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| Comparing Suitability Standards | ||
|---|---|---|
| Suitability Type | Description | Example Actions |
| Reasonable-Basis Suitability | Requires a broker to have reasons to believe the recommendation is suitable for at least some investors. | Understanding the risks and benefits of a complex investment product before recommending it. |
| Customer-Specific Suitability | Requires a broker to have reasons to believe the recommendation is suitable for a specific client based on their investment profile. | Recommending a conservative investment to a risk-averse retiree. |
| Quantitative Suitability | Requires a broker to have reasons to believe that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together. | Discouraging excessive trading in a customer’s account that would lead to high transaction costs. |
| Regulation Best Interest | Requires broker-dealers to act in the best interest of retail customers when making a recommendation of any securities transaction or investment strategy involving securities, without placing their financial or other interests ahead of the retail customer’s interests. | Recommending the best available investment option without being influenced by higher commissions or incentives. |
Financial Status
Knowing about your client’s finances is arguably the most important of the four points in this article. Clients in higher tax brackets might benefit more from municipal bonds or tax-deferred savings vehicles, while those in lower brackets might have different priorities.
Understanding the client’s liquidity needs is also crucial, as investments like annuities or long-term bonds may not be suitable for those who need immediate access to their funds due to potential surrender penalties or negative pricing.
Investment Goals
Advisors should know their clients’ objectives when guiding their strategy. For example, a young couple saving for their child’s college education may benefit from a 529 college savings plan. By understanding a client’s goals and needs, advisors can build trust and make necessary adjustments to ensure the investment plan stays on track.
Knowing what a client needs not only builds trust within the relationship but also allows the advisor to recommend changes as circumstances arise.
2. Understanding Reasonable Basis Suitability
The next basic thing to know when investing for others is called reasonable basis suitability. In essence, this says a financial professional must have valid reasons to believe an investment or strategy could be appropriate and beneficial for at least some investors.
It’s not about being right for everyone, so it doesn’t mean every investment has to be a winner or appropriate for every client. Instead, it’s a very low bar that needs to be crossed, namely that you see some merit and benefits that could apply to some investors (though not necessarily your clients).
For example, penny stocks are very risky. Still, there might be a reasonable basis to recommend them to a highly speculative, risk-tolerant investor who understands the potential for total loss.
In 2020, FINRA adopted Regulation BI, amending its Rule 2111 so that “a broker-dealer that meets the best interest standard would necessarily meet the suitability standard.” This means that, beyond the suitability standards for financial advisors discussed below, broker-dealers must also ensure that investments are in the client’s best interest.
3. Understanding Customer-Specific Suitability
As a financial advisor, it’s not enough to recommend investments that are generally suitable for someone; they need to be a reasonable fit for your client. An investment that works for one client might be a poor choice for another.
To ensure your recommendations are a good fit, consider all the data you have on your client’s investment profile: their objectives, comfort with risk, timeline, financial picture, etc. These will help you match them with investments that align with their needs and preferences. Those penny stocks we mentioned earlier? Not likely to cross this bar very often.
4. Understanding Quantitative Suitability
Your responsibilities extend beyond ensuring that individual investments are suitable for your clients. You must also consider the overall impact of your recommendations, especially when you have actual or de facto control over a client’s account. This is where FINRA’s quantitative suitability rule comes into play.
Quantitative suitability requires a reasonable basis for believing that a series of recommended transactions, even if viewed in isolation, are not excessive and unsuitable for the client when taken together. In other words, you must avoid overtrading or churning your clients’ accounts. Red flags include a:
- High turnover rate (frequently buying and selling securities in a client’s account)
- High cost-to-equity ratio (generating commissions that represent a significant percentage of the client’s invested capital)
- In-and-out trading (trading the same security within a short time frame)
To ensure you’re following FINRA regulations, document your rationale for recommending a series of transactions, demonstrating that they are not too much or unsuitable.
How Does a Financial Advisor Measure Risk?
Financial advisors often use questionnaires to measure their client’s risk tolerance. These questionnaires are best when they allow open-ended answers, encouraging the client to share their feelings about losing money.
What Challenges Do Financial Advisors Face?
One of the biggest challenges that financial advisors face is managing client expectations, including returns expectations. Beyond that, other challenges include managing contact with customers.
What Do Clients Want From Their Financial Advisor?
The biggest thing clients want from their financial advisors is someone trustworthy. According to Vanguard, investors are more comfortable with a human touch. As many as 76% of people surveyed said they trusted a financial advisor’s advice while 17% preferred a combination of human and digital advisory services. Only 4% said they trusted a digital advisor or service while 3% said they managed their own finances.
The Bottom Line
When managing other people’s investments, financial advisors must adhere to FINRA Rule 2111, which mandates that recommendations are suitable for each client. To fulfill this obligation, advisors should focus on four key aspects. First, they must understand the client’s investment profile, including their risk tolerance, time horizon, preferences, financial status, liquidity needs, and investment goals. This information is used to create personalized investment strategies that align with the client’s needs and goals.
Advisors must also conduct reasonable diligence to ensure recommended investments are suitable for at least some investors (reasonable-basis suitability) and understand each investment’s risks and potential rewards before recommending it to clients. Third, advisors must determine that recommendations suit each client based on their unique investment profile (customer-specific suitability). Finally, advisors must avoid excessive trading in customer accounts over which they have actual or de facto control (quantitative suitability).
By focusing on these four essential aspects of managing other people’s money, financial advisors can fulfill their legal and ethical obligations, build trust with clients, and help them work toward achieving their financial goals while effectively managing risk.