Compliance Watch

Money And Savvy Don’t Always Go Together

By Jaime Levy Pessin
A DOW JONES NEWSWIRES COLUMN

NEW YORK — A new client comes into your office. A 50-something man in the market for financial advice, he just sold his successful business for millions of dollars. Clearly, this guy knows what he’s doing.

Not necessarily. Assume the business was a heating and air-conditioning company, or a chain of car washes. A smart businessman doesn’t have to be well-versed in investment decisions, and a large amount of wealth doesn’t always translate to financial sophistication.

That basic tenet of assessing suitability may have more relevance in a world of baby boomers made newly wealthy by selling their businesses, selling their real estate, inheriting money or cashing out of their savings plans. (A Practice Management column, also published Wednesday, addresses how to serve clients with new wealth.)

From a compliance perspective, it’s essential for brokers and advisors to really know their customers — not just how much they have in the bank, but how they got it and what that means about their financial savvy.

“More people coming out of the workforce… have just put away money every month in their 401(k)s and leave with $2 million to $3 million,” said Todd Taylor, managing director in charge of financial advisor recruitment and development at Morgan Stanley (MS). He added that those investors may have invested sums only in the thousands of dollars in the past. “This newfound wealth is a large account by any standard… but sophistication may or may not be there.”

Although the Financial Industry Regulatory Authority’s suitability rule doesn’t name sophistication as a factor that must be considered when brokers recommend investments, it has a broad requirement that brokers “make reasonable efforts to obtain” information that may factor into what’s appropriate for a particular customer.

Suitability is always a regulatory concern, but it’s become an especially hot topic given regulators’ current emphasis on protecting seniors, retirees and those nearing retirement. A broker who misjudges a client’s sophistication and comfort level and therefore makes an unsuitable recommendation can find himself in big trouble. FINRA’s November disciplinary actions show that it barred one registered representative and fined and suspended another for making unsuitable recommendations.

“It’s easy for advisors to assume that because someone has a lot of money that they are more sophisticated,” said Craig Rappaport, an author and financial advisor at Janney Montgomery Scott in Radnor, Pa. “It’s also easy to assume those people are willing to take extra risk.”

Research released this spring by marketing and research consulting firm Harrison Group Inc. and American Express Publishing Corp., a division of American Express Co. (AXP), shows that wealth doesn’t necessarily correlate with investment experience.

More than 1,300 people with household discretionary incomes of at least $125,000, or incomes after mortgage and taxes, participated in the late 2006 survey.

Almost 80% of respondents grew up middle class or below and nearly 70% have been wealthy for less than 15 years. About one-third run their own business and one-third run someone else’s business.

Sixteen percent of respondents’ wealth was earned through financial investments.

That’s why it’s critical to ask certain questions upon meeting a new client: “Have they invested in securities, mutual funds, different asset classes? How often? Were they the primary decision-makers? All these tests are designed to assess sophistication and suitability,” said Andres Vinelli, chief economist at FINRA. “Financial sophistication is very different from being a sophisticated person in general.”

Many brokerage firms include these types of questions as part of the basic information customers provide when they open accounts.

At Morgan Stanley, financial advisors are taught to dig deep into their clients’ investing experience as part of a “discovery process,” Taylor said. They don’t just find out how many years the client has been investing, but they gauge the depth of that experience: In the firm’s “investor style questionnaire”, financial advisors ask clients to say whether they agree or disagree with statements such as “investing intimidates me” or “I follow the stock market on a regular basis.”

Beyond that, Taylor said, FAs might ask about a client’s best and worst investments in the past, or their previous relationships with advisors.

“It’s very important they understand what the clients know and don’t know about investments,” Taylor said. “As products become more complex and clients’ needs become more complex, there are a lot more issues out there for an advisor to uncover… It takes a more thoughtful approach.”

Not only will being thoughtful in considering clients’ sophistication help advisors build rapport, but it will also help keep them out of regulatory hot water.

“Sophistication and being wealthy are just not one concept,” Vinelli said. “Representatives should be attuned to that reality. (There are) pretty intelligent and sophisticated individuals who don’t have a clue how to evaluate products on the market.”