Investments  

What you need to know about TCF

  • To asses the different regulatory objectives for TCF.
  • To understand how to address suitability.
  • To ascertain how to demonstrate TCF in investment advice.
CPD
Approx.30min

Consumers should have access to products and services that are well governed and deliver value for money in competitive markets that work in their interests.

This is the FCA's objective. But what the industry regards as innovation has often proven to be highly complex products being sold.

In fact, many of the past FCA reviews of past (miss) sales have had a complex proposition at the root of the problem, leading to poor marketing and product literature or unsuitable advice being given.

The root of that has been due to a lack of product understanding from both the adviser and client.  Suitability and product governance arrangements should be in place to monitor and manage risks to the consumers and the associated processes should prove to work as intended.

Meeting customers’ fair and reasonable expectations should be the responsibility of firms, not the regulator.    

TCF is about getting the right outcomes for customers, as opposed to complying with a set of compliance rules. 

1) Matching risk and rewards

Financial planning solutions aim to meet a client’s current and anticipated needs, allowing funds to be used to say protect the lifestyle of a client and their family and be achievable within an affordable manner.

All options,though,come with risk, especially those that can decrease in value, such as investments, so it is important that any risk return profile of the client matches that of the recommendations (the product).

In that respect, it is also important to make sure the client’s “comfort level of risk” is taken into account and not just relying on a tick-box algorithm.  

2) Suitability (COBS – principle 9 - principles for Businesses)

Rules on suitability apply when a firm makes personal recommendations relating to designated investments, managed investments and advice given and taken up (paid for).

The rules aim to make sure that recommendations or decisions to trade are suitable for the client. In order to assess suitability, there are three different elements concerning the client that need to be considered:

  • Knowledge/experience (to understand the risks)
  • Financial situation (to bear the risks and losses)
  • Objectives (purpose of investment).

Suitability of the advice helps with prioritising what is important now versus a long-term holistic financial plan.

Suitability, while being a regulatory requirement, helps with neutralising any biases from an adviser and a client’s own financial knowledge and experiences.

Therefore, suitability can be seen as a format or guideline to follow; to arrive at the most suitable answer/recommendation.   

3) Developing suitability under MifidII

Mifid II is increasing the scope of investment products for which appropriateness and assessments must be undertaken. This means conducting additional due diligence to ensure the more complex products recommended are suitable for clients.  

One important area in being able to confirm suitability is to ascertain the level of risk a customer wants but at the level of risk they can afford to take.

The main problem is that investors often do not understand what risk really entails. Further complicating the matter is that excessively low-risk investments can be just as damaging to an investor's portfolio as those that carry unsuitable levels of risk.

Hence there needs to be some sort of process in place to make sure that only suitable products and services are recommended and that they remain suitable to the client.  

The reason is to avoid any future client detriment, hence to root out any potential risks before they become issues. The FCA requires firms to pre-empt any potential customer detriment or other financial problem. In essence, create a governance culture focused on good customer outcomes – section 8 of Mifid II Investor Protection.

The ideas and rules behind suitability and appropriateness are to make sure that all recommendations to clients are understood in terms of how appropriate they are to solving the client’s need.

To achieve this, firms need to make sure that at the heart of their products and services there is consideration for:

  • good customer outcomes
  • a reduction in client conduct risks
  • products are sold (distributed) to the right client (segments) and in the right way.

Hence all financial firms should make sure there are no gaps within their organisation in terms of service quality, oversight and controls and product governance - in other words, ensuring there are good products and carrying out an ongoing review of client conduct risks. Product governance is about avoiding customer detriment, thereby helping to put consumer confidence back into the industry.

4) Service and product due diligence

Any recommendation, such as to provide for retirement or for long-term care, conducting due diligence on the product or service and ensuring its suitability for the client’s needs is at the very core of financial planning.

Without proper due diligence, the client could actually be better off from never having taken financial advice in the first place, e.g. the mortgage endowment policies of the 1980s and 1990s and the pension miss-selling issues.

To help with suitability, product governance aims to make sure that, at the point of sale and ongoing, the products and services remain appropriate, solve a need and perform as originally envisaged.

At the client level, suitability helps the adviser and client understand what the product is, the features and benefits, why it is needed and the risks involved.     

5) Assessing suitability FCA COBS 9.2.(2)  Treating Customers Fairly

The suitability of an investment, product or service for a particular person is at the very heart of the advice process.

A suitable investment means that an investment is appropriate in terms of an investor's willingness and ability (personal circumstances) to take on a certain level of risk. It is essential that both these criteria be met.

If an investment is to be suitable, it is not enough to state an investor is risk friendly, but the client must also be in a financial position to take certain chances. It is therefore necessary to understand the nature of the risks and the possible consequences.

6) Necessary information to assess suitability

Firms should make sure that there is a mandatory minimum level of client information that should be gathered for all financial advice recommendations. In addition, document any time a client has not wished to provide appropriate information to help with making sure a recommendation is suitable.  

7) Investment risk

A firm needs to describe, in a manner that is clear, fair and not misleading (TCF outcome 3), what it means by risk and the criteria it uses to determine the different risk categorisations.

These explanations should somewhat match those of the products being recommended, such as a discretionary investment management service.   

For integrated firms, it is important that the communiques accurately reflect the firm’s service offering. What a product governance process aims to do is provide the link between the products being managed and the advice given to clients.

Firms should have established systems and controls to ensure that the investment models, strategies, levels of risk and returns are actually followed, delivered and any departures documented and explained to the client. 

8) Ability to bear investment risk

The obligation under Mifid II is to ensure that a firm has a reasonable basis for believing, that in making a personal recommendation or taking a decision to trade, the client is able to financially bear any related investment risks consistent with their investment objectives. 

The term ‘capacity for loss’ does not appear in Mifid or the FCA rules. The term is used in the FCA’s guidance on assessing suitability and refers to the customer’s ability to absorb falls in the value of their investment.  

As such, capacity for loss is not judged by reference to an individual holding or the client’s portfolio but by reference to the client’s overall financial situation.

9) Client trust

The integrity of the adviser and of the advice given is of the greatest level of importance to the issue of client trust, so it must be made very clear to any client why and how any recommendations suit their specific requirements (TCF outcome 5 – consumers are provided with products that perform as expected).  

So following on from TCF, Mifid II is aiming to make sure firms understand not only the customer's demands and needs, but also whether their products and services delivered, including the processes, do fairly and reasonably meet those needs.  

Mifid II is looking to align products more appropriately with actual consumer segments and individual client levels of risk, needs and capacity for loss.

This will have the benefit of allowing the potential client to better understand the particular product being recommended, as opposed to in the past products being designed for a kind of “catch-all” market place.  

10) Know Your Customer – target segment 

Good product governance (a FCA consumer outcome) includes understanding the needs of customers, to allow the development of products to meet those needs, to ensure the correct type of customer is identified with the right product.

Furthermore, there is a need to ensure that products remain appropriate for their target audience throughout the lifetime of the product. 

11) Product monitoring

Overriding all should be a consideration of the original usage of the product, if it still remains appropriate and that the performance (or level of service) is continuously compared to the initial characterisation of the product.

Collecting evidence throughout the year on the product is essential and should include sales volumes and trends against projections.

If for no other reason, this evidence collection should be done so that a firm might investigate instances of particularly high sales volumes or complaints. 

12) Conclusion

“Those involved in the manufacturing and distributing of financial instruments, in order to avoid and reduce, from an early stage, potential risks of failure should regularly review their product governance policies as well as the products they manufacture.” (ESMA)  

To sign-off on suitability it must be shown that a client’s needs and wants are being matched and addressed by the solution/product.

Just as important as suitability, is that firms are striving (and can show this) that they are creating fair/good customer outcomes when deciding on financial products and services to offer an identified client (target segment).  

And finally, the management body needs to have effective control over the firm’s product governance process and associated management information.

Matthew Priestley is a Chartered FCSI

CPD
Approx.30min

Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

  1. According to Mr Priestley, what does suitability of the advice help with?

  2. Whose responsibility should it be to meet customers’ fair and reasonable expectations, Mr Priestley says?

  3. What does Mr Priestley say Mifid II is doing to appropriateness and suitability assessments?

  4. How does Mr Priestley describe the integrity of the adviser and the advice given?

  5. What is the duty of product providers, according to ESMA?

  6. What does Mr Priestley say is essential to do during the year?

Nearly There…

You have successfully answered all the questions correctly, well done!

You should now know…

  • To asses the different regulatory objectives for TCF.
  • To understand how to address suitability.
  • To ascertain how to demonstrate TCF in investment advice.

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