The European Supervisory Authorities (ESAs) are a triumvirate of EU regulators representing the securities market, insurance, and banking and collectively oversee the EU financial sector. For several years, the ESAs have been working to frame a suitable investor disclosure regime in the form of the Packaged Retail and Insurance-based Investment Products (PRIIPs) regulation. PRIIPs has been one of the more contentious regulatory rollouts in Europe in recent years. As we have covered before, the area of PRIIPs causing the most debate has been the Key Investor Document (KID). A KID is a mandatory three-page A4 document provided to an investor prior to investment in an EU investment fund, structured product, or insurance product. PRIIPs sets out very prescriptive mandated disclosures as well as methodologies in how to calculate the quantitative disclosures required.
Despite multiple consultations both prior to and post implementation of PRIIPs, the market is still trying to push the ESAs to address certain problem areas. Earlier this month the ESAs answered the industry’s call in the form of a new consultation paper. The consultation paper not only acknowledges the industry’s feedback and concerns but suggests paths to resolution. The industry has called, and the ESAs appear to have answered.
Both the level of required information and how certain data points are calculated have been a frustration to both investors and KID providers to date. Performance scenarios and cost methodologies and presentation are two of the more pressing issues the ESAs address in the consultation paper.
The proposed amendments to the performance scenarios clause are arguably the most significant component of the entire consultation. In terms of its thrust and volume, it is the performance scenarios that take up the lion’s share of the consultation paper. Under PRIIPs future product performance expectations, asset managers must provide varying market conditions to prospective investors which is a departure from the age-old practice of disclosing past performance of products.
Use of past performance to extrapolate future performance has two obvious downsides:
- it assumes that the future will replicate the past
- investor expectations regarding future performance may be wholly under or over stated as actual market conditions vary from the modeled conditions
Managers argued throughout the PRIIPs process that when a product has experienced high returns over the previous five years, it is more likely that it will experience lower returns in the next five years. This phenomenon is known as pro-cyclicity. The current methodology however suggests what has happened in the past will continue into the future.
The consultation seeks to address this by removing the historical growth rate as the key determinant of the expected growth rate in the scenario methodology and replacing it with a calculation. The calculation will be based on the sum of a reference rate common to all asset types as well as an asset specific risk premium to be developed by the EU regulators.
The consultation paper also suggests ways in which the various performance scenarios could be simplified by removing both the stressed and intermediate scenarios from the menu of market conditions. In anticipation of PRIIPs being applicable to UCITS, the consultation paper also proposes retention of past performance information in the KID for certain funds including UCITS, AIFs, and unit linked insurance-based investment products. This is a welcome suggestion to the industry who are long used to disclosing tangible and audited past performance figures to investors rather than portents to an uncertain future.
Costs Methodologies and Presentation
The ESA’s consultation paper acknowledged that cost calculation methodology and its presentation has been an issue for product providers since the inception of PRIIPs. In fact, they outline several different components that may be deemed sub-optimal including not well understood terminology and acronyms, unrealistic assumptions, provision of too much information in certain areas, not enough information in others, and inappropriate or unintelligible legends and charts.
Specifically, the calculation known as “slippage costs,” the difference between the price paid for an asset and the market price that existed at the time of the transaction (arrival price), has been an area of concern. In general, asset managers do not use the arrival price for anything else in their business and so to calculate it for PRIIPs alone, which combined with a separate cost disclosure methodology for MiFID II was a source of great frustration.
The consultation foresees major possible revisions and enhancements including making the costs elements of PRIIPs consistent with MiFID II in terms of cost methodology and disclosure. This would be optimal for all interested parties for consistency and comparative purposes.
On the slippage issue, the consultation suggests amending the arrival price methodology and moving to a higher-level principles-based approach. The second might be easier for product providers to implement but would lend itself to variability in calculation method that could make comparing product costs more difficult for investors.
UCITS Specific Issues
The consultation paper also importantly discusses application of the KID regime for UCITS funds. This is an important consideration given the scale of UCITS funds in Europe. According to EFAMA’s most recent report, UCITS AUM is over $10 trillion. Currently, UCITS funds have a temporary PRIIPs KID exemption which runs until December 31, 2021. The consultation paper asks the industry whether or not revisions contemplated should be made to existing PRIIPs during 2021 before the expected end of the current UCITS exemption, or would it be better that the proposed amendments be deferred to be aligned with the expected end date of the UCITS exemption. It also asks whether UCITS should provide different investor documents to its retail and professional investors or whether the PRIIPs KID should suffice for all investor types.
The industry can comment on the consultation paper until January 13, 2020. Thereafter we can expect a review of PRIIPs, including some consumer testing of the revised scenarios and cost disclosures, in the first quarter of 2020 and a submission of final revision proposals to the European Commission will follow shortly afterwards. On this timeline we could reasonably expect the actual revisions to the PRIIPs regime to be concluded within 2021. The question then becomes whether to implement them before or at the UCITS exemption period of December 31, 2021. Time really does fly in financial regulation!