Journal of Financial Planning: July 2011
Harold Evensky, CFP®, AIF® (editor), is chairman of Evensky & Katz in Coral Gables, Florida. He is an internationally recognized speaker on investment and financial planning issues, and is the author of The New Wealth Management and co-editor of Retirement Income Redesigned.
Robert W. Moreschi, Ph.D., RFC®, is professor of finance in the department of economics and business at the Virginia Military Institute in Lexington, Virginia, and serves as a managing principal of Presidio Securities Inc.
For practitioners, one of the privileges of membership in the Academy of Financial Services (www.academyfinancial.org) is the opportunity to network with academics whose interest is financial planning. As we strive to be recognized as a true profession, the interaction of academics and practitioners becomes increasingly important. Toward that end, I’m pleased to share an extended academic networking opportunity with the gracious support of the AFS via this research column. This contribution is by Robert Moreschi, a professor at the Virginia Military Institute, where he teaches finance, investments, and portfolio management. In this column Moreschi addresses one of the most critical issues facing practitioners—regulation with an emphasis on the question of risk tolerance (a subject covered in detail in my new book The New Wealth Management). Whether you are a broker subject to a suitability standard or an adviser subject to a fiduciary standard, you’ll find Professor Moreschi’s observations and references of value.
The Changing Face of Suitability
Recently, the SEC approved two new rules promulgated by FINRA: 2090 (“Know Your Customer”) and 2111 (“Suitability”). Together these two rules (original effective date October 7, 2011, recently extended to July 9, 2012) replace rule 2310 (“Recommendations to Customers”).
Why is this rule change important to you? Whether you are an adviser or broker, you are obligated to make recommendations suitable to your customer (of course, advisers are held to a higher fiduciary standard than brokers). On one level, suitability lies at the heart of an effective agent/customer relationship. Making suitable recommendations is integral to building a successful business practice. On another level, avoiding unsuitable recommendations is apt to help you avoid legal and regulatory headaches. The enforcement section on the FINRA website includes a litany of unfortunate situations involving a customer and an unsuitable recommendation from an agent.
A review of the March 2011 FINRA enforcement actions revealed two suitability cases:
- A registered representative (RR) from Minnesota submitted a Letter of Acceptance, Waiver, and Consent in which he was barred from association with any FINRA member in any capacity. Without admitting or denying the findings, the RR consented to the described sanction and to the entry of findings that he made an unsuitable recommendation to a customer, in light of the customer’s financial situation and needs, for the purchase of a private placement offering. The findings stated that the RR recommended the customer take equity out of her home through a refinanced mortgage and use $100,000 of the proceeds to purchase the private placement offering.
- A registered representative from Oregon submitted an Offer of Settlement in which the RR was fined $7,500 and suspended from association with any FINRA member in any capacity for five months. The fine must be paid either immediately upon the RR’s re-association with a FINRA-member firm following his suspension or prior to the filing of any application or request for relief from any statutory disqualification, whichever is earlier. Without admitting or denying the allegations, the RR consented to the sanctions and to the entry of findings that he recommended and effected purchases of an exchange-traded, closed-end fund with predominantly speculative characteristics without having reasonable grounds that his recommendations were suitable for the customers in light of their risk tolerances, investment objectives, and investment positions in relation to their entire liquid net worth. The findings stated that the RR signed customers’ names to transaction, reinvestment/withdrawal, and account application forms without their knowledge, authorization, or consent, and submitted the forms to his member firm.
Suitability Per the Regulators
Current rule 2310 states:
a. In recommending to a customer the purchase, sale, or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer, upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
b. Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
1. The customer’s financial status;
2. The customer’s tax status;
3. The customer’s investment objective; and
4. Such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.
The new rules expand in a significant way the actions required of an agent to ensure a suitable recommendation.
Rule 2090 states: “Every member shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” While rule 2090 does not give guidelines for maintenance, it is explicit in requiring updates to essential facts.
Rule 2111 requires gathering more information about both institutional and non-institutional customers than rule 2310 did. Rule 2111 states:
a. A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. A customer’s investment profile includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation.
b. A member or associated person fulfills the customer-specific suitability obligation for an institutional account, as defined in NASD Rule 3110(c)(4), if (1) the member or associated person has a reasonable basis to believe that the institutional customer is capable of evaluating investment risks independently, both in general and with regard to particular transaction and investment strategies involving a security or securities and (2) the institutional customer affirmatively indicates that it is exercising independent judgment in evaluating the member’s or associated person’s recommendations. Where an institutional customer has delegated decision-making authority to an agent, such as an investment adviser or a bank trust department, these factors shall be applied to the agent.
Compared with rule 2310, rule 2111 is more explicit in listing factors the regulators consider important and expect an agent to consider in developing an investment profile of a customer. In addition, an agent having an institutional client that makes its own decisions will have to consider suitability on either a trade-by-trade basis, asset-class-by-asset-class basis, or by considering all potential transactions for the client. If the institutional client uses an outside adviser and has delegated authority to that adviser, the agent will have to make the same suitability determination about the adviser.
Thinking About Risk Tolerance
The more challenging work for advisers is with non-institutional clients. While certain aspects of an investment profile are routine (age), others are not (risk tolerance). Of all the factors to consider in constructing an investment profile, risk tolerance is certainly one of the most challenging. Risk tolerance has received a significant amount of attention in the past three decades from academics. Because risk tolerance is a key component to providing suitable advice and because regulators will soon require its explicit consideration, it makes sense to review the literature. Research has focused on demographic and financial factors that may explain a customer’s risk tolerance, including age, gender, education, race, personality, income, wealth, marital status, dependants, and use of an adviser. In addition, research has also focused on the merits of questionnaires in eliciting accurate information about risk tolerance. I’ll include here some recent and not so recent articles worth reading.
Measurement of Risk Tolerance
“Measuring the Perception of Financial Risk Tolerance: A Tale of Two Measures” by Gilliam, Chatterjee, and Grable in the Journal of Financial Counseling and Planning 21 (2), 2010. A useful paper comparing the explanatory power of a multi-dimensional questionnaire against one-dimensional data from the Survey of Consumer Finances. Results indicate that both tools offer insightful information about risk tolerance. But, a well-designed questionnaire appears to be a better tool for assessing risk tolerance.
An older but important study along these same lines is “Questioning the Questionnaire Method: Insights on Measuring Risk Tolerance from Psychology and Psychometrics” by Roszkowski, Davey, and Grable in the Journal of Financial Planning 18 (4), 2005. Psychometrics is the measurement of attributes such as abilities, knowledge, and attitudes using statistically valid measurement instruments. The study is a useful reminder of the limitations in the field and in the robustness of questionnaires.
Demographic Variables and Risk Tolerance
The challenge for practitioners is that even after three decades of insight, there is still much to learn. Seemingly dependent on period and data source, competing studies are not always consistent in results. Still, it is important to be well-read in this area to be attuned to how demographics might influence the risk tolerance of a customer.
“The Role of Assertiveness in Portfolio Risk and Financial Risk Tolerance Among Married Couples” by Gilliam, Dass, Durband, and Hampton in the Journal of Financial Counseling and Planning 21 (1), 2010. Though focused on married couples, the study finds that assertiveness may not be a useful gauge of risk tolerance.
“Risk Aversion and Personality Type” by Filbeck, Hatfield, and Horvath in the Journal of Behavioral Finance 6 (4), 2005. The authors investigate what, if any, relationship exists between personality type and risk tolerance. Using the familiar Myers-Briggs Type Indicator of personality types, the authors find that personality type does, in a statistically significant way, explain individual risk tolerance.
“An Empirical Investigation of Personal Financial Risk Tolerance” by Hallahan, Faff, and McKenzie in Financial Services Review 13 (1), 2004. Though a few years old, it remains a valuable study. The authors use a large, robust data set and find results consistent with many other studies. That is, men seem more risk tolerant than women, risk tolerance rises with more years of formal education, retirees and the elderly have less risk tolerance than young adults and the middle aged, single adults are more risk tolerant than married adults, and risk tolerance rises with income and wealth.
“Racial Differences in Risky Asset Ownership: A Two-Stage Model of the Investment Decision-Making Process” by Gutter and Fontes in Financial Counseling and Planning 17 (2), 2006. This article finds that differences between black and white households is likely a function of access and awareness barriers but not personal preferences. Controlling for ownership, the authors find no difference between blacks and whites in the percentage of wealth invested in risky assets.
Given the impending changes in customer suitability compliance requirements, now is the time to renew your efforts to understand risk tolerance and incorporate its assessment into your practice.