'We do not make changes for the sake of making them,' Henry Ford apparently said, 'but we never fail to make a change once it is demonstrated that the new way is better than the old way.'
Some in the financial services industry will say much of the recent regulation-driven change around client focus has been overblown.
Yet Ford’s wisdom is worth reflecting on at the end of a year in which providers and advisers have been wrestling with wide-ranging changes that demand new ways of meeting client needs.
Mifid II has had a huge impact. So much so that other sets of new rules seem to have flown under the radar.
The product intervention and product governance sourcebook (Prod) has forced advisers and providers to consider improvements to demonstrating suitability.
Prod requires all firms to ensure they offer ‘good product governance’, which means products should meet the needs of one or more identifiable target markets; be ‘sold to clients in the target markets by the appropriate distribution channels’; and deliver ‘appropriate client outcomes’.
One of the most eye-catching elements of Prod is the need for advisers to have processes in place to identify the right target markets for the products they recommend (and, just as importantly, to ensure they remain the right ones).
Prod demands they understand the financial instruments recommended to clients and assess the compatibility of those instruments with the needs of their clients, while ensuring they are distributed only when they are in the client’s best interest. In other words, it places a much greater emphasis on advisers to evidence suitability by client segment.
Up the ante
Advisers already had stringent suitability requirements to meet, but Prod ups the ante when it comes to evidencing that products are in the client’s interest. It also provides a clear link between client suitability and product appropriateness that wasn’t clearly explicit.
A key plank in this is the way advisers match risk profiles to investments (and keep them aligned over time). This is an area in which some advisers (and providers) have been found wanting, with ensuing concerns, in particular, over the accuracy of portfolio recommendations in relation to suitability.
The accepted approach across the fund management industry is often to simply map risk tolerance scores to the range of equity exposure in a portfolio. But risk tolerance is just one part of the picture. Incorrect mapping to portfolios is inevitable and potentially dangerous.
The second set of rules emerges from the expansion of the senior managers regime (SMR) next year to all Financial Conduct Authority authorised firms that will concentrate minds on this point.
The SMR, already in force for major banks, will make the designated senior managers accountable for taking steps to prevent regulatory breaches and demonstrate that governance requirements are met, among other demands.
The evolution of risk profiling processes means there’s no good excuse for firms to rely on risk tolerance alone to indicate the suitability of a portfolio recommendation.
Risk profiling evolution
Risk profiling processes are evolving, driven by a combination of regulation and technology in a way that underscores Ford’s point about new ways being better than the old ways.
For example, improvements in risk profiling mean risk tolerance, an investor’s willingness to take risks, and risk capacity, their ability to take risk, can each be measured accurately and objectively in a way that also takes into account factors such as time-horizon, behaviour, experience and composure.
This is a significant raising of the suitability bar, moving away from fund mapping processes that focus excessively on risk tolerance and too little on risk capacity.
That risk profiling process should be part of an ongoing suitability assessment that also accounts for factors such as behavioural insights (such as the investor’s emotional response to the ups and downs of the investment journey).
Only when suitability is built into the financial planning framework in this way can firms deliver optimal customer outcomes and demonstrate they are working in the client’s best interest while responding to change in a way that enhances their reputation.
The challenge isn’t so different to those faced by Henry Ford and his contemporaries. If it’s clear there’s a new way of doing things that improves on the old way, the only alternative to change is to fall behind.
Paul Resnik is executive director of PlanPlus Global and co-founder of FinaMetrica.