ICWIM - 005 Fiduciary Relationships

Chapter Five
Fiduciary Relationships
1. Fiduciary Duties 129
2. Advising Clients 135
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3. Determining Client Needs 143
4. Investment Objectives and Strategy 149
5. Taxation 169
This syllabus area will provide approximately 19 of the 100 examination questions
1. Fiduciary Duties
Learning Objective
5.1.1 Know when fiduciary responsibilities arise and the main duties and responsibilities of a
financial adviser
A fiduciary relationship is one in which one person places special trust, confidence and reliance in, and is
influenced by, another who has a fiduciary duty to act for the benefit of that person. In discharging their
responsibilities, the fiduciary must be absolutely open and fair and act with integrity and in a manner
consistent with the best interests of the beneficiary of the fiduciary relationship.
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Fiduciary relationships are generally treated as including:
• agent and principal

• director and company
• lawyer and client
• banker and customer
• stockbroker and client
• trustee and beneficiaries.
As a result, a fiduciary relationship can be seen to exist between an adviser and a client, whether it
is acting as agent, banker, stockbroker or trustee, or in any other capacity. The responsibilities that a
regulated financial adviser must follow therefore include the following:
• act in the utmost good faith for his client

• not make a profit from the trust placed in him
• not place himself in a position where his own interests conflict with his duty to the client
• refrain from misusing confidential information for his own advantage or the benefit of a third person
without the fully informed consent of the principal.
This list is far from comprehensive, but gives a good indication of the conduct expected of someone
such as a financial adviser. Some of their key responsibilities are as follows:
Client’s Best Interests

To act honestly, fairly and professionally in accordance with the best interests of the client. An adviser
should not exclude or restrict any duty or liability they owe to a client unless it is honest, fair and
professional to do so.
Information Disclosure
Before providing services to a client, a financial adviser must provide appropriate information about the
firm, its services, its charges and the basis of its recommendations that will enable the client to make a
full and informed decision about whether to proceed.
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Suitability
Any recommendations made should be in the best interest of the client, based on all information
known and sought to ensure the appropriateness of the advice given and the suitability of the solution
recommended.
We will look at some of these duties more fully in the following sections. The rules surrounding the
duties of a financial adviser will necessarily differ from country to country, so those in operation in
Europe are used as the basis for the following sections.
1.1 Client’s Best Interest
Learning Objective
5.1.2 Know the definition of ‘client’s best interest’ and the implications of this rule for a financial
adviser
Always acting in the client’s best interest has to be a fundamental rule for all financial advisers. It is
certainly one that interests regulators worldwide, who consider investor protection as one of their
principal priorities, and therefore it is the subject of extensive ‘conduct of business’ rules. In particular,
following the financial crisis, regulators have introduced new rules and codes of conduct to put the
client (or the customer) at the heart of regulation and the way a financial firm treats customers fairly.
Acting in the client’s best interest may take many forms, from ensuring that the financial adviser has
sufficient information to be able to properly advise the client, through to selecting suitable investments
to meet the client’s needs, to undertaking transactions. What it demands as an overriding requirement
from the financial adviser is that they conduct themselves in such a way that they put the interests of
the client first and the demands of their firm and its own interests second.
Section 2, ‘Advising Clients’, looks at the considerable number of rules that have been established to
set business standards in this area and to ensure that firms and financial advisers act in the client’s best
interest.
That is not to suggest that the provision of financial advice is so well regulated that issues do not arise.
Major reforms of the financial advice process have been undertaken in both the US and the UK and are
ongoing in many other countries to remedy what is seen as inappropriate conduct by advisers and to
toughen regulations accordingly. The changes introduced in various countries have similar objectives:
• improving the clarity with which firms describe their services to consumers
• addressing the potential for adviser remuneration to distort consumer outcomes
• increasing the professional standards of advisers
• improving the level of qualifications for all advisers giving financial advice to retail clients
• requiring advisers to demonstrate that they are maintaining their professional competence by
undertaking appropriate continuing professional development (CPD).
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1.2 Duty to Disclose Material Information and Client

Reporting
Learning Objective
5.1.3 Know the extent of an adviser’s duty to disclose material information about a recommended
investment
As well as acting in the client’s best interest, financial advisers also need to ensure that they provide
sufficient information about their firm and any proposed investments to the client.
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The purpose of this duty to disclose material information is to ensure that the client has all the
information needed to ensure that they are in a position to make a full and informed decision about the
suitability of the recommendations being made.
What constitutes ‘material information’ will depend upon the investments and products being
recommended but would include areas such as charges, cancellation rights, early encashment penalties,
risk warnings and any special or non-standard terms.
The sort of information that should be provided includes details of:
• the firm and its services

• the investments and proposed investment strategies, including appropriate guidance and warnings
of any associated risks
• any leverage that is involved, and its effects and the risk of losing the entire investment
• the volatility of the price and any limitations on the available market for such investments
• where the client has entered into derivative-type transactions, the fact that they might assume
obligations additional to the cost of acquiring the investments
• any margin requirements or similar obligations applicable to certain investments
• the execution venue that will be used
• all costs and associated charges.
Examples of the scenarios in which disclosure of material information may be relevant include
financial planning reports and suitability reports, key investor information documents and simplified
prospectuses for a mutual fund.
• It is generally regarded as best practice that the rationale behind investment and other
recommendations is included in letters or reports to clients, so that, in addition to having essential
information about the product or investment, the client can see how the adviser has assessed why
the particular solution is suitable and appropriate for them.
• Key investor information documents are designed to provide all of the key information about a
product in a standardised, easy-to-understand format. In a later section, we will look in detail at
an example of what information must be given to a customer who intends to invest in a collective
investment scheme.
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Where the firm will be providing ongoing services, it should provide details about how it will go about
managing the client’s money and the arrangements it will put in place for safeguarding the client’s assets.
Where firms manage investments for their clients, they should establish a meaningful way of evaluating
and reporting performance to the client. They should inform clients of the nature, frequency and timing
of the reports to be provided, including:
• the method and frequency of valuations

• the details of any delegation of the discretionary management of their portfolio
• what benchmark their portfolio’s performance will be assessed against
• what types of investment may be included in their portfolio and what types of transaction may be
carried out (including any limits)
• the management objectives and levels of risk that the manager may incur on their behalf and any
constraints on the manager’s discretion.
Where firms hold client money or investments, they should provide the following information, where it
is appropriate:
• A summary of the steps the firm has taken to protect the client’s money/investments, including
details of any relevant investor compensation scheme or deposit guarantee scheme.
• That the investments may be held in an omnibus account if this is the case. (An omnibus account
is where the investments of all clients are pooled together in order to make the investment
management of the investments and their administration more efficient.)
• Where the investments cannot be separately designated in the country in which they are held by a
third party, what this means for the client and what the risks are and what this means for their rights
over them.
• The terms under which the firm may exercise any rights it may have over the investments where
they are held as security for any borrowing.
• That the investments/money may be held by a third party on the firm’s behalf.
• What the firm’s responsibility is for any acts/omissions of that third party.
• What would happen if the third party were to become insolvent.
1.3 Conflicts of Interest
Learning Objective
5.1.4 Understand the concept of a ‘conflict of interest’ and of its significance when giving client
advice
5.1.5 Know the importance of transparency relating to indirect and direct cost of services
A conflict of interest is where someone in a fiduciary position has personal or professional interests that
compete with their duty to act in the client’s best interest.
The duty to disclose material information becomes more important where the adviser or firm may have
an interest in the customer’s undertaking of the transaction – for example, earning fees or commissions.
In such situations, there is the potential for a conflict to exist between what is good for the adviser or
firm and what is good for the firm’s clients.
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While removal of the conflict of interest is clearly the best way to resolve potential conflicts of interest, that
is not always possible. The financial adviser needs to bear in mind constantly their fiduciary duties to the
client and their responsibility to act in the client’s best interest. All recommendations should be driven by
the customer’s needs and never by the potential to earn commission for the adviser or the firm.
Open disclosure of any fees or commissions can aid removal of this conflict.
Conflicts of interest also arise where a firm is dealing on behalf of a client. The firm may wish to place
an order in the same security and it may have orders from other clients for the same security. In such
circumstances, it should place the orders in due turn so that it is not giving priority to any particular
client, and should refrain from placing its own orders if they may prejudice the client’s trade.
In Europe, investment firms are required to have a documented ‘conflicts of interest’ policy. Firms under
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these obligations are required to:
• maintain and apply effective organisational and administrative arrangements designed to prevent
conflicts of interest from adversely affecting the interests of their clients
• have in place appropriate information controls and barriers to stop information about investment
research activities from flowing to the rest of the firm’s business
• where a specific conflict cannot be managed away, ensure that the general or specific nature of it is
disclosed (as appropriate to the circumstances). Note that disclosure should be used only as a last resort
• prepare, maintain and implement an effective conflicts policy
• provide retail clients and potential retail clients with a description of that policy
• keep records of activities where a conflict has arisen.
A firm’s terms and conditions should detail how it deals with potential conflicts of interest. There will
be times, however, when it is not possible to avoid conflicts of interest, and the firm or adviser should
recognise the need in those circumstances to withdraw from the transaction.
Avoiding conflicts of interest is an obligation included in all regulatory systems and in codes of ethics,
and so features heavily in a firm’s compliance policy and compliance checks.
1.3.1 Inducements
A firm should not pay or accept any fee, commission or provide or receive any non-monetary benefit,
that would impact on its fiduciary duty to its clients.
The receipt or payment of any such benefit should only be permissible in the following circumstances:
• It is disclosed in accordance with set standards prior to the provision of the service to the client.
• It is a fee, commission or other paid benefit, paid directly by the client with a clear explanation.
• Payments or receipts from a third party are only permitted where they will not impair compliance
with the firm’s duty to act in the client’s best interest and the amount is clearly disclosed to the
client.
• They are fees which enable or are necessary for the provision of investment business or services,
such as custody costs, settlement and exchange fees, regulatory levies or legal fees and which, by
their nature, cannot give rise to conflicts of interest or conflicts with the duties to act honestly, fairly
and professionally in accordance with the best interests of clients.
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1.4 Fiduciary Responsibilities of Intermediaries
Learning Objective
5.1.6 Know the fiduciary responsibilities of intermediaries
So far, we have looked at the fiduciary responsibilities of financial advisers, but these also extend to their
firms and other financial intermediaries. These are the subject of a wide range of rules imposed on firms
and intermediaries that include the following:
• the terms of the contract agreed by the parties.

• regulatory rules.
• legislation that sets legal standards and obligations.
• legal cases that establish case law on areas such as fiduciary duties, duties that attach to the exercise
of a power and duties of care.
Each of these sources may both impose and modify duties of market participants to act in the interests
of another. They impose a variety of controls on participants in the investment chain:
• These control the manner in which powers are exercised, require that firms and intermediaries do
not exceed the scope of a power, and not exercise a power for an improper purpose.
• Where firms and intermediaries owe fiduciary duties, participants in the investment chain must
avoid conflicts and not make unauthorised profits by virtue of their fiduciary position. Other
participants may owe a duty of care.
• The law may also require participants to exercise reasonable care and skill and hold professionals or
those that hold themselves out as having special skills or experience, to a higher standard.
Example
The UK’s FCA expects firms to have the right culture so that consumers get the best outcomes by
applying a series of Principles.
Some material ones to note include a firm’s responsibilities when it is dealing. Firms have a duty to
ensure the client’s orders are executed in a timely manner, to achieve ‘best execution’ and to ensure
that any of their own account deals are not done in such a way that prejudices those of the client.
Large professional clients now regularly look at the ethical behaviour of the financial intermediaries
they do business with. They will assess and monitor areas that might give rise to concern and consider
some or more of the following:
• Whether any improper conduct has resulted in financial loss to clients or third parties.
• Evidence suggesting a questionable corporate culture that might give rise to acts of misconduct.
• The way in which senior management accept their responsibility for the ethical conduct of the
company and those working for it.
• The approach that management take to dealing with breaches that suggest that problems are deep
seated or that remedial action is ineffective and to dealing with staff involved in inappropriate
conduct.
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Not all firms or intermediaries have a fiduciary responsibility but they undoubtedly have a duty of
care and a duty to ensure that they respect the trust and confidence placed in them by the client or
counterparty in all of their dealings. In carrying out these responsibilities, they should demonstrate
appropriate professional conduct. All participants in the investment chain should observe fiduciary
standards in their relationship with clients and customers even where no fiduciary duty is owed.
Consumers get the best outcomes from markets when they are treated fairly.
2. Advising Clients
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Having considered what constitutes fiduciary relationships and the duties this places on advisers and
wealth managers, we can now turn to look at what this means in practice when advising clients.
The investment planning process:

• collate relevant client information
• ascertain needs and, if relevant, individual goals
• establish macroeconomic, risk and liquidity drivers
• identify any other considerations and constraints
• decide whether the strategy will invest into direct assets or use indirect investment products
(collectives)
• review the range of solutions and identify which is most suitable for the client
• construct a portfolio based on the investment strategy
• present the recommendations to the client.
The following sections are based on EU rules and cover both the rules and their rationale in order to
demonstrate some possible best practice principles that can be derived.
2.1 Types of Customer
Learning Objective
5.2.1 Understand client categorisation
Classifying clients is at the heart of financial services regulation. The reason for this is simple, namely
that the conduct of business rules issued by regulators are designed to give the greatest protection to
those who are most vulnerable.
Clients are categorised into one of three types: retail, professional and eligible counterparty.
An eligible counterparty is another financial services firm such as an investment firm, an insurance
company or a mutual fund. A professional client can be a financial services firm, an institutional investor
or a private investor who can meet certain tests. Any client who is not one of these is then classified as
a retail client.
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A firm is required to notify a client of how they have been categorised before they undertake any
services for them, and of their right to be re-categorised.
If a private investor wishes to be treated as a professional client, the firm must assess whether they
have the experience and skills necessary to understand the risks involved and can demonstrate that
they have traded regularly and have sufficient financial resources. This is usually carried out by an
‘appropriateness test’. If they meet this test and are classified as a professional investor, then the firm
must give a written warning of the regulatory protections they will lose. The reason a retail client might
opt for this is so that they can have access to different financial products not available to retail clients,
such as those involving derivatives and other complex products.
Client classification therefore drives the level of regulatory protection that a client is entitled to. There
are further practical implications as well. Regulatory rules may restrict the marketing of higher-risk
products to retail investors, or prevent the offering of certain services that carry greater risk.
2.2 Terms of Business and Client Agreements
Learning Objective
5.2.2 Understand terms of business and client agreements
Regulators require a firm to pay due regard to the information needs of its clients, and communicate
information to them in a way which is clear, fair and not misleading.
It is a requirement that a customer has all of the information it needs about a firm, the services they
intend to use, their charges and the basis on which the firm will be doing business with them before a
firm acts for a client. Typically, this will be achieved by the firm providing its customers with a document
that sets out the terms on which it will do business, such as a ‘Terms of Business’ document.
Example
In the UK, this is referred to as an initial disclosure document, and the regulator requires it to begin with
a statement that the document has been designed by the regulator to be given to consumers buying
certain financial products and that the information provided can be used to decide if the services are
right for the customer. It should then go on to state:
• whose products are offered

• what services will be provided
• what the customer will have to pay for the services provided
• who regulates the firm
• details of financial firms that have made loans to the firm or own a share of the firm
• what to do if the customer has a complaint
• whether the firm is covered by the Financial Services Compensation Scheme (FSCS).
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Details of these terms of business must be provided to a client before any investment business is
conducted, and, for other customers, within a reasonable period after beginning to conduct investment
business.
Like terms of business, a client agreement sets out the basis on which investment business will be done
and the major difference is that it requires the customer’s acceptance, namely their signature indicating
acceptance of the terms. If a firm enters into investment business with a retail or professional client, a
firm must have an agreement that sets out the essential rights of the firm and the client.
A client agreement must be used when a retail or professional client is agreeing to complex services
being provided, including:
• advising on investments
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• managing investments
• arranging investments
• safeguarding and administering investments.
2.3 Status of Advisers and Status Disclosure
Learning Objective
5.2.3 Understand the status of advisers and status disclosure to customers
Firms are required to disclose the basis on which they select products that they recommend to the
client.
A firm or an investment adviser may sell the products of one or a limited number of firms only, or ones
from across the whole marketplace. For example, a financial institution could choose to sell either its
own range of mutual funds to its customers or ones it selects from across the marketplace. It may do
either, but it must make clear to its customer the basis on which it is operating.
Before providing services, a firm must therefore disclose the scope of its advice and whether its
recommendations will be based on products:
• from the whole of the market – independent advice

• limited to a single or several product providers – restricted advice.
An investment firm which offers only its own products, or those of a limited number of other companies,
may advise only on those products and must disclose this to the client. A firm that selects products from
across the market must ensure that it selects the best products and does not enter into any commercial
arrangements that might adversely affect its ability to give independent advice.
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2.4 Advice and ‘Know Your Customer’ Rules
Learning Objective
5.2.4 Understand the ‘know your customer’ rules and their impact on investment planning
Financial services firms are required to take reasonable care to ensure the suitability of its advice and
discretionary decisions. To comply with this, a firm should obtain sufficient information about its
customers to enable it to meet its responsibility to give suitable advice. Similarly, a firm acting as a
discretionary investment manager for a customer should ensure that it has sufficient information to
enable it to put suitable investments into the customer’s portfolio. When advisers are making their
recommendations to a client, best practice should involve sending the client a report on why the
recommendation made is suitable for them.
This requirement to gather sufficient information about the customer is generally referred to as the
‘know your customer’ (KYC) requirement.
The purpose of gathering information about the client is clearly so that financial plans can be devised
and appropriate recommendations made. The types of information that should be gathered include:
• personal details – name, address, age, health, family and dependants

• financial details – income, outgoings, assets, liabilities, insurance and protection arrangements
• objectives – growth, protecting real value of capital, generating income, protecting against future
events
• risk tolerance – cautious, balanced, adventurous
• liquidity and time horizons – immediate needs, known future liabilities, need for an emergency
reserve
• expected investment time horizon (short or long)
• tax status – income, capital gains, inheritance tax (IHT), available allowances
• investment preferences – restrictions, ethical considerations.
As we will see in the next section, firms must ensure that any recommendations they make are both
suitable and appropriate. In order to do so, a firm should ensure that the information they gather also
includes details about:
• A client’s knowledge and experience in relation to the investment or service that will be considered
for recommendation – this could cover a client’s past financial investment products.
• The level of investment risk that the client can bear financially and whether that is consistent with
their investment objectives. For example, a client might want as much risk as possible and have full
investment experience; however, the only savings they have are the ones they intend to use for this
investment. Hence, it would be prudent, in that instance, to ask what the client would do if their life
savings were to diminish in value – what would they live on? This is called ‘capacity for loss’.
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2.5 Suitability and Appropriateness
Learning Objective
5.2.5 Understand the suitability and appropriateness of advice
Once having gathered sufficient information about the customer, the steps expected of a firm to
ensure its recommendations are suitable and appropriate will vary depending upon the needs and
priorities of the customer, the types of investment or service being offered and the nature of the
relationship between the firm and the customer. It should be also noted that when making a financial
recommendation, the firm or adviser needs to have the support to monitor those recommendations,
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especially if an investment solution has been recommended.
When a firm proposes to offer investment advisory services or discretionary portfolio management, it
must first assess whether such services are suitable. If the firm intends to offer other investment services,
eg, trading derivatives such as contracts for difference, then it must ensure that they are appropriate for
the customer.
In assessing the customer’s knowledge and experience, the firm should gather information on:
• the types of services and transactions with which the customer is familiar
• the nature, volume, frequency and time that the customer has been involved in such services and
transactions
• the customer’s level of education, profession or relevant former profession
• In addition, some firms have introduced a potential vulnerable customer (PVC) policy to make
sure that no advice, without proper safeguards, is given to particularly vulnerable people.
The general requirement is that the firm must take reasonable steps to ensure it makes no personal
recommendation to a customer unless it is suitable for that customer. Suitability will have regard to the
facts disclosed by the customer and other facts that the firm should reasonably be aware of.
If the firm is acting as investment manager for a customer, there is an ongoing requirement that it must
ensure that the portfolio remains suitable. Equally, if a customer has agreed to the firm pooling their
funds with others, the firm must take reasonable steps to ensure that any discretionary decisions are
suitable for the stated objectives of the fund, as found in the mandate.
Having assessed which services and products are suitable and appropriate, the firm should provide the
customer with a report which should set out, among other things, why the firm has concluded that a
recommended transaction is suitable for the customer.
If the firm determines after assessment that the service or product is not appropriate for the customer,
then it should issue a risk warning to the customer. If the customer still wishes to proceed despite the
warning, then it is up to the firm to decide whether it will do so. If the client still wishes to go ahead,
the adviser/firm would still be responsible for suitability. Hence, this is quite a high-risk endeavour for
financial firms to continue to offer unsuitable products to the wrong target market.
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Where a firm offers services without providing advice, it may need to undertake an appropriateness test.
This is typically required where firms arrange deals in derivatives or other complex instruments and it
requires firms to ask the client for information about their knowledge and experience in the investment
field of the specific type of product, or service offered or demanded so that it can assess whether the
product or service is appropriate.
2.5.1 Suitability Report

If a firm provides investment advice, it must provide a retail client with a suitability report that specifies
the advice given and how the recommendation provided is suitable to meet their needs. Regulators
expect a firm to be able to demonstrate, by means of sufficient evidence, that it has acted in the best
interests of the client and has met its suitability obligations.
The report should include how it meets the client’s objectives and personal circumstances with
reference to the investment term required, the client’s knowledge and experience and their attitude to
risk and capacity for loss.
Where the recommendations are likely to require a retail client to seek a periodic review of their
arrangements, firms should draw this to the client’s attention in the report. This includes, for example,
where a client is likely to need to seek advice to bring a portfolio of investments back in line with the
original recommended allocation where there is a probability that the portfolio could deviate from the
target asset allocation.
2.6 Execution-Only Sales
Learning Objective
5.2.6 Know the meaning of execution-only sales
An execution-only sale is one where no advice is given to the customer and the firm simply undertakes
the transaction. In such cases, the transaction is carried out on the instructions of the customer and no
advice is provided about the suitability of the course of action or product.
In such cases, a number of the rules referred to above do not apply so that, for example, a fact-find to
establish full details about the customer is not required. If the customer decides on the course of action
but then, having been provided with information, asks whether the product or certain features are
suitable for them, then clearly this would no longer be execution-only business, and the firm would then
need to go through a fact-find (know your customer) process.
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2.7 Charges and Commissions
Learning Objective
5.2.7 Know the requirement for disclosure of charges and commission
Whenever a firm conducts investment business for a customer, it must make the customer aware of
the costs so that they are better able to make informed choices. It has to do so in writing and before it
conducts any business. It must also disclose any product-related charges and any commissions it may
receive from a product provider. For packaged products, this is usually included within a key features
document (KFD) that is required to be provided to the customer. For mutual funds, this is provided in the
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key investor information document (KIID).
The information to be supplied includes:
• the total price to be paid including all related fees, commissions, charges and expenses and any
taxes payable via the firm
• if these cannot be indicated at the time, the basis on which they will be calculated so that the client
can verify them
• the commissions charged should be itemised separately
• if any costs or charges are payable in a foreign currency, what the currency is and the conversion
rates and costs
• if other costs and taxes not imposed by the firm could be payable, how they will be paid or levied.
2.8 Cooling Off and Cancellation
Learning Objective
5.2.8 Know the requirement for cooling off and cancellation
In certain circumstances, customers who are entering into an investment arrangement are entitled to a
period of reflection during which they can decide whether or not to proceed with their purchase.
If a right to cancel is provided to a customer, the firm must give a clear and prominent notice in writing,
either before or, if not possible, immediately after the sale.
They must inform the customer of:
• the existence of the right to cancel or withdraw

• its duration
• the conditions for exercising it, including any amount the customer may have to pay
• what happens if the customer does not exercise the right
• any other practical details the customer may need.
If the customer exercises their right to cancel, the effect is that they withdraw from the contract, which
is then terminated.
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2.9 Product Disclosure
Learning Objective
5.2.9 Know the requirement for product disclosure
As mentioned in section 2.7, packaged products are attractive to retail customers and the regulator
therefore requires certain features of the products to be highlighted in the KFD. Key features are
intended to optimise the ability of the customer to make comparisons between different packaged
products. In Europe this area comes under the Packaged Retail and Insurance-based Investment
Products (PRIIPs) regulation. This is to encourage efficient EU markets by helping investors to better
understand and compare the key features, risk, rewards and costs of different PRIIPs, through access to a
short and consumer-friendly KIID.
For mutual funds, the following information must be disclosed in the KIID:
• where details of the latest estimated distribution yield, and buying and selling prices can be found
• for purchases, how and when the price to be allocated in respect of each payment will be determined
• whether certificates will be issued and, if so, where they will be sent
• how units or shares may be redeemed and when payment on redemption will be made
• the names and addresses of the scheme manager, authorised corporate director (ACD) and
depository
• when and how copies of the scheme’s particulars, annual and half-yearly reports and accounts and
prospectus can be obtained
• an explanation of any relevant right to cancel or withdraw, or that such rights do not apply
• how complaints and queries are dealt with and how further details of compensation arrangements
can be obtained
• a summary of the customer’s potential liability to tax
• whether income can be reinvested and whether interest is paid on such monies
• information about dealing costs and any dilution levy
• whether stamp duty may be incurred
• details of any protection arrangements or guarantees
• if there is a class of limited shares, a summary of the restrictions.
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3. Determining Client Needs
Learning Objective
5.3.1 Understand the key stages in investment planning and determining investment objectives and
strategy
The financial planning process can be divided into six distinct stages:
• Introduction to describe the service on offer and for the adviser to get an idea of the client’s financial
position and what they want to determine if it is appropriate for them to offer a financial service (in
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addition at this stage it also allows an adviser to hand out and go through any relevant regulatory
documentation, such as terms of business)
• determining the client’s requirements
• formulating the strategy to meet the client’s objectives
• implementing the strategy by selecting suitable products
• revisiting the recommended investments to ensure they continue to meet the client’s needs
• periodically revisiting the client’s objectives and revising the strategy and products held, if needed.
Diagrammatically, the process can be seen as follows:
Introduction to
describe the service
Determine client’s
requirements
Formulate a strategy Revisit investments,

to meet objectives objectives and strategy
Assess existing assets

and potential solution
Produce recommendations
and a financial plan
The nature of any relationship with a client will depend upon the service being provided. This can
range from providing the facilities to execute transactions without any advice, to ongoing relationships
that deal with selected financial areas only, are limited to investment management only, or extend to
in-depth wealth management or private banking.
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The client relationship can therefore be a one-off service to satisfy a client’s specific needs, or a long-
term relationship where the wealth manager is an integral part of the client achieving their investment
objectives.
Whatever the service, an adviser has a fiduciary duty to their client that requires them to observe
the highest standards of personal conduct and fully respect the confidence and trust implicit in that
relationship.
The main responsibilities of the adviser can, therefore, be seen as to:
• help clients to decide on goals and prioritise objectives

• document the client’s investment objectives and risk tolerance
• determine, and agree, an appropriate investment strategy
• act in the client’s best interest
• where agreed, keep the products under review
• carry out any necessary administration and accounting.
3.1 Client Information

An adviser must know the customer before being able to provide appropriate advice. It is essential to
establish the fullest details about the client – not only their assets and liabilities but the life assurance
or protection products or arrangements that they may have in place. Their family circumstances, health
and future plans and expectations are equally important.
In this section, we will consider some of the key client information that an adviser needs to establish, in
terms of providing holistic financial advice.
3.1.1 Establishing Rapport

Most financial firms spend significant amounts of time and money on training their advisers in
communication techniques. Techniques that need to be honed include:
• establishing rapport with the client

• making clear early on what the purpose of a meeting is
• explaining that the information collection exercise is to ensure the quality of the advice that will be
given
• using a mixture of open and closed questions to establish the information needed
• using everyday terminology and explaining jargon when it has to be used
• checking understanding
• establishing the priorities and getting the client to confirm their agreement
• guiding and controlling the pace of the interview.
It is also about listening – the best financial advisers are the ones who listen to what the client wants,
establish rapport with the client and then mutually agree what needs to be done.
At the end of the day, short-circuiting the process by not ascertaining all relevant information is alien to
any professional approach and is in fundamental contradiction to the adviser’s fiduciary duty and to all
regulation.
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3.1.2 Collecting Details

There is no simple way of establishing all of the necessary information quickly. The adviser will need
to undertake a detailed, and potentially lengthy, interview with the client in order to understand what
existing assets and liabilities they have before turning to developing a true understanding of what their
needs are.
There is also no single way of collecting all of the required information. Most firms use a ‘Know Your
Customer’ questionnaire or fact-find that the adviser completes during their interview with the client
so that the information can be collected in a logical and straightforward manner and can be available
for later use. The advantage of this approach is in its consistency, the factual record it creates and the
opportunity for quality-checking that it provides. Its disadvantage is the customer’s reaction to what
they may perceive as a lengthy form-filling exercise – hence the need for good communication skills.
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In addition, to be able to match clients’ levels of risk and expectations for returns, financial firms have
introduced computer-based questionnaires to include behavioural finance techniques, eg, risk tolerance
questionnaires. Only having completed this process can the adviser then start on the next significant
stage: to identify potential solutions and then match these to the client’s needs and demands.
Before we look at why this information is required, use the following exercise to work through your own
ideas. Be aware that the scale of potential information that might be relevant is significant, so there is no
simple ‘right’ answer. Everyone is different, so the information needed will vary.
Exercise
Use the following table or a separate piece of paper to record why such information might be needed.
Information needed Why needed?
Personal details
Health status
Details of family and dependants

Details of their occupation, earnings
and other income sources
Estimates of their present and
anticipated outgoings
Assets and liabilities
Any pension arrangements

Potential inheritances and any estate
planning arrangements, such as a will
The following sections provide examples of why the information above is needed.
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3.1.3 Personal Details
Details of the client’s name and address will need to be verified to comply with anti-money laundering
requirements by inspecting photo ID plus official documents that prove the address, such as a utility
bill. Due to the strict US laws such as the Foreign Account Tax Compliance Act (FATCA), not all firms are
presently willing to manage US clients due to the stringent and expensive reporting requirements to
the US authorities.
The client’s date of birth will clearly establish their age and this should immediately start to indicate the
stage of life they have reached, which may have implications for any asset allocation strategy. It will also
give an indication of their potential viewpoint on long-term investments.
The client’s age may also be relevant when looking at their assets. If they hold quoted investments that
are showing substantial gains, then their age may be a relevant factor in considering the extent to which
these should be sold and diversified into other investments.
The client’s place of birth should be established, as this may have a bearing on their residency and
domicile, which in turn may affect their tax liabilities. Tax ID numbers will also be needed, as they may
be required for any tax-free wrappers that may be selected and for any tax-reporting requirements that
may have to be met. In addition, this could have a bearing on any future inheritance tax liabilities.
3.1.4 Health Status

The client’s health status will need to be established: that is, whether they are in good health or have
any serious medical conditions that may influence their investment objectives and attitude to risk.
3.1.5 Details of Family and Dependants

Details of the client’s family and dependants will normally be established as part of the fact-finding
exercise.
Where the client has been married previously, the adviser should determine the extent of any ongoing
divorce payments that might be relevant to the investment strategy.
Where the client has young children, there may be a need to provide funds for school fees or university
education. These may need to be planned for separately, and give rise to not just multiple investment
objectives but potentially different attitudes to risk.
While a client might tick all the right boxes to be invested in a high-risk investment product, the
appropriate advice for clients with dependants would be to make sure that they are financially catered
for first. In that sense, protection should be reviewed first along with capacity for loss – what would
happen if the investment strategy did not work out as expected?
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3.1.6 Details of Occupation, Earnings and Other Income Sources

The fact-find will seek to establish details of the client’s business and occupation and the income that
they earn from this and other sources.
Clearly, it will be necessary to establish what the client’s income is, from whatever source(s) it arises.
However, the client’s occupation may be a relevant factor for investment decisions in other, less obvious
ways. First, the client’s occupation or business will give a good indication of their experience in business
matters. Establishing the client’s occupation may also lead the adviser to realise that there may be issues
with dealing in certain stocks if the client holds a senior position in a company.
A client may also potentially be a politician or hold a senior position which is in the public spotlight.
Where that is the case, they often need to distance themselves from any investment decision-making so
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that there can be no accusation of them exploiting their position or knowledge. In such cases, it is often
common to establish a blind trust, where all investment decisions are taken on a totally discretionary
basis and where the client is deliberately kept unaware of trading decisions or their rationale.
3.1.7 Present and Anticipated Outgoings

The client’s outgoings need to be understood in conjunction with their income, where it is necessary to
look at budgeting, planning to meet certain liabilities or generating a specific income return.
3.1.8 Assets and Liabilities

Full details of the client’s existing assets and liabilities will need to be known.
As part of the anti-money laundering checks (reviewed in chapter 2, section 2.1.2) that the adviser will
need to undertake, the source of the client’s funds will need to be established. When investigating
the source of the client’s wealth, it is possible that the adviser may become aware that the client
has undertaken some dubious activity such as deliberately evading paying tax. The adviser needs to
exercise extreme care over this, as tax evasion and similar exercises are classed as financial crime.
As well as obtaining details of the client’s assets, the adviser should also look to establish:
• the location of the assets and whether any investments are held in a nominee account
• the tax treatment of each of the assets
• whether any investments are held in a tax wrapper
• acquisition costs for any quoted investments held, including any calculations needed for assessing
any liability to capital gains tax
• details of any early encashment penalties.
The information needed will vary by type of asset.
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Asset Information needed
Account type and details
Balance
Bank and Savings Branch where account is held
Accounts Interest rate on the account
When interest is paid and whether there are any bonuses payable
Any early encashment penalties
Full title of each instrument
Nominal amount of stock or shares held
Quoted Dates of purchase
Investments Acquisition costs
Where the stock is held and in what name it is registered
Details of any pending corporate actions and dividends
Full title of each fund
Number of units or shares held
Mutual Funds/ Dates of purchase
Collective Acquisition costs
Investment Whether the holding is certificated or uncertificated and in what name it is
Schemes registered
Any exit fees
Frequency of valuation points if fund redemptions are infrequent
Account type and details
Eligibility criteria for tax exemption
Tax-Exempt Assets and cash held
Accounts Whether further additions can be made in current tax year
Whether account can be transferred without loss of tax-exempt status
Tax ID reference
Type of product
Details of sum payable and any guarantees
Conditions to be met for payment
Structured
When purchased and cost
Products
Term and repayment date
Any early encashment penalties
Whether quoted or unquoted
Policy type and details
Policy conditions
Life Assurance Whether it is with-profits or unit-linked
Bonds Details of unit-linked funds and number of units held
When purchased and costs
Any encashment penalties
Details should be established of any liabilities that the client has, and whether these are covered by any
protection products if they are either large or requiring high interest payments.
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3.1.9 Pension Arrangements

The pension arrangements the client has made will need to be closely linked to the investment strategy
that is adopted both for retirement and other financial objectives. Retirement planning is covered in
more detail in chapter 8. The availability of tax exemptions for pension contributions may influence the
choice of investments and so clearly needs to be factored in at this stage.
3.1.10 Potential Inheritances

Finally, the client should be asked to provide details of any potential inheritances they may receive and
of any trusts where they are beneficiaries. The adviser should also check whether the client has left any
specific gifts of shares in their will and, if so, whether this would prevent any sale of such a holding.
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4. Investment Objectives and Strategy
Learning Objective
5.3.2 Understand how to assess a client’s risk tolerance, capacity for loss, investment experience and
the impact of these factors on the selection of suitable investment products
Having collected all of the core information needed about the client, the adviser can then turn to
agreeing their investment objectives and risk profile, either as a lump sum investment or as individual
goals and therefore priority of objectives, which could come with different risk profiles. But overall there
should be a maximum risk profile (a comfort level) which the individual goals should not exceed.
Objectives
The options for investing our savings are continually increasing, yet every single investment vehicle can
be easily categorised according to three fundamental characteristics – safety, income and growth. While
it is possible for an investor to have more than one of these objectives, the success of one must not
come at the expense of others. It is also important that advisers make sure clients have suitable home
and buildings insurance and other appropriate protection products.
In collecting the information above, the adviser will have started to build a picture of the client’s needs.
They should be able to classify these needs along the lines of the following:
• maximising future growth

• protecting the real value of capital
• generating an essential level of income
• protecting against future events due to being unable to work because of an illness or accident or
as part of inheritance tax planning. These would be protection products, such as life assurance or
critical illness cover. Alternatively, these would feature as part of inheritance tax planning.
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The adviser will want to convert this into an understandable investment objective and will use
classifications such as income, income and growth, growth, and outright growth. The purpose of this is
so that there can be a common understanding of what the client is trying to achieve. The adviser may
not personally manage the client’s investment portfolio, and so there is a need to have common terms
of reference so that any investment decisions are suitable for what the client is aiming to achieve.
The adviser will therefore want to ensure that the client understands the terminology being used and
agrees that the correct investment objective has been selected. A typical definition of each investment
objective is as follows:
• Income – the client is seeking a higher level of current income at the expense of potential future
growth of capital.
• Income and growth – the client needs a certain amount of current income but also wants to invest
to achieve potential future growth in income and capital.
• Growth – the client is not seeking any particular level of income and their primary objective is
capital appreciation.
• Outright growth – the client is seeking maximum return through a broad range of investment
strategies which generally involve a high level of risk.
Prioritisation Process
Simply because a need has been established does not mean that it can be addressed. Affordability will
be a major constraint on a client’s ability to protect against all of the risks that might arise. The adviser
will, therefore, need to guide the client through a planning and prioritisation process. This will involve:
• listing the areas that need to be dealt with

• quantifying the impact and likelihood of each
• ranking them in order of importance
• reviewing existing arrangements
• assessing the cost of providing protection
• identifying the extent and scope of protection that the client can afford
• establishing a plan which will allow some, or all, of their needs to be addressed.
Whilst this chapter deals with the investment strategy, it is equally important that the ‘protection side’,
such as adequate life cover is dealt with first, especially if there are currently dependants and a lack of
cover.
Once the client’s investment objectives are agreed and any protection needs have been covered, the
adviser needs to look at developing an investment strategy to meet the objectives. In developing an
investment strategy, the adviser will need to determine the following:
• risk tolerance and capacity for loss

• investment preferences
• liquidity requirements
• time horizons
• tax status.
We will now look at each of these in more detail.
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4.1 Risk Tolerance

The risk tolerance of a client will have a considerable impact on the financial planning strategy that an
adviser recommends. It will exhibit itself in the importance that is given to financial protection and in
what is an acceptable selection of investment products. Risk is measured in terms of the customer’s
potential loss, enabling investment strategies to be aligned with their capacity for loss or ability to take
on risk, as opposed to the traditional subjective ‘willingness to take on risk’.
There are three distinct elements in the client education and advice process when establishing risk.
There should be a comprehensive and detailed process which should examine the client’s investment
history and how they perceive investment risk. This should represent a starting point for a wider
conversation with the client surrounding risk.
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There are three pillars:
1. how much risk clients need to take (a financial fact)

2. how much risk they are willing to take (a psychological trait), and
3. how much risk they can afford to take (another financial fact).
Capacity for Loss

This is linked to the level of risk a client can face, but is more subjective and relies on the adviser
collecting as much information as possible to make sure the final advice they give is suitable.
A client could have a capacity for risk, as they may have no dependants (all married and moved out of
the family home), be mortgage-free and have many years’ experience of financial products. Ordinarily,
that could put this client in a high-risk tolerance band, but if the only money for investment and to live
off is their entire life savings, then this should temper the level of risk. Consequently, this client has a low
capacity for loss as the lack funds to fall back on if their investments perform badly. Their standard of
living would be affected, as they would have no income to pay ongoing bills.
Attitude to risk, and its definitions, are themes that financial services companies constantly revisit. The
reason for this is simple: namely that they want to be able to categorise a client into a risk category and
then be able to say which of their products are suitable for clients within that risk profile.
However, definitions of risk profiles are imprecise and, after reviewing the suggested classification
in the next section, you will understand why trying to turn this into a mathematical exercise is not
straightforward. As a result, advisers need to understand even more about suitability and risk, and
recognise that it is only with the application of skill and knowledge that solutions can be matched with
client needs.
To investigate this further, the following sections look at:
• what risks investors face

• how risk profiles can be categorised
• how an individual investor’s risk profile can be determined.
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4.1.1 Main Types of Risk for Investors
Volatility in the prices of investments is inevitable. At a personal level, this means that when a client
needs funds, their investments may be depressed and they may potentially have to realise assets
at a loss. A client needs to have a very clear understanding of their tolerance to risk and investment
objectives.
Risk is subjective and dependent upon the emotional make-up of a person. It is also objective, in that
age will affect how much risk a client can assume; if markets fall, is the client young enough to see
markets recover? Experience of investing and having wealth/assets already can also influence, in a
greater way, the client’s risk levels (the client’s appetite for risk).
Market (or Systematic) Risk

This is the risk that the whole market moves in a particular direction. It is typically applied to equities and
is brought about by economic and political factors. It cannot be diversified away. For example, political
crises or general recessions will tend to bring about falls in the market value of all shares, although they
may affect different company shares to different degrees.
Interest Rate Risk

This is the risk that an interest rate movement may bring about an adverse movement in the value of
an investment. It is particularly acute when the investment is a fixed-interest bond and the interest rate
rises. Because of the inverse relationship between bonds and interest rates, the value of the bond will
fall. Interest rate risk is largely removed if the bond is floating-rate, since the coupon will be reset in line
with the higher market interest rate. Floating-rate notes can, however, be susceptible when there is a
de-coupling between rates and inflation, as we have seen recently.
Unanticipated Inflation Risk

When inflation is more substantial than the investor expected, the value of the investments held may
fall. Generally, bonds will suffer because the fixed cash payments that they deliver are less valuable.
Floating-rate bonds will suffer less because the higher inflation will bring about a higher interest rate,
but the real value of the principal at redemption will fall. Index-linked bonds will not suffer, however, as
the coupon and the principal are linked to a measure of inflation, so the investor will not lose out.
Equities and property cope reasonably well with unexpected inflation. Companies are able to increase
their prices and deliver larger dividends, and the property market as a whole tends to reflect the
inflationary increases. This is reversed if inflation causes negative economic effects and a slowdown in
business and profits.
Exchange Rate (or Currency) Risk

For investments that are denominated in a currency other than the base currency of the investor, an
adverse exchange rate movement will create an adverse movement in the value of the investment.
Clearly, this is particularly relevant if an investor buys shares of a foreign company that are priced in
another currency, or invests in a local company that earns a substantial part of its earnings overseas.
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Liquidity Risk
If an investor needs to realise the cash from their investment quickly, they may suffer from liquidity risk.
This is the risk that the value may suffer because the investment needs to be sold immediately. This
could be the case for equities, bonds or property, if the need for cash coincided with a market downturn
or just general market inactivity.
Cash and money market investments tend to suffer least from liquidity risk because they are already in
the form of cash or near-cash.
Credit Risk
Investors in bonds face credit risk. This is the probability of the issuer defaulting on their payment
obligations. Credit risk can be assessed by reference to the independent credit rating agencies, mainly
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Standard & Poor’s, Moody’s and Fitch Ratings.
The rating agencies split bonds into two distinct classes: investment grade and non-investment grade
(alternatively referred to as speculative or junk). The three agencies apply similar criteria to assess
whether the borrower will be able to service the required payments on the bonds. Then the bonds are
categorised according to their reliability. Triple A tends to be the best and the next best is double A
(although the rating agencies can have lesser notches using pluses and minuses).
Very few organisations, except some Western governments and supranational agencies, have triple A
ratings, but most large companies boast an investment grade rating. Issues of bonds categorised as
sub-investment grade are alternatively known as junk bonds because of the high levels of credit risk.
If the rating agencies downgrade the issuer of a bond, potential investors will look to compensate for
the increased risk by demanding a greater yield on the issuer’s bonds. This will inevitably result in a
lower price for the bond.
Shortfall Risk
Shortfall risk relates to the inability of the investor to reach their financial goal. They may have been
saving or investing in order to reach a target amount at some time in the future, such as to pay off a loan
or mortgage, or to build up a particular level of retirement income.
If they choose investments with no or low risk, their returns are likely to be lower and could fall short
of the amount of money needed. Alternatively, bond or equity markets could fall, reducing the value of
their investments.
As a result, they may have to change their target, increase their investment or save or invest for a longer
term.
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Other Risks
The above are some of the main risks faced by investors but clearly there are many more, including:
• Equity capital risk – this is a type of credit or default risk and simply refers to the risk that the
company whose shares are owned may fail and go into liquidation.
• Regulatory risk – the risk that securities laws and regulatory supervision are inadequate, leading to
losses for the investor.
• Income risk – this is simply the risk that the level of income may fall below that required by the
investor.
• Reinvestment risk – this relates to bonds and is the inability of the investor to reinvest coupon
payments at the same rate as the underlying bond.
4.1.2 Risk Classifications

A client needs to have a very clear understanding of their own tolerance to risk, as it is essential to
choosing the right investment strategy. Risk tolerance is a very personal subject, however, and is very
dependent upon the emotional make-up of a person. It is also objective, in that age will affect how much
risk a client can assume because, as you get older, there is less time to recover from poor investment
decisions or market falls, and so the appetite to take risk may change.
Attitude to risk will affect the investment policy that is implemented. If we look at three simple
definitions of risk tolerance – cautious, moderate and adventurous – we can see how this might
influence the choice of investments contained within each of the investment objectives discussed at the
beginning of this section (income, income and growth, and growth/outright growth).
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Investment
Risk tolerance Attitude to risk and possible investments
objective
Willing to accept a lower level of income for lower risk.
Cautious
Exposure to high-yield bonds and equities will be low.
Seek to balance potential risk with potential for income.
Moderate
Income Exposure to high-yield bonds and equities will be higher.
Willing to adopt more aggressive strategies that offer potential
Adventurous for higher income.
Exposure to high-yield bonds and equities may be substantial.
Seeking maximum growth and income consistent with
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Cautious relatively modest degree of risk.
Equities will form a relatively small percentage of the portfolio.
Seeking to balance potential risk with growth of both capital
Income and and income.
Moderate
Growth
Equities will form a significant percentage of the portfolio.
Able to adopt a long-term view that allows them to pursue a
Adventurous more aggressive strategy.
Equities will form the principal part of the portfolio.
Seeking maximum growth consistent with relatively modest
Cautious degree of risk.
Equities will form a significant percentage of the portfolio.
Seeking to balance potential risk with growth of capital.
Growth Moderate
Equities will form the principal part of the portfolio.
Able to adopt a long-term view that allows them to pursue a
Adventurous more aggressive strategy.
Equities may form the whole of the portfolio.
Linking risk tolerance to possible investments helps further our understanding of a client’s attitude
to risk towards a point where we can start to identify assets that might be suitable to both the client’s
investment objective and their attitude to risk.
This only takes us so far. We now need to broaden our understanding of what level of risk the client is
prepared to accept so that we can select investments that will meet his or her investment objectives and
still be within his or her risk tolerance.
Below we will consider how further classifications might be applied that can then be used to identify
which assets could be selected for inclusion in the portfolio.
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There are no agreed classifications, but an overall approach could include:
• No risk – the client is not prepared to accept any fall in the value of their investments. Appropriate
investments may be cash-type assets or short-dated government bonds priced below par.
• Low risk – the client is cautious and prepared to accept some value fluctuation in return for
long-term growth but will invest mainly in secure investments.
• Medium risk – the client will have some cash and bond investments but will have a fair proportion
in direct or indirect equity investments and, potentially, some in high-risk funds.
• High risk – the client is able to keep cash reserves to the minimum, will hold mainstream and
secondary equities and be prepared to accept other high-risk investments.
To understand the client’s attitude to risk properly, the adviser needs to link this back to his or her
investment objectives and demonstrate how the selection of a classification will drive the choice of
investments held in a portfolio. The following diagram seeks to demonstrate this with some simple
suggested possible investments.
Cash Deposits
Money Market
No Risk Short-Dated
Government Bonds
Cautious
Fixed-Term Deposits
Low Risk Government Bond Funds
Guaranteed Bonds
Income
Bond Funds
Balanced Medium Risk Equity Funds
Global Equity Funds
Global Bond Funds

Adventurous High Risk Equity Funds
Sector Funds
The practical use of such a classification should therefore be immediately apparent, namely that it can
either suggest a range of potentially suitable products or exclude others. For example, a collective
investment fund that invests in high-risk and specialist recovery situations is likely to be inappropriate
for a client with a cautious attitude to risk.
To see what effect this has in practice, undertake the following exercise, which brings together a range
of investments and asks you to identify their risk characteristics and then classify them for the type of
investor for which they may be suitable.
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Exercise
For the following list of investments, consider which risks are associated with each and note these in
the appropriate column. Then assign a risk category based on the above classification of low to high
risk. Finally, consider which of these investments might be suitable for clients with differing investment
objectives and attitudes to risk.
Asset class Investment Risk characteristics Risk classification
Savings accounts
Cash Fixed-rate deposit
Money market mutual funds
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Government bonds
Supranational bonds
Corporate bonds: investment
grade
Bonds
Corporate bonds:
non-investment grade
Eurobonds
Bond fund
Direct property investments
Property mutual funds

Property
Property shares
REITs
Direct equities
Index trackers
Equities Global funds
Country-specific funds
Sector-specific funds
Guaranteed equity bond
Hedge funds
Other assets
Gold fund
Commodities fund
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4.1.3 Determining an Investor’s Risk Tolerance
As we have seen, individuals vary in their ability to tolerate financial risk, but again there is more detail
to be examined within this basic fact. Academic research has suggested that risk tolerance can be
broken down into two main areas:
• ability to take risk, or risk capacity

• willingness to take risk, or risk attitude.
A client’s ability to take risk can be determined in an objective manner by assessing their wealth and
income relative to any liabilities.
By contrast, risk attitude is subjective and has more to do with an individual’s psychological make-up
than their financial circumstances. Some clients view market volatility as an opportunity, while for
others such volatility would cause distress.
We consider each of these objective and subjective factors below.
Objective Factors
As we have seen above, determining a client’s ability to take risk needs to be as accurate as possible, as
it will drive both priorities and solutions.
There are a number of objective factors that can be established that will help to define this, including:
• Timescale – the timescale over which a client may be able to invest will determine both which
products are suitable and what risk should be adopted. For example, there would be little
justification in selecting a high-risk investment for funds that are held to meet a liability that is due
in 12 months’ time. By contrast, someone in their 30s choosing to invest for retirement is aiming for
long-term growth, and higher-risk investments would then be suitable. As a result, the acceptable
level of risk is likely to vary from scenario to scenario. See section 4.2.3.
• Commitments – family commitments are likely to have a significant impact on a client’s risk profile.
For example, if a client needs to support elderly relatives, or children through university, this will have
a determining influence on what risk they can assume. While by nature they may be adventurous
investors, they will want to have more certainty of being able to meet their obligations, and this will
make higher-risk investments less suitable. In this example, time also plays an important role in risk.
The shorter the investment horizon due to upcoming bills, the less risk should be undertaken.
• Wealth – wealth will clearly have an important influence on the risk that can be assumed. A client
with few assets can little afford to lose them, while ones whose immediate financial priorities are
covered may be able to accept greater risk.
• Life-cycle – stage of life is equally important. A client in their 30s or 40s who is investing for
retirement will want to aim for long-term growth and may be prepared to accept a higher risk in
order to see their funds grow. As retirement approaches, this will change as the client seeks to lock
in the growth that has been made and, once they retire, they will be looking for investments that will
provide a secure income that they can live on. See section 4.2.3.
• Age – the age of the client will often be used in conjunction with the above factors to determine
acceptable levels of risk, as some of the above examples have already shown.
• Certainty – the more necessary and time-limited a goal is (eg, payment of school or university fees
versus a dream of eventually owning a yacht). Therefore, this is where objectives can be part of goal
or prioritisation planning.
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Subjective Factors
Establishing objective factors is clearly a simpler and more accurate part of defining a client’s risk
tolerance, but subjective factors also have a part to play.
Subjective factors enable an adviser to try and establish a client’s willingness to take risks – their ‘risk
attitude’. A client’s attitudes and experiences must play a large part in the decision-making process. A
client may well be financially able to invest in higher-risk products, and these may well suit their needs,
but if they are cautious by nature, they may well find the uncertainties of holding volatile investments
unsettling, and both the adviser and the client may have to accept that lower-risk investments and
returns must be selected.
When attempting to determine a client’s willingness to take risks, areas that can be considered include:
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• A client’s level of financial knowledge – generally speaking, investors who are more knowledgeable
about financial matters are more willing to accept investment risk. This level of understanding does
still need, however, to be tested against their willingness to tolerate differing levels of losses, in
terms of capacity for loss.
• A client’s comfort level of risk – some individuals have a psychological make-up that enables them
to take risks more freely than others, and see such risks as opportunities (for further information on
this topic, candidates should read more on behavioural finance).
• A client’s preferred investment choice – risk attitude can also be gauged by assessing a client’s
normal preferences for different types of investments, such as the relative safety of a bank account
versus the potential risk of stocks and shares.
• A client’s approach to bad decisions – this refers to how a client regrets certain investment
decisions, and is the negative emotion that arises from making a decision that is, after the fact,
wrong. Some clients can take the view that they assessed the opportunity fully and therefore
any loss is just a cost of investing. Others regret their wrong decisions and therefore avoid similar
scenarios in the future.
Attempting to fully understand a client’s risk attitude requires skill and experience, but we can enhance
the classifications that we have used so far as suggested below.
Classification Characteristics
Typically have very low levels of knowledge about financial matters and very
limited interest in keeping up to date with financial issues.
Have little experience of investment beyond bank and savings accounts.
Very cautious
Prefer knowing that their capital is safe rather than seeking high returns.
investors
Are not comfortable with investing in the stock market.
Can take a long time to make up their mind on financial matters and can often
regret decisions that turn out badly.
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Typically have low levels of knowledge about financial matters and limited
interest in keeping up to date with financial issues.
May have some limited experience of investment products, but will be more
familiar with savings accounts than other types of investments.
Do not like to take risks with their investments. They would prefer to keep
Cautious investors
their money in the bank, but would be willing to invest in other types of
investments if they were likely to be better for the longer term.
Prefer certain outcomes to gambles.
Can take a relatively long time to make up their mind on financial matters and
can often suffer from regret when decisions turn out badly.
Typically have low to moderate levels of knowledge about financial matters
and limited interest in keeping up to date with financial issues.
Have some experience of investment products but are more familiar with
Moderately savings accounts.
cautious investors
Are uncomfortable taking risks but willing to do so to a limited extent,
realising that risky investments are likely to be better for longer-term returns.
Prefer certain outcomes and take a long time to make up their minds.
Typically have moderate levels of knowledge about financial matters but will
take some time to stay up to date with financial matters.
May have experience of investment products containing equities and bonds.
Understand they have to take risks in order to achieve their long-term goals.
Balanced investors Willing to take risks with at least part of their available assets.
Usually prepared to give up a certain outcome providing that the rewards are
high enough.
Can usually make up their minds quickly enough but may still suffer from
regret at bad decisions.
Typically have moderate to high levels of financial knowledge and usually
keep up to date with financial matters.
Are usually fairly experienced investors who have used a range of investment
Moderately products in the past.
adventurous Are willing to take investment risk and understand this is crucial to generating
investors long-term returns. Are willing to take risk with a substantial proportion of their
available assets.
Will usually make their mind up quickly and are able to accept that occasional
poor outcomes are a necessary part of long-term investment.
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Have high levels of knowledge and keep up to date with financial issues.
Will usually be experienced investors who have used a range of investment
products and may have taken an active approach to managing their investments.
Adventurous
investors Will readily take investment risk and understand this is crucial to generating
long-term returns. Willing to take risks with most of their available assets.
Will usually make their mind up quickly and are able to accept that occasional
poor outcomes are a necessary part of long-term investment.
Have high levels of financial knowledge and a keen interest in financial matters.
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Have substantial amounts of investment experience and will typically have
been active in managing their investments.
Very adventurous Looking for the highest possible returns on their assets and willing to take
investors considerable amounts of risk to achieve this. Willing to take risks with all of
their available assets.
Have firm views on investment and will make up their minds on financial
matters quickly. Do not suffer from regret, and accept occasional poor
outcomes without much difficulty.
4.1.4 Methods of Assessment

As will be clear from the above, establishing an investor’s risk profile is not straightforward. Classifications
such as the ones above, and a detailed understanding of the risks associated with different asset and
product types, will clearly help.
Defining risk profiles has limitations, not least in trying to help a customer to understand the difference
and then agree which is applicable. As a result, many financial services companies have different
methods of assessment. Some will rely on detailed client/adviser discussions, whereas others produce
far more sophisticated versions of the risk classifications which employ decision trees that require a
client to answer a whole series of questions in order to determine what products might be suitable –
this is in the form of psychometric testing. Some companies expand this further by applying the client’s
responses to sophisticated financial modelling that aims, based on historic investment performance
data, to predict the probability of certain returns, as required by the client, being achieved, eg, stochastic
modelling. These types of model projections look to predict performances of investment solutions,
based on assumptions, giving expected returns for a level of expected risk. These are sometimes
presented as fan charts.
The key point is that the adviser needs to understand the client’s attitude to risk and the risk
characteristics of different assets and products, if they are to match appropriate solutions with the
client’s needs.
A measure of a client’s risk tolerance is provided by discussing the client’s reaction to risks that will need
to be taken if their stated investment objective is to be met. If the client believes these risks are too
great, then the objective itself will need to be revised.
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Whatever method is used, it is essential to remember that ascertaining a client’s true attitude to risk is
critical for any adviser in assessing suitability and making an investment recommendation. Some of the
key points that both an adviser and the firm must take into account are:
• Risk should be explained in terms that a client can understand.

• Where the client has little experience or knowledge of investments, a detailed and clear explanation
of the inherent risk of each investment should be made.
• When presenting investment recommendations, the adviser should make reference as to why the
recommended investments are consistent with the client’s attitude to risk.
• Clients may have different appetites for risk at different times in their life, dependent on the circumstances
and their investment objectives, and so the adviser should regularly review their appetite for risk.
4.2 Client Preferences
Learning Objective
5.3.3 Understand how investment strategy and product selection are influenced by: ethical
preferences; liquidity requirements; time horizons and stage of life; tax status
4.2.1 Ethical Preferences

An adviser will need to establish whether the client has any specific investment preferences that
must be taken account of within the investment strategy. These may take the form of restrictions or a
requirement to follow a particular investment theme.
Some investors may wish to impose restrictions on what should be bought and sold within their portfolio.
For example, they may impose a restriction that a particular holding must not be disposed of, or they may
prefer to exclude certain investment sectors from their portfolios, such as armaments or tobacco.
Alternatively, a client may want to concentrate solely on a particular investment theme, such as ethical
and socially responsible investment, or may require the portfolio to be constructed in accordance with
Islamic principles. The more restrictions that are placed over a portfolio of investments, the more the
performance will vary from the original expectations. Hence, clients will need to be made aware of
this. Equally, it is also important that this could invalidate the discretionary mandate under which the
portfolio is being run. Whether a portfolio is advisory or discretionary, the adviser still owes a duty of
suitability to the client, even if there are investment restrictions.
Ethical funds were launched in the 1980s, but received a muted response. After a slow start, however,
the popularity of ethical investing gathered pace as public awareness of environmental issues grew and
governments began to respond with a combination of environmental legislation and taxes.
The growing interest in actively encouraging corporate social responsibility is central to what has
become known as socially responsible investment (SRI), the phrase designed to describe the inclusion
of social and environmental criteria in investment fund stock selection. Indeed, SRI funds have been at
the forefront of an industry-wide move to include the analysis of the non-financial aspects of corporate
performance, business risk and value creation into the investment process.
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Two principal SRI approaches can be identified: ethical investing and sustainability investing, both of
which are considered below.
Ethical funds, occasionally referred to as dark-green funds, are constructed to avoid those areas
of investment that are considered to have significant adverse effects on people, animals or the
environment. They do this by screening potential investments against negative, or avoidance, criteria.
As a screening exercise combined with conventional portfolio management techniques, the strong
ethical beliefs that underpin these funds typically result in a concentration of smaller company holdings
and volatile performance, though much depends on the criteria applied by individual funds.
Sustainability funds are those that focus on the concept of sustainable development, concentrating on
those companies that tackle or pre-empt environmental issues head-on. Unlike ethical investing funds,
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sustainability funds, sometimes known as light-green funds, are flexible in their approach to selecting
investments.
Sustainability investors focus on those risks which most mainstream investors ignore. For instance,
while most scientists and governments agree that the world’s carbon dioxide absorption capacity is fast
reaching critical levels, this risk appears not to have been factored into the share valuations of fossil fuel
businesses. Factors such as these are critical in selecting stocks for sustainability funds.
Sustainability fund managers can implement this approach in two ways:
• Positive sector selection – selecting those companies that operate in sectors likely to benefit from
the global shift to more socially and environmentally sustainable forms of economic activity, such as
renewable energy sources. This approach is known as ‘investing in industries of the future’ and gives
a strong bias towards growth-orientated sectors.
• Choosing the best of sector – companies are often selected for the environmental leadership they
demonstrate in their sector, regardless of whether they fail the negative criteria applied by ethical
investing funds. For example, an oil company which is repositioning itself as an energy business
focusing on renewable energy opportunities would probably be considered for inclusion in a
sustainability fund, but would be excluded from an ethical fund.
With the growing trend among institutional investors for encouraging companies to focus on their
social responsibilities, sustainability-investing research teams enter into constructive dialogue with
companies to encourage the adoption of social and environmental policies and practices so that they
may be considered for inclusion in a sustainability investment portfolio.
Integrating social and environmental analysis into the stock selection process is necessarily more
research-intensive than that employed by ethical investing funds and dictates the need for a substantial
research capability. Moreover, in addition to adopting this more pragmatic approach to stock selection,
which results in the construction of better-diversified portfolios, sustainability funds also require each
of their holdings to meet certain financial criteria, principally the ability to generate an acceptable level
of investment return.
Typically, financial, environmental and social criteria are given equal prominence in company
performance ratings by sustainability-investing research teams. This is known as the triple bottom line.
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A common misconception with ethical and socially responsible investing is that it will involve accepting
poorer investment returns compared to mainstream investments. Ethical Investment Research Services
(EIRIS) has undertaken research which shows that ethical investing need not necessarily involve
accepting lower performance. Several of its studies have indicated that investing according to ethical
criteria may make little difference to overall financial performance, depending on the ethical policy
applied. For example, five ethical indices created by EIRIS produced financial returns roughly equivalent
to the returns from the FTSE All-Share Index.
There is a range of indices that can be used to track performance, such as the FTSE4Good indices, which
cover most sizeable companies around the world and set three global benchmarks against which
companies are judged for inclusion.
4.2.2 Liquidity Requirements

Liquidity refers to the amount of funds a client might need both in the short and long term. When
constructing an investment portfolio, it is essential that an emergency cash reserve is put to one side
that the client can access without having to disturb longer-term investments.
A client may have known liabilities that will arise in the future which will need to be planned for, and it
will be necessary to factor in how the client will raise funds when needed. Markets can be volatile and
so the investment strategy needs to take account of ensuring that funds can be readily realised without
having to sell shares at depressed prices. Consideration needs to be given as to whether it is sensible
to plan for realising profits from equities, as market conditions may be such as to require losses to be
established unnecessarily. Instead, conservative standards suggest investing an appropriate amount in
bonds that are due to mature near the time needed, so that there is certainty of the availability of funds.
In planning terms, the adviser should agree with the client how much of a cash reserve should be held.
Recognising the long-term nature of investment, this should represent their expected cash needs over,
say, three to five years.
This should then be supplemented by ensuring that the portfolio will contain investments that are
readily realisable in the event of an emergency and which otherwise will be available to top up the cash
reserve in future years.
This could be achieved, for example, by using a bond ladder, which involves buying securities with
a range of different maturities. Building a laddered portfolio involves buying a range of bonds that
mature in, say, three, five, seven and ten years’ time. As each matures, funds can become available for
the investor to withdraw or can be reinvested in later maturities.
Alternatively, fixed-term cash products or structured products such as guaranteed capital growth
bonds could meet the same objective, subject to establishing a spread of providers and checking the
counterparty risk involved.
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4.2.3 Time Horizons and Stage of Life

Time horizon refers to the period over which a client can consider investing their funds. Definitions of time
horizons vary, but short term is usually considered to be from one to five years, while medium-term refers
to a period from five to ten years and long term is considered to be for a period of ten years or more.
Time horizon is very relevant when selecting the types of investment that may be suitable for a client.
It is generally stated that an investor should only invest in equities if they can do so for a minimum
period of five years. This is to make the point that growth from equities comes about from long-term
investment and the need to have the time perspective that can allow an investor to ride out periods of
market volatility. Assuming that the client is able to invest for the longer term, then their stage of life will
have an important effect on the investment strategy followed.
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The investment strategy that is developed to meet the client’s needs will use an asset allocation process
to design a portfolio that fits with their personal circumstances, investment objectives and attitude to risk.
The adviser needs to recognise, however, that this will change as the client gets older and so, as their
requirements change, the investment strategy will need to change with them, as will the percentages
allocated to different asset classes. A client in their 30s or 40s who is investing for retirement will want to
aim for long-term growth and will be prepared to accept a higher risk in order to see their funds grow.
As retirement approaches, this will change as the client seeks to lock in the growth that has been made
and, once they retire, they will be looking for investments that will provide a secure income that they
can live on.
Below, we will look at some sample asset allocations to explore this point. For this example, we will take
a UK-based client with a moderate attitude to risk and suggest some potential asset allocations that
could be used at different ages in order to explain how their changing circumstances and investment
objectives might be reflected in their asset allocation.
Example
Age Group: Under 40

With at least 25 years to go to retirement, they are building up their income and savings for the future.
The client can afford a high degree of exposure to the stock market and can accept the likelihood of
greater volatility in smaller companies, international shares and property for the higher long-term
returns that can be generated.
Asset Class Under 40
Cash 5%
Bonds 25%
Larger UK shares 40%
International shares 20%
Smaller UK shares 5%
Property 5%
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Age Group: 40 to 49
The client is now more financially secure with greater income, but expenses are building up for the
children’s education. On the investment front, the long term is now becoming the medium term as
there are fewer economic cycles to ride before retirement. It is time to slightly reduce the exposure to
equities and increase the proportion in bonds.
Asset Class Under 40 40 to 49
Cash 5% 10%
Bonds 25% 35%
Larger UK shares 40% 30%
International shares 20% 15%
Smaller UK shares 5% 5%
Property 5% 5%
The caveat here is that we have assumed no mortgage or need for any more protection policies. If there
are dependants, then protection, mortgage payments and education bills would be the priority.
Age Group: 50 to 59
The client is probably far better off now than ever, the children have left home and they have a greater
level of disposable income that they are using to meet their dreams and enjoy greater leisure activities.
Maintaining this will be important, as will greater security in their finances, as they will not want a stock
market downturn to ruin the work they have done in growing their assets.
Asset Class Under 40 40 to 49 50 to 59
Cash 5% 10% 10%
Bonds 25% 35% 50%
Larger UK shares 40% 30% 25%
International shares 20% 15% 5%
Smaller UK shares 5% 5% 5%
Property 5% 5% 5%
Most countries now require people to work longer into middle age and hence potentially this group
could be working for longer. The main reasons for this are because investment returns are coming down
and people are living for longer. That means that the eventual savings pot or pension needs to work
harder and last longer.
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Age Group: 60 to 69
The client has now reached that age where accumulating wealth has given way to the need for income
and stability. The portfolio will now need to generate income to enable the client to maintain their
standard of living, and this will involve further reducing the exposure to equities and increasing the
percentage held in cash assets.
Asset Class Under 40 40 to 49 50 to 59 60 to 69
Cash 5% 10% 10% 35%
Bonds 25% 35% 50% 45%
Larger UK shares 40% 30% 25% 15%
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International shares 20% 15% 5% 5%
Smaller UK shares 5% 5% 5% 0%
Property 5% 5% 5% 0%
Age Group: Over 70

The client is now in a position where they need absolute certainty that they have an investment portfolio
that can meet their income needs and are not prepared to put their capital at risk.
Asset Class Under 40 40 to 49 50 to 59 60 to 69 Over 70
Cash 5% 10% 10% 35% 50%
Bonds 25% 35% 50% 45% 50%
Larger UK shares 40% 30% 25% 15% 0%
International shares 20% 15% 5% 5% 0%
Smaller UK shares 5% 5% 5% 0% 0%
Property 5% 5% 5% 0% 0%
These are examples only, but they demonstrate how the financial adviser can use asset allocation as a
tool for ensuring that the high-level construction of the recommended portfolio matches the client’s
circumstances as well as their attitude to risk. The key point to note is that it is partly the client’s
circumstances that drive their investment objectives and attitude to risk.
Once these are established, asset allocation can be used as a tool to determine how a portfolio can be
constructed that meets those needs. Only when that is done can the choice of underlying funds be
considered.
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Suitability of Financial Advice or Investment Management
The suitability of a strategy for a particular person is at the very heart of the investment process. This
concept is a fundamental one, both from a legal perspective and in terms of putting an investor’s money
to work sensibly and prudently.
A suitable investment means that an investment is appropriate in terms of an investor’s willingness and
ability to take on a certain level of risk. It is essential that both of these criteria are met. If an investment
is to be suitable, it is not enough to state that an investor is risk-friendly. They must also be in a financial
position to take certain chances. It is also necessary to understand the nature of the risks and the
possible consequences of financial loss, ie:
• The investment portfolio is consistent with the customer’s attitude to investment risk and objectives.
• The investment service is provided as described and agreed with the customer.
• Information on the customer’s attitude to investment risk and objectives was recorded and kept up
to date, which is relevant to the continuing suitability of the portfolio.
• Levels of portfolio turnover are in line with the agreed investment strategy and did not indicate
churn or neglect.
• In-house products or funds held in investment portfolios are in the best interests of customers and
the charges levied on the portfolio are in line with those quoted to the customer, and are set out
clearly in the periodic reports to customers.
4.2.4 Tax Status

Although tax rules vary from country to country, establishing the client’s tax position is essential so that
their investments can be organised in such a way that the returns attract the least tax possible. This
requires the investor to be aware of what taxes may affect them, such as taxes on any income arising or
on any capital gains, how these are calculated and what allowances may be available.
Consideration also needs to be given to any tax that may be deducted on investments that may be
selected for the client, for example, income tax that may have been deducted from a distribution from a
collective investment scheme (CIS). It is necessary to identify whether tax has been deducted and if so,
whether this can be offset against any other tax liability or else reclaimed.
The client’s residence and domicile status may also impact upon how any investments are structured.
The adviser will therefore need to establish:
• the client’s residence and domicile position

• the client’s income tax position
• how tax will affect any investment income
• any tax allowances which can be utilised
• how capital gains tax will affect any gains or losses made
• any capital gains tax allowances which can be utilised
• ability to invest in certain securities and mindful of inheritance tax laws on ‘sited assets’
• eligibility for any tax-free accounts
• opportunities for and the desirability of deferring any tax due.
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5. Taxation
An understanding of tax is needed in investment management, but should not drive the strategy. It is
the client suitability and objectives that are most important.
The interaction of taxes needs to be fully understood so that the client’s assets are suitably invested
to minimise the impact that tax will have on either growth or income for the client. This can make
a substantial difference to the returns from an investment and, at the same time, complicate the
investment decision-making process.
Although it is important to maximise the use of tax allowances, exemptions and reliefs, investment
decisions should never be based solely on the tax considerations. With certain exceptions, tax breaks are
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usually only given in exchange for accepting a higher level of risk.
When managing tax implications for a client, it is important to appreciate the difference between tax
evasion and tax avoidance: tax evasion is a financial crime and is illegal; tax avoidance is organising your
affairs within the rules so that you pay the least tax possible. The latter is a responsibility of the adviser
when they are undertaking financial planning and must be conducted in accordance with acceptable
practices.
The types of tax that an investor will face will vary widely from country to country, with some countries,
such as the UK, imposing a wide range of taxes on an individual’s income and gains, while others may
not impose any at all, as is the case in the Middle East. Governments can also offer companies and
individuals various tax concessions and incentives. For example, Shenzhen in China was one of the first
special economic zones established by the Chinese government to encourage business development
and trade. For individuals, many countries offer tax concessions on pension contributions and pension
plans and some permit specialised tax-free savings accounts.
In this section we will first consider the taxes that affect companies in order to understand the impact
that this can have in the selection of investment opportunities, and then the taxes that affect individuals.
5.1 Business Tax
Learning Objective
5.4.1 Understand the application of the main business taxes: business tax; transaction tax (ie, stamp
duty/stamp duty reserve tax); tax on sales
5.1.1 Corporation Tax

Companies are generally liable to some form of business or corporation tax on their total profits. Total
profits include both the profits from their activities and any chargeable gains.
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Unlike individuals, who pay tax for a set fiscal year, companies pay tax for what is known as an
‘accounting period’, which is normally the period covered by the accounts and, for tax purposes, is
usually never longer than 12 months.
An accounting period starts when:
• a company first becomes chargeable to corporation tax, or

• the previous accounting period ends.
An accounting period ends when the earliest of the following takes place:
• the company reaches its accounting date

• it is 12 months since the start of the accounting period
• the company starts or stops trading.
The rates of corporation tax that a company is liable to pay will vary from country to country and often
change each year. Companies submit details of their taxable profit to the tax authorities after the end
of the company’s accounting period. The authorities review the company tax return to determine how
much tax is payable and issue a corporation tax assessment to the company, showing the amount of tax
due.
5.1.2 Sales Taxes

Value added tax (VAT) and goods and sales taxes (GST) are forms of indirect taxation that are being
increasingly deployed across the world and which are also being applied to an increasing number of
items. Indirect taxes are charges levied on consumption or expenditure as opposed to on income. As
a result they are sometimes referred to as consumption taxes and are a form of regressive taxation
because they are not based on the ‘ability to pay’ principle.
5.1.3 Financial Transaction Taxes

Financial transaction taxes are imposed by governments on any sale, purchase, transfer or registration
of a financial instrument.
Many G20 countries currently impose some sort of financial transaction tax, and the most common is a
tax on the trading of equities in secondary markets. They are generally ad valorem taxes based on the
market value of the shares being exchanged, with the tax rate varying between 10 and 50 basis points.
The trend in share transaction taxes over the past several decades has been downward. The US
eliminated its stock transaction tax as early as 1966. Germany eliminated its stock transaction tax in 1991
and its capital duty in 1992. Japan eliminated its share transaction tax in 1999. Financial transaction
taxes have, however, become of particular interest to governments since the financial crisis of 2007–09
with studies into whether a global transaction tax should be imposed and more recently an EU plan to
impose a tax on securities transactions.
Increasingly countries want other nations managing assets on behalf of their citizens to report back to
them and put in place regulations and laws to do so, eg, FATCA.
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5.2 Personal Tax
Learning Objective
5.4.2 Understand the direct and indirect taxes as they apply to individuals: tax on income; tax on
capital gains; estate tax; transaction tax (stamp duty); tax on sales
An investment manager needs to be fully aware of the tax rules in their own country and how these will
affect their clients. But it is also important to be particularly careful when they are dealing with a client
who is resident overseas or has significant overseas income.
In this section, we will consider some of the general principles underlying income tax, capital gains
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tax and estate taxes and how these affect a client and impact on the construction of investment
recommendations.
5.2.1 Income Tax

In most tax systems, the amount of income that is subject to income tax is the total that is received in a
financial year. The year in question may be a calendar year or start at some other arbitrary point, such as
in the UK, where the tax year runs from 6 April in one year to 5 April in the next.
It is often referred to as the year of assessment, recognising that it is the income arising in that year that
will be assessed to tax.
Income can usually be grouped into three main sources:
• Income arising from earnings.

• Interest income arising from bank deposits, money market accounts and bond interest.
• Dividend income.
The reason for the grouping will vary and may include each being liable to different tax rates, having
certain allowances and in which order they are treated, if there are higher rates of tax payable.
Tax rules and allowances will differ widely from one country to another but there are a few core concepts
that an investment manager should be aware of.
Probably, the main concept is the residence of the individual, which will determine whether they are
liable to tax and, if so, on what sources of income. Another is the concept of gross and net and grossing
up. Very simply, a gross payment is one that is made without any tax being deducted and a net payment
is one that has had tax deducted before payment. Grossing up simply involves converting a net return
into a gross one, so that any tax liability can be calculated. It refers to identifying the amount of income
that was due before tax was paid. For example, if bond interest is paid net of tax at 20%, then the net
amount represents 80% of the gross and to find out the gross amount simply divide by 80 and multiply
by 100.
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Investment managers should also be aware of any tax deducted from overseas dividends. This is covered
in section 5.3.
In addition, an investment manager should be aware of the treatment of accrued interest on a bond
purchase or sale. Bonds are quoted clean, but settled dirty, which means that accrued interest is added
to the contract afterwards. The interest accrued up to the date of settlement of the sale is treated as due
to the seller. It is, therefore, added to the cost paid by the purchaser and paid to the seller in addition to
the proceeds of sale.
Such payments are usually regarded as interest and are liable to income tax or can be claimed as a
deduction. If the interest was not treated as income, then an investor could reduce their taxable income
by appropriately timed sales, a process known as ‘bond washing’; a loophole which tax authorities
closed some years ago.
Another concept of which an investment manager should be aware is the treatment of zero coupon
bonds such as STRIPS. These carry no interest and instead are issued or bought at a discount to their
eventual maturity value. Tax authorities, such as those in the UK and US, have rules to ensure that these
do not escape a charge to income tax and will usually revalue the holding at the end of the tax year and
treat any gain or loss arising over the tax year as income.
5.2.2 Capital Gains Tax (CGT)

Capital gains tax (CGT) is charged when an individual disposes of an asset and CGT typically arises
on the gain that is made when shares are sold or when a gift is made. This would also depend on any
associated tax wrapper, such as a pension. A tax wrapper shelters any investment held within it from
further tax. Tax can, however, be liable once the investments are removed from the tax wrapper.
As with all taxes, the detailed rules will vary from country to country, but an investment manager should
be aware of the tax rules in their own country and ensure the client has specialist advice if they have
assets overseas or are non-resident.
As with income tax, there are some core concepts that can be explored.
The first is to understand which assets are liable to capital gains tax and which are exempt. While this will
vary, common features are that gains made on equities are chargeable whilst there are usually exemptions
for gains on government stocks and an individual’s principal home. Understanding which are chargeable
and which are not may have a material impact on the choice of assets that are invested in.
The next is to ensure an understanding of the availability of any accounts or schemes that offer tax
advantages, whereby assets held within such a wrapper are free of capital gains tax, eg, pension plans,
savings wrappers and the special treatment of some venture capital investments. Again these may direct
certain investments that are considered or held in such accounts because of their tax efficiency.
The adviser should also be aware of how gains are calculated and the various exemptions and allowances
that are available and whether there is different treatment for short- versus long-term gains.
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5.2.3 Estate Taxes

Some countries, or jurisdictions, have no estate or inheritance taxes, some charge on what a person
gives away or leaves on death, and others charge on what a person receives.
Having spent a lifetime building up their estate, clients are often dismayed by the amount of estate taxes
that are due, before it can be passed on to their family. Reducing this liability can be a major financial
planning need for wealthier and older clients.
In most countries there are exemptions and allowances that can be taken advantage of to mitigate the
eventual inheritance taxes that will be due. When a will is drafted, it will specify who the client wishes
to inherit their estate, but careful consideration should also be given to drafting it in such a way as to
maximise the use of exemptions and allowances.
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Since the last financial crisis, inheritance tax and the gifting of assets have come under scrutiny by various
governments investigating those looking to avoid paying tax through dubious tax schemes. Tax planning,
though, is a legitimate strategy to plan a financial future to meet certain needs and eventual goals. Advisers
should be aware of the various inheritance tax thresholds allowed in the countries where their clients are
based. Clients should consider, therefore, making gifts during their lifetime to reduce the eventual size of
their estate liable to tax. In most countries, such gifts need to be made a number of years before the client
dies otherwise the tax advantage is lost, and so forward planning and taking action in plenty of time is,
therefore, important.
5.2.4 Tax Planning Considerations

There is a need to recognise the effect of tax on investments as it may influence choice. Some clients are
averse to paying tax on gains made by their investments and hence investment managers need to pay
attention to any client restrictions placed over the management of the portfolio. Of course, this could
affect the future performance of the portfolio and move the client away from their original mandate.
Keeping to the investment mandate is imperative, but an investment manager may be able to move
higher producing income assets into a tax-free wrapper, to reduce the client’s income tax bill, without
altering the client’s mandate.
173
5.3 Overseas Taxation
Learning Objective
5.4.3 Know the principles of withholding tax: types of income subject to WHT; relief through double
taxation agreements; deducted at source
5.4.4 Know the principles of double taxation relief (DTR)
5.4.5 Know the implications of FATCA and other relevant legislation
If investors hold shares in overseas companies, they will receive dividends that may have had tax
deducted before payment. This is known as ‘withholding tax’ and is usually deducted at source by the
issuer or their paying agent.
If an investor receives a dividend from an overseas company that has had withholding tax deducted,
it will still remain liable to income tax and that raises the risk of the double taxation of the dividend or
interest income.
To address this issue, governments enter into what are known as double taxation treaties to agree how
any payments will be handled. In very simple terms, the way that a double taxation agreement operates
is that the two governments agree what rate of tax will be withheld on any interest or dividend payment.
Where overseas dividend income arises, it is important to be aware of the two main ways in which any
tax deducted can be dealt with.
The first is ‘relief at source’. Under this method, it is possible for a reduced rate of withholding tax to be
deducted, instead of the normal domestic rate, by making appropriate arrangements in that country and
obtaining the necessary documentation. In some countries, such as the US, significant documentation
is required to put this into place.
Where relief at source is not available, or the arrangements cannot be put in place in time before the
dividend is paid, relief can only be obtained by making a repayment claim.
However, to be able to claim relief from foreign tax or a repayment requires a detailed understanding of
the relevant double taxation treaty, the tax laws of the country concerned and how the tax authorities in
that country operate. This is why the specialist tax services of a custodian are usually used, as they have
the knowledge required to manage this, and access to their network of sub-custodians to make the claim.
5.3.1 Foreign Account Tax Compliance Act (FATCA)

The Foreign Account Tax Compliance Act (FATCA) is a 2010 United States federal law requiring all United
States persons including those living outside the US to file yearly reports on their non-US financial accounts
to the Financial Crimes Enforcement Network (FinCEN). It requires all non-US (foreign) financial institutions
(FFIs) to search their records for anything indicating US person status and to report the assets and identities
of such persons to the US Department of the Treasury.
174
Various governments and institutions around the world have interpreted FATCA in their own way; for
example, Under the FATCA Agreement, Australian Financial Institutions (AFIs) do not report information
directly to the Internal Revenue Service (IRS). Instead, they report to the Australian Taxation Office (ATO)
and the information is made available to the IRS, in compliance with Australian privacy laws, under
existing rules and safeguards in the Australia-US Convention for the Avoidance of Double Taxation and the
Prevention of Fiscal Evasion with respect to taxes on income (the Convention).
FATCA is designed to prevent tax evasion by US citizens using offshore banking facilities. It is used to
locate US citizens (usually non-US residents, but also US residents) and US persons for tax purposes and
to collect and store information about individuals, including total asset value and social security number.
The law is used to detect assets, rather than income, and it does not include a provision imposing any tax.
Under FATCA, financial institutions must report the information they gather to the US IRS; as implemented
by the intergovernmental agreements (IGAs) with many countries, each financial institution will send the
5
US person’s data to the local government first. Financial institutions which do not agree to provide this
information will suffer a 30% withholding tax on payments of US-source income.
5.3.2 Organisation for Economic Co-Operation and Development

(OECD) Automatic Exchange
For many years, the Organisation for Economic Co-Operation and Development has taken a leading role
in developing policy and technical solutions for the exchange of tax information between countries. The
after-effects of the financial crises of 2007–09 saw increasing demands for decisive action to tackle tax
evasion and avoidance and ensure all taxpayers pay their fair share. To make this work internationally,
required a system for internationally agreed standards between tax authorities including providing
particular information for specific tax investigations and a broad range of information automatically on
financial accounts and assets held offshore.
The Common Reporting Standard was developed in response to a G20 request to enable the automatic
sharing of information on an annual basis. It sets out the financial account information to be exchanged,
the financial institutions required to report, the different types of accounts and taxpayers covered, as
well as common due diligence procedures to be followed by financial institutions.
The Common Reporting Standard was introduced in 2014 and since then over 100 jurisdictions agreed
to the standards and to automatically exchange information with other countries.
175
End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.
1. In what types of scenario does a fiduciary relationship arise?

Answer reference: Section 1
2. Where firms manage investments for their clients, what details about their reporting
arrangements should be provided to the client?
Answer reference: Section 1.2
3. What type of client categorisation would be nominally applied to an investment bank?

4. Explain five pieces of information an adviser should gather to ensure that any recommendation
is suitable and appropriate?
Answer reference: Sections 2.4 & 2.5
5. What information should be disclosed to a customer investing in a collective investment

scheme?
6. What are the six key stages of the investment planning process?
7. What are the four main investment needs an adviser should consider when a greeing investment
objectives?
8. What type of investment funds might be suitable for a client who requires income and is
classified as low risk?
Answer reference: Section 4.1.2
9. How does the investment screening exercise differ between ethical and sustainability funds?
10. Why might asset allocation change with age?

176

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Chapter Five

2. Advising Clients 135

4. Investment Objectives and Strategy 149

• agent and principal

• act in the utmost good faith for his client

Client’s Best Interests

1.1 Client’s Best Interest

1.2 Duty to Disclose Material Information and Client

The sort of information that should be provided includes details of:

• the firm and its services

• the method and frequency of valuations

1.3 Conflicts of Interest

• the terms of the contract agreed by the parties.

The investment planning process:

2.1 Types of Customer

2.2 Terms of Business and Client Agreements

• whose products are offered

2.3 Status of Advisers and Status Disclosure

• from the whole of the market – independent advice

• personal details – name, address, age, health, family and dependants

2.5 Suitability and Appropriateness

2.5.1 Suitability Report

2.6 Execution-Only Sales

2.7 Charges and Commissions

The information to be supplied includes:

2.8 Cooling Off and Cancellation

They must inform the customer of:

• the existence of the right to cancel or withdraw

3. Determining Client Needs

Diagrammatically, the process can be seen as follows:

Formulate a strategy Revisit investments,

Assess existing assets

The main responsibilities of the adviser can, therefore, be seen as to:

• help clients to decide on goals and prioritise objectives

3.1 Client Information

3.1.1 Establishing Rapport

• establishing rapport with the client

3.1.2 Collecting Details

Information needed Why needed?

Details of family and dependants

Any pension arrangements

3.1.4 Health Status

3.1.5 Details of Family and Dependants

3.1.6 Details of Occupation, Earnings and Other Income Sources

3.1.7 Present and Anticipated Outgoings

3.1.8 Assets and Liabilities

The information needed will vary by type of asset.

3.1.9 Pension Arrangements

3.1.10 Potential Inheritances

• maximising future growth

• listing the areas that need to be dealt with

• risk tolerance and capacity for loss

We will now look at each of these in more detail.

4.1 Risk Tolerance

1. how much risk clients need to take (a financial fact)

Capacity for Loss

To investigate this further, the following sections look at:

• what risks investors face

Market (or Systematic) Risk

Interest Rate Risk

Unanticipated Inflation Risk

Exchange Rate (or Currency) Risk

4.1.2 Risk Classifications

Global Bond Funds