtor arranges with the creditors to reschedule the
repayment of the debts over a specified period. An IVA can be set up only
if creditors who represent at least 75 per cent of the debt agree to the
arrangement. The scheme must be supervised by an insolvency practitioner.

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Certificate in Financial

Administration and Planning

Updated for 2016/17

The London Institute of Banking & Finance

Captured, authored, published, delivered and managed in XML

Printed and bound in the UK by CPI Antony Rowe, Chippenham, Wiltshire

© The London Institute of Banking & Finance 2016

1 Key inﬂuences in the UK ﬁnancial services industry 1

© The London Institute of Banking & Finance 2016 v

vi © The London Institute of Banking & Finance 2016

© The London Institute of Banking & Finance 2016 vii

viii © The London Institute of Banking & Finance 2016

© The London Institute of Banking & Finance 2016 ix

1.2 The functions of the financial services

© The London Institute of Banking & Finance 2016 1

u generally acceptable to all parties in all transactions;

2 © The London Institute of Banking & Finance 2016

u Risk transformation: individual depositors are generally reluctant to lend all

1.2.2 Risk management

© The London Institute of Banking & Finance 2016 3

1.2.3 ‘Product sales’ intermediaries

1.3 Financial institutions

u retail banking services;

u mortgage services through a subsidiary that is a former building society;

4 © The London Institute of Banking & Finance 2016

u investment banking, including financing, risk management and corporate

1.3.1 The Bank of England

© The London Institute of Banking & Finance 2016 5

Management Office within the Treasury in order to avoid conflicts of interest

1.3.2 Proprietary and mutual organisations

6 © The London Institute of Banking & Finance 2016

1.3.3 Credit unions

Traditionally, credit unions operated in the poorer sections of the community,

1.3.4 Retail and wholesale markets

© The London Institute of Banking & Finance 2016 7

These institutions are, as described in section 1.2.1, acting as intermediaries

8 © The London Institute of Banking & Finance 2016

u These third parties can be other organisations and individuals, such as

1.3.4.1 The Financial Services (Banking Reform) Act 2013

© The London Institute of Banking & Finance 2016 9

1.3.5 The London Stock Exchange and AIM

10 © The London Institute of Banking & Finance 2016

1.3.5.1 Participants in the markets

1.3.5.2 Off-market trading

1.3.6 The government bond market

© The London Institute of Banking & Finance 2016 11

1.4 The role of government

12 © The London Institute of Banking & Finance 2016

− eg the compliance department of a life assurance company that monitors the

1.4.1 The influence of the European Union

1.4.2 The Basel Committee on Banking Supervision

© The London Institute of Banking & Finance 2016 13

1.4.2.3 Basel III

14 © The London Institute of Banking & Finance 2016

1.4.2.4 The Capital Requirements Directives

1.5 The clearing process and settlement

© The London Institute of Banking & Finance 2016 15

1. What is the main purpose of the financial services industry?

3. List the main types of financial institution in the UK.

4. What is the role of the Monetary Policy Committee?

6. Which type of customers are credit unions aimed at?

10. What is ‘clearing’?

16 © The London Institute of Banking & Finance 2016