Hayden Royal Practice Management: Suitability Best Practice

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In litigation commenced by clients against financial advisors, the core of the claim often centers around the financial advisor’s: (i) inability to invest the client’s investment portfolio consistent with her risk and suitability profile; or (ii) failure to modify or update the client’s profile and related investment strategy after external factors, that the advisor should have known about with regular client communication, would have compelled the advisor to modify the client’s investment strategy. This article will discuss the importance of the risk and suitability assessment and the need for meaningful discussion with the client in order to construct and update an objective investment strategy that meaningfully takes all of the client’s information and objectives into consideration.

FINRA Rule 2111 provides that brokers/advisors must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.   Although the Investment Advisers Act of 1940 does not contain express statutory language regarding suitability, the SEC has issued guidance regarding suitability that states that “[a]s fiduciaries, investment advisers owe their clients a duty to provide only suitable investment advice. This duty generally requires an investment adviser to determine that the investment advice it gives to a client is suitable for the client, taking into consideration the client’s financial situation, investment experience, and investment objectives.”  With respect to constructing a risk and suitability profile, FINRA Rule 2111 lists the following factors to be taken into consideration:

  • Age
  • Other investments
  • Financial situation and needs (e.g., annual income and liquid net worth)
  • Tax status/rate
  • Investment objectives
  • Investment experience
  • Investment time horizon
  • Liquidity needs
  • Risk tolerance (e.g., willingness to risk losing some or all of the original investment in exchange for greater potential returns)

 

CONDUCTING MEANINGFUL RISK AND SUITABILITY ASSESSMENTS

When a financial advisor conducts a risk and suitability assessment, the advisor often relies upon a paper or electronic form that generally touches upon all of the FINRA factors listed above.  However, it is very easy for an advisor to fall into the trap of conducting a cursory “check-the-box” exercise where the advisor takes the client’s answers at face value and leaves the meeting and formulates and executes an investment plan consistent with the client’s answers.

However, skin-deep risk assessments may not result in an investment plan that delivers what is in the client’s best interest.  Rather, a risk and suitability assessment requires a meaningful dialogue with the client where the advisor should process and digest the information supplied by the client.  This is important in order to secure a concrete understanding of the client’s investment objectives and recommend an investment strategy that might not necessarily be consistent with a client’s dream to achieve aggressive, market-beating returns. But to the contrary, a strategy that takes the client’s full risk and suitability assessment into consideration.

For example, a client may indicate that she desires an ultra-aggressive investment strategy with heavy weighting toward technology-related equities – as some of her friends and relatives achieved outsized investment returns in years past with a similar strategy.  However, the client has also indicated that she has: (i) limited investment experience; and (ii) investment objectives that include generating predictable income and funding retirement.

Obviously, these objectives are somewhat inconsistent.  Therefore, a frank discussion with the client should take place to fully understand what is most important to the client.  Ultimately, a client’s wishes with respect to her investment strategy should prevail.  However, as the client’s fiduciary, a financial advisor must act in a way that is in the best interest of the client and her investments.  Accordingly, as a fiduciary, a financial advisor should insure that a risk and suitability assessment is a two-way discussion where all factors leading to the construction of an investment strategy consistent with a client’s profile are fully vetted.

UPDATING SUITABILITY PROFILES – KEEP UP WITH WHAT IS GOING ON IN YOUR CLIENT’S LIFE

I often hear from advisors that they try to meet with clients at least annually to go over the client’s portfolio and investment objectives.  And to be fair, some clients would rather get a root canal than sit down with their advisor to go over these things.  However, as clients continue to age, move closer to retirement or actually commence retirement, it is important to increase the frequency of the client check-ins and ideally use the risk and suitability profile as the centerpiece of the meeting – outside of the review of the client’s portfolio.  Often, the risk profile will not change after the client check-in meeting.  However, by conducting the meeting and documenting that the risk and suitability profile has not changed will create a record that may protect the advisor if the client ever alleges any wrong doing on the part of the advisor.

Further, by staying in touch with clients and knowing what is going on in their lives, may provide signals to advisors that they need to revisit their client’s risk and suitability profile in order the act in her best interest.  For example, on the negative side, staying apprised of potential job loss, sickness, bankruptcy, litigation judgments or other factors that may detrimentally affect a client’s financial situation, should compel an advisor to reach out to the client to discuss her evolving investment needs.  To the contrary, a client may have received an inheritance or gotten a better job that might compel the client to revisit factors such as her short-term cash needs.  In all cases, staying in touch with clients and knowing how to consider life changes in updating suitability profiles will insure a better advisor/client relationship and ultimately protect the advisor in the event of client dissatisfaction.

DON’T FALL IN LOVE WITH YOUR TECHNOLOGY. . . TOO MUCH

Often times, advisors will use technology tools to collect client risk and suitability data, which will spit out the outlines of an investment plan.  Don’t get me wrong, these tools are a great addition to an advisor’s “bag of tricks” in generating charts and graphs that paint a nice picture of what the client’s investment strategy will look like.

However, many tools are built around coded assumptions that generate output based on the data that has been supplied by the advisor from the client risk assessment.  For example, there are default assumptions of a client’s life expectancy.  Life expectancy assumptions, however, are somewhat flawed and reactively built around currently-available mortality data. If an advisor digs a little deeper with the client about probable life expectancy by looking at factors like: (i) overall health; (ii) lifestyle; and (iii) family history, an advisor can make a subjective, yet reasonable assumption about life expectancy that may ultimately protect a client in later years.  This subject frequently comes up in retirement cash flow planning.  If a retirement plan contains an assumption that the client will die in her early 80s and contemplates retirement income being generated from the portfolio annually, she may reach her 80th birthday and be healthy as a horse.  However, her portfolio value may be dwindling and the prospects of running out of funds prior to death are a stark reality.

In short, technology tools are very useful with respect to providing good client service.  But, by doing a “sanity check” on the key assumptions utilized by the technology product based on a full understanding of a client’s overall profile will go a long way in giving a client a realistic portrayal of all of the moving parts that go into their ever-evolving investment strategy.

 

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