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When a regulator issues a guidance consultation that includes the statement, “as we apply our intrusive and intensive supervisory approach,” you get the idea they mean business and the FSA has come out swinging in their latest guidance consultation on accessing suitability. From the opening paragraph the regulator takes a consumer focuses approach that is in my opinion is openly hostile to the financial services industry.
I am impressed. In the very high stakes game of reforming the UK’s financial services sector and feeling the pressure to act and prevent consumer exposure to another financial meltdown, the FSA provides guidance based on empirical data.
The FSA specifically calls to task the financial industry’s globally recognized business practice of quickly running a potential client through a risk tolerance profiler, assigning an often vague risk category or risk number, and then selling investment products that “fit” the assigned risk category. These flawed business processes were designed to meet the vaguely defined “suitability” standard for advisers providing personal recommendations or a decision to trade.
The regulator is loudly yelling, we know what caused consumers pain in the past and we are no longer going to tolerate the business as usual culture of the last 20 years. I do not believe it should be taken as a subtle point that the dates selected were March 2008 to September 2010. The FSA is taking full note that businesses have not changed their practices since the market meltdown.
I could not agree more with the regulators criticism of the suitability standard as it is executed in practice. All of their points are valid and backed by research. The recent market meltdown only emphasized the point that most consumers don’t understand the true risks to their futures of being in one risk category or another or owning specific investments.
It was due to these antiquated business practices that my partners and I founded Voyant. From our personal experiences, the entire client interaction between adviser and consumer was completely relationship based and these relationships were most often thin. As both owners of a software development and consulting firm specializing is custom development projects for large financial institutions and a personal investors, we realized that most financial advisers knew little about their clients’ real needs and consumers knew even less about their own needs and ability to take risks in the financial markets. We saw first hand how the industry was just doing the very least to it could to sell products and meet a minimum suitability standard. Voyant was started before the market meltdown. Our reasoning was simple. As the Internet made financial information more accessible to all, consumers would demand better service from their financial institutions and advisers. We developed Voyant as a technology based solution to allow advisers and consumers to collaborate on all aspects of a clients financial future and see with a higher level of detail the potential risks and possible rewards of different investment, savings, spending, and borrowing scenarios. The model was design so the consumer provides the financial data and personal information such as needs and goals, while to adviser provides the professional expertise. Voyant was designed for all type of planning and for all levels of wealth.
While we have had great success in the marketplace, we have come across stiff resistance to change from many large organizations unwilling to change their age old sell at any cost business practices. I have had numerous conversations with large enterprises that were unwilling to implement any type of meaningful engagement with their clients and wanted the entire discovery process to be no more than 6-8 questions, before the adviser began providing recommendations. My favorite risk profiler in the world is used in the UK and is exactly 8 questions long with arbitrary and almost meaningless results. I am stunned this meets any professional standard.
The FSA has obviously recognized this resistance and published this guidance to motivate these aspects of the financial industry. The cleverest aspect of this guidance was not to argue that organizations currently following the suitability standard should be subject to RDR in 2013 and fall under a fiduciary standard, but to specifically define a new level of service expected to even be consider suitable as of today. The guidance reads
“By ‘capacity for loss’ we refer to the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take.”
This adds a whole new element to concept of suitability. The regulator is now specifically defining that for an adviser to meet the suitability standard they must have a deep understanding of a client’s financial condition. The commentary continues,
“Some firms unduly focus on the risk a customer is willing to take and fail to take sufficient account of the customer’s other needs, objectives and circumstances: for example failing to consider whether the customer would be better placed repaying debt, or failing to select an investment that meets a customer’s need for access or the term for which the customer wishes to invest.”
Having to consider debt as a measure of not only how a client should invest but whether the client should invest at all is something most product sales focused organizations are not prepared to do and creeps very close to a mandating almost holistic planning.
I believe this is the key. For all of the discussion in the guidance paper about the proper use and design of risk profilers, the regulator makes the point very clear that no only should the risk profiler used be fit for purpose but using this alone is not nearly enough. Enterprises and advisers from pension providers to private bankers need to take notice. This new suitability standard is tough. While new disclosures and charging structures might be on hold until 2013, the regulator expects the business practices surrounding advice and guidance associated with an RDR compliant firm to be in effect today for all firms. Change needs to be made now or firms risk drawing the condemnation or more of the regulator.
While UK advisers are going to feel the immediate direct impact of this new definition of suitability, this guidance could reverberate globally. Numerous regulatory bodies around the globe including the Securities and Exchange Commission (SEC) in the United States are struggling to decide proper business processes and professional standards that should be used by financial advisers in wake of the recent market meltdown. The arguments are similar if not identical. The SEC is mandated to report to the US Congress on January 21 its recommendation on whether all levels of advisers in the US should fall under a fiduciary standard. The SEC could make the move to push for the fiduciary standard or they could follow the FSA’s lead and just redefine what is suitable advice. In all cases, change is still coming to the global financial services industry.
I have just finished installing and testing Voyant on a touch screen tablet. There are a few small tweaks to make to fit touch interaction, but overall it works exceptionally well. I can see using a touch device to collaborate with a client at a coffee shop or in the lobby of a bank being a very positive experience. There are no barriers such as desks or monitor stands to get in the way. Clients and advisers can sit around a touchable screen and have a conversation.
I cannot say that I am too surprised that Voyant works so well. Voyant has always been designed as a platform independent “APP.” The development staff smartly stayed away from interactions such as right clicks that were platform specific and the APP was always designed to work whether there was a network present or not. Starting at our early development days, I have run Voyant on a pen based tablet PC running Windows XP, as well as my MacBook Pro, while others developed it on various Linux variants.
While the iPad is all of the rage and I personally like it, I don’t see Voyant running on an iPad in the near future. The iPhone Operating System (iOS4) is a closed development environment and the iPad as hardware is very limiting. There isn’t even a USB port for attaching external hard drives, keyboards, mice, or cameras. The close operating system would mean that Voyant would have to have a dedicated development staff just for the iPad and this is not cost effective.
Numerous other operating systems will launch on tablet devices soon, everything from Google Android, Microsoft Windows, to Linux based custom systems are due out in the coming weeks. Most of these other operating systems should support Voyant in its current incarnation.
The tablet I have been testing it on (see screenshot) came loaded with a proprietary Linux variant. I deleted this operating system and installed Microsoft Windows 7. Windows 7 runs very effectively on the touch screen. I have been pleased with the interactions and responsiveness. It is also a huge positive to have access to the Microsoft Office Suite, so there is less of a need for multiple computer systems. There are certainly improvements that can be made, but I expect some of these to come from Microsoft and the various hardware companies that expect to launch Windows 7 based tablets in the coming months.
The device I have been testing came with a USB port, so plugging in a hub for additional storage and a keyboard has been a big plus. I don’t mind touching the screen to type a URL or even data entry in Voyant, but writing this post would be a difficult experience with my large fingers and no keyboard.
Voyant certainly has our eye on the tablet market. As new devices and operating systems become available we will be testing them and I will let you know the results. As and when you have questions or feedback, please send them our way.
I am often asked why Voyant doesn’t have a standard risk tolerance questionnaire built into our base product. While we will implement a custom risk tolerance survey for our clients, I get a lot of puzzled looks when I respond by noting that risk surveys are a big reason for consumers’ disappointment in and distrust of the financial services industry.
After the recent market meltdown, consumers are realizing that these assessments are inaccurate, vague, provide very little value or insight – and often exist to only satisfy obligatory compliance and legal requirements, rather than to provide serious investment risk mitigation and protection. I would like to see the financial services industry reevaluate the risk tolerance survey and develop more valuable and reliable methods for determining a consumer’s need for investment risk. This should include a stronger value proposition that helps consumers achieve their personal goals, while incurring as little investment risk as possible.
I recently got an email from a major online brokerage suggesting I re-plan my retirement exactly the same way I had planned it before the recent meltdown. Fool me once, shame on you. Fool me twice, shame on me. If consumers have learned anything, it’s that the market does go down, and it can go down dramatically. Many consumers also realize that there is little their advisers can do to predict such downturns. If they could, then the recent losses would have not been nearly as large, especially for their clients closest to retirement with moderate or low risk profiles.
Consumers now know that the risk tolerance questionnaire is really just a sales gimmick for advisers to suggest the achievability of the highest potential returns based on a client’s survey responses, while protecting the adviser from legal action if the returns are not met. Most advisers and consumers do not understand the portfolio theory behind these surveys. Even those who develop the stochastic models can’t defend their accuracy, value or the existence of key mathematical components such as correlation coefficients. But they are still being pushed by the industry, using key disclaimers such as “previous performance is not indicative of future returns,” as a way to offload the risk to consenting consumers.
Asking how much risk a consumer is willing to take is less honest than asking them how much they are willing to lose by gambling. Most risk assessments include absurd questions that give little exposure to the underlying mathematical risks such as (real question taken from a risk questionnaire),
How do you feel when you suffer a financial loss?
a. I think I’m a bad person.
b. I feel guilty.
c. I view it as a personal failure.
d. I see it as an obstacle to be overcome.
e. I almost never suffer losses, because I don’t take risks that would lose me money.
I would like to see the risk assessment that includes the question:
How much of your portfolio’s value are you willing to lose in a single year?
a. 5%
b. 10%
c. 20%
d. 30%
e. 40% or more
Most people would likely answer a or b. However, these two answers would put them in very low risk categories, meaning that the market returns that could reasonably be illustrated would be very modest and the advisers perceived value might be reasonably low as well. I’d venture to guess that most people who are less than 10 years away from retirement and invested in moderate risk model portfolios that recently lost more than 40% never knew their tolerance survey would have had them answering e.
Without really digging into their clients’ personal needs, goals, deeper financial issues, or tolerance for market risk, how can an adviser recommend a reasonable model portfolio — no matter what the risk questionnaire says? Once a reasonable financial plan is built true guidance can be provided. Advisers need to educate consumers in the idea that increasing savings, reducing expenses and developing alternate strategies can do a lot to reduce the need to take investments risks. Advisers should focus less on how much risk the consumer is willing to tolerate and more on what the market can reasonably do to help them achieve their financial goals. In the long run this will increase customer satisfaction and assets under management. Without this change, consumers are going have less tolerance for the financial services industry.
Everyone say hello to the era of libertarian paternalism, pragmatism, and consumer protection for financial services regulation.
I don’t mean to brag, but I have been telling people this was coming for a while. I have been telling people that the financial services industry needed to reinvent itself – and that if it didn’t provide consumers greater value for their money, market forces or the government would step in and ”help” it do so. That’s one of the reasons my partners and I decided to found Voyant — to provide a new model for consumer interaction in the financial services industry. The recent market turmoil, scandals and administration change have greatly expedited the timetable for change. And now the government is reacting to the recent crises with a swift and serious plan.
Several consumer financial protection measures are already making their way through the legislative process. Some have big names like the Consumer Financial Products Administration, while others have more innocuous ones such as the 401(k) Fair Disclosure and Pension Act of 2009 and the Financial Regulatory Reform Plan. And don’t forget, we are only in the beginning stages of this new, uncharted era.
A key element of these new measures is the use of behavioral science in public policy to develop new “choice architectures” that can sensibly nudge people toward the best decision without restricting their freedom of choice. For those not familiar with these concepts and the term “libertarian paternalism”, I highly recommend the book “Nudge”, written by Richard Thaler, a University of Chicago professor of behavioral science and economics, and Cass Sunstein, a Harvard Law professor, both with very strong ties to the Obama administration.
As the premise goes, for consumers to have free choice, they require transparency and access. This is very apparent in the 401(k) Fair Disclosure bill and the Financial Regulatory Reform Plan, which seek to remove conflicts related to investment advice. Both measures aim to hold investment advisers to a “fiduciary” standard, rather than the current “suitability” standard. I’m willing to bet that a large percentage of consumers believe their financial advisers are supposed to do what is in their client’s best interest (fiduciary standard), rather than provide their clients advice that is good enough but might actually be in the adviser’s best interests (suitable standard). The government is now invoking a “behavioral science” approach to legislation by removing this conflict and forcing the industry to live up to the standards expected by consumers.
While this might seem like a subtle change to most outsiders, it is going to wreak havoc in the industry. Conflicts are so ingrained in financial institutions’ business, that meeting the fiduciary standard is going to require sweeping changes, especially around advisor–consumer interaction. (Simply creating a giant new disclaimer page listing all of the conflicts will not meet the standard, since behavioral science would show that people do not read disclaimers. I never do.)
To meet the fiduciary standard, advisers are going to have to recommend the best financial products for their clients. This is going to be almost impossible outside the context of a larger financial plan that considers the client’s personal life needs and goals. The current model of simply running a client through a risk questionnaire, suggesting an asset mix, and picking assets to fix this mix won’t work, even if you remove any potential conflicts. Unless you know what the client hopes to do with their money, and when they hope to access their money, how do you recommend the right set of financial products and meet the fiduciary standard?
Whether using Voyant or other systems, the new standards are going to push financial enterprises to provide simple and clear advice to consumers, and to take a more holistic approach to planning that considers their larger needs and goals. To do so, enterprises will need to adopt new processes and technologies that engage clients in more collaborative, interactive ways.
A non-conflicted and transparent system will be good for everyone. The early adopters will have a huge advantage and be able to quickly reengage clients and rebuild their brands. And consumers will benefit from a greater sense of security and well-being, knowing they have made the right choices for the right reasons.
“Do you have enough life insurance?”
This is a common question asked by individuals of themselves and by adviser toward their clients.
Voyant’s life insurance needs simulation makes it a lot easier to find an objective answer to this question.
Found under the “Simulations” tab on the main chart, the “Life Insurance Need” simulation allows a user to determine how much additional money, in a lump sum form, is necessary at time of death of either spouse in the plan in order to cover future goals and expenses detailed later in the plan, taking into account existing life insurance products.
The simulation interface allows the user to specify a point in the near future to at which to simulate the death of either spouse in the plan. Usually, one picks one, two, or 3 years as the time period from which to simulate a premature passing. The simulation moves the death event of the dying individual to the specified year, and then, using the information in the plan, and the current market performance assumptions, calculates the additional amount of money needed as a lump sum in the year of death, in order to prevent a shortfall from occurring in any subsequent year in the plan.
Using this technique, the simulation is able to take into account a large number of variables such as future earnings and savings contributions of the passing individual, as well as the future goals the passing spouse had for the family such as the children’s college expenses, etc. Additionally, current life insurance benefits, government insurance (Social Security in the US, and State Pensions in the UK) are also taken into account as part of the simulation.
The Silber’s
Let’s take a look at the Silber’s life insurance needs.
The Silber’s are comprised of two working parents, Isaac and Rachel, and one child, with a second child planned for the near future. The Silber’s plan for both their children to go to college, and ideally they would like to send their children to private grade schools. Isaac currently has a 25 year term policy with $100,000 benefit, while Rachel has no insurance. Isaac’s currently salary as an architect earns him about $120K, while Rachel’s job earns her $70K
The red event markers on the chart indicate the simulated death event for each spouse. The top chart illustrates result of Isaac’s premature passing without additional insurance, while the bottom illustrates Rachel’s premature passing without additional insurance.
Running the simulation for Isaac, Voyant ends Isaac’s salary at the new simulated death event, ends any future retirement savings contributions associated Isaac, and ends any expenses solely assigned to Isaac. Since Isaac already has a $100K term policy, this policy is paid out and included in the available funds upon Isaac’s death. All other expenses, contributions, property purchases remain in the plan. One can see from the top chart that with Isaac gone, unsurprisingly, the Silber’s future plans are in serious jeopardy.
For Rachel early simulated death, a similar procedure is carried out by the simulation. Her salary ends, and all her solely owned expenses are removed from the plan. Just like with Isaac, the Silber’s plans will need some major adjustment in the event of a premature passing without additional insurance on both Isaac and Rachel.
Voyant calculates Isaac needs approximately $620K more in life insurance to insure the goals he has for the family. For Rachel, Voyant calculates that she needs an additional $330K in insurance.
With this, one could go back add an additional term policy each for Isaac ($700K) and Rachel ($350K), re-run the simulation, and see that the additional need for Isaac and Rachel has been reduced to zero or near zero.
The Silber’s: Changing the Market Assumptions
Since future market performance plays a role in the calculated need, we should test how the market assumptions affect the Silber’s insurance needs. Using the Performance slider (the subject of a future article along with the Historic Performance simulator), we adjust the average market assumptions used in the simulation to reflect an overall lower performing market during the timeline of the Silber’s plan. We lower the performance slider so the Silber’s assets only perform at the bottom 40th percentile of their average throughout the lifespan of their plan.
Life insurance simulation using performance slider
Using this less optimistic outlook, we see the Silber’s life insurance needs, as expected, are increased, and by a good margin.
In short, the base need calculation may not be sufficient given the affect of a lesser performing market.
Some important things to note
- Expenses solely owned or designated for the dying individual are stopped at death event. If the dying spouse has an expensive hobby like boating, or spends a good amount of money every year following his or her favorite football team around the country, then those expenses will not be included in the calculation after the spouse has passed. From this, one should hence be sure to mark essential expenses such as child care or housing, etc. as owned by both spouses to avoid the expense being eliminated at death and thus incorrectly reducing the need.
- Currently, the life insurance lump sum is paid out as cash and allocated to the first cash based taxable savings or checking account in the plan. As part of the simulation, the lump sum calculated is based mostly on the lump growing at default growth rate or the cash growth rate. In a future version of Voyant, we will allow the existing insurance policies to designate how to allocate the payout among the different savings accounts in the plan. One will be able to specify a portion (or 100%) of the payout be allocated to a more aggressive, but more risky, taxable savings account that could have an overall higher average growth rate. With this, a lower calculated need would be ascertained.
Conclusion
“Do you have enough life insurance?” Voyant’s Life Insurance Needs simulation tool provides one of the most comprehensive and easy ways for individuals to answer, and for advisers to help their clients answer this question through the context of a holistic plan.
There are a large number of variables that factor into determining life insurance need. With the insight provided by Voyant, one can see how these factors add up into an objective answer.
