Joseph Dinolfo, a Director with Treliant, has nearly 20 years of financial services experience. His areas of expertise include regulatory compliance, risk management, audit, and banking, with an emphasis on consumer credit, mortgage origination, and mortgage servicing. His specialties include regulatory exam management, regulatory risk management, audit program development and…
Recent actions by federal and state regulators have underscored their increased emphasis on sales practices in wealth management.
In part one of this series, we discussed the evolving regulation of sales practices and how they are impacted by innovations in technology. Here, we delve into these risks in more detail and offer suggestions on how to mitigate them.
Investment Appropriateness and Suitability
Most investment advisors conduct some type of suitability test when opening investment accounts—for example, using a standard form or online questionnaire. However, investors often fail to fully understand the potential risks associated with each investment decision. For their part, brokers might be biased toward advising customers to make riskier investments with higher commissions or fees.
As the CFA Institute states, “The current practice of using questionnaires to identify investor risk profiles is inadequate and unreliable, typically explaining less than 15 percent of the variation in risky assets between investors.” Instead, it is important to consider a number of factors when assessing an investor’s risk profile. If the level of suitability analysis is too high, advisors may be missing clients’ needs or misidentifying them. Advisors themselves must fully understand the characteristics and risks of the securities, and discern whether clients truly understand the risk of their investments and strategy, since failure to properly identify investor risk profile and investment needs increases legal, regulatory, and reputational risks.
Particularly for discretionary accounts, a written statement of investment objectives should be kept on file and updated as a client’s investment strategy changes. The rationale for any transactions falling outside of the agreed scope of investment objectives should be thoroughly vetted and documented by the compliance function. It is particularly important to ensure that brokers are recommending suitable products and strategies for the elderly, as high-risk or long-term investments that provide high commissions for the broker can be construed as elder financial abuse. In addition, suitability questionnaires used by robo-advisors deserve particular scrutiny, as there is greater risk that a potential investor answering questions without assistance may not understand the questions or terminology.
If advisors are working with accredited investors under Regulation D, they should consider whether to limit their investor assessment to the Qualified Investor Rule. Relatively naïve investors may meet the Qualified Investor standard, based on income and assets, but may need additional advice and disclosures based on their actual levels of sophistication.
Lastly, it is equally important to review procedures when funds are “swept,” to ensure compliance with guidance on self-dealing and conflicts of interest in the investment of fiduciary funds. As the Federal Deposit Insurance Corporation (FDIC) states, “the use of own-bank deposits as a trust investment is by definition a conflict of interest and self-dealing, since the bank is investing funds held as a fiduciary with itself.” Therefore, it is necessary to ensure that sweeps and other movements of money with discretionary accounts are clearly disclosed, documented, and in the client’s best interests.
Most of the risks related to investment appropriateness and suitability detailed in the section above will also apply to fiduciaries in meeting a similar, but even higher, fiduciary standard. Fiduciaries must take additional steps to ensure that they are always serving in the best interest of the client. This includes addressing any potential conflicts of interest in arrangements such as revenue-sharing agreements or the offering of proprietary investment products.
Automated Solutions and Tools
Robo-advisors, which provide automated financial guidance and services, have had a significant impact on the industry, with nearly every major bank and brokerage adopting or launching their own version of a robo-advice platform. Like human advisors, robo-advisors are required to register with the SEC, and they are held to the same laws and regulations as broker-dealers, namely suitability. Moreover, SEC guidance has emphasized that since registered as investment advisors, robo-advisors will be held to the same fiduciary standard as 1940 Act RIAs. Further, FINRA guidance suggests that automated offerings be onboarded with increased training for employees, as well as frequent assessments of how well the tools are performing, including fees, costs, and conflicts.
Mitigating Risk in an Evolving Landscape
Innovation necessitates managing new digital risks, such as cybersecurity, as well as technology’s impact on existing risks, such as suitability. More than ever, it is vital that banks and brokerages have clear and strong risk governance structures to not only address existing needs, but also to anticipate the heightened standards and net new risks posed by the evolution of their business models toward more automated solutions.
With respect to marketing, banks and brokerages need to ensure that advertisements and sales literature accurately reflect wealth managers’ qualifications, abilities, services, and products, while adhering to all applicable regulatory requirements. Areas of areas of regulatory focus include deficient fee disclosures, insufficient communication regarding high-risk investments, and misaligned advisor incentive structures.
It is also essential for banks and brokerages to centralize client suitability and fiduciary analyses within a compliance management system. Firms can leverage analytics and other information to scan sales activities across their brokers, detecting undesired and unusual behavior, and taking corrective action to prevent future issues. Particularly with regard to high-fee, high-risk, and high-volatility products, increased scrutiny and oversight should be a requirement.
An assessment of client suitability should not only cover the initial recommendation. Ongoing monitoring and annual review processes should take into account any changes in a customer’s profile, investment objectives, or risk appetite, and advisors should determine if existing investments still meet the suitability standard. Suitability requirements should be updated at least annually, or as circumstances dictate, such as upon retirement, a change of marital status, or other life events.
Consistent with regulatory expectations for robust model risk management, institutions should conduct a validation of models, algorithms, and decision trees that includes regulatory compliance considerations before implementation, and with every algorithm change. Further, institutions should create, approve, and execute a pre- and post-implementation testing and monitoring plan. Testing should include comparing both recommendations and executed trades with a customer’s profile, to ensure that asset allocation, rebalancing, and tax-loss harvesting activities and performed in a suitable manner.
Lastly, firms should aim to manage risk and improve on existing automated advice solutions by developing more robust suitability questionnaires and by leveraging artificial intelligence and machine learning (AI/ML) capabilities to better identify risk-based exceptions that may require human intervention. Firms are increasingly using AI/ML to include and interpret new data points as they occur (e.g., life events, liquidity events) in determining “next best action” recommendations, allowing advisors to provide more customized servicing to existing clients. The development and adoption of such technology, however, brings its own unintended consequences, and thus requires rigorous testing and validation.