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Capital Adequacy: experiences from the front line
Changes to the rules on capital reserves for SIPP operators took effect on 1 September 2016. They are one of the most-talked-about changes in the SIPP industry for years. There has been a spate of takeovers since their announcement and at least two companies have gone into administration, although it is difficult to say to what extent the demand for higher reserves contributed to these situations. However, there are some effects of this new regime which fall directly on SIPP members, as well as operators.
It is over four years now since change was first mooted, and a quick re-cap would be useful. The Financial Conduct Authority (FCA) has introduced a new formula for calculating how much capital SIPP operators must keep in reserve. It is based on the value of assets that the SIPP operator has under administration (AUA) and the number of SIPPs that are invested - wholly or partly - in assets the FCA classifies as 'non-standard'.
The formula includes a square root function, which has the effect, other things being equal, of increasing reserve requirements more slowly than asset growth. Importantly, the presence of non-standard assets in a SIPP demands significant extra capital reserves. By contrast, before 1 September 2016, the calculation of the minimum capital needed was based on a SIPP operator’s expenses and was equivalent to either 6 or 13 weeks’ expenses. (We should note, however, that some providers were, and will continue to be, covered by a completely separate regime.)
"Even before its introduction, the effects of the new regime on the SIPP market have been dramatic. "
Even before its introduction, the effects of the new regime on the SIPP market have been dramatic. Its formula encourages rapid growth and acquisition, and so it is not surprising that there has been more corporate activity in the last three years than at any other time since SIPPs’ inception in 1989.
Investment flexibility has taken a hit, too: the formula effectively discourages SIPP operators from allowing investment in non-standard assets, leading some to impose a ban.
And with the new capital requirements being generally higher, in some cases much higher, than the previous ones, some providers have either had to put up fees, or introduce new ones, in some cases running into hundreds of pounds.
Eight months on from the introduction of the new regime, the remainder of this article focuses on some of the other challenges that we (and presumably, other SIPP providers) have encountered, whilst building the requirements of capital adequacy into our day-to-day processes.
The use of the value of AUA was a 'proxy' in the regulator’s words. However, because the formula for determining the amount of capital reserves is based on regularly-updated valuations using AUA, we are now told that all individual assets - be they 'standard' or 'non-standard' - have to be valued at least once every year.
This requirement is inconsequential when dealing with listed investments, (except in relatively rare instances such as, say, property funds being temporarily closed, following last year’s EU Referendum outcome).
However, it is a problem when dealing with investments such as commercial property and unquoted shares.
It never used to be a problem. Generally, such assets only needed to be formally and independently re-valued at critical junctures; for example, selling the asset, or the drawing of benefits. At other times, the expense of undertaking this would generally have served little purpose for the member.
At times when they are not being sold, or formally valued for a benefit crystallisation event, the value of a commercial property or unquoted shares inevitably involves a degree of opinion. For property, desktop valuations and limited use of indexing are possible, so reducing the cost implications.
But, in the case of unquoted shares, that opinion – in the form of an independent valuation – will inevitably be an expensive business, as it will require suitably-qualified accountants poring over accounts and other publicly-available information about the company in question.
Property
For property, we now need to have up-to-date valuations, and a method of indexing and identifying when values might have moved beyond a set percentage between valuations. This has required undertaking client communications, and putting in place a desktop valuation service.
There has also been the need to fully interrogate our SIPP property book; for example, classifying the different types of property and their geographical locations, in assessing them for use with suitable indices.
Unquoted shares
As there is no method of indexing unquoted shares available to us, it is necessary to have all unquoted shares valued. It has not proved easy to find cost-effective valuation services, although we do have two in place now, with reputable and experienced accountancy practices.
Unsurprisingly, this has come as an unwelcome surprise to clients, due to the costs of annual valuations that were not factored in when their unquoted shares were originally acquired.
As a consequence of this, several lower-value unquoted holdings have been sold by clients to avoid the recurring costs, going forward. We have also witnessed reduced investment in new unquoted shares, due in part to the cost consequences of annual valuations.
Overseas unquoted shares have proved an even bigger challenge, because if the client is unable to arrange a valuation themselves, we cannot do so on their behalf, as there are rarely any readily-available published accounts for independent auditors to work from. This is a ‘historic’ matter for ourselves, however, as we haven’t allowed overseas unquoted shares for some time.
Other observations
On the new business front, we are witnessing plenty of enquiries for Sipps that still allow Non-Standard Assets to be held, due to many other Sipp Operators no longer permitting them.
Eight months into the introduction of the new capital adequacy regime, we have undeniably encountered a number of challenges, incorporating its detailed requirements into our day-to-day operator processes.
As this article has demonstrated, unquoted shares – particularly those for companies based overseas – has proved the most problematic non-standard asset to value. The rules are not optional, and so clients with unquoted shares are encouraged to reduce the expense associated with annual valuations by getting the valuation from the company’s auditors, who already know the company, or deciding whether to sell – or personally purchase - the shares out of their Sipp.
This latter route, however, would still require a current valuation, as HM Revenue & Customs would deem it to be a transaction between connected parties. In addition, the taxation treatment of unquoted shares would change, once outside a pension. As ever, we would encourage our SIPP Members to speak to their financial adviser.
SIPP members’ judgement of the implied minimum investment in unquoted shares, given the extra costs arising as a result of the capital reserves regime, has inevitably increased. Indeed, it could be argued that a rare SIPP investment has become rarer still.