Client segmentation under the spotlight as rule changes near

Under Prod rules, are providers making sure the correct products are aligned with the right clients to meet regulatory requirements?

The product intervention and governance rules ushered in by Mifid II appear to have taken a back seat with advisers after being overshadowed in the headlines with cost and charges disclosure requirements.

Firms Money Marketing spoke to at the beginning of May were still very much occupied with this cost and charges disclosure.

But with Prod rules coming into force at the end of the year, how are they ensuring that segmentation and investment selection exercises will be up to the task Prod requires, so that the right products get into the hands of the right clients?

Adviser view

Tim Morris
Planner, Russell & Co Financial Advisers

I do segment my clients partly based on accumulation compared with decumulation. The former tends to be for clients with larger assets. Those, and the higher earners, are who I would consider for a venture capital trusts or enterprise scheme investment. Inheritance tax planning is also more relevant as those clients tend to be older. I have quite a few younger clients, so will ensure they are utilising all tax wrappers, including the Lifetime Isa. However, they tend to be business owners and prioritise pensions to extract their profits in a tax-efficient manner. 

In regards to alternative assets or diversifiers such as commodities and infrastructure, property funds could also come into this. I would consider these for any clients. However, it is dependent on their attitude to risk and because they all have equity content, it tends to be clients with balanced and above-risk profiles.

Taking the time to target
The Prod rules are aimed at both “manufacturers” – i.e product providers – and “distributors” – i.e. advisers. Under Prod, providers will have to specify which type of client they are catering to with their product, as well as identifying the type of client “for whose needs, characteristics and objectives the financial instrument is not compatible”.

Advisers will be asked to understand the providers’ descriptions of the product and match it (“distribute it”) to the right type of client.

But critics have pointed out that there are cases where a financial planner can use a certain financial instrument’s characteristics to their client’s advantage, even though it was not meant for that client’s particular market segment.

Belmayne Independent Chartered Financial Planners partner David Bashforth says there are a number of such examples where there are “benefits not created by design”.

For instance, these can include investment bonds and the coincidental exclusion from care costs, using business property relieved investment in a discretionary trust to mitigate a periodic charge, using the different pension rules between defined benefit and defined contribution to the client’s advantage for annual allowance purposes, and using the chargeable event regime to maximise benefits in terms of personal and savings allowances by creating gains.

Bashforth says: “I could go on. The point is that each of the recommendations should be judged on its own merits, not simply discounted because the provider didn’t think of the benefit at the time [when designing their product].”

Apart from their knowledge of providers’ product descriptions, advisers will still have to know their audience. Regulatory and compliance experts suggest a way to do this is by splitting a firm’s client bank into clearly defined segments.

Research by consultancy The Lang Cat, which in August 2018 tested planners’ awareness of and preparedness for Prod, showed high variance between how advisers split their client banks. Out of those who divided their clients into groups, the most common criteria for splitting was by assets and age, and whether the client was in the accumulation or decumulation phase of planning.

Expert view

Segmentation processes need to meet criteria
Advice firms now need to ensure their client segmentation processes are aligned with product manufacturers’ target market criteria across client type, their knowledge and experience, ability to bear losses, objectives and needs, risk appetite and the distribution channel (i.e. the adviser firms).

We will see if advisers can start to segment clients with this criteria in mind, showcase how this works in their client terms and agreements, and blend in their clients’ behaviours, such as propensity to purchase, based on their goals and sensitivities to fees. Only then will their suitability process be watertight and clearly understood by clients.

Advisers need to understand and implement the Mifid II suitability criteria, which is essentially applying Prod across their service proposition. There are challenges here as not all product providers are playing ball and communicating their target market criteria well enough. So advisers need to be robust and demand full disclosure so they can ensure their client segmentation strategy matches the product provider’s, and this is communicated to clients in a clear manner.

Regulatory obligations show that advisers need to be completely up-to-date with the latest features and benefits, costs and charges of products, and ensure they meet client needs in relation to their knowledge and experience, financial situation and investment objectives, including risk tolerance. So if challenged by a third party, advisers should be able to confidently articulate that their advice, knowledge and suitability process meets the current rules and client needs.

Chris Davies is founder of compliance services provider Model Office

Some advice firms had not considered how they would group their clients, however.

This was especially the case for one-man-band advice firms, many of which said that given they were only looking after a small number of clients, they would look at each case individually.

While some argue that this approach is surely in line with keeping the client at the centre of their proposition, and that creating a further directory of how clients should be categorised would be obsolete, the question remains over how the regulator, which has hinted at a retreat from a process-focused to an outcome-based approach in recent papers, will measure whether or not firms are meeting their tests.

The use of higher-risk investments for client segments they may not be appropriate for could be one issue that rears its head with Prod rules.

While a recent survey of 1,000 investors by asset manager Legg Mason shows advised investors received 7.5 per cent returns in 2018, higher than the 5.9 per cent for non-advised ones, the advised investors were found to hold nearly four times as much in alternative investments, including commodities and hedge funds.

Legg Mason head of UK distribution Alex Barry says: “People who tend to choose their own investments take less risk than those who take advice, which can have a significant effect on returns. What our results show is that there is no substitute for expert knowledge when it comes to investing.

“A good adviser will take a considered view on higher-risk investments and search for higher returns in areas that perhaps most DIY investors wouldn’t, while at the same time ensuring that clients are adequately diversified to withstand any market shocks.”

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. Christopher Petrie 14th May 2019 at 2:21 pm

    7.5% average returns in 2018?
    Really?

    I’m not sure Legg Mason themselves made that!

  2. The debate about Prod underlines how little attention TCF ever received since the TCF includes exactly these requirements. Product providers were quick to point out that they do not know the client – indeed in some cases do not know who they are – without developing any imaginative ways of meeting the requirement. Will anyone bother with it this time around?

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