In setting out new Guidance on assessing suitability in investment choices the Financial Services Authority (FSA) made clear it would be taking an "intrusive" and "intensive" supervisory approach. But as firms begin to look at what the report's findings mean to them, are the action points clear and will the measures taken be viewed as sufficiently "robust" by the FSA?
The Guidance consultation "Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection" was issued by the FSA in January 2011. A response to continued concern over the level of unsuitable advice in the market, it applies new Guidance to advisory services and transactions undertaken by private client discretionary wealth managers.
The FSA has stated it will be looking to see how firms have acted on the report. Among the factors it will consider are the types of procedures, tools and risk category descriptions put in place to establish and check the level of risk a customer is willing and able to take. It will also look at how well these are used to assess the suitability of investment selections.
Following on from the report, the FSA expects to see improvements in the standards of advice and private client discretionary management. Although "Guidance" the FSA has stressed it will continue to take tough action where poor practice is identified.
Key points summarised
The Guidance applies to advisory services (recommendations) and transactions undertaken by private client discretionary wealth managers.
The FSA has focussed on the "risk a customer is willing and able to take"
Key FSA findings
- Most advisers and investment managers consider a customer's attitude to risk but fail to take appropriate account of their capacity for loss. By "capacity for loss" the FSA intend the customer's ability to absorb falls in the value of their investment. Any potential material detriment to their standard of living, caused by capital loss, should be taken into account when assessing tolerance for risk.
- Where questionnaires are used to collect information from customers, these often use poor question and answer options, have over-sensitive scoring or attribute inappropriate weighting to answers.
- A failure by firms to have a process to identify customers that are best suited to placing their funds in cash deposits because they are unable or unwilling to accept the risk of capital loss.
Following on from this report, the FSA will be applying their intrusive and intensive supervisory approach and reviewing how firms have acted on the Guidance.
There is a hint that this "intrusive and intensive" approach stretches the parameters of the status of FSA Guidance. Guidance, according to the FSA Enforcement Guide is not binding on regulated firms nor is there a presumption that departing from Guidance indicates a breach of a rule. The supervisory approach introduced above suggests otherwise.
The Guidance focussed on:
- Whether methodologies for assessing a customer's appetite for risk were fit for purpose;
- Whether descriptions used by firms to reflect levels of risk are fair, clear and not misleading; and
- Whether processes for choosing investments result in suitable selections, including the use of asset-allocation tools.
Key risks for firms to consider
In the FSA's view, poor outcomes can occur if firms fail to assess a customer's capacity for loss. The FSA states that although most firms consider a customer's risk preferences or appetite for loss, they often do not consider their capacity for loss.
An example of good practice cited by the FSA was a firm that used one process to assess the customer's attitude to risk and a separate process to assess their capacity for loss. In doing so it ensured that both were appropriately considered as part of the suitability assessment.
This raises an interesting question which was highlighted at one industry roundtable in formulating its response to the FSA. The view was that the ability to withstand loss is, ultimately, a question for the investor; particularly if the firm does not provide a service requiring it to have an insight into the whole of the customer's wider finances. If the firm is providing only a discretionary broking or a fund management service it will be concerned with the quality of the customer's portfolio and not with the customer's broader financial issues. The view of the roundtable was that to require anything other of firms would be to require every discretionary manager to have a financial planning service.
Other key risks identified by the FSA included:
Not having a robust process in place to identify customers that are best suited to placing their money in cash deposits because they are unwilling or unable to risk loss of capital.
- Using poor questions and answers to establish the risk a customer is willing and able to take.
- Inappropriately interpreting customer responses to questions especially when using risk assessment tools.
- Using vague, unclear or misleading descriptions or illustrations to check the risk that a customer is willing and able to take.
The FSA's statement of requirements in the Guidance is an embellished re-statement of COBS 9.2.1R.
Firms must obtain such information from a customer "as is necessary to understand the essential facts about them" and be able to demonstrate a reasonable basis for believing in the suitability of the recommendation.
In addition to meeting the customer's investment objectives and taking account of the customer's knowledge and experience, the firm must collect sufficient information to give a reasonable basis for the adviser to demonstrate the customer is: "able financially to bear any related investment risks consistent with their investment objectives."
The focus of this section of the Guidance shifts to the selection of investments following the establishment of the customer's willingness and capacity for risk.
The FSA highlights the potential for poor customer outcomes aligned to the following key risks:
- Firms not taking account of all aspects of a customer's investment objectives and financial situation. This includes the risks they are willing and able to take as well as their knowledge and experience.
- Firms not challenging cases where automatically generated investment selections, for example, through the use of model portfolios or asset allocation tools, are unsuitable for the customer.
- Recommendations or transactions that are not consistent with the risk description confirmed with the customer.
- Relying solely on volatility as a proxy for risk.
- Firms not recognising the importance of considering diversification.
Firms not understanding the nature and risks of the products or assets selected for customers. The FSA reiterates the assertion that if none of the investment selections available to the firm are suitable for the customer, no recommendation or transaction should be made. Further, where the customer does not have capacity to sustain a loss inherent in a higher-risk strategy, the firm must explain to the customer that his need for a higher return cannot realistically be met. Importantly, in some cases, the customer has a higher capacity to sustain capital losses and is willing, following discussion, to tolerate a higher level of risk to potentially generate the desired level of return. In these instances, the firm should document that this is the risk that the customer is willing and able to take along with the reasons for this.
The FSA have found examples of model portfolios and asset-allocation tools which use volatility as the sole measure of the risk. They point out other measures of risk to be taken into account, where relevant:
- Underlying assets in a fund;
- Risks related to the structure of the product;
- Inflation risk;
- Liquidity risk;
- Risk arising from lack of diversification;
- Specific risks associated with the features of a particular product; and
- Counterparty risk.
The FSA's concern is that where volatility is used as a proxy for risk, ignoring other risks, an investment selection can result in the inclusion of complex assets that are not suitable given the risk a customer is willing and able to take. They give as an example, assets which are not traded daily on mainstream markets and can be difficult to value or appear to have low volatility, but are not low risk.
The industry has argued that a complex product is not necessarily a volatile or unsuitable product. It has been pointed out that many complex products will have simple outcomes- for example index products - and that such products may have had added complexity in order to specifically reduce their risk and volatility.
The FSA expresses concern that some firms do not have a sufficient understanding of the features and risks of their investment selection.
The FSA expects advisors and discretionary managers:
"Not to assume that a fund whose name appears to match a customer risk category is suitable without taking reasonable steps to ascertain that it is compatible and relevant for the level of risk a customer is willing and able to take. The underlying asset selection should be suitable for the particular customer. In other words, a fund labelled as "balanced" may not be suitable for a customer assessed as having a "balanced" attitude to risk; it would depend on, amongst other things, the content of the fund, the fund's investment strategy and the nature of the risk category description. The advisor or discretionary manager may also have a meaningfully different concept of a "balanced" attitude to risk to one used by the fund manager."
So what immediate actions should firms consider when it comes to addressing the issue of assessing suitability?
- Firms are advised to carry out a timely audit of their methods and processes for assessing suitability, making sure those processes are robust, clear and fit for purpose.
- If sales teams use risk-profiling tools, they should mitigate any shortcomings and consider the risk that they may not provide the right answers in all circumstances.
- There should be clear lines of communication between the product design teams and sales teams.
- Training for sales teams should be to the highest standard with an eye to the professionalism requirements of the Retail Distribution Review.
- The FSA has since released a discussion paper (TP11/1) on product intervention. Although dealing with matters higher up the supply chain, it is clear that the substance of the two papers is the subject of the same type of scrutiny and active intervention on the part of the FSA. The regulator will be looking at how firms design products, ensure that products function as intended and reach the right customers.