7

Advising Clients

1. Client Categorisation

1.1 Client Categorisation
Learning Objective 7.1.1

Know generally accepted approaches to different categorizations of investment clients.

Regulatory rules in most countries differentiate between different types of clients. One such rule requires firms to categorize clients, and the resulting categorizations are used to set different rules and provide varying levels of protection to clients. The products and services available to customers of financial services firms range from straightforward ones that can be readily understood and are suitable for most people, to highly complex products designed for experienced investors.

The underlying rationale for client categorization is primarily aimed at protecting ordinary investors who may not possess adequate knowledge or experience to evaluate the suitability of a product effectively or to assess whether the product aligns with their investment goals and financial situation.

Additionally, categorizations allow for different regulatory rules and approaches for experienced investors who do not require the same level of protection. While the names given to different categories of clients vary from country to country, the key theme is to differentiate between ordinary ‘retail investors’, who require the greatest protection, and ‘non-retail’ investors, such as experienced investors, institutional investors, and financial firms.

Summary: The approach indicates that the greatest protection is afforded to those with the least knowledge and experience. This can be further illustrated in a diagram showing:

  • Most Knowledge and Experience

  • Least Knowledge and Experience

  • Most Protection

  • Least Protection

These classifications also drive the types of services and products available to clients, with higher risk and more complex options available only to those categorized as professional or institutional clients. Wealth managers must establish the appropriate client categorization at the onset of the relationship and keep it under review.

In some countries, retail clients have the option to request re-categorization as professional clients if they meet certain regulatory requirements, which pertain to their investment experience, financial knowledge, and financial situation. Wealth managers should explain the implications of selecting another regulatory category where this option is available and ensure that the client meets the required regulatory standards.

1.2 Client's Best Interest
Learning Objective 7.1.2

Know the definition of ‘client’s best interest’ and the implications of this rule for a financial adviser.

Financial advisers occupy a unique position in dealing with their clients, as clients rely on their experience and integrity. This reliance is especially critical for retail clients, who may face significant losses if the advice provided is conflicted or of poor quality. This relationship is often described as a fiduciary relationship, in which one person places special trust, confidence, and reliance on another who has the duty to act for the benefit of the person dependent on them.

Advisers must act with absolute openness and fairness and maintain integrity consistent with the best interests of the client. An example from the U.S. illustrates this principle:
Regulation Best Interest establishes a standard of conduct for broker-dealers when making recommendations to retail customers, stating that,
“When making such a recommendation to a retail customer, you must act in the best interest of the retail customer at the time the recommendation is made, without placing your financial or other interests ahead of the retail customer’s interests.”

Definition of Client’s Best Interests:
Act honestly, fairly, and professionally in accordance with the best interests of the client. The associated responsibilities include:

  • Acting in the utmost good faith for the client.

  • Not profiting from the trust placed in them, nor creating a personal conflict of interest.

  • Refraining from misusing confidential information for personal or third-party gain without fully informed consent from the principal.

This list, while not exhaustive, provides a good representation of the expected conduct of a financial adviser.

The implications of acting in the client’s best interest manifest in various forms, including ensuring that advisers gather sufficient information to provide appropriate advice, selecting suitable investments to meet the client’s needs, and executing transactions that align with the client's investment strategy. In recent years, many countries have undertaken significant reforms requiring advisers to prioritize their clients' interests during investment advice processes.

1.3 The Investment Advice Process
Learning Objective 7.1.3

Know the factors to consider when providing financial advice: ‘Know Your Client’ (KYC) and suitability principles underpinning the fiduciary relationship; nature of the client relationship, confidentiality, trust and client protection; information required from clients and methods of obtaining it.

The advice process can be delineated into several distinct stages defined by the Financial Planning Standards Board (FPSB). These six steps form an ongoing cycle and can be outlined as follows:

  1. Establish and define the relationship with the client

  2. Gather data

  3. Analysis

  4. Action Plan

  5. Implementation

  6. Review

As the adviser moves forward in this process, key focus areas will include:

  • Building a relationship with the client and obtaining details of their financial position and requirements.

  • Determining the client’s risk profile.

  • Analyzing the client’s financial position, assets, and cash flow based on their requirements and risk profile.

  • Formulating an investment strategy that meets the client’s objectives, considering factors such as time horizon, liquidity, tax implications, and any client constraints.

  • Implementing the strategy through selection of appropriate products or constructing an investment portfolio.

  • Periodically revisiting the client's objectives and revising the strategy and products held, as agreed with the client, to ensure continued alignment with their needs.

1.3.1 Establishing Client Relationships

In establishing the client-adviser relationship, the adviser must:

  • Identify the client’s needs, assessing whether these needs are within the services offered by the firm and whether the adviser possesses the requisite skills and competencies.

  • Explain the services provided by the firm, outline the process, and disclose required regulatory information.

  • Determine if the firm can adequately meet the client's needs and if advice from other professionals (e.g., lawyers or tax experts) is necessary.

The adviser’s role is to cultivate a relationship with the client that allows structured collection of necessary information for effective advice and to guide the client through their options. Effective communication is essential to this process.

Key Communication Techniques include:

  • Establishing rapport with the client.

  • Clearly stating the purpose of meetings early on.

  • Explaining that the information collection process aims to ensure high-quality advice.

  • Using both open and closed questions to extract necessary information.

  • Simplifying terminology and explaining jargon when necessary.

  • Verifying client understanding.

  • Establishing priorities and confirming client agreement.

  • Guiding the interview at a suitable pace.

Listening is crucial; the best advisers are those who attentively hear what clients articulate, build rapport, and agree on necessary actions collaboratively.

1.3.2 Know Your Client (KYC)

Before advising clients, advisers must understand their various needs, expectations, preferences, and financial situations through the KYC process. Gathering all necessary information is often time-consuming, and clients may struggle to appreciate the importance of thorough information collection. To facilitate the process, advisers must build rapport to encourage clients to express personal needs and concerns, capturing all facts needed for sound recommendations.

Wealth management firms typically adopt a structured approach to collecting client information, enhancing consistency in the advice process. Common methods include:

  • Electronic systems

  • Printed questionnaires

  • Forms

  • Meetings

  • Telephone conversations

  • Email or postal correspondence

A single questionnaire is unlikely to capture all information; therefore, advisers should review questionnaire responses and ask supplementary questions to gain comprehensive insights into client preferences and needs, including risk comfort levels and potential influences of family values such as religious or ethical beliefs on investment decisions.

1.3.3 Client Information

The purpose behind collecting information from clients is to formulate appropriate financial plans and recommend suitable actions.
The information typically collected will include:

  • Personal details

  • Health status

  • Details of family and dependents

  • Details of occupation, earnings, and other income sources

  • Anticipated and present outgoings

  • Assets and liabilities

  • Pension and insurance arrangements

  • Potential inheritances and estate planning arrangements

Gathering individual details involves:

  • Name and address: Verification for compliance with AML requirements.

  • Date of birth: Understanding age impacts risk tolerance and investment strategy; older clients may prefer conservative strategies.

  • Residency and domicile: Influence tax implications for returns.

  • Health status: Affects investment strategy; client health can dictate risk tolerance and investment horizon.

  • Details of family and dependents: Related to future education and health.

  • Occupation and income: Essential for determining risk capacity and investment options.

  • Outgoings: Budgeting and assessing necessary income generation and managing liabilities.

  • Assets and liabilities: A comprehensive understanding is vital for risk assessments and future planning.

  • Pension arrangements: Critical for retirement planning and tax implications.

  • Potential inheritances: Current financial strategies may require adjustments based on expected benefits.

1.3.4 Prioritisation Process

The facts gathered during the KYC process help establish client needs; however, identifying needs does not guarantee they can be fulfilled due to affordability constraints. Advisers are tasked with guiding clients through planning and prioritization of their objectives based on the information collected, ensuring realistic and feasible investment goals.

1.3.5 Client’s Goals and Objectives

This stage encompasses identifying personal information, financial objectives, needs, and priorities, aiding in financial position analysis and suitable solutions identification. This may necessitate helping the client clarify and prioritize their goals, including assessing the feasibility of any unrealistic aspirations. Understanding the client’s background enables advisers to tailor recommendations effectively, aligning recommendations with client desires and financial realities.

1.4 Other Key Financial Planning Considerations

1.4.1 Information Disclosure

Financial services firms must disclose specific information to clients at the relationship’s outset, ensuring clients understand all details needed to make informed decisions about advice. Material information might include:

  • Charges

  • Cancellation rights

  • Risk warnings

  • Specific terms of service

1.4.2 Unregulated Retail Products

The term ‘unregulated financial markets and products’ varies by jurisdiction, with items like cryptocurrencies varying greatly in regulation. Advisers must ensure clients fully understand that unregulated products may lack protective oversight or investor protection schemes, presenting potential risks for client investments.

2. Risk Profile

2.1 Risk Assessment
Learning Objective 7.4.1

Be able to analyze a client's risk tolerance, capacity for loss, investment experience, and these factors' impact on suitable product selection, and various factors influencing risk exposure.

Investment involves a risk-return trade-off, with different clients' risk tolerance varying widely, influenced by individual differences in circumstances, experiences, and psychological composition. A client’s risk profile comprises three elements:

  1. Risk Tolerance: Client's willingness to endure fluctuations in portfolio value without the immediate urge to sell.

  2. Risk Perception: Individual's judgment on associated investment risks based on prior knowledge and experiences.

  3. Risk Capacity: Client’s ability to endure potential financial losses from an investment.

Commonly, the process begins with an exploration of attitudes toward risk before evaluating risk capacity.

2.1.1 Risk Tolerance

Risk tolerance reflects a client’s comfort level with uncertainty in regard to potential losses. Low risk tolerance indicates discomfort with any potential loss, leading to vulnerability to inflation risk due to adverse fluctuations. Factors influencing risk tolerance include:

  • Investment timescale

  • Family commitments

  • Wealth

  • Stage of life

  • Age

2.1.2 Risk Perception

Risk perception derives from personal judgments about potential risks of investment options, often shaped by subjective views compared to alternative opportunities. Clients with little investment experience may perceive low-risk accounts as safe, failing to recognize inflation's erosive effect on capital value over time.

2.1.3 Risk Capacity

Risk capacity emphasizes actual financial implications of sustaining losses. It is largely factual, needing consideration of overall portfolio value during risk assessments. Understanding risk exposure also varies and is dependent on investment amounts relative to total portfolio value, influencing overall risk assessment for a client.

3. Investment Objectives and Strategy

3.1 Investment Preferences

Investment strategy development must take into account the objectives defined through previous steps, including:

  • Maximizing future growth

  • Preserving capital value

  • Generating income

  • Preparing for unforeseen events

Beginning with objective-setting, advisers will classify objectives such as:

  • Income

  • Income and growth

  • Growth

  • Outright growth

3.2 Liquidity Requirements and Time Horizons

Liquidity refers to a client's need for readily accessible funds, pivotal in portfolio construction. Establishing cash reserves enables clients to comfortably weather potential market volatility without unhelpful liquidation of investments.

Time horizons significantly influence asset selection and investment suitability, generally defined as:

  • Short term: Up to 5 years

  • Medium term: 5–10 years

  • Long term: Over 10 years

3.3 Tax Considerations

Understanding the client's tax status is crucial in determining the investment strategy developed. Advisers should identify the following:

  • Client residency and domicile status

  • Income tax position

  • Capital gains implications

  • Tax wrappers

  • Any capital gains allowances or deferrals available

3.4 Considerations for Other Types of Clients

The investment advice process must also incorporate ethical desires and investment beliefs for various categories of clients, such as those seeking to invest in alignment with Shariah laws or charitable trusts, each reflecting societal beliefs and suitability standards.

4. Investment Recommendations

4.1 Service Types
Discretionary Management

In this service, clients allow portfolio managers discretionary power to manage and adjust investments on their behalf.

Advisory Management

This service requires client engagement, with advisers suggesting changes while clients retain decision-making authority regarding their portfolio.

Execution-Only Services

Here, clients offer specific instructions for transactions, limiting firms' obligations regarding suitability advice. Regulatory standards necessitate careful consideration of the implications of such transactions.

4.3 Portfolio Solutions

Strategies include:

  • Fund portfolios

  • Managed portfolios

  • Bespoke portfolio management

Each portfolio type has distinct characteristics, with bespoke services targeting high-net-worth clients with customized management reflecting personal investment patterns and requirements.

4.4 Recommendations

Creating a financial plan requires matching investment solutions to client needs based on a comprehensive understanding of existing financial situations and constraints.

4.5 Investment Policy Statement

The Investment Policy Statement (IPS) summarizes the client's strategic objectives and expectations for managing their portfolio, encompassing expected returns, risk profile, and portfolio constraints.

5. Review

Importance of Regular Reviews

Regular assessments ensure the financial plan remains aligned with the client's evolving circumstances, reflecting changes in objectives or financial environments requiring necessary adjustments to the investment strategy. Reviews should ensure compliance with updated regulations and the ongoing effectiveness of the financial advisors' recommendations, addressing areas needing re-evaluation or modification.

6. Wealth Management Charges

Types of Charges

  • Management fees

  • Financial planning fees

  • Performance-based fees

  • Transaction charges

  • Product-related charges

Disclosures regarding charges should clearly define the total expenses associated with services and products before any engagement with clients, ensuring transparency and alignment with regulatory standards.

7. Taxation

Personal Taxes

Understanding income tax regulations, capital gains tax implications, and implications of estate taxes are essential for proper advice delivery based on governmental financial structures, which can vary widely by jurisdiction. Advisers should stay updated on relevant tax legislation affecting both local and foreign assets.

Residency and Domicile

Understanding residency impact on tax implications is vital in advising clients effectively to avoid unintended liabilities associated with global assets. Advisers must evaluate tax laws diligently as they pertain to taxpayers from distinct jurisdictions.