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What Do Tougher FINRA Suitability Standards Mean for You?

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As the fiduciary debate rages on, suitability changes are already here. New guidelines have just been announced that increase sanctions for violations of the Financial Idustry Regulatory Authority’s suitability rule 2111 from a one-year suspension to two years. In the worst cases, offenders can be barred for life. When suitability violations involve a firm, the sanctions mandate a 90-day suspension of business activities and can even result in permanent expulsion. 

These new rules have elevated the importance of risk profiling and risk tolerance, which are often lost in the shuffle. This is unfortunate — and surprising — given that risk profiling deficiencies have been shown to be the leading cause of suitability failures.

These guidelines should also be a warning sign to RIAs as stricter regulatory standards governing investment advice are all but guaranteed, especially now that the White House and Department of Labor (DOL) have entered the fray. There is even talk on the need to harmonize FINRA and Securities and Exchange Commission rules.

Risk Profiling Tool Concerns

Let’s look at the experience in the U.K., which has led global investment suitability regulation. Following the 2008-’09 financial crisis, British regulators conducted a study to uncover factors that led to unsuitable advice. The subsequent report concluded a majority of cases that failed suitability requirements “did so because the investment selection did not meet the customer’s attitude to risk.” In fact, 9 out of the 11 risk profiling tools evaluated by the regulators were deemed “not fit for purpose.” 

A similar pattern has emerged in the U.S. where the number of FINRA arbitration cases rose 62% following the Internet bubble, and more than doubled after the global financial crisis in 2008. “Taking too much risk” has been an oft-cited reason for these cases.  It seems bear markets are marvelous at verifying the worthiness of reliable risk profiling tools and weeding out unreliable ones that fail to deliver at arguably the most crucial time in the client-advisor relationship.

Due diligence questions in choosing a risk tolerance test

It is important to understand that you are liable for the risk profiling tools that you use, and that you bear the ultimate responsibility for giving suitable advice.  If you want to steer clear of suitability violations, then it is imperative that your investment recommendations meet your client’s attitude to risk. This is where having an accurate measure of your client’s risk tolerance is of the utmost importance – but where a lot of risk profiling tools fail.

These are helpful hints to consider when choosing a risk profiling tool:

  • Is it legally defensible?
  • What is the track record? Are there longitudinal studies that demonstrate stable scores across market cycles?
  • Is there test/retest data to verify the validity, reliability and accuracy of the scores?
  • Has the tool been evaluated by an expert third party and, if so, by whom?
  • How are couples treated? Are couples assessed separately and do the instructions explain how to manage risk tolerance mismatches within a couple?

As flawed risk tolerance results are most frequently exposed during bear markets, the best time to consider your options is right now. FinaMetrica has developed a comprehensive list of questions that can help advisors conduct due diligence on any risk tolerance test.

How to protect yourself

Having a proven methodology to map risk tolerance to portfolio risk is absolutely essential in delivering suitable advice. Unfortunately, there are no easy answers, and while taking short cuts may help you win clients in the short term, it may well leave you exposed to suitability violations in the long run. We suggest that you follow these steps prior to making any investment recommendations:

  • Assess risk tolerance, risk required and risk capacity
  • Identify any mismatches and assist with trade-off decisions
  • Confirm clients understand the risks and obtain their properly informed consent.

For more on risk tolerance, see 10 Myths About Risk Tolerance and How to Accurately Measure It