There appears to be an element of mischief making in the financial news this morning concerning self investment personal pension ('SIPP') operators and their capital requirements.
Citywire New Model Adviser are reporting commentary by ever-cheeky analyst Abraham Okusanya, director at research firm FinalytiQ. You can read it here and follow the links to the back-story.
In summary, the much reported 'cap ad' requirements for SIPP providers came in to force on 01 September this year. These resulted in a spike in capital requirements - a 'capital surcharge' for those providers with a large proportion of SIPP arrangements containing 'non standard' investments. In raising additional capital, some providers have opted for 'Tier 2' capital in place of 'Tier 1' capital.
This, it is insinuated, is a bad thing. It implies that "firms are effectively borrowing to meet" these new requirements, as if they have somehow gone overdrawn as a last resort, or put their capital adequacy on the credit card. "If you have to borrow" we are told "then that says something over whether or not it is sustainable." Advisers are then told that they "should be aware of what kind of capital Sipp providers are using because it may be significant further down the line."
This analysis of the SIPP market is wrong on three levels.
Capital and IPRU(Inv)5
Firstly, and at a most basic level, it mis-states the nature of Tier 1 & 2 capital. Tier 2 capital is usually preference shares. Alternatively it can be long-term subordinated loans. Either way, it does much the same job as Tier 1 capital. The holders of Tier 1 & 2 capital both carry the lion's share of the financial risk. In the event of large losses, it’s the shareholders or holders of subordinated debt who take the hit, not trade creditors, ordinary bond holders or those with regulatory or legal claims against the company. There is no short-term borrowing keeping these firms afloat. They are not dependent on any form of debt ranking equally, let alone ahead, of trade creditors or clients.
Secondly, it confuses decisions around capital structure. Any economist or accountant knows that a firm has a 'cost of capital', and there is a cost regardless of whether that capital is debt or equity (let alone ordinary shares, preference shares, senior debt or whatever). They also know that the cost of any particular instrument has a tendency to get impacted by the obscurities of tax considerations. A firm providing SIPPs will usually look for capital from familiar sources: its existing shareholders or its wider Group (if it has one). That is what has in practice been happening.
In subscribing additional funds, consideration is being given to tax, and also to the ability to extract the monies in due course if they are no longer required or are to be replaced e.g. a retiring director being bought out. Whether a SIPP provider is ticking a 'Tier 1' or a 'Tier 2' box, its capital is coming from the same place: its long-term investors, not its bankers or the directors' credit cards.
The sustainability of the SIPP sector depends on whether there is to be return on capital, not the choice of Tier 1 or Tier 2 capital. For any provider in the genuinely 'bespoke' pensions sector - what we used to call "Directors' Pensions" - that sustainability is a question of whether the market persists and whether they have the distribution strategy to reach it and the operational capabilities to deliver their expertise efficiently. Whether they are meeting their capital requirements entirely through Tier 1 or partly through Tier 2 capital instruments is an irrelevance: their consumers will meet the cost of capital if their products provide the value. For advisers and their clients, what matters is that such a provider is in fact meeting capital requirements and that it is recognised as being any good at what it does.
Choice of Capital Requirements for SIPP Providers
On the third level, the analysis being reported is no more than a partial analysis of the SIPP market. There is more than one type of "SIPP" being offered. What is more, for those wider-market SIPPs, there is simply more than one category of SIPP provider out there and more than one capital requirements regime that can apply.
Take NMA's table of "the biggest SIPP firms":
(NB. Dentons have since confirmed they are using entirely Tier 1 capital)
Readers might be forgiven for asking "Where are the biggest SIPP firms?" Curtis Banks is reputed to be the largest player on this table, and at July 2016 it had about 73,000 SIPP customers with the EPM acquisition. Yet Transact was reported as starting the year on 50,000 SIPP customers whilst Hargreaves Lansdown currently has 260,000. These are omitted from the analysis for a reason: they just don't fit it.
In truth, the regulatory regime acknowledges at least three categories of SIPP operator and contains three quite different sets of capital requirements:
- Insurers subject to Solvency II;
- MiFID investment firms subject to the joys of CRD IV and the Capital Requirements Regulation ('CRR'); and
- Others, subject to the so-called SIPP operator capital requirements [IPRU(Inv)5].
Even this is not the complete picture: some wealth firms operating SIPPs are BIPRU firms, for example. In essence though, a firm only falls into that residual category of SIPP operator subject to the much-vaunted SIPP operator capital requirements if it does little else by way of regulated activity. And a firm only faces the 'capital surcharge' for 'non standard investments' if it falls into that residual category. The CRR regime carries its own delights - a base requirement of €125k (about £105k), all the joys of capital planning and a cure for insomnia - but in some cases produces decidedly less onerous capital requirements.
Why is this significant?
Put simply, it seems unlikely that providers selling those wider-market SIPPs with 'standard' investment types will in future confine their energies to just operating SIPPs. Increasing commoditisation of their products, the visibility of price competition, adviser preferences for wrap-around services for their clients, HM Treasury's agenda of continually squeezing the pension tax regime whilst broadening ISAs (and LISAs), the march of technology - all these are drivers for such SIPP firms broadening their offerings. When they do, they will come out of that residual category of 'SIPP operator capital requirements'.
For advisers concerned about the longevity of SIPP providers, this means keeping an eye on whether they are meeting their capital requirements. It also means keeping an eye on whether the SIPP provider is any good and has much of a strategy. But Tier 1 versus Tier 2 capital? Forget it.
For SIPP providers - and this of course is my long awaited punchline - it means that you have a choice. Capital requirements need not be the straight-jacket holding you back. As ironic as it may be in the context of EU Directives, you can "take back control" (to a degree). The capital requirements you face can depend as much on your choice of business strategy as anything else. And in these matters, we would of course be happy to assist you.
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