Were you to track regulatory changes over time, you would see a clear direction of travel. Aligning your suitability processes with this direction can transform meeting the rules from a burden to a competitive advantage.

You do this by shifting your focus from the letter of the laws – what they say: the isolated boxes to tick; to their spirit – why they exist: to ensure good client outcomes.

A focus on the boxes to be ticked rather than the reasons the boxes exist can lead to laws being technically followed at the expense of meeting the very outputs the laws are there to produce.

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

The letter of the regulations says you must account for a client’s risk tolerance, knowledge and experience, and so on. But that’s not really what the regulations are after. Because it’s perfectly possible to ‘account’ for these in a counterproductive way.

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For example, in its 2011 guidance, the Financial Conduct Authority (FCA) stated that they’d ‘reviewed 11 risk-profiling tools and were concerned to find that nine tools had weaknesses which could, in certain circumstances, lead to flawed outputs.’ And in its 2023 MiFID II guidance, the European Securities and Markets Authority (ESMA) spelled out: ‘In assessing a client’s knowledge and experience, a firm should also avoid using overly broad questions with a yes/no type of answer and or a very broad tick-the-box self-assessment approach.’

It pays to ask why these guidelines exist. Shouldn’t the rules themselves be enough, without requiring separate guidelines on how to follow them? The regulators would not have bothered releasing additional guidelines if the ways the risk tolerance and knowledge and experience boxes were typically ticked were good enough. The problem wasn’t what was being done, it was the way in which it was being done.

This is arguably even more apparent in the way Mifid II guidance and the Consumer Duty rules have incorporated the requirement to account for client behaviours. For example, the need not only to tell a client something but to take reasonable steps to make sure they have actually understood it.

We see something similar too with the new Sustainability Disclosure Requirements and their guidance to tackle greenwashing.

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Problems of a checklist-focused approach to suitability

It is undoubtedly tempting to believe that methodologically extracting each requirement from the lines of legislation and ensuring they’re covered in some way will add up to a clean bill of regulatory health. However, this decontextualised line-by-line approach has some practical pitfalls:

1. It encourages ineffective upfront loading – Confirming the right level of investment risk for a client prior to investing is non-negotiable. But that right level is subject to dynamic change. Understanding of both the client and how they interact with their investments naturally grows over time. Outputs also decay. Of the main elements of suitability, only risk tolerance is broadly stable across time. Trying to get everything out of the way as soon as possible is effective for a checklist, but counterproductive for a client outcome.
2. It hinders client understanding – A client’s understanding of what they’re investing in (and why) is not helped by haste or volume, or by the lack of a clear link between information requested and its ultimate importance for them.
3. It leaves advisers playing catch-up – A focus on the letter of the law can leave advisers feeling like they’re playing a constant game of catch-up: tweaking processes, and bolting-on additional steps to meet each new requirement. However, 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.

Future-proofing your suitability processes

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.

This isn’t about abandoning the checklists in favour of assuming that if a client is comfortable then all is well. It is simply about where to angle your attention. To see that the best suitability processes focus 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.

The study found that, despite European Securities and Markets Authority (ESMA) updating its guidelines on the integration of sustainability factors, risk and preferences into investment firms’ organisational requirements last September, 13% of wealth managers say that they don’t know what the directives on sustainability assessments are or are unsure that they understand them.

The research found that 30% strongly believe that the ESMA Mifid directive on sustainability assessments will improve investor outcomes. Over half (57%) said that they do believe that it will improve investor outcomes, and 11% are not sure whether it will or not.

It also revealed that just over a quarter (28%) of European wealth managers strongly believe that their current process for establishing a client’s sustainability is helpful to building their relationship.

Around 61% believe their processes are helpful but 11% are not sure whether their current process for establishing a client’s sustainability preferences are helpful to building their relationship or not.

Client insights

James Pereira-Stubbs, chief client officer at Oxford Risk, said: “It’s concerning just how many wealth managers still aren’t up to speed with Mifid II requirements, given that it’s nearly year since they came into force.

“The list of requirements may be long, with sustainability assessments making up just one part, but the key to understanding the solutions is simple. It’s all about client insights − better insights into a client’s sustainability preferences, better evidencing of these preferences and better presentation to clients of how these preferences match up with suitable investments for them.

“Get this right and you not only follow the spirit as well as the letter of the law, but also have more engaged clients, better asset growth and higher retention.”

It has issued its warning following additional guidance by European regulator European Securities and Markets Authority (Esma) highlighting a need for improvements in how the legislation is currently being applied to investor suitability assessments, with a focus on what firms are overlooking.

Oxford Risk said it is seeing “a lot of confusion” from advisory firms and, in some cases, major firms are “asking clients to sign off their own risk level even though the legislation specifically prohibits this”.

Esma’s latest guidelines on certain aspects of the Mifid II suitability requirements published in April highlight how the requirements to account for investors’ sustainability preferences are the most inconsistently applied, Oxford Risk says.

Mistakes

Other common mistakes Oxford Risk sees include confusing risk tolerance with the right level of risk for investors, and not combining risk capacity and risk tolerance in determining overall suitability.

Advisers and wealth managers also often incorrectly measure objectives and time horizons in relation to an investment and not the investor.

In addition, advisers and wealth managers often don’t measure investor preferences in a robust and scientific way, while confusing owning or not owning investments with having knowledge and experience relevant to the investing experience.

Oxford Risk is concerned that firms are not assessing suitability preferences in sufficient depth and emphasises the need to assess preferences more granularly than simple yes or no questions.

James Pereira-Stubbs, chief client officer for Oxford Risk, said: “The list of Mifid II requirements may be long, but the key to understanding the solutions is simple: it’s all about client insights. Better insights into a client’s financial, psychological, and emotional situation; better evidencing of these insights; and better presentation to clients of how these insights match up with suitable investments for them.

“Get this right and you not only meet the spirit as well as the letter of the law, but also have more engaged clients, better asset growth and higher retention.

“Stepping back to consider how these requirements can be best met in the context of the legislation’s overall intent can pay enormous dividends for both advisers and their clients. Unfortunately, we see many banks resorting to a box check exercise leading to a lack of compliance and investors in the wrong solutions.”

The amendment to article 62 of the Mifid II regulations – known as the 10% drop rule – was announced as part of chancellor Jeremy Hunt’s ‘Edinburgh reforms’, which saw wide-ranging amendments to financial services regulation.

The FCA had paused the rule at the beginning of the covid pandemic to help firms support consumers during market volatility linked to covid-19 and the Brexit transitional period. The reinstating of the rule was then deferred while a consultation took place around its future.

David Tiller, commercial and propositions director at Quilter, said: “Ditching the 10% rule is long overdue and has always had the capability of being detrimental to customer investments by breeding the exactly wrong sort of behaviour we would expect from long-term investors.

“The regulator [FCA] itself effectively admitted the rule was not fit for purpose given the rules were changed as a result of the Covid market falls we saw. Taking that example, if a customer sold out when a 10% drop notification was triggered, they would have missed out on the substantial returns seen in 2020.

“This does not mean providers and advisers simply do not communicate the bad news to clients. Doing so would be a complete dereliction of duty. However, and this is where the Consumer Duty can play a crucial role, using behavioural science techniques and properly framing your communications will be crucial to aid customer understanding and help produce good outcomes.

“People are taking more notice of their finances as a result of digital enhancements, and we need to tap into this and inform them of their investment performance that way. This can be so much more tailored and engaging, giving them the context and assurances they crave during volatile times.

“With this rule now consigned to history we must take this chance and put more of our energy into consumer engagement with their investments.”

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For example, regulators implemented the Sustainable Finance Disclosure Regulation (SFDR) last year, requiring financial market participants to disclose relevant information related to the sustainability of products and processes.

One of the major aspects of SFDR was the classification of investment strategies into three groups: Article 6, 8 and 9.

Strategies promoting environmental or social characteristics are labelled as Article 8, while those with sustainable investments as the investment objective are Article 9.

While SFDR was a major step forward in terms of labelling and disclosures in relation to investment vehicles, it was merely the tip of the regulatory iceberg.

The next major stop on the regulatory journey for the investment community is an extension to Mifid II, which comes into effect this summer, on 2 August. Among a host of Mifid II requirements is one major change for advisers – the need to incorporate sustainability preferences in the overall client suitability assessment.

While determining client sustainability preferences is something some advisers are currently choosing to do, it will soon become something everyone must do.

Advisers face many crucial considerations

The ongoing sustainability revolution should not come as a surprise to the adviser community. In a recent survey we conducted with 1,200 retail investors across Europe, three-quarters of respondents were of the belief investment decisions can make a difference in creating a more sustainable society.

This desire to deliver a positive social and environmental impact has been a primary driver behind the significant demand for ESG-aligned solutions in recent years.

Even though some advisers may still be grappling with SFDR fund classifications, the expanded Mifid II regime goes above and beyond the SFDR product categorisation – which will undoubtedly heighten complexity in the coming months and beyond.

While all funds classified as Article 9 under the SFDR are expected to be Mifid-eligible, not all Article 8 funds will be. There are additional criteria the managers of investment products must meet, over and above an Article 8 label, which is likely why we have recently seen numerous instances of fund classification changes in recent months across the industry.

Advisers have a lot of choices ahead. Firstly, they must need to choose whether they will operate a sustainability product offering alongside a more traditional range, or simply transition to a sustainable suite of strategies.

They will also need to determine where the bar is set in terms of the sustainability products they select. This is a careful consideration, particularly as the current focus on greenwashing is only going to intensify in the months and years ahead.

Asset managers must impart expertise

Continued investor demand for sustainable solutions represents a massive opportunity for advisers already well along the business model transition path. However, there will be many intermediaries daunted by the ever-evolving regulatory maze.

This is why asset managers must continue to play a leading role in the regulatory evolution.

Many asset managers, such as us at Nordea, have undertaken significant work on our own Mifid II implementation.

Therefore, it is imperative our industry works with advisory groups of all sizes to educate workforces, as the new Mifid will require a robust knowledge of regulations and ESG.

While all of our Article 8 and 9 funds – which represent 66% of our total AuM – will qualify as suitable for clients with sustainable preferences once the new Mifid eligibility requirements are in place, advisers cannot assume this will be industry standard.

While the asset management community must improve disclosure levels the post-Mifid world, ultimately the decision about client suitability rests with the adviser. With only a few weeks until the regulation comes into force, there is no time like now to ensure you have all the building blocks in place for a successful future.

This article was written for International Adviser by Christophe Girondel, deputy chief executive at Nordea Asset Management.