Suitability, Minimum Standards & Fiduciary Duty in the Canadian Financial Services Industry
We all live in the same investment universe; we just occupy different positions within it. This investment universe holds all asset classes with varying, risk, return and liquidity characteristics. Each asset class could within reason be included in any individual portfolio.
However, what defines the proportion to be invested in each is determined by the nature of risk and return at a point in time and the nature of risk and return over time relative to the needs of the investor (in technical terms, liabilities) over time. Effectively any investment is suitable but suitability can only truly be addressed by assessing the whole; that is the relationship between an investor’s total financial assets and total financial needs over time.
Industry suitability rules do not address the total relationship and do not address the total relationship over time because they are not trained to assess the whole.
This section of the site defines the true components of suitability and the prerequisites of suitability.
There are five dimensions or component rules that comprise suitability. These are as follows.
An investment that is recommended must relate to a) the actual size and timing of financial needs over time and b) the relationship between financial needs and total assets over time (both current and future disposition of capital).
After relating the allocation to a given investment or set of investments based on financial demands on the portfolio over time, the investment must then be able to relate to attitudes to risk and investment preferences. It is these risk and performance preferences that either increase the income and capital security of the portfolio or increase/reduce the risk/return relationship of the portfolio.
We all live in the same investment universe but our risk preferences (in addition to our financial needs) determine our final position within it. These relationships are again complex, but simple to solve providing you understand the decision rules that relate risk preferences and financial needs to all points of the universe.
Thirdly, the recommendation must relate to all existing investments and the relationship that exists between these investments and financial needs at a point in time and over time. A recommendation may be a suitable investment if we just look at a simple profile, but if you already have enough of it, it may not be suitable. Being able to identify the asset allocation gaps in the portfolio and being able to relate the security to an asset allocation (and hence a valuation framework) is not an easy job.
Fourthly, the recommendation made must make sense given the price of the investment at the time and the risks the investment is exposed to over time. Initial investment risk is a key risk aversion for many investors and many investors rely on their advisor’s assessment of initial investment risks.
Buying an overpriced security (or portfolio of securities) poses significant risks to future financial security. Indeed, while it may be virtually impossible to predict market timing it is possible to ascertain valuation risks to future return. If you are managing suitability you should not just be managing volatility but liability risks (risks to the ability of assets to meet planned financial needs over time).
Suitability can only be fully assessed with client interaction in the decision making process. This also means that education and communication regarding the basics of investment, the risks of investment, the manager’s investment style and how portfolios are constructed, planned and managed to meet financial needs over time are key to agreeing suitability of transactions, products and recommendations.
Education and communication are also key to managing fiduciary risk which is a risk organisations take if they do not address the importance of education and communication. But as with all the above components, the ability to manage these components effectively requires a centralised wealth and asset management process.
Without communication of where the advisor stands on the first four rules of suitability, it is unlikely that a client is able to make an informed ex ante decision about transactions within an advisory relationship and an informed ex post assessment within a discretionary relationship or about the suitability of portfolio management structures within both advisory and discretionary relationships.
If your advisor does not know the disposition of all your assets and the disposition of all known or likely needs, or the specific assets and specific needs related to the mandate at hand, he or she cannot fulfil rule 1.
Irrespective of the process or discipline used by an advisor, transactions need to pass a suitability test defining the process in which the structure, planning and management of assets meet financial needs as and when they arise while managing the risks and the costs of such a process.
Since every investor has the right to know the limitations of the service they are receiving in this respect, a fiduciary duty should involve communication of the portfolio construction, planning and management process and its limitations with regard to suitability.
An organisation where the logically inherent limitations of a service are not communicated to a client, is taking a fiduciary risk, especially when promises of personalisation, customisation or risk management are made.
Since the structure of the portfolio and how it manages the risks to the ability to meet financial needs over time is key to risk aversion, the client also needs communication of this discipline and to be able to assess their aversion to this risk.
If the amount that is allocated to each primary asset class and security is based on financial needs then each recommended portfolio should be unique.
However, what may be the most efficient asset allocation of transactions for the advising company’s assessment of the investment universe, based on their disciplines, may not be one which the investor feels comfortable with.
Advisors that do not relate the structure, planning and management of assets to meet financial needs to all key risk factors (liability, performance/style and volatility/aggressive/conservative) will not be able to address the suitability of the portfolio to the client’s main risk preferences. As such the management of expectations regarding these key risks cannot be effectively conducted.
This leaves the advising company exposed to suitability risks, irrespective of whether the relationship is advisory or discretionary. It also implies that the company has taken responsibility for the management of this risk themselves, which implies a fiduciary duty. Indeed this applies to any component of suitability which is not explicitly explained to the client or managed by the advisor.
It is therefore important for organisations where rule 1 is not assessed and where attitudes to the risks associated with rule 1 are not addressed, that they specifically explain that these risks are not addressed within the construction, planning and management of assets.
This fiduciary risk is particularly important where investors are depleting capital over time and where inappropriate portfolio structures and costs will impact on the ability of the proposed transaction solution to meet needs and protect against risks.
Sadly the industry does not consider itself responsible for managing these risks. Unless a firm specifically states that it will not manage these risks and explains the consequences to investors of not managing these risks, it should be responsible. Otherwise the advisor will be asking individuals to manage risks they do not understand and are incapable of assessing or compensating for while recommending transactions that are unsuitable, without structure and proper risk management.
It is paradoxical that in the absence of statements to the contrary, minimum industry standards that do not satisfy rules 1 and 2 are effectively forcing a higher level of fiduciary responsibility onto the companies themselves.
After all fiduciary duty, rightly or wrongly, implies the existence of discretion over issues which the investor is ignorant and incapable of managing on their own, which the individual has implicitly devolved to the advisor and, for which the advisor has implicitly accepted responsibility. This responsibility is not assessed within the legal system or the complaints process because of ignorance over suitability and its structure.
Indeed, within an advisory relationship the only decision which an individual has retained control over is the acceptance or not of the transaction initiated and understood in the first instance by the advisor and, to which less information than is needed to develop the recommendation is provided to the investor. Again, a significant level of discretion is retained over the decision by the advisor in advisory relationships.
All recommendations should take place within an asset allocation framework determined by financial needs, risk preferences, the manager’s investment style and valuation/risk relationships.
The individual security selection should relate to the recommended asset allocation and security selection for a given client return/yield/risk/liability profile.
A broker cannot just phone you up and say, “I have this great investment” nor can a discretionary manager include the flavour of the month investment without being able to relate it back to the portfolio construction, planning and management framework.
The justification for a security recommendation cannot be your profile as suggested by the “know your client form”. If this were the case any investment on its own would be suitable.
The suitability of an investment can only be viewed by its position within the portfolio, its affect on asset allocation, valuation and on risk and return over time relative to financial needs. As discussed later the “Know Your Client” form does not actually provide a structure for the management of assets and needs. It is a transaction profile wholly inappropriate for the proper management of assets and financial needs.
The only time a broker should be recommending a single transaction is where the client is in a transaction relationship. Such a relationship should only exist where the client has knowingly taken full responsibility for the management of their assets. Indeed a great many advisory relationships are actually relationships in which the individuals wholly rely on the advisors expertise.
If suitability relates to the management of risks likely to affect the ability of assets to meet financial needs over time, then the initial investment decision is important.
The current valuation of an asset is material to the suitability of the asset and the management of expectations.
It is not enough to say that an asset is high risk/high return, since valuation is the biggest factor in risk at a point in time. Most risk statements do not cover the current valuation risk material to understanding the investment decision.
If the current valuation and hence the valuation risks of an asset are not being taken into consideration then advisors are in breach of their fiduciary duty irrespective of whether they are operating under a discretionary or an advisory mandate. Indeed, those operating under an advisory mandate have discretion over the parameters of the initial investment decision if they fail to disclose current valuation risks and only disclose historical risk/return relationships.
Whether you are in an advisory or discretionary relationship the initial investment decision is material and both discretionary managers should go through the same risk assessment process with regard to this risk and need to disclose the process in which these risks are assessed and managed.
If a client has not been educated over the portfolio construction, planning and management process used by the advisor and cannot relate this to the management of their financial objectives, it is unlikely that they can realistically have accepted the recommendation.
If a client has not been educated over the basics of investment or the risks of investment, then the advisor is taking discretion over the suitability of an investment and the resulting transaction recommendation irrespective of the client relationship, whether it be advisory or discretionary.
Education and communication is important in terms of determining where in the universe the client is in relationship to the investment advisor. Communication (reporting) is important in confirming the rationale for all material decisions and for communicating the rationale for the management of the portfolio and the attendant risks of the strategy. Quite how an investor is bound to accept the risks of an investment transaction without clear and formal communication is of enormous concern. Investments should not be considered only as transactions unless the client has specifically requested and self initiated a transaction request and has confirmed responsibility for the suitability components.
Further information on the communication process (reporting, education, risk assessment) can be found on the TAMRIS web site.
The only time a transaction can be clearly assessed as a stand alone transaction should be when an experienced and sophisticated investor uses his or her investment advisor to solicit a security or a trade idea. In this sense, the individual investor is assumed to have taken full responsibility for the consequences of the transaction and for all issues of suitability.
Individual investors who do not have the expertise to be initiating transaction decisions, but do, are also taking responsibility for issues of suitability and relieving their investment advisors of their fiduciary duty. All the investment advisor has responsibility for in this instance is that the trade recommended matches the suitability profile of the individual, although even here advisors are allowed to execute unsuitable trades if the client specifically requests this.
Investors relying on their investment advisor for advice and are inexperienced in investment must note that it is important that they do not start initiating transaction decisions. Although, making sure you actually have a proper mandate and agreement as to how the account will be managed is an important prerequisite.
In terms of suitability, once an individual investor starts to initiate their own transaction decisions they may negatively impact the portfolio construction, planning and management framework instituted by their advisor. Individual investors without the necessary expertise are going to be making trades that do not meet the rules of suitability and that will violate the structure of the portfolio. An advisor should not be held responsible for this, although they should be responsible for informing the individual of the risks they are taking.
The current know your client form is more or less appropriate for transactions initiated by the individual investor.
It is important that the mandate for the advice and the framework in which the relationship will be carried out is agreed in advance so that issues of responsibility, suitability, duty of care and fiduciary duty are covered.
What is also important to understand is that there are two types of transaction within the wider environs of suitability. There is the transaction between securities designed to reduce risk and or enhance return and there is the transaction initiated by the relationship between financial needs and assets.
An investor can initiate the second type of transaction without violating their mandate or the advisor’s fiduciary duty towards them as long as it is the manager that makes the transaction decision. For example, I need to spend C$30,000 in two years time, please provide me with the capital at the time.
It is important to realise that whatever the relationship mandate, advisory or discretionary, where the client is reliant on the advice of the advisor that the advisor will be initiating the recommendation and the reasons for the recommendation. Because of this it is therefore important that suitability lies behind all decisions irrespective of the mandate (advisory or discretionary).
An organisation must have the necessary expertise, investment discipline, resources, business and services processes and systems needed to deliver personalised wealth management in order to be able to deliver suitability.
If you are recommending an asset class but do not know how to value it, manage it or to incorporate it within a portfolio suitable to client financial needs and risk preferences, then are you being negligent and in breach of an implicit fiduciary duty. Most clients have to trust their advisors and because of this most clients are vulnerable if their advisors do not have the expertise, systems, resources or business and service processes to deliver.
Suitability is a framework, not a transaction. It is unlikely that a client could ever fully ratify suitability without knowledge of the rationale for the transaction and structure in which the risks and returns of the investment are managed. In this sense even an advisory relationship is operating with discretion over the framework governing suitability.
It is also unlikely that a client who has not been properly educated about the construction, planning and management process will be able to understand whether something is suitable or not and therefore is unlikely to ever fully be able to mitigate unsuitable or inappropriate advice successfully.
Since it is the responsibility of all advisors, whether they be discretionary or advisory, to ensure that all transactions and structures are suitable, even a discretionary relationship should have structures developed by interaction with the client.
In fact we need to assess the true nature of suitability in order to fully understand the responsibility that all advisors are taking and, the duty of care they are responsible for providing. Most clients are vulnerable in the face of the complex world of portfolio personalisation.
Just what is the difference in duty owed by an advisor who works on a discretionary basis to one who works on an advisory basis? For investors who do not possess the expertise and who rely on their advisors, next to no difference whatsoever
Suitability is a cornerstone of all portfolio management. It is where the management of assets meets the management of financial needs and where the approach and discipline of the manager is tailored to the risk and performance preferences of the individual. All factors noted above also apply to the management of discretionary portfolios.
