Investment Suitability Controls
June 21, 2018
What has happened?
The suitability of firms’ investment advice and portfolio management decisions remains a hot topic for the FCA, as the regulator’s reviews carried out in December 2015, February 2016 and April 2016 bear witness.
Suitability continues to be the number one conduct risk for most UK wealth management businesses. Much has been written about the evidence needed on a client file to demonstrate that clients’ investment portfolios are suitable from the outset and remain suitable over time. But rather less has been written about the governance and controls that wealth management businesses should use to check that the selected investment service and strategy is suitable for clients and that portfolios are being managed in line with the mandate given by the client.
In a recent industry survey about suitability controls and governance, wealth management firms were asked about the controls they have in the first line (i.e. embedded in the front office), and the second line (i.e. the compliance function). This survey focused on wealth management services (e.g. discretionary and advisory portfolio management) and a total of 30 firms responded. Between them, they hold assets under management of over £200bn and employ over 600 investment managers, representing a significant proportion of the UK wealth management industry.
The controls firms should have in place depend on the scale and complexity of their business, so the survey respondents were divided into three size categories; five large firms, 13 medium firms and 12 small firms.
The survey asked: ‘Do you review client files for suitability in the first line?’ Unsurprisingly, all five large firms said they do this. More surprisingly, medium firms are no more likely to have first line suitability reviews in place than small firms – slightly less than half in each case. The survey also suggests that smaller firms are more likely to rely on peer reviews, rather than using a dedicated Quality Assurance resource – and that the reverse is true for larger firms. Even so, some large firms do use peer reviews in addition to a QA team.
All the large firms, slightly less than half of small firms, and slightly more than half of medium sized firms, said their second-line compliance team conducted client file reviews for suitability. More firms do risk-based sampling (e.g. focusing on certain investment managers who are seen as higher risk), or thematic sampling (e.g. certain types of clients).
Overall, 11 of the 30 firms do not require all advisers to be covered by regular first or second line client file reviews. In our view, it is difficult to see how you can evidence that the recommended service and mandate is consistently suitable, or that advisers are doing their jobs properly, without reviewing some client files.
The survey also asked about the consequences for staff who consistently fail first and/or second line suitability checks, covering results of both client file reviews and monitoring of portfolio content against the agreed mandate. Only about a third of respondents mentioned that their regime includes an impact on bonuses or a remuneration clawback mechanism. Indeed, a few firms seemed to impose no consequences on advisers or IMs at all, other than to remediate the client file where necessary.
Respondents were then asked to indicate how confident they are in the effectiveness of their KYC refresh process for ongoing suitability purposes on a scale of 1-5, taking account of the quality of the periodic client reviews in their rating, not just whether they happen on time. Most firms selected within a range of 2-4.
The final survey question was – ‘If the FCA asked, who would you say has responsibility for suitability in your organisation?’ The majority of firms are placing responsibility for suitability with the CEO and/or the front office. Whoever heads up the front office would be a logical person to take ownership of suitability, and we definitely do not think it should be owned by Compliance. Ideally, responsibility should sit with a single person/role, rather than being split between two or more individuals.
Overall, there seem to be four main issues emerging from the survey for firms to consider:
- A significant number of small and medium sized firms do not appear to be reviewing (enough) client files to evidence consistent suitability standards,
- Some firms have not yet grasped the nettle of directly linking suitability standards to adviser/IM remuneration and incentives,
- Many firms are not yet confident that their periodic KYC refresh process is consistently effective in evidencing ongoing suitability, and
- As SMCR looms on the horizon for investment firms, many of them need to agree an answer to the question of which individual should own suitability in the firm.
How can Thistle help you?
Thistle will continue to keep this area under review and will issue further updates where necessary.
Please contact Thistle if you need assistance in relation to any of these issues.