Three weeks ago, the FSA delivered welcome clarification on issues it considers important when assessing the suitability of investments.
It has rightly been criticised for the lack of a reasonable consultation period on what is a crucial matter and that some of their sampling data appears weak to say the least. That said, the document brings together a number of key issues that should be addressed in a structured way and is valuable guidance for the market.
The consultation paper continues to use the approach, adopted in many of the platform papers, of giving practical examples of what the regulator sees as good and bad practice. In many ways, there is little, if anything, new in what has been documented but it brings together a range of issues which should be considered when addressing the subject.
I believe it is helpful to summarise that not only should firms consider a client’s attitude to risk but also that they should measure an individual’s capacity to take risks and the consequences if the risks have adverse outcome.
In addition, a further test is required to identify if applying capital or income to a specific objective is the best use of the money. This may be more challenging as against this measure it could be argued that only those who have cleared down all debt could be advised to make investments, if one argued that the saving of interest is, in effect, a guaranteed yield on the funds applied.
On this criteria, can we expect to see the ombudsman awarding compensation against the Nest Corporation for auto-enrolling an investor in its pension scheme when applying the same funds to the reduction of debt might arguably have achieved a better outcome?
Clearly this would be absurd but if such an approach is absurd for Nest, what are the chances that the ombudsman would be consistent in its determination if it was adjudicating on a pension sold by an IFA?
The compensation culture that dominates financial services fundamentally fails to recognise that neither financial products nor advisers can work miracles. There will be situations where a client’s resources will simply not allow he or she to achieve their objectives. There will doubtless be situations where clients will accept more risk than is prudent and the FSA guidance makes it clear that advisers should identify such situations.
The wild cards in all this are the Financial Ombudsman Service and the Financial Services Compensation Scheme, both so spectacularly out of control that there must be a very real risk that they will cause longterm strategic damage to the UK economy.
The regulatory culture in the UK, and especially the compensation scheme, has created an environment where multinational financial service institutions no longer consider the UK a good place to employ capital. This was reiterated to me just before Christmas by one of the world’s biggest insurers when discussing its future plans for the UK, or more accurately the lack of them.
From a practical perspective, even if the adviser documents all the risks in any solution and has a client sign to confirm they understand them, the ombudsman may challenge if the customer actually understood the risks they were accepting.
It is valuable that the FSA is planning to codify the need to explore additional areas over and above attitude to risk when assessing suitability. This guidance, however, will only have limited value if there are not serious attempts to reign in the excesses of those who seem to want to remove any risk in financial products from consumers, in effect, making investments and advice guarantees.
This suggest to me there is a need for firms to implement additional processes for their own protection, to be able to demonstrate when challenged that not only did they explain all the risks in any strategy and any conflicts but also that they have been able to measure that the client understood these risks.
Perhaps it is time to keep a complete audio recording of every meeting and phone conversation but even that may not fully protect the firm conducting the business. But if it is possible to challenge a client signing to say they understood risk, the ombudsman will doubtless challenge an audio recording of them saying they understand risks.
In the absence of any reform of the excess of the ombudsman, it appears to me that we have reached the stage where perhaps advisers need to require their clients to take a test to demonstrate that they have actually understood a product.
This may sound excessive but how else can a firm prove a client understood the risks in a course of action after the event? Such an approach might be particularly advantageous in the execution-only market as a way of addressing concerns over suitability raised via Mifid.
This consultation lays down challenges to anyone using most of the packaged attitude to risk tools in the market. My researchers are drafting additional questions to benchmark these solutions, the results of which I expect should be able to provide some valuable insight, given the FSA has refused to be drawn on which systems did not meet its requirements.
In addressing this issue, the FSA has started a valuable debate but it is essential that it be the beginning, not the end, of these discussion.
The extent to which technology can help firms understand clients’ requirements and the understanding of the solutions provided will increase significantly over the next few years.
It should be seen as important to capitalise on these tools and embrace them rather than constrain their use, as potentially they have the capability to make a valuable contribution to choosing the solutions that best suit individual clients.
Ian McKenna is director of the Finance & Technology Research Centre