Outcomes of the Suitability Test Investigation in Wealth Management and Investment Advice

Outcomes of the Suitability Test Investigation Investigation into the suitability test in wealth management and investment advice Publication date: November 2021 Report afm.nl/suitability-test

2 Outcomes of the Suitability Test Investigation Table of Contents 1 Introduction 3 2 Content and Scope of the Investigation 4 2.1 Background of the Investigation 4 2.2 Scope and Design of the Investigation 4 3 Overall Picture of the Investigated Enterprises 5 3.1 Client Inventory and Update 5 3.2 Understanding of Instruments 6 3.3 Selection of Instruments and Composition of (Model) Portfolios 6 3.4 Alignment of Client Information 6 Choice of Investment Profile and Corresponding (Model) Portfolio 6 Return Expectations of (Model) Portfolios Not Always Realistic 7 Determining the Risk Characteristics of (Model) Portfolios 8 3.5 Investment Switch 9 3.6 Suitability Declaration 9 4 Next Steps 9

3 Outcomes of the Suitability Test Investigation 1 Introduction The Dutch Authority for the Financial Markets (AFM) conducted a market-wide investigation in 2020-2021 among 13 investment firms and banks regarding the implementation of the requirements surrounding the suitability test in investment services1. This was part of an investigation carried out by various national supervisors under the coordination of the European supervisor, the European Securities and Markets Authority (ESMA). Individual findings were fed back to the enterprises involved in this investigation and discussed with them in most cases. Improvement plans have been implemented and are partly still in progress. The individual feedback also included an overview of the main outcomes among the investigated enterprises. With this publication, the AFM shares these outcomes with the rest of the market. The AFM calls on enterprises that were not involved in the investigation to determine for themselves to what extent these points of attention also apply to them and, if so, to make the necessary adjustments. In general, the investigated investment firms are aware of the regulations regarding the suitability test, processes have been put in place, and there is policy in place to comply with regulations. Nevertheless, the AFM signals a number of points of attention and improvement that we also wish to share with enterprises that were not involved in the investigation. The main outcomes of the investigation are summarized below. • In client inventory, enterprises generally follow the regulations well. However, there were several points of attention regarding parts of the inventory at various enterprises, such as obtaining risk tolerance more concretely, specifically the risk that the investor will not achieve their goal. • Regarding the alignment of the investment portfolio with the obtained client information, the AFM observed several points of attention. A clear, traceable link between all relevant, specifically obtained client information and the recommended or managed investments is not always present. The AFM saw this both in a scoring system and in 'professional judgment'. For these enterprises, there is a greater chance that the recommended investments or managed portfolio do not align with their clients. Enterprises were able to explain the system in most cases, but had to take steps to improve their processes in this area to ensure consistency. • The AFM questions the realism of sometimes very high expected returns on defensive and neutral (model) portfolios. Additionally, the AFM sees room for improvement in determining the risk characteristics of (model) portfolios. • Finally, there were points of attention regarding the newest parts of the suitability test. The majority of the enterprises in the investigation do not perform a cost-benefit analysis during an investment switch, and almost all enterprises have made no or insufficient connection in their suitability declaration with the characteristics of the client. As a result, the suitability declaration is too general in nature and adds little value for the client. 1 Article 25(2) and (6) of Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU and Articles 54 and 55 of Commission Delegated Regulation (EU) 2017/565 of 25 April 2016; Article 4:23 of the Financial Supervision Act (Wft).

4 Outcomes of the Suitability Test Investigation As a result of this investigation, the AFM and ESMA are taking several next steps. The AFM has, among other things, started an investigation earlier this year into the investment policy of investment firms, focusing on the calculation of expected returns and expected risks. The AFM is also publishing an update and merger of previously issued guidelines on the suitability test simultaneously with these outcomes. ESMA has announced that it will adjust and clarify, where necessary, the 'Guidelines on certain aspects of the MiFID II suitability requirements'. 2 Content and Scope of the Investigation 2.1 Background of the Investigation The AFM's investigation was part of a joint supervisory action carried out in cooperation with various European national supervisors and ESMA. This relatively new form of cooperation between European supervisors and ESMA is called 'common supervisory action (CSA)'. The AFM supports the overarching objective of the CSA: promoting consistent implementation and application of EU financial legislation in EEA member states. The goal of the investigation was for the AFM to form an image of how investment firms implement the suitability test requirements for retail investors. Proper design and execution of the suitability test increases the protection of investors who are advised or have chosen wealth management, as they invest in investment portfolios that align with their situation. The AFM believes it is important that investors can continuously rely on the fact that the investment advice or wealth management they receive is in their interest. 2.2 Scope and Design of the Investigation The investigation focused on several elements regarding the design and execution of the suitability test in investment services (investment advice and wealth management)2. The investigation focused on the following parts: • Client inventory • Understanding of instruments • Selection of instruments and composition of (model) portfolios • Alignment of client information • Investment switch • The suitability declaration Regarding client inventory, the AFM investigated how the investigated investment firms ensure that sufficient information is obtained for each client to provide suitable advice or to manage a suitable portfolio, and how it is ensured that this information is of sufficient quality, reliable, and 2 For further details on these elements, we refer you to the ESMA Supervisory briefing on suitability of November 2018 and Guidelines on certain aspects of the MiFID II suitability requirements of November 2018, as published on the ESMA website.

5 Outcomes of the Suitability Test Investigation up-to-date. Updating client information was addressed in general terms and specifically during the corona crisis. Regarding understanding of instruments and selection of instruments, it was investigated how investment firms ensure that advisors and/or wealth managers understand the characteristics and risks of the financial instruments in the product assortment. Part of this was also the manner in which investment firms ensure that equivalent alternatives are weighed when selecting financial instruments, taking into account the costs, risks, and complexity of the different instruments. Several topics were addressed under 'alignment of client information'. The AFM investigated the manner in which investment firms ensure that the characteristics of a portfolio and the instruments in the portfolio align with the characteristics and needs of the client. In light of current market conditions of very low or even negative interest rates on many bonds and savings accounts, the AFM also investigated how investment firms ensure that the return expectations they use in the suitability test process are realistic. It was also investigated how enterprises determine the risk characteristics of (model) portfolios and how investment firms ensure that clients whose investment goal and/or expected return and risk tolerance are in tension are served correctly. It was also investigated how investment firms implement regulations regarding an investment switch. That is: the simultaneous sale of an instrument and the purchase of another instrument or the exercise of a right to bring about a change regarding an existing instrument. Regarding the suitability declaration, it was investigated how investment firms ensure that it contains all required information and is provided to the client in a timely and correct manner. 3 Overall Picture of the Investigated Enterprises 3.1 Client Inventory and Update In general, the investigated investment firms have put in place sufficient policy and processes to obtain reliable and relevant client information for offering suitable wealth management or advice services. The AFM has also noted several points of attention. For example, the investment objective and risk tolerance are not always fully inventoried in practice. Some investment firms do not use or use insufficiently clear terms for achieving the investment objective. The feasibility of the objective is also not always sufficiently mapped. The willingness regarding risks at the end of the investment horizon (the risk that the client will not achieve their goal) is insufficiently inventoried by about half of the investigated investment firms. However, this is necessary information to be able to recommend or manage investments whose (risk) characteristics align with the client profile. At all 13 enterprises, we see that updates take place periodically, usually annually. For some enterprises, the update can be worked out more concretely in policy and processes, for example regarding the actions that must be taken when the client profile becomes outdated or is about to become outdated.

6 Outcomes of the Suitability Test Investigation Due to the outbreak of the corona crisis and its (financial) impact on people's personal situations, the previously obtained client information may be outdated or become outdated in the short term for some ongoing advice and wealth management clients. This creates the risk that advice and management portfolios no longer align with the new client situation. Following the AFM's call3, and sometimes even earlier, all investment firms have contacted customers to inform them about market developments. About half of the enterprises have also actively started updating client information. Some of these investment firms have approached risk-based (the most vulnerable or affected) customer groups or even all customers extra to update their client profile. Only a small part of the enterprises has not demonstrably paid sufficient attention to updating customer data during the corona crisis. 3.2 Understanding of Instruments The investigated investment firms have put in place procedures to ensure that they have insight into the nature and characteristics of the financial instruments selected for their clients. The quality of these procedures varies. Almost all enterprises have documented sufficient processes for knowledge building. Where this is not documented, knowledge is shared in a central body (for example, an investment committee). Additionally, product governance processes are part of the instrument analysis at the majority of enterprises. Regarding the use, quality, and evaluation of information sources, the AFM notes room for improvement. At the majority of the investigated enterprises, there is a lack of traceable justification for the use of certain information sources and their evaluation. Investment firms can improve by anchoring this in policy and procedures and making relevant information sources accessible to the employees involved. 3.3 Selection of Instruments and Composition of (Model) Portfolios Most investment firms classify instruments into categories of equivalent instruments. However, the criteria and weighting of those criteria for the selection of instruments are not always clearly documented. It is noticeable that when an enterprise uses a central body (for example, an investment committee) responsible for the selection of instruments and the composition of model portfolios, more concrete procedures and policy are put in place, and thus the selection criteria and their weighting are more consistent and unambiguous. Additionally, the AFM sees that one investment firm has documented clear qualitative and/or quantitative exclusion criteria to arrive at a list of instruments. For example, a minimum fund size, a maximum in (fund) costs, or the use of ratings from external parties. 3.4 Alignment of Client Information Choice of Investment Profile and Corresponding (Model) Portfolio The AFM's investigation shows that most investigated investment firms use investment profiles with corresponding model portfolios to align the client profile. However, the AFM notes that investment firms implement this in highly varying ways. Sometimes there is a tightly controlled process where answers from the client inventory are translated via a scoring system and corresponding scale distribution into investment profiles and 3 On May 20, 2020, the AFM called on investment firms to pay extra attention to updating the client profile, as it is likely that the personal situation of some clients changes as a result of the corona crisis: https://www.afm.nl/nl-nl/nieuws/2020/mei/oproep-klantactualisatie.

7 Outcomes of the Suitability Test Investigation model portfolios. At some investment firms, answering certain 'knock-out' questions blocks the recommendation of a (very) offensive investment profile. In some cases, the enterprise translates the obtained client information from a 'professional judgment' of the individual advisor or wealth manager into a suitable investment profile and model portfolio. Here, the obtained information such as investment horizon and goal, risk tolerance, and affordability is taken into account, often in dialogue with the client. Both in a scoring system and in 'professional judgment', the AFM notes that in the processes of a large part of the investigated investment firms, no clear traceable link appears between all relevant, specifically obtained client information and the recommended or managed investments. This means that for these enterprises, there is a greater chance that the recommended investments or managed portfolio do not align with their clients. In cases where a scoring system was chosen, the AFM cannot always reconstruct the justification and rationale behind the scoring and the corresponding assignment of a risk profile. Where the choice of the suitable profile is more a 'professional judgment' of the individual advisor or manager, the AFM sees a varying picture to ensure that this is done carefully and consistently via controls and monitoring (four-eyes principle, role of compliance). Enterprises were able to explain the system in most cases, but had to take steps to improve their processes in this area to ensure consistency. The AFM also notes that when giving advice regarding the implementation of the chosen profile with specific instruments, advisors often have room to deviate from the standard advice formulated by an investment committee or other central body. As a result, the quality of the outcome (suitable advice) and the reconstructability of deviations strongly depend on the quality of the respective advisor and the quality of the control mechanisms an enterprise uses. Some investigated enterprises have compiled advice lists with multiple alternatives per product category in this regard. This reduces the chance that deviating advice leads to unsuitable advice, while an individual advisor can simultaneously take into account the specific needs and wishes of the client. Return Expectations of (Model) Portfolios Not Always Realistic The AFM sees the creation of realistic return expectations for investment profiles or model portfolios as an essential part of ensuring a suitable investment portfolio. This strongly depends on which investment profile an enterprise considers a certain investment goal to be achievable with, or how much money a client must invest in a certain investment profile to reach a certain target amount at the end of the investment horizon. The AFM notes that there is a wide range of expected returns among the investigated enterprises. On a neutral profile (invested in almost equal proportions of stocks and bonds), the range runs from just above 3% to 6%. On comparable defensive profiles, a large part of these parties uses an expected return of 3 to 4%, but another part has expected returns of 2% or lower. The investigated enterprises use varying calculation methods to determine expected returns. For example, some enterprises take the current low interest rates on government bonds as a starting point and include this low interest rate in the determination of expected returns for investment grade corporate bonds, high yield bonds, and stocks. Other enterprises base the used expected returns on historically achieved returns, reference indices, or their own investment portfolios, with or without an adjustment for the

8 Outcomes of the Suitability Test Investigation low interest rate. These seem based on favorable historical returns driven by the decline in bond interest rates to extremely low levels. At least one enterprise updates the forecast returns monthly and includes the actual forecast returns of the investment profile and tactical asset allocation in its client inventory. However, the AFM has seen multiple examples where the enterprise has not updated the return forecasts and risk characteristics of the model portfolio for years. The widely varying expected returns on defensive and neutral profiles are largely attributable to these different calculation methods used by enterprises. This lies mainly in the manner in which enterprises weigh the current low interest rate in expected returns, and less in the differences in the implementation of the portfolios (asset allocation and instruments). The AFM questions the realism of sometimes very high expected returns on defensive and neutral (model) portfolios. Determining the Risk Characteristics of (Model) Portfolios The AFM notes that many of the investigated investment firms use wide asset allocation bandwidths, especially in neutral and defensive portfolios. Many investment firms also have considerable flexibility in implementing the defensive part of the portfolio, with wide bandwidths for riskier bonds (high yield bonds, emerging market bonds, bonds without credit rating, and subordinated bonds). These wide bandwidths give investment firms considerable flexibility in implementing the portfolio to also respond to market developments. This can serve the client's interest. However, for a part of the investigated enterprises, it is also the case that the AFM cannot reconstruct whether this happens within the limits of the client's risk tolerance and the standard deviation or other risk parameters that characterize a (model) portfolio. To determine the risk of the investment profiles, many enterprises mainly use the volatility (measured by standard deviation) of returns. Often this is based on the CFA-VBA risk standards where standard deviations and correlations of various broadly diversified indices are used. The AFM has noted that it is not always ensured that this calculation method leads to a standard deviation that aligns with the actual portfolios that investment firms advise or manage for clients. A minority of the investigated enterprises has also predetermined in advance for each model portfolio which 'risk budget' or risk limits are acceptable and actually checks whether the quantitatively obtained client information aligns with the risk characteristics of the actual portfolios. This also enables these enterprises to better monitor and adjust the suitability of client portfolios during their term. Other types of risks or definitions of 'risk' than standard deviation are also relevant in assessing suitability, such as concentration risk, counterparty risk, or liquidity risk. A minority of the investigated enterprises has neither in the investment policy nor in any other way elaborated which standards and rules they use to, for example, achieve sufficient diversification or to limit counterparty risk and liquidity risk. The findings regarding the determination of expected returns and risks of (model) portfolios have been an additional reason for the AFM to start further investigation into these elements of the investment policy.

9 Outcomes of the Suitability Test Investigation 3.5 Investment Switch The majority of the enterprises in the investigation do not perform a cost-benefit analysis during an investment switch (the simultaneous sale of an instrument and the purchase of another instrument or the exercise of a right to bring about a change regarding an existing instrument). As a result, the investment firm cannot demonstrate that the expected benefits of the investment switch outweigh the costs. A part of the enterprises argues that this is also not necessary, because the enterprise has no interest in making many trans