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I work with many great advisers around the world. We often talk about the processes that underpins the integrity of their planning and subsequent investment recommendations. Their activities can be summarised as a handful of recorded outcomes: the five proofs that lead to best practice investment suitability process.
1. That they know the client and have interrogated, recorded, and tested where necessary, their current circumstances, financial needs, hopes and expectations, risk capacity and attitude to risk;
2. That they explored with the client personal trade-offs, alternative strategies and the application of a range of investment products/portfolios. For example, do they show the resolution of key differences in individual’s risk tolerance reports and between couples? Did they calculate the consequences of paying down debt, retiring later and/or saving more? Did they explore the benefits of taking out insurances or converting lazy assets such as holiday homes to investments? Did they review effectiveness of their client’s tax management practices? Did they discuss how the selection of active or passive management matched their client’s needs and circumstances?
3. That they know the risks in the services, strategies and products explored and selected. The FCA’s emphasis on advisers being responsible for evaluating the tools, systems, services and products they utilise puts portfolios and how they are delivered into sharp focus. Advisers must review for weaknesses and detail how they intend to manage and compensate for them
This brings attention to recommendations of simpler, lower cost funds/portfolios with straightforward management practices that can be easily explained. This in turn leads to an agreed investment policy with predictable portfolio growth behaviours and downside expectations.
4. That they explained the risks in the strategy, services and product/s selected to the client. “To explain something effectively, it needs to be understood thoroughly”. There is little evidence that educating clients about investments and risk changes their risk tolerance or overly influences their financial decisions when markets are running but there is ample evidence that clients cope better with poor outcomes if they are not surprised by them. This naturally leads to the final proof which both meets regulatory obligations and common sense; and
5. That they received their clients’ properly informed commitment to accept the risks in the plan and the products selected. For example, Jim wants to retire at 60 with £300,000, He knows that he has to save £15,000 each year. If it’s not saved future lifestyle preferences will likely not be achieved. He understands that a portfolio with 50% exposure to growth assets is highly likely to deliver that sum. Jim also knows he could make do with £250,000 if he lived a more humble life. He understands that the portfolio will be somewhat volatile and should not be surprised if it dropped over 25% several times prior to his retirement.
The client’s properly informed commitment is one of the best compliance, business and reputation protections an adviser can have. It’s also a pretty good sign that the investment suitability process in place is robust.
A very useful way to test if your suitability practice is consistent with the client’s experience is for you to score each of the five proofs against a scale of 1 low and 5 high. Then ask the client to also score. Compare the two. If there are any differences it might be time to review your process.
If you have these five practice points moving in the right direction you are probably well on the way to joining the financial advisory elite. And will you keep the FCA at bay? The proofs are consistent with the intent of the suitability regulation, so I would be hugely surprised if they didn’t work as an effective legal prophylactic. What do you think?