Industry Lukewarm on ‘Quick Fixes’ to PRIIPs Rules

The worst kind of rules must be those that achieve the opposite of what their designers intended. The European Union’s (EU’s) disclosure requirements for retail investment products fit that description—and, after months of calls for change, regulators are finally taking action.

The trio of the bloc’s top financial supervisors have put forward amendments to rules on key information documents (KIDs) mandated for packaged retail and insurance-based investment products (PRIIPs), including steps to address the overoptimistic performance scenarios that the rules have produced.

Banks and funds have welcomed the proposals but say they do not go far enough. Many fear the scenarios will continue misleading investors—going directly against their purpose—and even expose PRIIPs providers to mis-selling accusations.

“When we look at these proposals in detail, we’re very concerned,” says Andreas Stepnitzka, senior regulatory policy adviser at the European Fund and Asset Management Association. “[They aim at] a quick fix to these issues when a holistic review is needed.”

A key problem the supervisors are trying to fix lies in the way the current regulation, in force since January 2018, requires potential returns to be calculated and presented in the KID. The firm manufacturing or selling the product must work out what returns investors can expect in a favorable, moderate, unfavorable and a stress scenario.

The prescribed methodology for the first three scenarios generally entails extrapolating future results from the performance of the underlying assets over the past five years, while the stress scenario is based on a different model. As many asset classes have performed well in recent years, the calculations have produced what much of the industry sees as unrealistic projections.

In one example, for a PRIIP based on a fund invested in Chinese equities, only the stress scenario pointed to possible losses. The other three scenarios all promised gains, ranging from +48 percent over five years in the unfavorable scenario to +521 percent in the favorable scenario.

“Because of the way that these scenarios are portrayed in the KID, investors may think that these scenarios are guaranteed to happen,” says Stepnitzka. “There are disclosures around this and small print, but people will probably not look at these in the same amount of detail that they will at the scenarios—especially if the scenarios are promising that they’ll receive a lot of money.”

Risk-Free Rate

In a November 8 consultation paper, the European Supervisory Authorities (ESAs) presented a number of options for amending the scenario rules, some of which could be used in combination.

One suggested route is to change the methodology for calculating the first three scenarios so that the expected performance for the assets underlying a PRIIP would be “the risk-neutral expectation based on the expected values of interest rates and all relevant cashflows”—in other words, adjusting the results to be closer to the forward view of the risk-free rate.

The regulators say this should remove the risk of misleading investors on future returns that could result from using data covering the tail end of a period of particularly positive or negative market performance. They add that, according to their analysis, the risk-free rate of return has a positive correlation with observed performance.

A senior structurer at one major dealer says this could work for some fixed income-based structured products.

“With the risk-neutral rate, what you’re making sure is that your future view of the world is anchored around the forward curve, and in layman’s terms the forward curve is the market’s best estimate of future outcome,” he says.

“[But] I could well imagine that certain fund managers would disagree with that as, if you need to promote an equity fund, it doesn’t look that fantastic if you use the risk-neutral performance,” he adds.

The European Structured Investment Products Association echoes this in its consultation response, noting that for equity-linked products a risk premium would probably have to be incorporated into the calculation model. Otherwise, it “would not reflect the perspective of investors who rationally invest in this asset class because they believe that this asset class carries a risk premium.” However, it notes there is no agreed methodology to calculate such risk premia.

Others are not convinced the ESAs have enough time to properly consider this option given the complexities surrounding such a change and the tight timeframe.

The supervisors are now examining responses to the consultation, which closed on December 6, and aim to submit their chosen amendments to the European Commission as early as possible in the first quarter of 2019 so they can then go to the European Parliament before parliamentary elections in May and the Council of the European Union. If approved, the amendments would apply from January 1, 2020.

“Using a risk-free rate would be a fundamental change in how to approach these scenarios, so to actually change the methodology would be a very time-consuming and complex process,” says Stepnitzka at the funds association. “I think the ESAs have thrown this in just to say something. I don’t think they have either the time or resources to actually follow through on this.”

Is the Past a Guide to the Future? 

Another, simpler option presented in the paper is to include in the KID information on past performance where it is available.

“When showing the future performance scenarios, the client doesn’t really understand what is driving them,” says the senior structurer. “[So] I think providing past analysis is a good way of explaining the product to the client, especially structured products.”

However, David Stuff, managing partner at Levendi Investment Management, notes the risk that investors will draw “false, inaccurate or misleading” conclusions from past performance, expecting similar returns in a wholly different set of market conditions. “You could also end up with people designing and developing products that backtest well rather than creating a product that is genuinely robust,” he warns. 

This option also runs into a practical hurdle: The KID cannot be longer than three pages of A4 paper. “If we start to include past performance disclosures in the PRIIPs KID, that information will be explained in graphical information and bar charts, which usually takes up half a page,” explains Stepnitzka. “The three-page limit to the PRIIP KID has already been reached with future performance analysis. … We can’t just make everything five font as no-one would be able to read it, which would go against the regulation.”

A third idea on the table is to include only the favorable and stress scenarios in the KID in a way that indicates a range of possible outcomes. The ESAs say this approach would avoid inadvertently leading investors to believe that only the specific scenarios analysed are possible—for example, the four required by the existing rules.  

 “I think this would actually help,” says the senior structurer at the major bank. “We don’t want to say ‘this is the future scenario’ because we don’t want to definitely tell investors that they’re going to get X percent. We want to give them a range regarding how this product will probably behave, between X and Y percent. The only downside to this is whether the client understands this, so I think we would still need to give an explanation of what an X percentile is and what that means. I don’t think my mother would understand what that means.”

Stepnitzka is also in favor: “It would help to indicate that these scenarios are really just a frame of reference, not concrete numbers that you’re putting forward.” But he doubts the change can be implemented by January 2020 as it would require a “massive” number of technical tweaks.

The ESAs admit the constraints imposed by the short timeframe, saying: “The proposals made are therefore limited to targeted amendments to address the most urgent issues.”

Also citing the limited time available, the supervisors write it will not be possible to test the suggested amendments on a sample of EU retail investors, but they believe the changes can still be made based on the feedback received since the PRIIPs regulation came into effect.  

Still, Stepnitzka laments that “only time will tell whether these changes will actually work.”

Legal Risk

However, many PRIIPs providers are abandoning the wait-and-see approach, fearing that, even with the amendments, performance scenarios will continue to mislead investors.

“If you knowingly provide investors with a disclosure that doesn’t conform to your own projections, there is a concern that an investor could sue on the back of the product not performing,” says Michael Logie, a partner at law firm Ashurst.

While he isn’t aware of any legal complaints yet, he says it wouldn’t be out of the question for litigators to compare the performance scenarios given to investors against how the product actually performed and to assess whether the seller had provided sufficient warning about the unreliable nature of the KID.

In this way, a PRIIPs provider’s regulatory obligation to follow the prescribed methodology—no matter how skewed the results—could be in contradiction with its duty of care to clients, Logie says.

Stepnitzka agrees, giving the example of a UK pension product whose KID states that the original £10,000 ($12,700) investment will grow to £1.2 million over 40 years in a moderate scenario after fees.

“The PRIIP rules are founded on the principle of being ‘fair, clear and not misleading’ and providing these KIDs breaches that. If a priip manufacturer knows that in 40 years’ time the investor is not going to get £1.2 million, are they not in breach of their own rules by providing investors with a KID that tells them that?”

As a result, some PRIIPs manufacturers are opting to discontinue certain products.

The senior structurer says his bank has stopped selling some US dollar Libor products as their KID scenarios often indicated future returns that were at odds with what their forward curves suggested. “We stopped offering a lot of structured products payoffs because we feel very uncomfortable selling products with misleading KIDs,” the senior structurer says.

Others have taken a different, and more audacious, approach: changing the scenario calculation methodology altogether—and going directly against the regulation and legal advice.

“These manufacturers are taking the view that the worst position is to mislead investors, regardless of technical non-compliance with the regulations,” explains Logie. “Providing a KID is a legal obligation and you’d assume the courts would have some sympathy for manufacturers strictly following it, but nevertheless manufacturers feel uncomfortable showing investors scenarios which are more optimistic than they should be.”

The industry hopes such drastic measures will not be needed in the future, provided a planned, more comprehensive review of the PRIIPs regulation produces a better solution to the scenarios problem, and many are calling on the ESAs to hold a more in-depth consultation as soon as possible.

A thorough review was due at the end of this year—two years after the originally planned date for the introduction of the rules. In the event, they came into force a year later, also delaying the review.

The consultation paper says the comprehensive analysis is expected to be conducted “in the coming years.”