A confluence of events could to lead to more misselling claims for the financial services industry, analysts at Berenberg have warned, with a bill of £1.8bn from potentially missold final-salary pensions transfers.

Even firms with strong processes are likely to be affected, due to the design of the UK’s Financial Services Compensation Scheme (FSCS), which implies additional cost pressure that will be “particularly unhelpful” for Hargreaves Lansdown PLC (LON:HL.) and St James’s Place PLC (LON:STJ), the analysts said.

Designed to compensate victims of financial fraud and misspellings, the FSCS’s operational expenses and the costs of its compensation are both funded via a levy on UK financial companies, with the total expense having grown at a three-year compound annual rate of 15%.

Last year this cost UK financial services firms a total of £516mln, a period that saw generally rising asset values, which the analysts said would be expected to limit claims for misselling.

For 2020, the costs of the FSCS are likely to constitute 12% of St. James’s Place’s cost base and 5% of Hargreaves Lansdown’s expenses, the analysts calculated, driving a hole in the operating margins of each the pair of 830 basis points and 230bps respectively.

Looking forward, with the bank payment protection insurance (PPI) misselling deadline having passed last year, the Berenberg analysts said they fear the smattering of claims management companies searching for “new markets” will alight upon the significant losses endured by investors from the coronavirus crisis to “drive an increase in misselling claims in the next few years”.

In particular, it was noted that 162,000 people transferred out of defined-benefit/final-salary pensions in the UK between April 2015 and September 2018, with a sample of these transfers examined by the Financial Conduct Authority finding that 29% were unsuitable, while the suitability of a further 23% of cases was unclear.

“Assuming one-third of the latter were unsuitable, this implies around 59,500 cases where pension transfers were potentially missold,” the analysts said.

“Applying the (optically low) average compensation from a recent case involving 88 British Steel workers, implies a potential liability of £1.8bn for the industry. Even if only one-third of people missold pension transfers apply for compensation, this still implies a £600mln bill.” 

In principle, the compensation should be paid by the advisors that provided the unsuitable advice, but it was noted that in practice few small advisor firms have the resources required to meet substantial findings against them so a large proportion of the resulting compensation expenses would be likely to fall on the FSCS.

While savings and investment compensation is capped at £85,000, compensation for pensions and insurance products is unlimited.

Berenberg noted that spreading the estimated £600mln cost over five years implies a c25% increase in the annual cost of the FSCS (in addition to the inflationary pressure the scheme was already experiencing).

“Our base case assumes an average 20% increase in the FSCS expense for SJP and Hargreaves Lansdown this year and next.

“Given the dynamics described above, we fear that the recent market weakness skews the risk of this expense to the upside.”

The bank kept its rating on both companies at ‘hold’.