C5. Client Advice

Question 1

Describe an instituional investor

Answer 1

They employ professional fund managers to manage funds on a large scale
Examples: Pension funds, insurance companies, hedge funds, and mutual funds

Question 2

Describe Individual (retail) Investors

Answer 2

They have limited time and resources, less investment sophistication and significantly more tax considerations

Question 3

What constitutes a high net worth investor (indivdual investor)

Answer 3

Person with an annual income of £100k +
or more that 250K of investable assets (excluding pension

Question 4

What constitutes a certified sophisticated investor

Answer 4

A person who has a certificate confirming they have been assessed by a firm as being sufficiently knowledgeable
Signed statement acknowledging the risk of loss
Can be self certified if:
Member of a network of business angels
Working in private equity (last 2 years)
Director of a company with an annual turnover of £1m+ (last 2 years)

Question 5

What are the main obligations of a firm towards its customers, set out in the FCA Principles of Business (PRIN)

Answer 5

6 - A firm must pay due regard to the interest of its customers and treat them fairly
7 - A firm must pay due regard to the information needs of its clients and communicate it in a fair clear non misleading way
12 - Firms must act to deliver good outcomes for all retail customers
12 is a much higher standard that 6,7

Question 6

What are the 4 outcomes from the consumer duty rules

Answer 6

Products and services - meet the needs, objectives, characteristics of the target market in creation and delivery
Price and value - (doesn’t need to be the same for all customers)
Consumer understanding - make the appropriate information available
Consumer support - Appropriate facilities to ensure products can be used as envisaged

Question 7

3 cross cutting obligations of the consumer duty requirements of a firm

Answer 7

Must act in good faith towards retail customers
Avoid causing harm
Enable and support retail customers to pursue their financial objectives

Question 8

In line with the FCA statement “Understanding user needs, and recognising where some users are vulnerable…. “ what are the actions firms should take, in the guidance issued by the FCA regarding vulnerable clients

Answer 8

Understand their needs
Ensure staff have the skills to identify and deal with their needs and continuously improve
Take practical action in product and service design
Monitor and evaluate outcomes

Question 9

Ideal sequence of the financial planning process

Answer 9

Establish and define client-personal finance planner / adviser relationship
Gather client data, determine goals and expectations
Evaluate financial status
Develop and present plan
Implement the FP recommendations
Monitor the FP and the FPing relationship

Question 10

What are the 3 main factors when determining an investors needs and objective

Answer 10

Return requirement
Risk tolerance (psychology)
Time horizons (liquidity of investments)
Other: Liquidity, Tax efficiency, Religious or ethical beliefs

Question 11

Explain the need to prioritise objectives to accommodate a clients affordability

Answer 11

Not always possible to meet all of a client’s objectives
Affordability can be established by preparing a cashflow statement

Question 12

Key parts of financial objectives

Answer 12

They should be quantified, in terms of how much money is wanted, when.

Question 13

Importance of the fact finding process

Answer 13

In order to establish a clients objectives, fact-finding is an important follow on process to help the financial adviser shape how the client goals can be met
This process builds a comprehensive picture of the clients current financial situation

Question 14

Difference between hard facts and soft facts

Answer 14

Hard facts: Personal details, name, address, NI number, Employment details…..
Soft facts: Involve asking open ended questions to form an understanding of preferences and aspirations

Question 15

How does an adviser obtain information that a client cannot answer during a fact find

Answer 15

The advisors will have to find the information from the respective places using a ‘letter of authority’
This is done with client authorisation

Question 16

Identify the factors shaping a clients circumstances

Answer 16

Clients history and background
An individuals attitude to risk is usually shaped by experiences
Thoughts on ethical issues

Question 17

What are the 3 main types of investment risks

Answer 17

Inflation risk - income will be eroded by inflation
Interest rate risk - Change overtime
Shortfall risk - If investments do not return at the rate we expect, investors wont meet their objectives

Question 18

What are the 3 other types of risk that may be relevant for consideration in the investment selection process

Answer 18

Credit risk - risk of default
Market risk - loss due to market fluctuations
Operational risk - risk of failure of an institution due to poor operating procedures

Question 19

Explain the role of diversification in mitigating risk

Answer 19

No single asset is low risk in all regards
A diversified portfolio at aggregate level can reduce various aspects of risk

Question 20

What are the 3 factors that make up a clients risk profile

Answer 20

Risk required - Risk associated with the return required to achieve client’s objectives
Risk capacity - Financial ability to absorb losses
Risk tolerance - level of risk the client is comfortable with

Question 21

What are the key factors that affect a clients risk profile

Answer 21

Timescale of the investment - long time horizon may take capital risk to reduce shortfall risk
Amount of risk capital - money to invest that would not affect a persons lifestyle if lost
Investment experience
Psychology - Is the prospect of loss distressing

Question 22

Detail the 2011 guidance on how the regulators expect risk profiling to be performed

Answer 22

In circumstances where a customer’s needs conflict with the level of risk they are willing to take, the firm should have a detailed discussion about the mismatch
Where a customer does not have the capacity to sustain losses of a higher risk strategy, firm should explain that objectives cannot be reasonably met
If a customer is able and willing to sustain greater losses, the firm should document this

Question 23

Explain the key methods of determining a client risk profile

Answer 23

Begin with a fact-find
Capacity for risk needs to be determined:
Risk tolerance: Analyse previous investments, Risk profiling questions based on psychometric principles,
Capacity for risk: Where losses would have a materially detrimental effect on a clients standard of living, the FCA requires this to be taken into account in the assessment of risk a client is able to take

Question 24

Explain what is meant by asset allocation

Answer 24

Refers to the mix of underlying asset classes held in a portfolio
Main asset classes are:
Cash, Fixed-income securities, alternative investments and equities

Question 25

Explain why asset allocation always comes before investment or product selection

Answer 25

Backed by studies Obtain diversification benefits as returns across asset classes will not be perfectly correlated, reducing risk without reducing returns 60:40 equities bonds is traditionally recommended for retail clients

Question 26

Whether tied to a specific fund provider or not (independent), what are the 4 factors that should be taken into account as part of the fund selection process

Answer 26

Charges Financial stability of the provider Past performance Due diligence in fund selection

Question 27

Explain the different types of fund charges a firm should consider when choosing a fund manager

Answer 27

One off charges - paid at the point of sale or exit Ongoing charges - made up of investment and administration costs and platform fees. The Ongoing Charges Figure must be displayed in the KIID of a unit trust or OEIC Other charges include trading costs due to commission to stock brokers and stamp duty

Question 28

Explain how the financial stability of the provider should be considered when choosing a fund manager

Answer 28

Liquidation of Woodford Equity Income Fund left investors with large losses Liquidity can be a problem, especially for funds investing in property, a downturn in the property market can cause investors to sell, which puts pressure on liquidity

Question 29

Explain how the past performance of a fund should be considered when choosing a fund manager

Answer 29

Indicator of the skill of the fund manager, stemming from the belief that winners persist. However there is a lot of research to suggest against this Warning from the FCA handbook is "past performance is not a reliable indicator of future performance"

Question 30

Explain how due diligence in fund selection should be considered when choosing a fund manager

Answer 30

Due diligence is important to ascertain the stability and independence of trustees, fund custodians and auditors To avoid investing in ponzi schemes / scams

Question 31

Explain the importance of reviews within the financial planning process

Answer 31

Reviews should be at least annual to: Check for any changes in clients circumstances, risk profile, and objectives Monitor investment performance against objectives (ideally a benchmark) Rebalance the portfolio in line with the agreed asset allocation

Question 32

How should performance be measured in realtion to client advice

Answer 32

Performance can be measured in terms of absolute return, but it is more meaningful when it is benchmarked against the performance of a similar investment fund or manager Must select the correct index as a benchmark

Question 33

What should the fact find cover

Answer 33

The fact-find should capture all pertinent details, including current and future circumstances, objectives, current and expected income levels, expenditure, financial status, entitlement of benefits and risk profile

Question 34

What are the most important investment institutions in the UK

Answer 34

Pension funds and insurance companies In October 2024 they account for more than 82% of the institutional client market

Question 35

What are the 2 main types of pension fund

Answer 35

Defined benefit scheme: Sponsor agrees to pay the member benefits equal to a pre-determined % of their salary. (e.g. personal pensions) Define Contribution: contributions are used to buy investments, and the returns on these investments determines the pension benefits 62% of pensions in the UK are DB 35% are DC 3% are in other pension arrangements 70% of DB schemes are private sector

Question 36

Features of pensions

Answer 36

Contributions made by individuals receive income tax relief Accumulated interest and capital gains are tax free as well as part of the proceeds being available as tax free PCLS A fund with a high proportion of employees closer to retirement is considered more mature, and might invest more in fixed-income securities and less in equities

Question 37

What was the main change to pensions in the pensions act 2008

Answer 37

those between 22-retirement age with annual income over £10K must automatically be enrolled into a workplace pension, referred to as automatic enrolment

Question 38

What are the changes introduced to DC pensions in 2015

Answer 38

From age 55: Take an uncrystallised funds pension lump sum (UFPLS), money drawn directly from the fund, 25% is typically tax free Purchasing a lifetime annuity with some or all of the accumulated funds that will pay an income until death ( a PCLS of up to 25% can still be accessed before the annuity is purchased) Entering a flexi-access drawdown plan, no limits but taxed as income but a 25% PCLS can be taken when the fund is put into drawdown

Question 39

What are the reasons for the closure of DB schemes

Answer 39

Increasing longevity, which means increased costs for the scheme Disclosure of schemes' funding position, revealing deficits Increasing pension deficits due to increasing longevity and falling returns on assets held by schemes

Question 40

What does an LDI strategy involve

Answer 40

Taking future liabilities as a given and building a portfolio of assets needed to meet those future liabilities

Question 41

3 options customers are given when they choose to enter a drawdown or transfer to a drawdown account

Answer 41

Choosing investment pathways Choosing their own investments Staying with the investments they already have

Question 42

Explain the features of life assurance companies

Answer 42

Difference between term assurance and life assurance Life assurance involves more long term liabilities and hence longer term portfolio of assets is held Subject to CGT and income tax so investment strategy is different to pension funds Some life assurance policies are 'qualifying' meaning that the proceeds of the policy are not taxable

Question 43

Explain the features of general insurance companies

Answer 43

Provide insurance against basic contingencies; fire, theft, etc... Usually a fixed premium over a year Liabilities are short term as claims are made immediately after the event To meet the demand of these requests, premiums are pooled into highly liquid securities

Question 44

What are the liquidity requirements for pension / insurance funds

Answer 44

Greater for a mature pension fund Need to be met by holding investments that are liquid and by investing in assets that generate income, such as fixed income securities General insurance funds have shorter maturity liabilities hence the need for capital growth is less important and the need to meet expenses is greater

Question 45

How do DB and DC pension schemes differ in asset allocation

Answer 45

Public DB: 50% equity, 18% bonds, 24% Alternative assets, rest cash Private DB: 11% equities, 55% bonds, 14% alternative assets, rest in cash DC schemes: 56% equities, 24% bonds, 3% alternatives, rest cash

Question 46

How does the asset allocation differ between Pension funds, life insurance, and general insurance

Answer 46

Majority bonds and equities: Pensions hold relatively: the most net short term assets and equities with the least bonds General insurance holds the opposite Pensions are the largest market ~3tr

Question 47

How do life insurance funds invest their assets

Answer 47

Very long term liabilities so 29% in equities 45% in fixed income securities to cover annuity liabilities

Question 48

How do life general funds invest their assets

Answer 48

Market £308bn Hold substantial proportions of short-term assets or short term fixed income securities to match the nature of their liabilities

Question 49

What is the effect of time horizons on a funds asset allocation

Answer 49

Very long term liabilities but analysts like to break them down into shorter 5 year periods to facilitate: Sensible evaluation of investment objectives and manage changes in circumstances and economic conditions

Question 50

What is the effect of liability structure on a funds asset allocation

Question 51

What is the effect of liquidity requirements on a funds asset allocation

Answer 51

DB different to DC DB depends on age distribution of beneficiaries As a pension matures, liquidity needs to rise Liquidity for a DC will depend on specific circumstances like employee turnover, withdrawal provisions. More need to pay out = more liquid Compared to long term insurance funds, cash flows of general insurance funds are uncertain creating need for greater liquidity

Question 52

What is the effect of liability structure on a funds asset allocation

Answer 52

Liabilities of long term insurance companies are similar to that of DB and DC with slightly greater liquidity needs reflecting the shorter time liability structure

Question 53

How are pensions and insurance businesses taxed differently

Answer 53

Pensions funds are exempt from income and capital gains tax. There may be unrecoverable tax on overseas investments Both general and life insurance businesses are taxed on their profits although exemptions apply to life assurance with-profits business or annuity business

Question 54

What is the effect that regulation has on general insurance and life assurance companies

Answer 54

General assurance and life insurance have detailed regulations to prevent them being unable to meet future liabilities General insurers are required to keep solvency margin expressed as a percentage of net assets to net premiums written

Question 55

What are the possible constraints that could impact the return objective of an insurance or pension fund

Answer 55

Liquidity needs Time horizon, longer time can afford more risks Tax Legal and regulatory, restrictions into what assets can be invested into ( apply's to UK unit trusts) Other constraints may exist: asset constraints, ethical issues, Climate reports for pension funds over £1bn, solvency regulations for insurance companies