Ian Tam, of Morningstar, guides WP through the key themes of the CSA's regulatory changes
The concept that the clients’ interest come first should, in theory, be at the heart of all wealth management. However, it’s a complicated ecosystem.
Different areas of the industry serve different needs and different companies have certain expertise they understandably want to capitalise on. Of course, in some instances, the wellbeing of the client can be pushed down the list of priorities as certain products and services are pushed their way. It’s the combination of these two elements that has prompted the Canadian Securities Administrators (CSA) to develop its client-focused reforms (CFRs).
Key themes
The CFRs were originally adopted by regulators in October of 2019, with the key thematic reforms phased in according to two main deadlines. Wealth management firms should already be deep into the process of complying but, for the record, here are the two important dates for your calendar.
By June 30, 2021, rules will come into effect regarding conflicts of interest and referral arrangements. And by December 31, 2021, obligations concerning know your product, know your client, suitability determination, misleading communications, and compliance training.
WP spoke to Ian Tam, Morningstar Canada’s Director of Investment Research, about the reforms, what they entail and why they were needed. He said the reality is that in Canada, clients face a broad spectrum of advice and that, clearly, not all advisors are created equal and the advice investors receive can vary depending on the amount of assets available to invest.
He explained: “From branch advice up to a full-service brokers, there’s a fairly broad range of advice being provided. The good thing about these reforms is that they essentially hold all advisors that are governed by the CSA to a higher minimum standard of conduct. In a way, it evens the playing field by requiring advisors to conduct processes such that the minimum standard of quality goes up go for all investors in Canada.”
Know your client
Two core prongs of the CFRs are the KYC and KYP sections. The main part of the KYC requirement is that the CSA has separated out risk tolerance and risk capacity, together forming what’s known as “risk profile”. Tam said this is important because, both are vital to enable an advisor to offer a suitable recommendation.
PlanPlus Global, which Morningstar recently acquired, are experts in this field. Back in 2015, they conducted a study for the Investment Advisor Panel of the OSC across multiple questionnaires used in Canada, and they found that there was a lot of variability in terms of the types and quality of questions, and the effectiveness of the questionnaire overall.
“Having specifications around risk capacity and risk tolerance will hopefully force firms to take another look at how they capture this vital information.”
He added: “A lot of this, especially risk tolerance, is a fuzzy area because it’s very psychological and highly dependent on the interpretation of questions. In order for this tool to be effective, you need to have something that's validated by psychometric analysis, which rarely happens. But hopefully, [the reforms] force a higher standard and prompt firms to take another look at the quality of their risk profiling process.”
Know your product
The second prong of the CFRs is the KYP requirement and is designed to stop the advisor from getting tunnel vision. It forces them to document that they've considered alternatives and to keep their eyes open to other potential products that might be available and suitable for the client.
Tam said: “The advisor has to disclose this process to the investor. From the investor point of view, this should be useful as it will provide transparency and reasoning as to why your advisor decided to recommend a particular investment.
Conflicts of interest
While firms have until the end of the year to prepare for those two, the end of June will see another important change ushered in. Conflicts of interest are a contentious issue around products, with banks and big firms having their own distribution networks and proprietary products. Naturally, they will push their own products, almost always creating a conflict of interest.
The CSA want these conflicts to be disclosed, addressed or avoided. Therefore, in order to address the conflict with selling proprietary products to clients, head offices must conduct a regular analysis to compare those bank products, or those proprietary products, against others in the market to make sure they're competitive both in terms of performance, costs and risk. This is designed to ensure companies will have a tighter, higher quality product shelf, from which advisors are picking.
Tam said: “Our banks and financial institutions have spent decades building gigantic distribution networks into their ecosystem, so of course it makes sense to take advantage of economies of scale . But at the same time, in looking out for the investor, we want to make sure that these products are of good quality. The regulation requires that regular analysis be conducted on these products, which is generally good practice and we feel is very important.”
Tam added that the relationship disclosure information within the new CFR requirements is also helpful for investors in that the disclosures should make clear what types of products are available from an advisor.
He explained: “When you're buying a car and you walk into a Honda dealership, it's very intuitive that you're getting a Honda, but it's maybe not as transparent when you're going to get advice from financial advisors. It’s not as intuitive, so it's important that that disclosure is made so the investor knows what they are going to get when they walk into a bank branch, for example.”
Tough for small firms?
For firms, Tam sees two big challenges. The first being training, which the MFDA and IIROC have put out guidance on. Ultimately, though, it’s the firm’s responsibility to make sure advisors are following these processes. He said: “If you haven’t already been doing some of these things, that's going to require a lot of effort.”
The second thing is technology. With tens of thousands of share classes available to investors in Canada, there is a lot of information to comb through to create a reasonable product shelf. Similarly for the advisor, when they look for alternative recommendations, they will need to leverage a reputable source of information to be able to do it objectively, consistently, and quickly. Firms also have to be able to effectively communicate that product shelf to the advisor channel in an efficient manner.
This will be a particular challenge for smaller firms that don’t have well-defined processes in place.
Tam said: “With this regulation, a firm’s product shelf has to be very well defined. Firms must be cognisant of creating a good quality shelf and a shelf that’s wide enough for an advisor to pick from. That’s going to be challenging for many firms, in particular smaller firms that will need to spin up these processes fairly quickly.”
Morningstar has also just launched a market research survey to better understand the challenges advisors are facing as they prepare for the client focused reforms.
