Key points

  • A focus on the boxes to be ticked rather than the reasons the boxes exist can lead to laws being followed at the expense of meeting the very outputs the laws are there to produce.
  • Overlooking the spirit of the laws is easy, but dangerous, because it is the spirit that will always be the final judge of whether a course of action is suitable or not.
  • When it comes to assessing suitability, the message you send about what is being invested in is less important than the one the client receives. The focus should be less on acquiring client knowledge, and more on how we use this knowledge that reflect an understanding of what truly matters to investors.

The letter and the spirit of the law

The spirit of financial advisory regulations is clear: to protect clients from bad investments, from unscrupulous salesmen, and from themselves. They aim to increase a client’s comfort and confidence with investing – to arm them with a greater understanding of what they are investing in, and why.

Comfort and confidence are emotional states, triggered by internal traits colliding with external circumstances. And you do not manage that by looking through a limited, letter-of-the-law lens. A focus on the letter of the law can leave advisers feeling like they are playing a constant game of catch-up. To make matters worse, a focus on the boxes to be ticked rather than the reasons the boxes exist can lead to laws being followed at the expense of meeting the very outputs the laws are there to produce. You get what you incentivise.

Moreover, understanding of both the client and how they interact with their investments naturally grows over time, built by the ongoing feedback loop fed by each adviser-client and client-investment interaction. A risk profile and financial personality assessment should have clear consequential prescriptions. Requests feel less demanding when the ultimate purpose is clear, and an emotionally understood investor is an engaged investor.

Think second of trust. The adviser-client relationship – and therefore a huge element of client comfort – relies on trust. That trust is eroded when the tools designed to help feel like a hindrance.

Overlooking the spirit of the laws is easy, but dangerous, because it is the spirit that will always be the final judge of whether a course of action is suitable or not. Recall, for example, the FCA’s 2011 guidance, which stated it had reviewed 11 risk-profiling tools and was concerned to find nine had “weaknesses that could, in certain circumstances, lead to flawed outputs”.

Or consider the ability to take risk. The spotlight is now turning on risk-capacity calculations, because they are commonly not calculations at all. Instead, capacity assessments are commonly based on qualitative statements or workarounds, which are not designed for the purpose of quantifying affordability over a lifetime in the context of fluid and uncertain circumstances.

Time horizon is perhaps the classic example of the potential for unintended consequences. It is entirely sensible an investor’s time horizons are considered. But the plural is important. ‘What is your investment horizon?’ is a meaningless question, usually with options – like ‘three, five or seven years’ – that are simultaneously leading and misleading.

Investment time horizons are, by definition, spread across competing, and flexible, goals. Reducing this to a single tick in a box often forces investors to state a horizon that is shorter than their true goals, which runs counter to all good advice on investing as a long-term activity.

Outputs also decay: suitability is an ongoing process, so snapshot assessments are insufficient. Of the main elements of suitability, only risk tolerance is broadly stable across time. Comprehensive compliance therefore must be as dynamic as the investment journey it supports. Confirming the right level of investment risk for a client prior to investing is non-negotiable. But that right level is subject to change: the assessment needs to keep pace.

Ultimate intention

Concentrating on the ultimate intention of the regulations also helps reduce confusion caused by trying to measure the suitability of a portfolio across different levels – that is, tied to a specific goal, general goals, an individual, or a family unit. Zoom out and assessing suitability becomes much clearer.

It could be argued that all talk of ‘spirit’ is a bit unscientific, and no defence against a regulatory judge. This would be wrong. It is far more dangerous to rely on blind box-ticking with evidence only of the answer, not the process, or the reason, or what the question was, or why it was being asked. When it comes to assessing suitability, the message you send about what is being invested in is less important than the one the client receives.

The focus should be much less on acquiring client knowledge for the purposes of ticking boxes, and much more on how we use this knowledge in coherent suitability frameworks that reflect an understanding of what truly matters to investors. And profiling should not stop when investment starts. It should be married to, not divorced from, the ongoing client relationship, dynamically adjusting to meet changing circumstances.

Regulations are growing more rigorous, but their pattern is predictable. And reacting to regulatory changes is less efficient than anticipating them. A focus on the spirit of the laws should ensure that regulatory requirements are met as a side-effect of following processes designed for other purposes.

Originally published in Professional Adviser on 2/8/2019.