Global Best Practices for Investment Suitability

By Shawn Brayman

President PlanPlus Inc

5/23/2012 PlanPlus © 2011 2

• PlanPlus Founder, 25 years experience in financial services • BSc (Applied & Computational Math), MES (Expert Systems) • Chartered Financial Planner (1997), Canadian Institute of Financial

Planning • Winner of 2007 “Financial Frontier Research Award” by Journal of Financial

Planning • Winner of 2011 “Best Paper Award” at Academy of Financial Services • International speaker on financial planning • Chairman FPA (US) Community Development Council , member of Annual

Conference Task Force, Global Advisory Council

Research Publications • “Beyond Monte Carlo Analysis: An Algorithmic Replacement for a Misunderstood Practice”, Journal

of Financial Planning, December 2007 • “Income Replacement Versus Expense Approach to Insurance Needs Analysis”, Journal of Financial

Planning, March 2009 • “Introducing the Debt Policy Statement”, Journal of Financial Planning, April 2011 • “Financial Planning Literature Survey”, Fagan, Brayman, Journal of Personal Finance, August 2011 • “Defining and Measuring Risk Capacity”, Academy of Financial Services, Las Vegas 2011

Shawn Brayman, President CEO

5/23/2012 PlanPlus © 2011 5

What do we mean by a best practice?

• A practice standard that meets or exceeds regulatory requirements

• Efficient for the advisor and firm providing a profitable business process

• Recognizes the client’s best interest. • Based on objective research

Best Practice

5/23/2012 PlanPlus © 2011 6

• Reminders of money make us

“more independent”, selfish, less helpful, more distant.

• http://www.youtube.com/watch?v=D_m_9N_3u7o

A Couple Behavioural Finance Observations

5/23/2012 PlanPlus © 2011 7

1. Returns have been awful since December 1999: USA 1.2%, World 1.5%, HK 4.9%, Singapore 5.6%, China 7.4%,Canada 8.5% Malaysia 10.5%

Six Challenges for Investment Advisors and their Clients

5/23/2012 PlanPlus © 2011 8

2. Fees have been high • 1999 average 2.25% TER in Canada • 2003 grew to 2.68%, 2006 to 2.87, 2009 down to

2.79% • UK currently1.66% • US currently 1.25% • Additional transaction fees between 1% and 2% • In some cases additional “insurance fees” 1% Worldwide, fund managers made more money than clients.

Six Challenges for Investment Advisors and their Clients

5/23/2012 PlanPlus © 2011 9

Risk Premiums in Canada 61 years (1950 to 2010) Inflation 3.76% Cash/savings 5.75% to banks (2% real return) Loans to clients, businesses 6.79% (3% real, 1% premium) Business returns 10.15% (equities) large cap (6.4% real, 3.5% premium) Last 20 years Inflation 1.85% Cash 4.06% (2.2% real) Fixed 7.91% (6.06% real, 3.9% spread) Can Equity 9.32% (7.47% real, 1.4% premium) Small Cap 9.99%, 8.13% real, .7% premium Emerging Market 10.75%, 8.9% real, .75% premium

Understanding Risk Premium

5/23/2012 PlanPlus © 2011 11

3. Client Return is not equal to Investment Return • Dalbar study 1984 to 2003, 2007 markets returned

12%+ and clients realized 2.5% to 3%

Six Challenges for Investment Advisors and their Clients

5/23/2012 PlanPlus © 2011 12

4. Sales costs are often high often adding little value • Front end loads of 3% to 6% • Firms and advisors know accounts are churned:

• You made your profit – sell; this is a bad fund – sell; we have a better fund – buy

• Research investor lost an average of 3.5% and paid a 0.5% commission!

• In 2003 Australia regulator reviewed 100 studies over 40 years from US, UK and Australia

• About half the studies found no correlation at all between good past and good future performance.

• Where persistence was found (1 or 2 years), the cost of swapping would outweigh trying to follow.

Six Challenges for Investment Advisors and their Clients

Source: Standard & Poors SPIVA Reports: http://www.standardandpoors.com/indices/spiva/en/us

Index Outperforms Active Managers

New Reports for US, India, Canada, Europe, Australia – no change in trend in any markets

5/23/2012 PlanPlus © 2011 14

5. We (the FI industry) invented “toxic products” • Lehman Brothers mini- bonds

• AFS October 2011, presentation on Retail Structured Notes – Investors Beware, Robert Dubil, University of Utah

• Catastrophe Bonds • Yields of 6% - Libor Rate • $52 billion sold in last 2 years • Legalized gambling with misleading labels like

“bond”

Six Challenges for Investment Advisors and their Clients

5/23/2012 PlanPlus © 2011 15

Impact of the Debt Crisis

Greece Mediteranian Europe Sovereign Global

Not the real problem

5/23/2012 PlanPlus © 2011 16

Soverign Debt

Public Debt Top 20, 2010 estimate (CIA

World Factbook 2011)

37 Trillion $

5/23/2012 PlanPlus © 2011 17

Capitaliztion of Stock Market

0

10 000

20 000

30 000

40 000

50 000

60 000

70 000Amérique du Nord Europe Asie-Pacifique Reste du monde

Source : World Federation of Exchanges.

5/23/2012 PlanPlus © 2011 18

Then came derivatives

Source : Capelle-Blancard (2010, International Economics)

5/23/2012 PlanPlus © 2011 19

Currency Trading

5/23/2012 PlanPlus © 2011 20

6. Many clients are in unsuitable investments • Advisor bias is to equities (make more money) and

rate clients 1 risk band higher than they are • FSA (UK) June 2011 letter to 260 CEOs of wealth

management firms: • Found that 79% of the files they reviewed the client

was in unsuitable investments or suitability could not be determined.

Six Challenges for Investment Advisors and their Clients

5/23/2012 PlanPlus © 2011 21

#7 - The Real Challenge

2007 – We are the Bubble 2008 – The Perfect Storm And every year since…

5/23/2012 PlanPlus © 2011 22

Financial vs. Real Economy

Since the 1980s the growth of financial services has surged ahead of GDP growth

5/23/2012 PlanPlus © 2011 23

Financial Lobbies are #1

Source : Igan, Mishra & Tressel (2010)

5/23/2012 PlanPlus © 2011 24

#7 - The Real Challenge

Financial Services makes up about 25% of GDP The “assets” of the banks are greater than 5x the World’s

entire GDP Over 50% of financial transactions, occur through

unregulated “Shadow Banking” 30% of global profits from all US companies from banking Banks levered 30:1 worldwide, 50:1 in Europe Assets are growing again, by 6.4%, to cross the $100

trillion mark and profits are soaring, up 77% to $709bn for the 2010 financial year, $80bn short of the pre-crisis peak

Source: TheBankerDatabase.com

5/23/2012 PlanPlus © 2011 25

#7 - The Real Challenge

Financial Services makes up about 25% of GDP The “assets” of the banks are greater than 5x the World’s

entire GDP Over 50% of financial transactions, occur through

unregulated “Shadow Banking” 30% of global profits from all US companies from banking Banks levered 30:1 worldwide, 50:1 in Europe Assets are growing again, by 6.4%, to cross the $100

trillion mark and profits are soaring, up 77% to $709bn for the 2010 financial year, $80bn short of the pre-crisis peak

Source: TheBankerDatabase.com

5/23/2012 PlanPlus © 2011 26

Summary

1 •Returns have been bad

2 •Fees have been high

3 •Investor return not investment return

4 •Sales charges high

5 •Toxic products

6 •Clients in unsuitable products

5/23/2012 PlanPlus © 2011 27

Outcome (so far)

1. Consumer trust shattered. Multi-year trend of consolidating wealth reverses

2. Regulators ban commissions in UK, Australia, Netherlands, Finland, India ,,,

3. Introduction of fiduciary standard in US – not if a product is suitable, if it is in the best interest of the clients.

4. Estimated 5x Global GDP (PV) – collateral damage

5. Get ready for another, more devastating problem

6. The regulators are all talking

5/23/2012 PlanPlus © 2011 28

FSA Guidance Jan 2011

5/23/2012 PlanPlus © 2011 29

FSA Guidance April 2012

5/23/2012 PlanPlus © 2011 30

Advisors Leaving the Marketplace

5/23/2012 PlanPlus © 2011 31

Where from here?

5/23/2012 PlanPlus © 2011 32

In a fiduciary relationship, one person, in a position of vulnerability, justifiably vests confidence, good faith, reliance and trust in another whose aid, advice or protection is sought in some matter. In such a relation good conscience requires the fiduciary to act at all times for the sole benefit and interest of the one who trusts.

Who do you work for?

5/23/2012 PlanPlus © 2011 33

1. Client BEST interest 2. Suitability of proposal 3. Client best interest in product

recommendation 4. No disservice in transition

Objectives

5/23/2012 PlanPlus © 2011 34

1. Proper psychometric risk test

2. Goals discussion

3. Enter current investments, savings

4. Review portfolio objectives

5. Product Selection – lump sum, periodic contributions, protection

6. Run plan document/proposal

7. Monitor & Review

How we do this

5/23/2012 PlanPlus © 2011 35

1. Risk Tolerance • How “bumpy” a ride can you live? • A psychological attribute like an IQ

2. Risk Capacity • How much can you afford to be off course when

you arrive? • A financial construct/analysis • The time horizon plays an important factor • Must be understood in terms of the need or goals

Two primary measures

5/23/2012 PlanPlus © 2011 36

Research, Regulation

Your Risk Tolerance Score Your Risk Tolerance Score enables you to compare yourself to a representative sample of the adult population. Your score is 58. This is a higher-than-average score, higher than 77% of all scores. When scores are graphed they form a bell-curve as shown below. To make the scores more meaningful, the 0 – 100 scale has been divided into seven Risk Groups. Your score places you in Risk Group 5. In answer to the last question, you estimated your score would be 60. Congratulations! You were close. Most people under-estimate their score by a few points.

5/23/2012 PlanPlus © 2011 37

1. Decreases with age

2. Males > Females

3. Correlations • Positive: wealth, income and education • Negative: marriage, no. of dependants • … but weak

4. May be changed by major life events

5. Is not changed by markets

Financial Risk Tolerance

5/23/2012 PlanPlus © 2011 38

Average Monthly Risk Tolerance Scores

0

20

40

60

80

100

Jan 2007 to Jun 2009

5/23/2012 PlanPlus © 2011 39

1.Is understood 2.There are credible tests in the market

• FinaMetrica • Oxford Risk (UK) • Netherlands

Financial Risk Tolerance

Low Risk

High Risk

Risk Tolerance

Too Little Risk Too Much Risk

5/23/2012 PlanPlus © 2009 40

Douglas Rice PhD, Golden Gate University

0%

20%

40%

60%

80%

100%

0.5 1 1.5 2 2.5 Least Risky

Answers

Most Risky

Answers

0%

70%

100%

50%

5/23/2012 PlanPlus © 2011 41

Defining and Measuring Risk Capacity

“Best Paper Award”, Academy of Financial Services,

Las Vegas October 2011

My Recent Focus

5/23/2012 PlanPlus © 2011 42

Other Factors

5/23/2012 PlanPlus © 2011 43

1.Goals • Time Horizon • Risk required

2.Risk Capacity • Downside on the portfolio • Value of the “catastrophic” dollar • Ability for client to adapt

3. Products

Other Factors

5/23/2012 PlanPlus © 2011 44

Risk Required

Risk Required – based on the goals and current behaviour, what return would be required to fund the goals.

5/23/2012 PlanPlus © 2011 45

Other Factors

Goals may be unachievable and require the client to rethink savings or future expenditures

5/23/2012 PlanPlus © 2011 46

1. The longer the portfolio is held, more likely the outcome 2. The downside risk is clearly related to the time

Time & Likely Outcome

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

MC 50% Algorithm +95% Algorithm +67% Algorithm -67% Algorithm -95%

5/23/2012 PlanPlus © 2011 47

1. Portfolio1 12.8% +/- 19.48 vs 12.1% +/- 16.23% 2. Tradeoff ratio 1.6:1.0 in 1 year

Time & Likely Outcome

5/23/2012 PlanPlus © 2011 48

1. Portfolio1 12.8% +/- 19.48 vs 12.1% +/- 16.23% 2. Tradeoff ratio 9.2:1.0 in 9 years

Time & Likely Outcome

5/23/2012 PlanPlus © 2011 49

Pass/Fail is not a useful metric

5/23/2012 PlanPlus © 2011 50

Multiple Factors

• Mortality randomization will result in a total number of “periods” over all simulations

• 9.26% arithmetic mean and 8.07% standard deviation generated simulations that averaged 8.96% geometric means, a 70% equity 30% fixed income portfolio and historical data from the last 60 years

• How many were negative overall? • When we had a shortage, what was the average percentage of target

income achieved. How deep was the hole? • If we looked at desired income across all periods, what percentage

was achieved?

5/23/2012 PlanPlus © 2011 51

Risk Capacity Metric

Illustrates a distribution of risk capacity metric based on depth and breadth of gaps.

5/23/2012 PlanPlus © 2011 52

No Pension, Flexible Lifestyle

$1,000,000 capital with the $70,000 a year target income down to $50,000

Between the 80s to mid-90s we have about 30 simulations (0.3%) with a gap.

5/23/2012 PlanPlus © 2011 53

Lifestyle Change & Risk Capacity

Consider difference between required and desired #1 $1,000,000 portfolio with a $70,000 withdrawal #2 half the capital, pension for $35,000. . #3 $70,000 a year, $500,000 capital and a $35,000 pension, but

could live with $50,000 – a 28.6% reduction in the goal. Never a shortage and the Risk Capacity Metric is 100%.

5/23/2012 PlanPlus © 2011 54

1. What percentage your goals needs to be funded by this portfolio?

• 100%, 75%, 50%, 25%

2. If the portfolio fails to achieve the expected return, how much can you adjust the goal?

• Not at all, 10%, 25%, 50%, 100%

3. How much more is receiving the first dollar of the goal than the last dollar?

• The same, twice, three times, five times

Three Risk Capacity Questions

5/23/2012 PlanPlus © 2011 67

#5 Implementation

1. Products and fees we will recommend

2. Analysis of existing positions to ensure changes we recommend improve the situation

5/23/2012 PlanPlus © 2011 68

What is Active Share? Cremers and Petajisto’s “active share” looks at what is inside portfolios then finds robust links between portfolios’ profiles and future performance. Looked at the performance of 2,740 all-equity US mutual funds from 1990 to 2009. They found that diversified stock pickers - funds with high active share but not the very highest tracking error - performed best, producing an average yearly benchmark-adjusted return over the period from 1990 to 2009 of 120 basis points after taking away all expenses and costs.

Sidebar: Active Share

5/23/2012 PlanPlus © 2011 69

• Recommend ETFs, index funds with lowest MER/TER for the core holdings in the portfolio.

• Use select specialty funds in limited segments for clients with sufficient funds to diversify.

• Charge a fee for the advice. Value linked to a financial plan and ongoing review.

Core/Satellite

5/23/2012 PlanPlus © 2011 76

1. Detailed “snapshot” of complete client plan initially and on each review.

2. Compare each component of the plan over time

3. Client accountability analysis on debt repayment and annual savings achieved

4. Scorecard for how we are doing in the plan

5. Separate review document keeps the engagement “alive”

#6 Review

5/23/2012 PlanPlus © 2011 77

Each aspect of the clients plan is recorded at each review to allow multi-period comparisons.

Review Process

5/23/2012 PlanPlus © 2011 78

5/23/2012 PlanPlus © 2011 79

The regulator and market are demanding change. The question is will your firm be proactive or reactive. You can do what is best for the client and make a good living while doing so.

Summary