Chapter Seven important

Very

Investment Advice
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-1. Advising Clients 291

~
2. Determining Client Needs 304

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3. Risk Profile 314

4. Investment Objectives and Strategy 319

5. Investment Recommendations 326

6. Review 334

7. Taxation >
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AAA 335

This syllabus area will provide approximately 21 of the 100 examination questions

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1. Advising Clients
In this section, we look at the framework
within which financial advice is given to
clients.

1.1 Client Categorisation

Learning Objective

7.1.1 Know generally accepted

approaches to different

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categorisations of investment
clients

Regulatory rules in most countries

differentiate between different
types of client and the resulting client
categorisations are used to set different
rules and provide different levels of
protection to clients.

The products and services available

to customers of financial services firms
range from straightforward ones that
can be readily understood and which are
suitable for most people to ones which
are highly complex and are designed for
the use of experienced investors. As a
result, the underlying rationale for client
categorisations is to protect ordinary
investors who may not have adequate
knowledge and experience to adequately
evaluate the suitability of a product and
whether the product is consistent with
their investment goals and financial
situation. They also allow for different rules
and approaches for experienced investors
who are not in need of such protections.

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 The following table shows some examples of client categorisations in different countries.

Client Categorisation
• As a generalisation, regulations distinguish between wholesale
and retail clients. Essentially, everyone is a retail client unless they
satisfy one of the requirements to be classified as a wholesale
client.
• The law is less prescriptive about the advice process for wholesale
Australia clients compared to retail clients, which means compliance
obligations are greatly reduced.
• Retail clients enjoy the consumer protections set out in the Future
of Financial Advice (FOFA) reforms. Wholesale clients generally do
not, but have access to a wider range of investments and products
compared to retail clients.
• Regulations across Europe introduced by the Markets in Financial
highest protection Instruments Directive (MiFID) require clients to be categorised as:
• A retail client – a retail client is any client who is not a professional
A
-

client or an eligible counterparty; they benefit from the greatest

X client protections.
• Professional client – these are institutions or large entities that have
Europe sufficient expertise to not require the same degree of protection. A
retail client who can meet certain quantitative and qualitative tests
can elect to opt up to be treated as a professional client, but will
lose the regulatory protections available to retail investors.
lowest C • Eligible counterparties – these are other investment firms that a
protection firm deals with when undertaking activities such as trading and so
need the least regulatory protection.

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Client Categorisation
• In the United Arab Emirates (UAE), licensed firms are required
to classify clients as retail clients, professional investors or
counterparties.
• Investors may be classified as:
• Professional investors, eg, regulated financial institutions, listed
Middle East
companies, single family offices or large undertakings.
• Professional investors (assessed), eg, individuals, special
purpose vehicles (SPVs), trusts and other legal entities who
meet certain criteria.
• Professional investors (service based).
• In the US, regulations distinguish between two categories of

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investors – retail investors and institutional investors.
US • The term retail investor is synonymous with individuals, whilst
institutional investors are, as the name suggests, large institutions
such as investment firms, mutual funds and pension funds.

The names given to different categories of clients differ from country to country, but an underlying
theme is to differentiate ordinary ‘retail investors’ who require the greatest protection from ‘non-retail’
investors such as experienced investors, institutional investors and financial firms.

In summary, the approach can be seen to be that the greatest protection is afforded to those with the
least knowledge and experience as the diagram below indicates:

Most Knowledge and Experience Least

Least Protection Most

These classifications also drive the types of service and products available to clients with higher risk and
more complex ones available only to those classed as professional or institutional clients.

Wealth managers need to establish the appropriate client categorisation at the start of the relationship
and keep it under review. It is sometimes possible to set a client category for all of the services offered
by a firm or in relation to a specific trade, service or product.

In some countries, retail clients may request to be re-categorised as professional clients if they meet
the qualitative and quantitative requirements set under regulation. Wealth managers should be able
to explain to clients the implications of choosing another regulatory category where that option is
available and that the client meets the required regulatory standards.

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1.2 Client’s Best Interest

Learning Objective

7.1.2 Know the definition of ‘client’s best interest’ and the implications of this rule for a financial
adviser

Financial advisers occupy a special position when dealing with their clients given that clients are relying
on their experience and integrity when they are advising them. This is especially the case for retail
clients who rely on personal advice and who may suffer significant loss if the advice is conflicted or is
not of good quality.

This relationship is described as a fiduciary relationship in the US and even if the term is not used in your
country, then the underlying principle will be familiar. Such a relationship is one in which one person
places special trust, confidence and reliance on, or is influenced by, another who has a duty to act for
the benefit of that person. In discharging their responsibilities, that person must be absolutely open and
fair, and act with integrity and in a manner consistent with the best interests of the client.

Example
In the US, Regulation Best Interest sets out a standard of conduct for broker-dealers when making
recommendations to a retail customer:

‘When making such a recommendation to a retail customer, you must act in the best interest of the retail
customer at the time the recommendation is made, without placing your financial or other interest ahead
of the retail customer’s interests’.

A definition of ‘client’s best interests’ could therefore be – to act honestly, fairly and professionally in
accordance with the best interests of the client. The responsibilities that must follow, therefore, include
the following:

• Act in the utmost good faith for the client.

• Not make a profit from the trust placed in them.
• Not place themselves in a position where their own interests conflict with their duty to the client.
• Refrain from misusing confidential information for their 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 a financial
adviser.

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 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 their own interests second.
In recent times, major reforms of the financial advice process have been undertaken in many countries
to require advisers to prioritise the client’s interests when providing advice to retail clients.

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1.3 Factors to Consider When Providing Financial Advice

Learning Objective

7.1.3 Know the factors to consider when providing financial advice: ‘Know Your Client’ and
suitability principles underpinning the fiduciary relationship; the nature of the client
relationship, confidentiality, trust and client protection; the information required from clients
and methods of obtaining it; information about the firm or adviser; monitoring and review of
clients’ circumstances; additional requirements needed when advising on unregulated retail
products

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1.3.1 Client Relationships
The relationship between a client and financial adviser is very important to the success of the planning
process. The role of the adviser is to build a relationship with a client that allows them in a structured way
to identify the information needed to provide sound advice and guide the client through the choices that
face them.

At the start of a client relationship, an adviser will be looking to establish rapport with a client so that
the information needed to provide investment advice can be obtained and also to set the basis for their
ongoing relationship where the goal of the adviser is to gain the deep trust of the client.

1.3.2 Know Your Client (KYC)

Individuals have varying objectives and expectations and before advising the client an adviser must be
aware of these various needs, preferences, expectations and the financial situation of the client.

The adviser must ‘know’ the client before being able to provide appropriate advice. Indeed, regulators
make this an essential requirement in many countries – the ‘know your customer’ (KYC) process.

Gathering all of the information needed to be able to properly advise a client is often a time-consuming

C
affair and clients often do not appreciate why so much information is needed or why so much time needs
to be spent. This requires the adviser to build rapport with the client so that they will feel confident about
expressing their personal needs and concerns in order to establish all of the facts that are needed for the
adviser to be able to make a suitable recommendation.

This process is known as a ‘fact find’. There is no simple way of establishing all relevant information about
a client quickly, nor is there a single correct way of collecting all of the required information. Collection
of information may be done face-to-face or at a distance; this will depend on the adviser’s method
of delivering services. The fact find is crucial to the investment advice process and so many firms use
electronic ways of collecting client information and risk attitude to improve the quality and consistency of
the firm’s advice process.

The fact-find process will need to go beyond just hard facts and elicit views and opinions from the client
which will allow the adviser to assess the level of risk they are comfortable with and the extent to which
family values such as ethical or religious beliefs will affect investment decisions.

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 The role of the adviser in all this is to build a relationship with a client that allows them in a structured way
to identify the information needed to provide suitable advice and guide the client through the choices
that face them.

1.3.3 Client Information

The purpose of gathering information about the client is clearly so that financial plans can be devised and
appropriate recommendations made. The following table provides some examples of why information
about the client’s personal and financial position is needed for investment planning purposes.

# Information Needed
Personal and Financial Details

Why Needed
Details of the client’s name and address will
need to be verified to comply with anti-money
laundering (AML) requirements.
Personal details
The client’s stage of life they have reached
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 health may influence the
investment strategy and allocations to cash,
bonds and equities.

If they are in good health, it may indicate a

need to generate a growing level of income
Health status
for many years. If they are in poor health, it
may drive an investment strategy to produce a
more immediate income.

A client’s health may also influence their

attitude to risk.
This may equally impact the client’s
investment objectives and attitude to risk.
Details of family and dependants
It may also indicate a need to fund immediate
or future spending on areas such as schooling
or weddings.

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Personal and Financial Details

Information Needed Why Needed

Existing income will impact the level of income
that needs to be generated from a portfolio
and the level of risk that the client is able to
tolerate.

Details of their occupation, earnings and other The client’s occupation or business will give
income sources a good indication of their experience in
business matters which may be relevant when
judging the suitability of a particular type
of investment that carries greater risk and

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where the firm is required to assess the client’s
experience before recommending it.
This will be needed in conjunction with
Estimates of their present and anticipated their income, where it is necessary to look at
outgoings budgeting, planning to meet certain liabilities
or generating a specific income return.
Full details of the client’s assets and liabilities
are clearly needed.

Assets and liabilities In addition, details will be needed of where

assets are held, their tax treatment, acquisition
costs and details of any early encashment
penalties.
The pension arrangements the client has made
will need to be closely linked to the investment
Any pension arrangements
strategy that is adopted both for retirement
and other financial objectives.
This will be relevant if the amounts due to
be inherited might influence the investment
strategy adopted.
Potential inheritances and any estate planning
arrangements, such as a will 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.

1.3.4 Information Disclosure

Financial services firms are required to make certain disclosures to clients at the start of the relationship
and provide the client with information about the firm and the scope of the services that are offered, how
it manages and safeguards investments, and the costs and charges that the client will incur.

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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.

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.

1.3.5 Suitability Principles

The regulatory 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.

1.3.6 Monitoring and Review

In many cases, a firm will agree to keep a client’s financial affairs under review. This is relevant as financial
planning is not a one-off process in part because of the possibility of change. A client’s plans can change
because:

• the environment changes around them such as changes to tax laws and allowances or stock market
performance is better, or worse, than anticipated, or
• the client’s circumstances change or so do their needs, wants and aspirations – eg, the client marries
or divorces, retires from full-time employment, inherits a sum of money or has a child. Not only will
their financial needs change, but their attitudes to finance may also alter and they may, for example,
become more or less risk averse.

It is important that clients’ plans and progress towards objectives is monitored and reviewed regularly,
otherwise it is impossible to know whether the financial goals are likely to be achieved. Quite small
changes in financial behaviour can, together, have a big cumulative effect on a client’s finances.

Periodic reviews can be very helpful in ensuring that the client stays on track. By repeating the planning
exercise (say) a year later, both adviser and client can see whether they are making progress towards the
client’s goals, or whether they are drifting off target and need to rebalance or use a little financial discipline.

The adviser should agree early on whether ongoing monitoring and review is going to fall within their
remit – in many cases, this will be so. If so, the adviser should have advised the customer of how frequently
they can expect to see an update of the plan and any new recommendations.

Periodic reviews to clients should include the up-to-date value of the client’s investments. Investments
should be valued on a basis which has already been agreed with the client (eg, when stocks and shares
are involved, the valuation process should be consistent as to whether bid or mid prices are used and
what exchange rate is used for any foreign assets). It will also generally include a statement showing
any transactions undertaken over the period (including any charges that have been deducted, and any
additions to or withdrawals from the client’s portfolio).

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If a full periodic review is being carried out, the adviser should re-verify the client’s details and establish
whether there have been any changes to their circumstances which might require an amendment
to the plan. If this is the case, the adviser should check the new details, and then go through the new
recommendations with the client to ensure they understand their implications in full, just as at the outset.

1.3.7 Unregulated Retail Products

What is included in the term ‘unregulated financial markets and products’ varies from country to country
and what may be unregulated in some countries may be regulated in others. A current example is
cryptocurrency which is banned in certain countries and accepted in others.

Possibly, the key point for advisers is to ensure that full disclosure is made to the client that the product
is unregulated and may, therefore, not be protected by any regulatory oversight or have the benefit of

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any investor protection schemes. A further consideration is that any advice may fall foul of a country’s
regulatory principles so the firm may face disciplinary action if the advice proves to not be successful and
the client complains.

1.4 Investment Services

Learning Objective

7.1.4 Know services associated with firms providing: advice; discretionary and advisory
management; execution only

1.4.1 Financial Planning and Advice

Financial planning is the process of developing strategies to help clients meet their goals and manage
their finances.

Financial Planning
The CISI website explains financial planning as follows:

‘Financial Planning is an ongoing process to help you make sensible decisions about money that can help
you achieve your goals in life; it is not just about buying products like a pension or an individual savings
account (ISA).

It might involve putting appropriate wills in place to protect your family, thinking about how your family
will manage without your income should you fall ill or die prematurely, spending money differently, but it
involves thinking about all of these things together, ie, your ‘plan’. You can build a plan on your own, or if
your needs are more complex you might want the help of a Financial Planner.

Start by working out your goals in life, in the short, medium and long term. Prioritise them and think about
the likely cost of those goals and when you will need the money, so you can start to plan your finances to
work out how to achieve them. Do not forget you also have to plan for some of the hurdles you may have
to overcome too. It is about getting organised; being in control of your finances rather than letting your
finances control you’.

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From this we can immediately see that financial planning is an evolving plan of action as distinct
from financial advice which is a one-off recommendation at a single point in time. Financial planning
will often involve financial advice, although it should be recognised that financial planning need not
necessarily involve product recommendations. In some cases, a rearrangement of the client’s affairs
may be enough. Financial planning recognises the consequence or knock-on effect that one action can
have upon other circumstances or objectives. It is comprehensive, in that it deals with a client’s affairs
in the round, unlike financial advice, which may be restricted to one or two areas of financial concern
treated in isolation.
manageasset
& Fund cides
1.4.2 Advisory and Discretionary Management
the
alloca
tion
-

Clients will often have sufficient funds to warrant an investment portfolio being established and
managed on their behalf. The investment management of their portfolio will be conducted on either an
advisory or discretionary basis. Both services involve managing a portfolio of investments for a client,
the fundamental difference being whether discretion over investment changes is given or not.

• A discretionary management service is where the client gives discretion to the investment firm to
manage their investments on their behalf. The investment manager manages and makes changes
to the portfolio without referring to the client, but within the constraints of the client’s investment
objectives and the strategy that has been agreed with them.
• An advisory management service is a service offered to clients who do not want to give up decision-
making and want to remain actively involved in their portfolio’s management. An investment
manager considers changes to their client’s portfolio and explains why certain changes are needed.
The client then decides whether or not to accept the advice.

Discretionary-managed portfolios can take a number of forms including:

• Fund portfolios that are a portfolio of various mutual funds or multi-manager funds.
• Managed portfolios which are standardised portfolios designed around a range of risk profiles that
can be matched to a client’s profile. They are typically constructed of mutual funds, but may have a
mix of direct holdings and funds. All clients in a particular profile receive exactly the same portfolios
and, crucially, are traded and adjusted at the same time by the discretionary managers.
• ‘Bespoke’ portfolio management is the traditional type of service offered by stockbrokers and
private client investment management firms. This involves constructing and managing a portfolio
around the specific needs of a client, and can be managed on a discretionary or advisory basis.

Bespoke portfolios tend to have the highest levels of personalisation and service, and the difference
between the various types that are offered is often down to the entry level for the service. Bespoke
portfolio management will often have high minimum investment levels compared to fund and managed
portfolios that are designed to appeal to a wider audience with relatively smaller funds to invest.
executes the order
- Manager only
1.4.3 Execution Only to be invested
↳ client decides where
An execution-only purchase or 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.

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In such cases, certain regulatory requirements do not usually 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 (KYC) process.

1.5 Wealth Management Charges

Learning Objective

7.1.5 Know how wealth management services can be paid for: management fees; transaction
charges; financial planning advice; performance-based fees; fees dependent on the nature and

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frequency of service to be provided

The fees charged for wealth management services depend on the nature and frequency of the service
being provided and include fees for providing financial advice, any management fees involved or fees
for managing client portfolios.

Providing financial advice to a client is a time-intensive exercise and so wealth management firms
expect to charge appropriately for provision of the advice. Charges can be either commission or fee
based. The advice provided by a financial adviser may be paid through the receipt of either an upfront
commission and/or commission paid from the product during its lifespan. Often, the latter type is built
into investment products and is a percentage of the value of the fund. Alternatively, the provision of
advice may be fee based where the fee is agreed in advance with the client or it may be a one-off fee or
hourly fee for specialist advice in certain areas.

Types of Charges
Investment products such as life insurance or mutual funds will carry a range of charges that may
include:

• An initial charge for investment in the product or fund based on a percentage of the amount
invested.
• Ongoing charges for managing the underlying investment portfolio along with the costs that
arise from trading and administering the portfolio.
• In certain types of funds, performance fees may arise based on the investment performance of
the fund.
• Exit charges may also be payable for certain funds or where an early exit from an investment
product is permitted.

These are normally paid from within the investment itself.

Where an investment portfolio is managed on behalf of a client, annual management fees will be due
that are usually based as a percentage of the portfolio value.

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Regulatory requirements will typically require firms to disclose to clients the nature of the services being
provided and usually the content of information that financial advisers must provide to their clients.
These obligations usually include the basis on which charges will be paid, any product-related charges
and any commissions it may receive from a product provider and will usually require this disclosure in
writing and before the firm conducts any business.

Fee Disclosure
The information to be supplied typically 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.

1.6 Conflicts of Interest

Learning Objective

7.1.6 Know the concept of a ‘conflict of interest’ and of its significance when giving client advice

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. As we saw earlier, acting in the client’s best
interest requires advisers to not place themselves in a position where their own interests conflict with
their duty to the client.

Membership of the CISI requires members to meet standards set out within the Institute’s Principles.
These Principles impose an obligation on members to act at all times, not only in compliance with the
rules, but also to support the underlying values of the Institute. The Principle relating to conflicts of
interest is shown below.

CISI Code of Conduct

‘Conflict of Interest – being alert to and actively manage fairly and effectively any personal or other
conflicts of interest, obeying legislation and complying with regulations to the best of your ability,
ensuring you are open and cooperative with all your regulators, challenging and reporting unlawful or
unethical behaviour’.

A financial adviser needs to keep in mind their 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

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can aid removal of this conflict. Disclosure of material information becomes more important where the
adviser or firm may have an interest in a customer undertaking a transaction. 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.

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.

Conflicts of Interest Policy Example

In Europe, investment firms are required to have a documented ‘conflicts of interest’ policy. Firms

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under 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.

While removal of a conflict of interest is clearly the best way to resolve potential conflicts of interest,
that is not always possible. 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.

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 2. Determining Client Needs
Learning Objective

7.2.1 Know the key stages in investment planning and determining investment objectives and
strategy
7.2.3 Know the purposes, merits and limitations of using questionnaires and interviews to elicit client
information
7.2.4 Know the main factors, resources and limitations shaping a client’s current and desired
financial circumstances: gather appropriate, relevant information about current and projected
income, expenditure, debt and savings; consider time horizons and the relative balance
of growth versus income; distinguish between what is essential and what is desirable, and
prioritise accordingly; agree clear, feasible, prioritised investment objectives

We will next look at the key elements of the investment advice process, the additional considerations
that are needed for certain types of client and the factors that should be taken into account in portfolio
construction.

2.1 Investment Advice Process

The advice process can be divided into a number of distinct stages. A description of the steps involved
in the financial planning process is defined by the Financial Planning Standards Board (FPSB) which
describes the process as including at least six steps that form an ongoing cycle as shown in the diagram
below.

like
A Financial Planning in Six Steps
Y getclientdetailare
s ent etc.
ex :
retirement
ex :
-
planning -
1. Agree goals
and objectives 2. Gather data

6. Review

3. Analysis

5. Implementation
4. Action Plan

Source: Financial Planning Standards Board ltd

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In this and the following sections, we will look at:

• Building a relationship with the client and eliciting details of their financial position and
requirements.
• Determining the client’s risk profile.
• Analysing the client’s financial position, assets and cash flow in light of the requirements, and risk
profile.
• Formulating an investment strategy to meet the client’s objectives that takes into account factors
such as time horizon, liquidity, tax and any client constraints.
• Implementing the strategy by selecting suitable products or constructing an investment portfolio.
• If agreed with the client, periodically revisiting the client’s objectives and revising the strategy and
products held to ensure they continue to meet the client’s needs.

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2.2 Establishing Client Relationships
The first phase of the financial planning process is for the adviser to establish a relationship with the
client. This involves:

• Identifying the needs of the client and determining whether this is within the range of services
offered by the firm and whether the adviser has the necessary skills, competencies and authorisation.
• Explaining the services the firm can offer and an outline of the process as well as the required
regulatory disclosures.
• Determining whether the firm can meet the needs of the client and if so, whether advice from other
professionals such as lawyers or tax experts is required.

The role of the adviser is to build a relationship with a client that allows them in a structured way to
identify the information needed to provide sound advice and guide the client through the choices that
face them.

Key to this process is the communication ability of the adviser. 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.

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2.3 Fact Find
The process of gathering the personal and financial information needed about a client is referred to as
a ‘fact find’.

Gathering all of the information needed to be able to properly advise a client is often a time-consuming
affair and clients often do not appreciate why so much information is needed or why so much time
needs to be spent. This requires the adviser to build rapport with the client so that they will feel
confident about expressing their personal needs and concerns, in order to establish all of the facts that
are needed for the adviser to be able to make a suitable recommendation.

Firms will usually adopt a structured approach to collecting client information; having a structured
investment advice process helps a wealth management firm to bring consistency to their advice
process. Firms may use any of the following methods or combination of methods to complete the fact
find:

• an electronic system
• printed questionnaires
• forms
• meetings
• telephone conversations, or
• email or postal correspondence.

It is highly unlikely that a single questionnaire will ever be detailed and flexible enough to capture every
piece of information required. The adviser needs to review the answers given in the questionnaire and
ask supplementary questions to understand fully the client’s needs, which most people are usually
unable to articulate with total clarity via a questionnaire.

The fact-find process will need to go beyond just hard facts and elicit views and opinions from the client
which will allow the adviser to assess the level of risk they are comfortable with and the extent to which
family values such as ethical or religious beliefs will affect investment decisions. The fact find is crucial
to the investment advice process and so many firms use electronic ways of collecting client information
and risk attitude to improve the quality and consistency of the firm’s advice process.

2.4 Client’s Goals and Objectives

This stage of the planning process involves the adviser identifying the client’s personal information and
financial objectives, needs and priorities so that they can subsequently analyse the client’s financial
position and identify suitable solutions. It also potentially involves helping the client to clarify and
prioritise their short- and long-term objectives including discussing with the client the feasibility of any
objectives that appear to be unrealistic.

This phase encompasses three main areas:

• agreeing the client’s investment and financial objectives and identifying any constraints
• establishing the clients risk profile, and
• collecting the quantitative and qualitative data needed.

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Although this is in a logical sequence, in practice, an adviser often ends up moving between the phases
and returning to previous ones as new information becomes available.

Understanding the client’s goals and expectations is vital to the investment advice process.

Finding out what clients want to achieve with their finances can be one of the longest and most difficult
aspects of the investment advice process. Some clients have a good understanding of their general aims
and objectives, but many have not thought through them, and so it may be important to help them to
consider these issues. In many cases, these are defined during, and as a result of, the process.

An experienced adviser often sets out to determine a client’s goals and expectations at the outset,
rather than embarking on a detailed fact find. The financial planning experience may well be the first
time that a client has thought seriously about their long-term future or tested their aspirations and
assumptions against financial realities.

A fact-find process is essential, but clients often see it as nothing to do with what they want to achieve.
A more successful strategy is usually to determine their goals and expectations, and then explain that a
detailed fact find will be necessary in order to be able to make recommendations.

Understanding a client’s background is important, as a person’s history always plays a dominant role
in shaping individual attitudes. Most individual’s attitudes and beliefs about money are shaped by
their experiences and the challenges they have faced in achieving a sense of financial well-being.
Understanding this helps with clarifying their attitudes to money and managing it, and contributes to
establishing their tolerance to risk.

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Equally, questioning a client about how satisfied they are with their life and financial position can
be illuminating and can add further to the background picture of the client. Satisfaction is personal
and dependent on an individual’s beliefs, and so the results may indicate key priorities that need to
be addressed or the degree to which investments need to be targeted at income production, wealth
preservation or wealth creation.

An adviser should also try to elicit what principles matter to a client. They may have strong views about
where their money should, or should not be, invested, or the level of risk they are prepared to take to
achieve objectives. Their attitude to money, and principles and values which matter to them, will help
the adviser understand what influences them, and this can be factored into recommendations.

It is also important to understand the stage of life that a client has reached. This may seem as obvious
as finding out someone’s age and making assumptions from that. Open questions about the client’s
intentions are likely to bring out useful information about their plans and the challenges they face.

Finally, these conversations lead nicely on to the client’s goals and aspirations. Questions designed to
find out what their plans are, what they hope to achieve and the lifestyle they want will all help ensure
that any recommendations are aligned with these.

Establishing goals and expectations in this way will help the adviser with the fact-find process, which
must follow if investment recommendations are to be made.

2.5 Factors Influencing Client Needs

The information that the fact find will aim to collect will depend on the service and products under
consideration, but will generally include:

• Personal details.
• Health status.
• Details of family and dependants.
• Details of occupation, earnings and other income sources of wealth.
• Estimates of present and anticipated outgoings.
• Assets and liabilities.
• Any pension arrangements and any life or insurance arrangements.
• Potential inheritances and any estate planning arrangements.

We will now look at each of these in more detail and identify what information is needed and why, when
undertaking investment planning.

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Personal Details
An adviser will seek to establish extensive personal details about the client as shown in the table below.

Name and address • Details of the client’s name and address will need to be
verified to comply with AML requirements by inspecting
photo ID and original documents that prove their address,
such as a utility bill.
Date of birth • 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

7
potential viewpoint on long-term investments.
• The client’s age may also be relevant when looking at their
assets. It may influence consideration of whether assets are
sold and capital gains tax (CGT) ncurred or whether estate
taxes have an impact on the sale or retention of certain
assets.
Residency and domicile • The client’s place of birth may have a bearing on their
residency and domicile. The adviser needs to establish
whether the client is resident or not in their country for tax
purposes and their domicile. If the client maintains that they
are not resident or domiciled, what evidence is available to
substantiate this if challenged by the tax authorities.
• Both of these factors could have a significant bearing on how
the returns from any recommended investments are taxed
and, therefore, on which are selected, and the net returns
that are generated for the client.
Tax ID numbers • Tax ID numbers will also be needed, as they may be required
for any tax wrappers that may be selected and for any tax-
reporting requirements that may have to be met.

Health Status
A client’s health status will need to be established; namely, whether they are in good health or have any
serious medical conditions that may influence their investment objectives and attitude to risk.

An individual in good health who comes from a family with members who traditionally live until a very
old age will certainly want to plan for the long term, and planning for income well into retirement may
well be very high on their list of priorities. This may influence the investment strategy selected as there
may be a need to generate a growing level of income for many years, implying the need for a higher
exposure to equities and the growing dividend stream these can provide.

At the other end of the spectrum, a client may be in poor health, and this may drive an investment
strategy to produce a more immediate income. This will then influence the asset allocation strategy
adopted, and sway weightings away from equities to cash and fixed-income instruments.

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A client’s health may also influence their attitude to risk. A client in good health who expects to live
well into old age may take the view that they need to be cautious in their approach or, alternatively,
that they have the time horizon that enables an adventurous approach. A client in poor health may
take the view that ensuring they have the funds to care for themselves is their overriding priority and
so may not be prepared to take undue risks. Equally, a client might take the view that they are going to
spend everything they have before they go and so being adventurous is right for them. In that example,
shorter-term goals demand quite different advice to long-term needs. You may need to determine and
document if your client is insistent on pursuing a short-term, high-risk strategy.

Details of Family and Dependants

Details of the client’s family and dependants will normally be established as part of the fact-finding
exercise. The information that will be collected will include:

• The name and date of birth of the client’s spouse or civil partner, as well as their health status, as this
may equally impact the client’s investment objectives and attitude to risk.
• The spouse’s attitude to risk if this might be a factor in investment selection.
• The extent of any ongoing divorce payments that might be relevant to the investment strategy.
• Details of children or other dependants should also be established, especially if there may be a need
to provide funds for school fees, university education or weddings.

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 a client’s income and the sources it arises from. While
generating a particular level of income may be important to the client (even if it is not), it will be
equally relevant as to how that income affects the client’s tax position.
• The client’s occupation or business will give a good indication of their experience in business
matters, which may be relevant when judging the suitability of a particular type of investment that
carries greater risk.
• Whether the holds a senior position in a company and so faces restrictions on dealing in the
company’s shares. To avoid the risk of dealing on inside information, arrangements need to be put
in place to request permission to trade, avoid closed dealing periods and ensure that any trading
takes place in a manner that places neither the firm nor the client at risk.
• Where a client may be a politician or hold a senior position which is in the public spotlight, they
may need to distance themselves from any investment decision-making so 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.
• Where the client is in business, the adviser will want to understand the client’s plans for the
business and any funds that may be forthcoming immediately or in the future that might affect the
investment plans that the adviser will draw up.

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Estimates of Present and Anticipated Outgoings

An understanding of the client’s outgoings will be needed in conjunction with their income, where it
is necessary to look at budgeting, planning to meet certain liabilities or generating a specific income
return.

Depending upon the client’s priorities, both their present and anticipated future outgoings may be
needed, for example, where the investment plan involves generating a certain income in retirement.

Standard practice is for customers to have some sort of reserve funds in case of volatility soon after
investing. The general rule of thumb is that advisers should consider six months’ worth of expenses
held by the client in reserves to avoid any short-term calls on the portfolio. The adviser should satisfy
themselves that, whatever amount is agreed with the client, it is suitable and commensurate with their
personal circumstances.

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Assets and Liabilities *
Full details of the client’s existing assets and liabilities will need to be ascertained. 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 and any present year gains or losses incurred, and
• details of any early encashment penalties.

The information needed will vary by type of asset; the following table gives an indication of some of
what is needed.

Asset Information needed

• Account type and details

• Balance
• Branch where account is held if needed
Bank and savings accounts • Interest rate on the account
• When interest is paid and whether there are any bonuses
payable
• Any early encashment penalties or lock-in periods
• Full title of each instrument
• Nominal amount of stock or shares held
• Dates of purchase
Quoted investments • Acquisition costs
• Where the stock is held and, where known, the ISIN or
other identification number
• Details of any pending corporate actions

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 Asset Information needed

• Full title of each fund

• Number of units or shares held
• Dates of purchase
• Acquisition costs
• Share class
• Investment structure, fund type and tax status
• Whether the holding is certificated or uncertificated and
Investment funds
in what name it is registered
• Any exit fees
• Frequency of valuation points if fund redemptions are
infrequent
• Dealing and notice periods, eg, some illiquid assets, such
as hedge funds and private equity funds, have quarterly
or yearly dealing
• Account type and details
• Eligibility criteria for tax exemption
• Assets and cash held
• Whether further additions can be made in the current tax
Tax-exempt accounts
year
• Whether account can be transferred without loss of tax-
exempt status
• Tax ID reference
• Type of product and features
• Details of sum payable and any guarantees
• Conditions to be met for payment
• When purchased and cost
Structured products
• Term and repayment date
• Cost structure
• Any early encashment penalties
• Whether quoted or unquoted
• Policy type and details to include if written in trust or not
• Policy conditions
• Whether it is with-profits or unit-linked
Life assurance bonds
• Details of unit-linked funds and number of units held
• When purchased and costs
• Any encashment penalties

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Pension Arrangements
The pension arrangements that the client has made will need to be closely linked to the investment
strategy that is adopted both for retirement and other financial objectives.

The availability of tax exemptions for pension contributions may be an influencing factor on the choice
of investments and so clearly needs to be factored in at this stage.

Where the client has some influence over where the funds are invested, the adviser will want to discuss
with the client about how the funds will be managed and whether they will be incorporated into any
overall asset allocation.

The firm may be able to manage the investments held within the client’s pension plan, and in so doing,
will need to decide whether that portfolio will be managed as a discrete entity or whether a holistic

7
view will be taken. This could involve the pension plan portfolio being treated as a sub-portfolio for
investment management purposes, with the investment manager looking at the combined picture of
a taxable portfolio, tax-free accounts and pension portfolios and allocating investments between the
accounts.

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. This will be relevant where the amounts due to be
inherited might influence the investment strategy adopted. For example, a client may be due to inherit
a substantial sum from elderly parents and so may be able to take a view that their investments should
be directed to outright growth.

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.

Prioritisation Process
The facts that will be gathered during the fact find will identify those factors that influence the client’s
needs. Simply because a need has been established, however, does not mean that it can be addressed.
Affordability will be a major constraint on a client’s ability to invest and protect against all of the
risks that might arise. The adviser will, therefore, need to guide the client through a planning and
prioritisation process.

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3. Risk Profile
Learning Objective

7.4.1 Know 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
7.4.2 Be able to analyse a profile of a client’s risk exposure and appetite for risk, based on the
following objective and subjective factors: level of wealth; timescale; commitments; life cycle;
life goals; investment objectives; attitudes; experiences; knowledge; capacity for loss

Investment always involves a trade-off between risk and return. However, different people are prepared
to tolerate different levels of investment risk and investment risk means different things to different
investors. Variations in attitude arise because of individual differences in circumstances, experiences
and psychological make-up.

A client’s risk profile is made up of three components:

1. Risk tolerance – this is the client’s willingness to accept a certain level of fluctuation in the value of
their investments without feeling an immediate need to sell.
-

2. Risk perception – this represents their personal opinion on the risks associated with making an
investment based on their prior knowledge and experience.
3. Risk capacity – this is the client’s ability to absorb any financial losses that might arise from making
a particular investment.
-

Taken together, these three elements along with relevant additional fact-find information should allow
a risk classification or profile to be determined that can be agreed with the client.

The risk-assessment process usually starts with investigation of attitudes; consideration of risk capacity
usually follows later since it requires knowledge of the client’s objectives and the particular investments
that are being considered.

3.1 Risk Tolerance

Risk tolerance is defined as the degree of uncertainty that an investor can handle, with regard to a
negative change in the value of their portfolio.

It reflects the extent to which an investor is comfortable with the risk of losing money on an investment.
If they are unwilling to take the chance that an investment might drop in price, they have little or no risk
tolerance. On the other hand, if they are willing to take some risk by making investments that fluctuate
in value, they have greater risk tolerance. The probable consequence of limiting investment risk is that
you are vulnerable to inflation risk, or loss of buying power.

There are a number of objective and subjective factors which can be established that will help define
this.

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Objective and Subjective Factors

Objective factors • The timescale over which a client may be able to invest will
determine both what products are suitable and what risk can be
adopted.
• Family commitments are likely to have a significant impact on
a client’s risk profile as they will want to meet their obligations
which may make higher-risk investments less suitable.
• Wealth will clearly be 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.
• Stage of life is equally important as it will impact the level of

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risk that can be adopted and the time horizon over which they
consider investments.
• The age of the client will often be used in conjunction with the
above factors to determine acceptable levels of risk.
Subjective factors • Investors who are more knowledgeable about financial matters
are more willing to accept investment risk.
• Some individuals have a psychological make-up that enables
them to take risks more freely than others, and see such risks as
an opportunity.
• A client’s preferred investment choice such as a client’s normal
preferences for the relative safety of a bank account versus the
potential risk of stocks and shares.
• A client’s approach to bad decisions. 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.

Establishing objective factors is clearly a preferable and more accurate way to help define a client’s risk
tolerance, but subjective factors clearly have a part to play.

Subjective factors enable an adviser to try and establish a client’s attitude to taking risks. A client’s
attitudes and experiences must also 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
by nature cautious, 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.

3.2 Risk Perception

Risk perception refers to people’s subjective judgments about the likelihood of negative occurrences
such as injury, illness, disease, and death. In investment terms, risk perception is a subjective view that
clients take on the risks involved in making a particular investment, when compared to the alternatives
available, based on their own knowledge and experience.

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Individuals evaluate risks mostly according to subjective perceptions, intuitive judgments, and
inferences made from media coverage and limited information. By contrast, experts try to base their
risk perceptions more on research findings and statistical evidence. Risk perception is a highly personal
process of decision-making, based on an individual’s frame of reference as developed over a lifetime,
among many other factors.

Risk is interpreted differently by people, and for some, taking on risk is acceptable while for others,
risk is something to avoid. A client may perceive that placing funds in a cash deposit account does not
present any risk to the value of their capital. However, this ignores the impact of inflation and, once this
has been explained and understood, the client may appreciate that the real value of their capital will
diminish over time, if the rate of return they receive on their savings does not exceed the current rate of
inflation.

As the client’s practical experience of investing increases, this is likely to shape their perception of risk
when considering future investment opportunities. Advisers need to be aware that this will happen and,
without being patronising, help the client deepen their understanding to whatever extent they wish.

3.3 Risk Capacity

Risk capacity is the client’s ability to absorb any losses that may arise from making a particular
investment.

Risk tolerance and risk perception are partly subjective, but risk capacity is largely a matter of fact. While
subjective factors largely determine risk perception and attitude, the key question in assessing risk
capacity is more about what would be the consequences for the client if losses were incurred.

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In some cases, risk capacity will play the most important role in determining the client’s overall risk
profile. The client’s capacity for risk will also be affected by the level of investment being considered.
If the amount at risk represents a significant portion of the overall portfolio, risk capacity may be
diminished. Risk capacity will be greater when the amount at risk is a small fraction of available capital.

3.4 Risk Descriptions

There are a number of approaches that can be taken to establish the client’s risk profile, as shown below.

Risk-Profiling Tools
• A much-used approach to establishing a client’s risk

7
profile is to describe different types of investment
attitudes to find out which is closest to the client’s view.
Risk descriptions • This has the advantage of simplicity.
• Its drawback is that statements such as ‘medium risk’
or ‘on a scale of one to ten’ mean different things to
different people.
• The aim of psychometric risk profiling is to assess the
client’s psychological risk tolerance or preference, rather
than their objective financial capacity to take risks.
• It uses a questionnaire to generate a risk score that can
be compared to other clients.
• Its advantage is that it allows clients to consider their
attitude to investment decisions very carefully and
to articulate them to the adviser, who can ask further
Psychometric risk profiling
questions and discuss the relationship of risk to the
behaviour of different asset classes.
• It is important to remember though that the
psychological profile is only one of the inputs into the
investment decision-making process. But it is a good
starting point to a discussion that could include the
impact of the profile on potential outcomes for the
client’s different goals.
• The stochastic model forecasts a range of possible
returns from different portfolios of investments. It helps
clients choose the appropriate portfolio by showing the
range of possible outcomes from each portfolio and the
probability of achieving them.
• Its advantage is that it helps to explain investment
Stochastic modelling
risk to the client, compare alternative strategies and
recommend a portfolio of suitable investments.
• It is important to understand that the model is making
predictions about the future and is, therefore, reliant on
its assumptions. A further drawback is that some clients
may think these projections are set in stone.

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Tools can usefully aid discussions with clients by helping to provide structure and promote consistency.
But they often have limitations which mean there are circumstances in which they may produce flawed
results. Where firms rely on tools they need to ensure they are actively mitigating any limitations
through ensuring suitability and the ‘KYC’ process.

The output of risk profiling is a description of investor risk appetites; examples of these are shown
below. These descriptions are intended to be only illustrative and bring out common traits as every
individual is different.

Investor Risk Appetites

• Prefer knowing that their capital is safe and they are not
comfortable investing in equities. They would rather keep their
money in the bank and are unlikely to have much experience of
other investments.
• They will usually suffer from severe regret if their decisions turn out
badly.
Low Risk
• Investors need to understand that their caution can mean that their
investments may not keep pace with inflation or that they may fall
short of their investment goal.
• Investors with time horizons of ten years or more typically have
portfolios with a majority of bonds and cash, with little exposure to
equities or other higher risk investments.
• Prefer not to take risk with their investments, but they can be
persuaded to do so to a limited extent. They would prefer to
keep their money in the bank, but they may realise that other
investments might be better over the long term.
Low-Mid Risk
• They can often suffer regret when decisions turn out badly.
• Investors with time horizons of ten or more years typically have
portfolios with a majority of bonds and cash, but with some
exposure to equities and other higher-risk investments.
• Understand that they have to take investment risk to meet their
long-term goals. They are often more willing to take risks with at
least part of their available assets and may have some experience of
investment, including investing in products containing higher-risk
assets such as equities and bonds.
Mid Risk • They can usually make up their minds on financial matters relatively
quickly, but they still suffer from some feelings of regret when their
decisions turn out badly.
• Investors with time horizons of ten years or more typically have
portfolios with a mix of higher-risk investments such as equities and
lower-risk investments such as bonds and cash.

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Investor Risk Appetites

• Willing to take on investment risk and understand the nature of
the long-term risk/return trade off. They are willing to take risk with
most of their available assets, are typically experienced investors
and have used a range of investment products in the past.
• They will usually be able to make up their minds on financial
Mid-High Risk matters quite quickly. While they can suffer from regret when their
decisions turn out badly, they can accept that occasional poor
outcomes are a necessary part of long-term investment.
• Investors with time horizons of ten years or more typically have
portfolios with a majority of higher risk investments such as
equities, but that also contain bonds and cash.

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• Want the highest possible return on their capital and are willing to
take considerable amounts of risk to achieve this.
• They are usually willing to take risks with all of their available assets,
and have substantial amounts of investment experience.
• High-risk investors have firm investment views and will make
High Risk up their minds on financial matters quickly. They do not suffer
from regret to any great extent and can accept occasional poor
outcomes without much difficulty.
• Investors with time horizons of ten years or more typically have
portfolios made up primarily of higher-risk investments such as
equities, with little in bonds and cash.

The results of risk profiling should support the KYC process and form a basis for discussion between the
adviser and client as to the types of investments that such a risk profile would suggest are suitable.

4. Investment Objectives and Strategy

Learning Objective

7.2.2 Know how investment strategy and product selection are influenced by: ethical preferences;
liquidity requirements; time horizons and stage of life; tax status

Having collected all of the core information needed about the client, the adviser can then turn to
agreeing their investment objectives. In collecting the information above, the adviser will have started
to build a picture of the client’s needs and will 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 (provision for) future events.

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 IPS : Investment Policy Statement

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:
->
Bonds
• 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.

Once the client’s investment objectives have been agreed, the adviser needs to look at developing an
investment strategy that can be used to achieve these objectives. In developing an investment strategy,
the adviser will need to take into account the following:

• risk profile
• investment preferences
• liquidity requirements
• time horizons, and
• tax status.

4.1 Risk Profile

As we saw earlier, a client’s risk profile is made up of a combination of attitudes and risk capacity – that
is the client’s ability to absorb any financial losses that might arise from making a particular investment.
These allow a risk classification or profile to be determined that can be agreed with the client.

Volatility in the prices of investments or the overall value of an investment portfolio is inevitable. At a
personal level, this translates into the risk that prices may be depressed at the time when an investor
needs funds and will mean that they will not achieve their investment goals.

A client needs to have a very clear understanding of their tolerance to risk as it is essential to choosing
the right investment objectives. Risk tolerance is a very personal subject and is very dependent upon
the emotional make-up of a person. It is also objective as well, in that age will affect how much risk a
client can assume. As you get older, there is less time to recover from poor investment decisions or
market falls, and so appetite to take risk may change.

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4.2 Investment Preferences

An adviser will also need to establish whether the client has any specific investment preferences that
need to 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 holding cannot be disposed of or they may
prefer to exclude certain investment sectors from their portfolios, such as armaments.

Alternatively, a client may want to concentrate solely on a particular investment theme, such as ethical
and socially responsible investment (SRI), or may require the portfolio to be constructed in accordance
with Islamic principles. Ethical and SRI is considered in chapter 6.

7
4.3 Liquidity Requirements and Time Horizons
It is also essential to understand a client’s liquidity requirements and the time horizons over which they
can invest as these will also have a clear impact on the selection and construction of any investments.

Liquidity and Time Horizons

• 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 which the client can
access without having to disturb longer-term investments.
• If there are known liabilities that may arise in future years,
consideration should also be given as to how funds will be realised
Liquidity
at that time.
>
money mkls • Consideration needs to be given as to whether it is sensible to plan
-

on 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.
• 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 four 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 • 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.

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 The lower the client’s liquidity requirements and the longer their timescale, the greater will be the
choice of assets available to meet the client’s investment objective.

The need for high liquidity allied to a short timescale, demands that the client should invest in lower-risk
assets such as cash and short-dated bonds, which offer a potentially lower return than equities. If the
opposite is true, the portfolio can be more proportionately weighted towards equities.

Whatever their requirements, it is important, however, that the client maintains sufficient liquidity to
meet both known commitments and possible contingencies.

4.4 Tax Status

The tax status of the client and the taxes to which any investment income or gains will be subject may
have a major impact on the investment strategy that is adopted.

The adviser will, therefore, need to establish:

• The client’s residency and domicile position.

• The client’s income tax position.
• How tax will affect any investment income.
• Any tax allowances which can be utilised.
• How tax will affect any gains or losses made.
• Eligibility for any tax-free accounts.
• Opportunities for deferring any tax due.

An adviser must establish the client’s residence and domicile status, as they may affect how any
investments are structured. Although tax rules vary from country to country, establishing the client’s
tax position is essential so that their investments can be organised in a way that attracts the least tax
possible on returns. This requires the adviser to be aware of what taxes may affect the client, such as
taxes on any income arising or on any capital gains, how these are calculated and what allowances
may be available. It should also be remembered that tax legislation is constantly being reviewed and
updated; therefore, future charges to taxation rules may render a tax-planning strategy ineffective.

Advisers also need to take care that any tax avoidance measures will stand up to scrutiny given the
increasing public disquiet regarding tax avoidance measures by companies and wealthy individuals.

illegal
Savine&
Tax Avoidance vs Tax Evasion
taxes ht • Tax avoidance involves taking steps to reduce the amount of tax that someone pays within the
throug law whilst making full disclosure of material information to the tax authorities.
right .
• Tax evasion is the attempt by individuals and companies to evade paying tax by illegal means.
strategy
Public perception of what is acceptable tax avoidance has lead to this being more carefully defined. The
term ‘tax mitigation’ is now being used to refer to acceptable tax planning. It refers to ways of minimising
tax liabilities in ways that are expressly endorsed by tax legislation. By contrast, tax avoidance flouts the
spirit of the law and is, therefore, thought by some to be unacceptable, albeit not criminal in the way
that evasion is.

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4.5 Considerations for Other Types of Client

In the previous sections, we have looked at the factors that should be considered when undertaking
a structured investment advice process for wealthy individuals. Wealth managers will also need to
take account of additional factors when dealing with trusts and charities and when they need to take
account of the ethical and religious beliefs of clients.

Islamic Finance
Islam sets out specific requirements in Islamic law (Shariah) with regard to investment. To support
their communities who follow these practices, a number of Islamic banks have become established
worldwide, while at the same time, conventional banks now provide a wider range of products and
services that comply with these laws.

7
Islamic finance refers to a system of banking or banking activity that is consistent with the principles of
Islamic law and its practical application through the development of Islamic economics.

Shariah prohibits the payment of fees for the renting of money (riba, or usury) for specific terms, as well
as investing in businesses that provide goods or services considered contrary to its principles (haraam,
or forbidden).

The overarching principle of Islamic finance is that all forms of interest are forbidden. The Islamic
financial model works on the basis of risk sharing. The customer and the bank share the risk of any
investment on agreed terms, and divide any profits between them.

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 g
The main categories within Islamic finance are:

• Ijara is a leasing agreement whereby the bank buys an item for a customer and then leases it back
over a specific period.
• Ijara-wa-Iqtina is a similar arrangement, except that the customer is able to buy the item at the end
of the contract.
• Mudaraba offers specialist investment by a financial expert in which the bank and the customer

E
share any profits. Customers risk losing their money if the investment is unsuccessful, although the
bank will not charge a handling fee unless it turns a profit.
• Murabaha is a form of credit which enables customers to make a purchase without having to take
out an interest-bearing loan. The bank buys an item and then sells it on to the customer on a
deferred basis.
• Musharaka is an investment partnership in which profit-sharing terms are agreed in advance, and

↓
losses are pegged to the amount invested.
↳ limited liability
Faith-Based Values
.

investment Responsible, sustainable and ethical investing was founded on religious roots. In the 1800s, the Quakers,
structures who were anti-slavery and anti-war, avoided investing in weapons production.

Today, faith-based investing is often a combination of socially responsible investing plus the screening
out of several other things germane to a particular religion. Each group decides both what their
financial goals are and their strategies to achieve those goals. They also look at their social and religious
teachings and that leads them to be willing to hold certain things in their portfolios.

Almost every religious denomination in the world has views and opinions which may impact how they
wish to invest, so they may favour certain causes, while at the same time, avoiding those that contradict
their values. When it comes to religious-based rules, there are a wide variety of interpretations based on
their teachings.

There are many more belief systems than it would be possible to cover within this text and they can
vary significantly between regions, denominations and individuals. In many cases, political and societal
factors will have a huge impact on shaping the key values for an individual; therefore, candidates are
encouraged to carry out their own additional research should they wish to find out further information
concerning specific belief systems.

Trusts
Trusts are a legal arrangement whereby assets are placed under the control of trustees for the benefit
of certain named beneficiaries or for a specified purpose and are covered in more detail in chapter 8.

Investment managers regularly manage portfolios on behalf of trusts and a different set of considerations
and obligations arise when doing so. Trusts are widely used to control the ownership of assets and to
mitigate tax liabilities. In managing the investments of a trust, it is essential to understand their various
forms, operation and relevant rules.

In order to carry out their obligations under the trusts, trustees have a range of powers and duties
that are conferred by either the trust deed or statute. Within a trust, there will always be assets or
investments of various kinds and therefore the trustees need powers to invest, as otherwise they would
be liable for any loss.

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Charities
Many charities have surplus funds not needed to fund their immediate charitable activities; often the
charity invests some or the entire surplus in order to generate extra income to fund future activities.
In advising charities, the process of determining their investment objectives, risk profile and the
investment strategy to be followed applies equally to them as to the other types of client.

The charity will be run by a board of trustees if established as a trust or by a council if it is a foundation.
The trustees or the council will have responsibility for the management of the charity’s funds.

The basic principle governing decisions about investing their charity’s funds is that they must take
a prudent approach. When investing charitable funds (especially those which represent permanent
endowment), the charity must seek to strike the right balance for their particular charity between the
two objectives of:

7
• providing an income to help the charity carry out its purposes effectively in the short term, and
• maintaining (and, if possible, enhancing) the value of the invested funds, to enable the charity to
carry out its purposes in the longer term effectively.

In order to discharge the duty to adopt a prudent approach to the investment of the charity’s funds, the
trustees or council members of the charity must:

• Know their investment powers.

• Discharge their duties properly when they take decisions about investments.
• Have proper arrangements in place for holding investments on behalf of the charity.
• Follow certain legal requirements if they are going to use an institution to manage the charity’s
investments on their behalf.
• Know what they can and cannot do if they are going to apply an ethical approach to the charity’s
investments.

If the size of the funds to be invested justifies it, trustees should decide on a formal investment policy
for the charity. This will, of course, vary in the level of detail and complexity depending on the size of the
charity, and on whether the function of investment has been delegated.

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5. Investment Recommendations
Learning Objective

7.4.4 Assess affordability and suitability based on a range of factors including product provider
quality, performance, risk, charges and client service
7.5.1 Apply a strategy and rationale that will meet the client’s objectives: highlight the pertinent
issues and priorities; formulate a plan to deal with them; offer proposals to achieve these
objectives; explain clearly the relative merits and drawbacks of each proposal and combination
thereof; agree a strategy that the client understands and accepts
7.5.2 Apply an appropriate strategy that best meets the following criteria: client’s financial
objectives and priorities; client’s risk tolerance; appropriate fees and charges; portfolio
turnover ratio (PTR); client suitability requirements; adequate diversification and correlation
benefits; additional risk, timing and liquidity factors where asset accumulation and
decumulation are relevant features
7.4.3 Know the main considerations for investing in accordance with Shariah law and other faith
values and those that should be taken into account when investing for charities and trusts
7.5.4 Assess the factors influencing the choice of benchmark and the basis for review: portfolio’s
asset allocation; risk/return profile; alternative investments; taxation; peer groups;
maintenance of capital value
7.5.3 Understand the factors which influence the way in which recommendations are presented and
understand how to check clients’ understanding of recommendations

After determining a client’s objectives and risk profile, the next stage is to collate all of the data that has
been collected, analyse the client’s financial position and prioritise the areas where action is needed.
This involves turning the data into a comprehensible form that allows it to be readily analysed. This can
be broken down into a number of areas such as:

• Net assets statement.

• Cash flow statement.
• Tax analysis.
• Lifetime cash flow projections.

After analysing the client’s current financial position and any constraints, the final stage of the
investment advice process is the development of solutions that are suitable for the needs of the client.

5.1 Developing a Strategy

Having established what the needs and objectives of the client are, and completed a thorough
assessment of their existing financial position, the adviser can assess:

• The affordability and suitability of the client’s existing arrangements.

• What the client is aiming to achieve.
• What should be the client’s priorities.

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It needs to be remembered that financial planning is a long-term process and not a one-off exercise.
Most clients will need to prioritise their needs and then deal with the most pressing first and others
when the constraints of affordability allow.

The development of a strategy will involve the following:

• Assessing where action is needed.

• Prioritising what should be addressed.
• Identifying where action should be left until a later date.
• Developing potential solutions to address the priorities for further investigation.

5.2 Assessing Existing Assets

7
Having determined a strategy to meet the client’s needs, the next stage is to check existing assets
and products for their suitability. This will involve determining the details of each product, assessing
whether they meet the client’s needs, and establishing any issues that may arise in moving these to
alternative options. There are many factors to consider, and these will be driven by the type of asset,
product or arrangement. Some items to consider include:

• Their relevance to the true needs of the client.

• Whether they are affordable options.
• The degree of risk associated with the product considered against the client’s risk tolerance.
• The extent of any diversification, or lack thereof.
• The liquidity (that is, the ease of selling it or otherwise converting it into cash).
• The level of charges compared to comparable products.
• Whether it is income producing or more suitable for capital growth.
• The tax treatment/efficiency.
• Performance of investments, growth achieved and any taxation treatment on encashment.
• How long any assets need to be retained to earn any bonuses.
• Any encashment penalties.

This analysis will then provide the basis for continuing the financial planning process. It will identify
which assets should be retained and which should be disposed of to finance meeting the client’s
objectives. The next steps are to identify suitable financial products that can meet the client’s
requirements and evaluating their features.

5.3 Investment Solutions

Whilst the investment policy statement sets out the client’s risk and return objectives, it is still necessary
to select an investment proposition that is appropriate, suitable and capable of achieving the client’s
goals.

There are a range of potential investment solutions to choose from that can cater for different types of
client including:

• A preferred fund panel for clients who want execution only services.
• A portfolio of low-cost mutual funds for clients with modest asset levels who required a low-cost
ongoing service.

327
• A model portfolio service for clients with a higher level of assets and investment experience, where
the additional costs are appropriate.
• Discretionary fund management for clients who required bespoke investment management
solutions.

There are other solutions but as a generalisation all fall essentially within two types of structure:

• Investment funds – where the client invests directly in mutual funds or managed solutions such as
multi-asset and fund of funds (FoFs).
• Discretionary management – where a portfolio is managed on behalf of the client by a discretionary
investment manager on a model portfolio basis or as a bespoke service.

Within these two categorisations there are a wide variety of different services and products and it is
important to appreciate the differences in order to be able to identify the right solution for a client.

5.3.1 Investment Funds

The essential characteristic of this type of investment service is the use of investment funds to access a
diversified portfolio of assets. They may use mutual funds or any of the other types of investment fund
such as closed-ended funds, absolute return funds or hedge funds. Examples of some general types are
shown below.

• Many investment firms run model portfolios of investment

funds that are targeted at different investment objectives
such as growth, balanced or income.
Return-focused portfolios • These are regularly monitored and adjusted depending
on market movements and fund manager changes. The
approach is return focused and aims to meet or exceed a
benchmark target.
• The concept behind such portfolios is to maximise returns,
but only by taking on a certain level of risk within pre-
defined volatility bands. Once a client’s risk profile has been
agreed a model portfolio is selected that is designed to
provide and maintain a suitable combination of asset classes
and funds that deviate little from the agreed risk parameters.
Risk-targeted portfolios • The fund’s aim is to ensure the asset mix within the fund
continues to meets the risk profile and does not simply
aspire to beat a sector average performance.
• As a generalisation, the constraints imposed on risk-targeted
funds can make it difficult for the fund to outperform its
benchmark and so significant outperformance should not be
expected.

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 Investment Advice

• An investment firm may construct and manage model

portfolios of funds itself or outsource the investment
activity by using a fund of funds approach or multi-manager
solution.
• FoFs – assets are invested in other mutual funds to utilise
the expertise of specialist managers in each asset class.
• Manager of manager (MoM) – assets are managed by
specialist managers in each asset class on a segregated basis
as mandated by the multimanager fund manager.
Model portfolios • A FoFs approach can be either fettered which means
that it only invests in funds managed by the same group
or unfettered where it may invest in any fund and fund

7
management group it chooses.
• With multi-manager funds, many funds will invest only in
traditional assets, whilst others will adopt a more multi-
asset approach, investing in commodities and hedge
funds, for example. It is important that advisers understand
the component parts of each fund as these could expose
investors to different types of risk.

In analysing such services, differentiating factors that should be analysed include whether:

• The approach is return focused or risk targeted.

• It involves management of a portfolio or the use of a fund of funds or multi-manager type solution.
• It uses only traditional asset classes or also includes alternative assets.
• The level of asset and geographic diversification and whether the investment approach is active
management, passive management or a blend of the two.
• The portfolio turnover ratio is appropriate. The portfolio turnover ratio is the rate at which assets in
a fund are bought and sold by the fund manager. Higher turnover may be appropriate, but implies
higher charges to cover the cost of trading.

5.3.2 Discretionary Investment Management

Discretionary investment management services vary widely and range from managed portfolios at the
lower value end of the market to bespoke portfolios that are tailored to the individual client at the other
end.

Model or managed portfolios are standardised portfolios designed around a range of investment
objectives and risk approaches that can be matched to a client’s own objectives and risk profile. They
will typically be constructed of a mix of direct holdings and investment funds and are managed centrally
in line with the portfolio’s investment objective. They are designed to appeal to a wider audience, but
will usually come without the range of services found in bespoke investment management.

Bespoke portfolio management is the traditional service offered by private banks, wealth managers,
stockbrokers and private client investment managers. This involves constructing and managing a
portfolio around the specific needs of a client and can be managed on a discretionary or advisory

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basis. Bespoke portfolio management will utilise a range of asset types from traditional asset classes to
alternatives. The minimum portfolio size for a bespoke service is quite high and is often banded so that
the wealthiest investors receive the highest service levels.

Some of the characteristics of bespoke investment management are:

• The investment mandate is agreed with the client with scope for increasing levels of customisation
for higher amounts.
• An investment manager will be appointed to manage the portfolio and the client will often have
direct access to the investment manager as well as their relationship manager.
• Both traditional and alternative asset classes will be used and existing assets can be incorporated
into the portfolio and large holdings managed separately.
• Charges will usually be by negotiation and dependent on the level of service provided.
• Reporting will be sophisticated with detailed performance reporting and analysis.

5.4 Recommendations
Advisers need to be able to apply a range of criteria when matching investment solutions to client
needs. They must recognise that each client has their own views, goals and attitudes. Attitudes to risk
vary widely according to their different objectives of the investor. Accordingly, investment choices vary
widely too.

Although a comprehensive and detailed formula cannot be delivered for every client, there are a series
of steps that an adviser takes, based on the objectives in terms of risk and return, that have been agreed
with the client, after taking into account their liquidity, constraints and other needs.

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Financial theory has established a linear relationship between risk and return. More simply, as risk taken
in investment increases, return has to increase to compensate investors for the additional risk taken. The
risk premium required is with the level of risk taken.

Traditionally, in a risk/return space generated by Markowitz, we can visualise the risk axis being split
into zones and defined by three major asset classes that are staple products in a conventional mutual
fund constructed by a traditional money manager. These zones are defined by money market-like
instruments, bond-like instruments and equity-like instruments; and risk increases from money market
-like instruments through to equity-like instruments. Alternative funds are contemporary investments
that have increased the risk space further and also bring with them diversification opportunities for
traditional funds.

The final stage of the process is, therefore, to produce recommendations and a financial plan for

7
presentation to the client. The plan should detail the following:

• Document the client’s existing position.

• Identify the areas that require addressing and what the priorities are.
• Detail the recommendations made and the reasons why they are suitable.
• Document the areas where action has been deferred until a later date.

Assuming the recommended solution is to offer ongoing investment services, then an investment
policy statement should be prepared and a suitable benchmark selected to monitor the performance of
the investment portfolio.

5.4.1 Investment Policy Statement (IPS) *

An investment policy statement can be thought of as a summary of a client’s investment objectives
that captures their required returns, risk profile and any constraints that the investment manager will
operate under. It sets these out along with the investment strategy that will be used to achieve the
client’s goals.

An investment policy statement should be unique to the client, but the following table shows some of
the essential factors that should be detailed.

Investment Policy Statement

• The investment objectives should be set out using a standard

wording that has been explained and agreed with the client such
as capital growth, wealth preservation or income.
• This should spell out the goals of the client that are relevant to
Investment Objectives
managing their investments such as to generate a steady level of
growth until retirement.
• It should also detail any specific returns that need to be met such
as a certain level of after tax income.
• The client’s agreed risk profile should be set out.
• It should also expand on their attitudes to risk and their capacity
Risk Profile
for risk taking.
• Views on volatility and drawdown.

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 Investment Policy Statement

• Any requirements for maintaining a certain level of liquidity.

• Any need to invest surplus funds or generate funds to top up the
Liquidity Requirements client’s emergency cash reserve.
• Details of known future liabilities that have to be met from the
portfolio.
• Factors that will affect the time horizon over which the client is
Time Horizon
investing such as date of retirement.
• Tax position of the client and its impact on investment selection.
• Use of any tax wrappers or accounts.
Tax Position
• Any considerations that should be applied to establishing
taxable capital gains.
• The investment solution to be adopted to meet the client’s
Investment Strategy objectives such as investment funds or discretionary investment
management.
• The IPS should set out all permissible asset classes in which the
portfolio may be invested.
• A target asset allocation can be set out with the proviso that this
Asset Allocation
may change depending on market factors.
60 % equity • Any constraints on the investment manager’s ability to adjust
30 % bond asset allocations.
Co % gold • Any ethical or other constraints that should be followed in
construction and management of the investments.
Constraints
• Any restrictions on the inclusion of particular stocks within a
portfolio or restrictions on the sale of any holdings.
• The benchmark against which the portfolio performance will be
Benchmark
judged.
• Any other factors that might influence investment selection and
Any Other Factors
management including items such as inheritances.

5.4.2 Choice of Benchmark

Once the portfolio has been constructed, the portfolio manager and client need to agree on a realistic
benchmark against which the performance of the portfolio can be judged. The choice of benchmark
will depend on the precise asset split adopted and should be compatible with the risk and expected
return profile of the portfolio. If an index is used, this should represent a feasible investment alternative
to the portfolio constructed. (See chapter 6 for more on how benchmarking can be used to measure
performance.)

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5.5 Presenting Recommendations

Providing a written report to clients is an important part of the process of giving financial advice.

A written report provides a way of putting across recommendations that have already been made orally
in meetings with clients. The written format makes some aspects of observations and recommendations
easier for the client to understand.

Furthermore, providing a written report is clearly an important way of providing a record of what is
being recommended, and on what key information it is based. A report in writing should avoid the
potential for misunderstandings about the advice that has been given, thus acting as a safeguard for the
adviser in justifying their work, as well as a document of record for the client.

7
The parts of a financial planning report to a client are normally as follows:

• A statement of the client’s objectives.

• A summary of the client’s income and assets and other relevant circumstances or problems.
• Recommendations, including any proposals for immediate action, as well as longer-term suggestions
for the client to consider in the future. These should be backed up by the reasoning behind them –
why they are felt to be suitable – and any risks or inflexibilities inherent in the proposed solutions.
These recommendations should include timescales for implementation.
• Appendices, including any data that is best presented separately, if appropriate.

Product quotations, illustrations and brochures should be presented in an orderly way, possibly with an
index listing the various items being sent to the client. The language in the report should be as concise
and clear as possible. The language used should not include jargon, except when necessary to explain
points being made.

Following the preparation of a written report, it is often sensible to have a face-to-face meeting with the
client, to give them an opportunity to clear up any misunderstandings that may have arisen with regard
to their objectives, and to allow them to ask questions where needed.

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6. Review
Learning Objective

7.5.5 Know the importance of regularly reviewing the client’s financial position and the factors that
may require changes: changes in client circumstances; changes in the financial environment;
new products and services available; administrative changes or difficulties; investment-related
changes (eg, credit rating, corporate actions); portfolio rebalancing; benchmark review

As we have seen, financial planning is a cyclical process, and it is the regular reviews of the financial plan
that enable this cyclical process.

Ultimately, the objective of each review is to tell the client whether they remain on track to meet
their objectives, and, if not, what additional actions may be required. The regular reviews may be an
opportunity to consider whether a client’s investment portfolio may need to be rebalanced towards a
target asset allocation. Regulations require that where an investment firm has an ongoing relationship
with the client, it should establish appropriate procedures in order to maintain adequate and updated
information about the client.

A financial plan should, generally, be reviewed at least every 12 months, but ad hoc reviews may also
be required if, for example, the client experiences a significant change of personal circumstances. The
review should look at a range of factors including:

• Reviewing the previous advice in light of any changes to the client’s circumstances and revising
recommendations where necessary.
• Changes to goals and objectives and the amounts targeted.

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• Reviewing and amending the assumptions used, where relevant, to take account of changing market
conditions, investment returns and future inflation rates.
• Net worth, income and expenditure.
• Asset allocation and client risk profiles (including rebalancing portfolios).
• Suitability of products and product wrappers held and revisiting the risk appetite and capacity for
loss of the client.
• Obtaining any documentation that may be required in the review meeting.
• Checking existing terms of business documentation and preparing updated documents, where
necessary.

In some cases, significant changes to one or more of the above may require that a new financial plan is
drafted; in others, the existing plan may be amended and updated. But in either case, it is important that
the client continues to fully understand how the financial plan works and how it will help them to meet

7
their objectives.

For financial planning to be effective, it must continually adapt to the circumstances, priorities and
aspirations of the client, which are guaranteed to change due to key life events, career changes,
increasing age, a growing or diminishing family, changes in health and desires or needs. At each step or
point in their life, the client is faced with numerous choices plus some options they may not be aware of.
Providing financial advice to a client continues throughout a working life and does not stop even at the
point of retirement.

direct
: income tax [Jocus]
~
7. Taxation -
> indirect : VAT

Learning Objective

7.3.1 Know the application of the main business taxes: business tax; transaction tax (eg, stamp duty
reserve tax); tax on sales
7.3.2 Know 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
7.3.3 Know the principles of withholding tax: types of income subject to withholding tax (WHT); relief
through double taxation agreements; deducted at source
7.3.4 Know the principles of double taxation relief (DTR)
7.3.5 Know the implications of domicile, residency status and location of assets

The types of tax that an investor will face will vary widely from country to country, with some countries
imposing a wide range of taxes on an individual’s income and gains, while others may not impose any
at all. 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.

335
 VAT
7.1 Business and Sales Taxes >
-

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.

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 business or 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, or
• the company starts or stops trading.

The rates of business or 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 tax assessment to the company, showing the amount of
tax due.

Sales taxes such as value added tax (VAT) and goods and services 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.

dutie
s
stamp
7.2 Financial Transaction Taxes >
-

Financial transaction taxes are imposed by governments on any sale, purchase, transfer or registration of
a financial instrument such as shares.

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.
For example, the UK charges a tax known as stamp duty at a rate of 0.50% on share purchases.

The trend in share transaction taxes over the past several decades has been downward, eg, 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; and Japan eliminated its share transaction tax in 1999. Financial transaction
taxes have, however, became of particular interest to governments following the global financial crisis
when the G20 requested the International Monetary Fund (IMF) to find ways of ensuring the financial
services sector makes a ‘fair and substantial contribution’ towards the costs of the financial crisis.

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7.3 Personal Taxes

In this section, we will consider some of the general principles underlying income tax, capital gains
tax (CGT) and estate taxes and how these affect a client and impact on the construction of investment
recommendations.
income
dividends.
Salary, business
,

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. 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.

7
Income can usually be grouped into different sources:

• Income arising from earnings or pensions.

• Interest income arising from bank deposits, money market accounts and bond interest.
• Dividend income.
• Income from property and other assets.

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 the following are a few core
concepts that an adviser should be aware of.

• Probably, the main concept is the residence of the individual, which

Residency will determine whether they are liable to tax and, if so, on what
sources of income.
• Advisers should also be aware of any tax deducted from overseas
Overseas Taxes
dividends; this is covered in section 7.4 below.
• Another is the concept of gross and net. 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
Gross and Net
one, so that any tax liability can be calculated. For example, if bond
↓ ↓ interest is paid net of tax at 20%, then the net amount represents
before after 80% of the gross and to find out the gross amount simply divide by
tax 80 and multiply by 100.
tax

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 • In addition, an adviser 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
Accrued Interest 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 (ZCBs). These carry
no interest and instead are issued or bought at a discount to their
eventual maturity value.
Zero Coupon Bonds
• 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.

Capital Gains Tax (CGT)

CGT is charged when an individual disposes of an asset and 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 adviser 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 CGT 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 CGT, 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.

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 Investment Advice

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.

Estate Taxes >

-

Property tax
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 onto their family. Reducing this liability can be a major
financial planning need for wealthier and older clients.

Advisers should be aware of the various inheritance tax (IHT) thresholds allowed in the countries

7
where their clients are based. In most countries there are exemptions and allowances that can be taken
advantage of to mitigate the eventual IHT 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.

Clients should consider 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.

7.4 Overseas Taxes

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’ (WHT) 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 WHT 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 (or
Double Tax Agreements or DTAs) to agree how any payments will be handled. In very simple terms, the
way that a DTA 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:

• ‘Relief at source’
• Under this method, it is possible for a reduced rate of WHT 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.

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• Repayment claim
• 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 DTA, 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 subcustodians to make the claim.

7.5 Residency and Domicile

Residence and domicile are concepts that are central to systems of taxation as they determine who is
liable to tax and importantly, what assets or income may be liable.

Domicile
Domicile is the country that a person treats as their permanent home, or lives in and has a substantial
connection with. Every person must have a domicile, and it is not possible at any time to have more than
one domicile. There are three types of domicile:

• Domicile of origin is the domicile that every person acquires at birth.

• Domicile of choice is acquired by a person residing in a country with the intention of continuing to
do so permanently or indefinitely.
• Domicile of dependency arises in respect of children, married women in certain countries and
mentally disordered persons.

The concept of domicile is of considerable importance in several areas of law. It is the link between a
person and the legal system or rules that will apply for matrimonial, legitimacy, succession and taxation
issues.

Residency
Each country has its own rules which determine an individual’s liability to tax either on income, gains or
on assets liable to IHT or a wealth tax. Residency and domicile play a major role in determining whether
an individual, a source of income or a transaction are subject to tax whilst some countries, such as the
US, adopt a citizenship test to determine liability to tax.

Most countries’ tax systems can be loosely categorised as either a worldwide or territorial-based system
of taxation.

• Under a worldwide system of taxation, residents of that country are taxed on their worldwide
income and capital gains irrespective of where the income or gains arise. For example, the US has a
worldwide-based system of taxation as has the UK, Australia, Germany, Italy and Japan.
• Under a territorial system of taxation, residents are taxed only on income and capital gains arising in
that country, and income or gains arising outside of that country are not liable to tax. Countries that
have territorial tax systems include France and Hong Kong.

Some countries that adopt the territorial system, however, extend the tax base of residents to include
overseas income and gains, but only if such income or gain is remitted to the country of residence.

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 Investment Advice

Whilst there are variations on the above three systems, most countries tax systems fall into one of these
types.

It is usual for taxes to be levied on the residents of a particular country; however, definitions of residency
vary from country to country. For individuals, physical residency is the most important factor, but
other factors such as, property ownership or the availability of accommodation can also be taken into
account. Many countries assess physical residency by the number of days that an individual spends in
the country and the regularity of their visits.

Location of Assets
The liability to some form of estate taxes usually depends upon the domicile of the individual and
the location of the assets they own. It is important that wealth managers who are dealing with clients

7
from another country have an understanding as to how these taxes operate as this may impact the
arrangements they put in place for their client and as an inappropriate arrangement can lead to an
unintended tax liability.

Domicile is a deciding factor in the liability to estate taxes. There are also complex rules that can result
in someone having a deemed domicile in a country and, therefore, becoming liable to pay estate taxes.

Countries will have a set of rules to determine the location of where property is situated. For some
clients who have limited assets overseas, this may not be an issue as the value may be below a minimum
threshold at which estate taxes are payable. For others, however, an unexpected liability may arise. It is
important, therefore, to recognise the need for caution when dealing with overseas assets.

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End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.

1. What is the purpose of client categorisation rules?

Answer reference: Section 1.1

2. What are the six steps involved in the financial planning process as defined by the Financial
Planning Standards Board (FPSB)?
Answer reference: Section 2.1

3. How might a client’s health status affect their attitude to investment risk?
Answer reference: Section 2.5

4. What three components need to be established in order to determine a client’s risk profile and
in what order should they be established?
Answer reference: Section 3

5. How does risk tolerance differ from risk perception?

Answer reference: Section 3

6. Why are liquidity and time horizons important considerations when advising clients?
Answer reference: Section 4.3

7. What is the main principle underlying Islamic finance?

Answer reference: Section 4.5

8. Explain the purpose of an investment policy statement.

Answer reference: Section 5.4.1

9. Why do regular reviews form an important part of the service that advisers offer clients?
Answer reference: Section 6

10. A client has received an overseas dividend with withholding tax (WHT) deducted. How is this
tax dealt with?
Answer reference: Section 7.4

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 Chapter Eight

Lifetime Financial
Provision
1. Retirement Planning 345

2. Protection Planning 359

3. Estate Planning, Trusts and Foundations 379

This syllabus area will provide approximately 13 of the 100 examination questions

343
344
 Lifetime Financial Provision

1. Retirement Planning

1.1 Introduction
It is generally recognised that people are
living longer than ever due to medical
advances and general improvements
in health and that most people’s life
expectancy has increased significantly over
the last few decades. A client’s health may
influence their attitude to risk. A client in
good health, who expects to live well into
old age, may take the view that they need
to be cautious because of the length of
time they expect to spend in retirement
and so may need to spread out their capital
over a number of years.

The bad news, however, is that to enjoy

those extra years means needing a level of

8
income that is enough to fund the lifestyle
that people would like to enjoy. Being able
to enjoy rather than endure retirement
requires individuals to plan and take action
to achieve that objective.

Worldwide, state pension benefits are

equivalent to only about 40% of net average
earnings. Changing demographics and the
increasing cost of state pension provision
will see this source of retirement income
decline and become, at best, modestly
adequate. The increasing cost of providing
state pensions is forcing governments to
reassess how much they pay. Relying on the
state, therefore, to provide a comfortable
retirement is clearly not going to work.
Existing pension plans may also fall short of
providing the funds needed in retirement.

Substantial amounts of capital need to be

built up to provide a worthwhile income
in retirement and, with the current
environment of low interest rates and
relatively low investment returns, that means
that the sooner the individual starts to save
for retirement, the more chance they have of
achieving a satisfactory result.

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1.2 Intended Retirement Age
Learning Objective

8.1.1 Understand the impact of intended retirement age on retirement planning

Once an individual finishes work they will clearly cease to generate income, yet they will still have to
meet their living expenses and other commitments. This presents a major financial planning need.

The age when retirement occurs will vary considerably, from those who plan to retire from work at
normal retirement age – say, 65 – to those who aspire to finish earlier – say, in their 50s – to make the
most of the opportunities it presents. Whichever, they are likely to have to fund at least 20 to 30 years of
living and leisure expenses. This is assuming that the individual enjoys good health and fortune and is
not forced to finish work earlier through either ill health or job loss.

This emphasises the need to plan for retirement and to start saving as early as possible. In an earlier
chapter, we looked at compound interest rates and future value calculations and using those concepts,
we can quantify the impact of delay in saving for retirement. To illustrate the impact of delay, let us
assume that an individual starts to save at age 25 into a pension fund that grows at an average rate
of 5% until retirement at age 65 and saves $1,000 in the first year and increases the amount saved by
10% each year. By retirement, they could expect to have built up a pension fund of close to $900,000,
but delaying starting saving for, say, five years would mean that the fund would be worth only around
$525,000 as the diagram below illustrates.

The difference over such a long period is clearly significant, but what is equally worth highlighting is the
effect that this would have on income in retirement. Assuming that the pension fund could generate an
annual income of 5%, then the larger fund would generate an income of around $45,000 compared to
around $26,000 by delaying the start of saving.

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 Lifetime Financial Provision

Example
We can estimate the future value of a series of regular savings by adapting the future value formula.
Whilst this will not provide as accurate an estimate as using a spreadsheet, it is useful to provide an
indication of how a pension fund might grow in size.

If investing at the start of each year, then the following formula may be used:

$ % ," 1# r
' 1 # r n &1*
, $ %
Fv ! Payment " )
) r
)( ,+
So, for example, let’s say that a client wants you to estimate what the value of their pension savings
would be if they invest $10,000 at the beginning of each year for 20 years and earns an average rate
of 5% compounded annually. The accumulated value of the fund at the of the 20 year period will be:

Fv = $10,000 x [(1.0520 - 1)/0.05)] = $10,000 x 33.06595 x 1.05 = $347,192

We can check this calculation in the following table:

Year Balance at start Rate Amount earned Balance at end

1 10000.00 5% 500.00 10500.00
2 20500.00 5% 1025.00 21525.00

8
3 31525.00 5% 1576.25 33101.25
4 43101.25 5% 2155.06 45256.31
5 55256.31 5% 2762.82 58019.13
6 68019.13 5% 3400.96 71420.09
7 81420.08 5% 4071.00 85491.08
8 95491.09 5% 4774.55 100265.64
9 110265.64 5% 5513.28 115778.92
10 125778.93 5% 6288.95 132067.88
11 142067.87 5% 7103.39 149171.26
12 159171.27 5% 7958.56 167129.83
13 177129.83 5% 8856.49 185986.32
14 195986.32 5% 9799.32 205785.64
15 215785.64 5% 10789.28 226574.92
16 236574.92 5% 11828.75 248403.67
17 258403.66 5% 12920.18 271323.84
18 281323.85 5% 14066.19 295390.04
19 305390.04 5% 15269.50 320659.54
20 330659.54 5% 16532.98 347192.52

If investing at the end of each year, then the following formula may be used:

$ % ,
' 1 # r n &1*
Fv ! Payment " )
) r ,
)( ,+

347
 So, for example, the accumulated value of the pension fund if the investments were made at the end
of the year would be:

Fv = $10,000 x [(1.0520 - 1)/0.05)] = $10,000 x 33.06595 = $330,659.

Note that the difference between this and the earlier example (of $16,533) is solely accounted for by
one earlier payment being invested over the entire twenty-year period, ie, $10,000 x (1.0520 – 1) =
$16,532.98.

This approach can also be used to illustrate to clients the impact of different intended retirement ages.
If we stay with the earlier example where the client starts to invest at age 25, imagine the client wants
to retire early and asks what the impact would be. The table below shows the estimated size of the
pension fund and retirement income it could generate. Seeing it presented in this way then opens up
the conversation about whether the client’s goals are achievable. The client can then consider whether
the estimated pension income is sufficient, whether they need to delay their intended retirement or
increase their pension savings to achieve their goal.

Intended Retirement Age Estimated Pension Fund Estimated Pension Income

50 $175,000 $8,750
55 $300,000 $15,000
60 $525,000 $26,000
65 $900,000 $45,000

An individual may be fortunate enough to have good pension arrangements through their employer
which can supplement savings made during their working life, or they may make their own arrangements
in any of a variety of ways, from saving, investment in property or business assets.

Retirement planning, therefore, needs to be based upon a broad approach and one that is flexible
enough to accommodate a wide range of strategies.

In an ideal world, one would know exactly how much one needed to save in order to live comfortably in
retirement, due to knowing exactly how long you will live for, and the expenses. However, life is not that
predictable – especially as we may live for a longer period in retirement than we have expected.

348
 Lifetime Financial Provision

1.3 Retirement Planning Products

Learning Objective

8.1.2 Know the types of retirement planning products, associated risks, suitability criteria and
methods of identifying and reviewing

Pension schemes tend to receive favourable tax treatment from governments, aimed at encouraging
individuals to make their own retirement provision and thus relieve the state of the need to fund it
beyond the basic state pension. The tax benefits tend to be twofold: tax relief on contributions made
into the scheme, and either exemption or additional allowances against tax on gains and dividend
income.

For this reason, pension arrangements will often provide one of the best investment vehicles for
meeting clients’ needs to invest for retirement.

The adviser will clearly need to determine the details of any scheme that a client is already part of
or has the option to join. In doing so, they will also need to establish the availability of benefits from
the arrangements. They will need to establish at what age the client can retire and take benefits and
whether these will be in the form of a tax-free lump sum, with the remainder as an ongoing income or
some other arrangement. For the ongoing income, it should also be established whether there will be a

8
continuing pension for the surviving spouse following the death of the investor.

The adviser should also identify the extent of any death benefits which may be provided in the event of
death before retirement. It is usual to provide for a lump sum to be paid by either a return of part of the
fund or by life assurance.

349
We will now consider briefly the major types of pension products.

1.3.1 Occupational Pension Schemes

Occupational pension schemes are, as the name implies, pension schemes provided by an employer,
usually as part of their employees’ remuneration and benefits package.

The main features of such schemes are:

• It is the employer that sets up the scheme.

• The employer contributes to the overall cost, providing a significant extra benefit to the employee.
• The scheme usually benefits from very attractive tax treatment.
• The scheme can provide a very efficient vehicle for meeting the retirement needs of an individual.

The amount of employee contribution will be for the employer to decide, as will any eligibility
conditions for joining, such as who the scheme is open to, and any minimum age and service conditions.
Occupational schemes usually require the employees to contribute a proportion of their earnings; these
are known as contributory pension schemes; in some cases, however, the employer funds the whole
cost and these are known as non-contributory schemes.

The benefits payable under a company pension scheme will depend upon whether it is a defined
benefit (DB) scheme or a defined contribution (DC) scheme. Establishing which type of scheme a client
is a member of is essential.

Defined Benefit (DB) Schemes

An occupational pension scheme that takes the form of a DB scheme, also known as a
final salary scheme, is where the pension received is related to the number of years of service and the
individual’s final salary.

A DB scheme essentially promises a given level of income at retirement, usually expressed as a

proportion of final earnings. Contributions to the fund will normally be made by both the employer and
the employee, although who contributes what will vary from scheme to scheme.

For the employee, this has the advantage of allowing retirement plans to be made in the knowledge
of what income will be received. Its potential disadvantages are that, in the final years of working, the
employee may not be earning as much as when they were at their peak earning power. In assessing
such a scheme, consideration also needs to be given to the funding position of the scheme and whether
it can afford to pay out the promised benefits.

In a DB scheme, the client can have some reasonable certainty about the amount of income that will
be received in retirement and so the main concerns for discussion with an adviser will be whether this
is sufficient, how any annual increases are calculated, and the long-term security of the pension fund.

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 Lifetime Financial Provision

Defined Contribution (DC) Schemes

Alternatively, the occupational scheme could take the form of a defined contribution scheme, where the
pension provided is related to the contributions made and investment performance achieved. A well-
known example of such is the 401K schemes found in the US which is a qualified retirement plan that
allows eligible employees to save and invest for their retirement in a tax-advantaged account.

In a DC scheme, the approach is different. Contributions will be made to the scheme by both the
employer and usually also the employee and these are invested to build up a fund that can be used
to purchase benefits at retirement. These funds will usually be held in a designated account for the
employee, and this gives certainty that the funds will be available at retirement.

In a DC scheme, the eventual size of the pension fund will depend upon its investment performance. At
retirement, the client will be looking to use this fund to generate the pension, possibly by purchasing an
annuity. The amount of pension that the client will be able to generate will therefore depend upon the
size of the fund at that time and the prevailing rates of interest at the time of retirement.

The disadvantage of a DC scheme, therefore, is that the actual income the employee will receive in
retirement will not be known in advance of retirement, and this therefore makes effective planning
significantly more difficult. In this pension, most risks are borne by the employee as no set pension
amount is defined. Hence a final pension is down to how much money has been invested and how well
the invested-in funds have done.

8
Identifying and Reviewing Types of Scheme
Identifying which type of pension scheme a client is a member of may be straightforward as it is
readily known to the client or in the market, but it may often require an examination of the scheme’s
documentation especially if it uses a title to describe the type of scheme that is not clear. In general
terms, the difference between the two depends on who funds the pension scheme and the basis on
which the resulting retirement pension is paid. In simple terms, the difference is:

• DB schemes may be employer funded or contributions may be made by both employer and
employee. They offer a promise of an income from the employer based on the number of years
worked and the person’s salary that will be payable usually until death, but are reliant on the
sponsoring employer standing behind that promise.
• DC schemes may be funded just by the employee or contributions may be made by the employer.
The contributions are invested and the size of the eventual fund depends on investment
performance. Retirement income depends on the size of the investment fund at retirement and how
much income can be generated from that fund.

The main difference between the two can be summarised as a DB scheme promises a specific income
and a DC scheme depends on factors such as the amount the individual pays into the pension and the
fund’s investment performance.

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1.3.3 Suitability
Although the general principle is that DB schemes should be preferred to DC ones, there is no way of
knowing whether a client would be better or worse off under a DB or DC scheme without determining
the clients requirements, risk profile and an analysis of the pension scheme.

Some factors to consider are:

• For DB schemes:
• Amount of retirement income that will be generated and any other benefits such as any pension
payable at death to a surviving spouse or partner.
• Security of income such schemes provide in retirement and how pension increases are
calculated.
• Investment risk in terms of funding the retirement pension sits with the employer, so the
financial position of the employer should be investigated to determine its ability to meet these
requirements.
• The funding of the scheme should be investigated to determine its viability in terms of the
certainty of ongoing payment of the pension income.

• For DC schemes:
• The options available to use the accumulated pension fund to provide an income in retirement
such as an annuity or an option to access the capital of the fund.
• As above, the amount of retirement income, how pension increases are calculated and other
benefits payable.
• The size of the fund at retirement depends on investment performance during the life of the
pension fund and very particularly at the time when retirement takes place which could be
when markets are high or when markets have crashed. Options to de-risk the portfolio as the
intended retirement age approaches should be established and whether lifestyling is automatic
or has to be initiated (lifestyling is an approach to automatically switch to lower risk assets as the
intended retirement age approaches.
• The retirement income that can be generated at retirement depends on the size of the
investment fund and so the prospects for annuity rates should be considered (or other options
that are possibly available).

• General:
• A client’s expected life expectancy and health may affect the choice of options. For example, a
client in poor health with limited life expectancy may wish to access the capital of the pension
fund rather than having to take out an annuity.
• A client’s wealth and general financial position may also affect the investment strategy and
suitable funds as the de-risking approach may need to be revised.

1.3.2 Personal Pensions

A company scheme is not available to everyone and, in this case, personal pensions are available for an
individual to provide a vehicle for providing retirement benefits; these are a form of DC scheme. These
will usually also benefit from the same generous tax treatment, making them an effective alternative. A
personal scheme has the benefit that the individual can choose the provider and the funds that they are
invested in, but is clearly at a disadvantage as there are no employer contributions.

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 Lifetime Financial Provision

Many employers actually organise group personal pension schemes for their employees, by arranging
the administration of these schemes with an insurance company or an asset management firm. Such
employers may also contribute to the personal pension schemes of their employees, but the employee
usually chooses their own investments from the list available with that provider, though each company
will also select a default option for employees not wishing to choose a custom allocation.

1.4 Quantifying Needs in Retirement

Learning Objective

8.1.3 Be able to calculate the financial needs for retirement

As with every other aspect of financial planning, preparation for retirement requires following a
structured process.

The key stages of the process are:

• establishing the client’s current financial position

• establishing the client’s aspirations for retirement
• determining what capital will need to be available at retirement to fund their plans

8
• determining how much income will be needed in retirement to fund their intended lifestyle
• assessing the client’s existing retirement plans along with their assets, liabilities and protection products
• developing an investment and protection strategy to meet their needs
• identifying appropriate solutions, and
• implementing that strategy and keeping it under regular review.

1.4.1 Current Financial Position

As with other types of financial planning, as part of the initial meeting with the client, the adviser will
need to collect all of the basic factual information regarding the client.

The principle of the fact-find was examined in chapter 5, section 3, but it is worth noting that the core
information relevant to retirement that will be needed includes:

• Personal information – this will include age, marital status and employment information.
• Dependants – details of children and any other dependants whose needs will require to be taken care of.
• Health – information about the client’s health, their job and whether they engage in any potentially
dangerous or hazardous activities.
• Assets – the extent of their assets and savings and any expected inheritances.
• Liabilities – what debts have to be serviced and how they would continue to be met or repaid in the
event of illness or death.
• Income and expenditure – details of the client’s income and expenditure so that their potential
income needs in retirement can be established.
• Protection – details of any protection policies in place that are relevant to the retirement planning
process.
• Any large expected costs – such as weddings and university fees.

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While the basic information needed is the same as for other types of financial planning, where the process
for collecting the information differs is that the emphasis is on analysing where the client is now and
where they expect to be at retirement. Additional information that will be needed will, therefore, include:

• anticipated retirement date

• expected lump sum payments from any existing pension arrangements
• estimates of the income the client can expect from any existing pension arrangements
• the amount of any state pension that might be payable, and
• what level of cash reserves the client will need for emergencies and the unexpected.

In order to develop a strategy from the information collected, the adviser will need to understand in
detail the client’s expectations and will need to consider, amongst other things, the following:

• an estimate of any lump sum that may be needed at retirement to repay items such as mortgages or
to fund things such as special holidays, and
• an estimate of the income they will need in retirement, taking into account inflation.

The next stage is, therefore, to quantify what the client’s aspirations and needs are.

1.4.2 Aspirations and Needs

People’s expectations of retirement have changed markedly over the last few decades, and the
adviser will need to understand the changing factors that may affect a client’s circumstances and their
retirement aspirations.

After establishing the client’s intended retirement age, the next stage is to make an estimate of both
the lump sum and income requirements that will be needed. This needs to take account of long-term
needs, as well as any immediate requirements, and to factor in the possible need for medical treatment
and long-term care.

One way of investigating with the client what income they will need in retirement is for the client to
complete an expenditure plan such as the following:

Outgoings Pre-Retirement Post-Retirement Difference

Rent or mortgage
payments
Other loan repayments
Credit card repayments
Local taxes
Food
Clothing
Power and water
Schooling costs

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Outgoings Pre-Retirement Post-Retirement Difference

Telephone and internet
connections
Car costs including fuel,
servicing and insurance
Socialising
Holidays and breaks
Other
Total

The client should use this to record their current expenditure and then make an estimate of what they
expect it to be post-retirement. Retirement will generally bring about a lowering of many items of
expenditure, such as reduced travel costs as there is no need to travel to work, but an increase in others
such as holidays and breaks. This assessment will give an indication of how much net annual income will
be needed in retirement to finance the client’s lifestyle aspirations.

Establishing future expenditure, however, can be difficult. If the client is not in a position to make a
realistic assessment, then, as a rule of thumb, it is generally reckoned that a person will need about

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three-quarters of their net income to maintain a similar lifestyle in retirement.

The next steps are to determine how much the client needs to fund themselves and how much they
can expect to be funded from any existing pension arrangements that they have, plus any state pension
payments they might receive.

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 Example
Let us assume that a client requires $50,000 of income annually to live off, before tax, and that they
can realistically expect to receive a pension of $30,000 from his own pension plan and $5,000 from a
state pension. They will, therefore, need to fund the difference of $15,000.

If we assume that current rates would allow the client realistically to earn 6% pa, then how much of
a lump sum will be needed? A simple calculation – dividing $15,000 by six and multiplying by 100 –
shows us that they will need a lump sum of around $250,000.

This assessment is, however, made in today’s money and the adviser will, therefore, need to make an
estimate of what this may need to be in the future to make an allowance for inflation.

To calculate this, we need to know the client’s intended retirement age and use an estimate of what
inflation might be over that period. Predicting what inflation might average over a period of time is
fraught with problems, but the adviser should look at the trend rate of inflation in their country and
then select a figure that will provide a conservative estimate for the client.

Let us assume, therefore, that the client intends to retire in 25 years and estimate that inflation might
average 4% per annum over that period. To calculate the lump sum that the client might require in 25
years’ time involves multiplying the lump sum needed ($250,000) by the annual rate of inflation, 25
times. To do that, do the following:

• Convert the rate of inflation to a decimal and add 1 to get 1.04.

• Multiply 1.04 to the power of 25.
• That gives us 2.66658 – let’s say, 2.67.
• Multiply the lump sum of $250,000 by 2.67.
• This gives an inflation-adjusted lump sum needed of $667,500.

(Using a scientific calculator you can enter the following and get the same result more quickly:
250,000 x 1.04^25 = 666,459.08. The symbol ^ indicates that 1.04 should be raised to the power of 25
which may be shown as the xy function on a calculator.)

This clearly is a much larger sum, but its relevance is to understand what size of fund the client really
needs to establish. After all, if the client’s savings grow to $667,500 and they can earn the expected
6% then the fund will generate $40,050. This is exactly the same as the annual income needed of
$15,000 allowing for inflation, in other words $15,000 times 2.67 equals $40,050.

This example assumes that the client will use the lump sum only to generate the required income and
not use part of their capital to supplement income. What this exercise does gives us though is a target
figure that needs to be generated by the investments the client will make.

Having established this, the adviser should add on any other lump sums that will need to be generated
to meet the client’s plans and aspirations. They will then take into account any expected lump sums that
the client may reasonably expect to receive, for example, from any protection policies they may have,
from any pension plan or from inheritances.

This will leave a net amount of capital that needs to be generated. Again, this will need to be adjusted
for inflation, and the same calculation as above can be used to determine this figure.

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1.4.3 Other Sources of Capital and Income in Retirement

Pension arrangements may represent a major part of the client’s assets that will be used in retirement,
but they are not the only solution, and a wide range of other assets will need to be taken into
consideration. The rest of the client’s assets will also contribute towards the funds that are needed to
finance retirement. This will include:

• Their home which, although still required in retirement, offers the opportunity for them to sell and
purchase something less expensive and thus free up capital for investment or use an equity release
scheme if available to unlock some capital.
• They may own property which is rented out and which can either provide a lump sum for investment
or a continuing income source.
• They may have their own business and there may be the opportunity to sell this as a going concern,
to realise assets, or for the business to be continued by others and for them still to receive income
through a reduced involvement, consultancy arrangement or dividends.
• There will also be the whole range of other assets that the client builds up during their life, including
cash deposits, collective investment funds and other investment products.

In almost all cases, a mix of asset types is likely to be necessary to meet the client’s retirement planning
objectives, along with appropriate protection products.

8
1.4.4 Assessing Existing Pension Plans
Having established when the client wishes to retire, what income and capital sum they will need to
achieve that, and what assets they already have in place, we can move on to assessing whether their
existing retirement plans are suitable for their objectives.

The adviser will need to determine what type of pension plan the client has and what retirement benefits
it will generate. It will, therefore, be necessary to identify:

• the age at which benefits can be taken

• the expected amount of income that will be payable if it is a defined benefit scheme and how future
increases to the pension are calculated
• if it is a defined contribution scheme, the value of the pension fund and which funds it is invested in
• any penalties, such as actuarial reductions, that may be made for taking retirement benefits early,
and
• the lump sum that can be taken at retirement.

As well as establishing what type of scheme the client may be a member of, the adviser should also look
at whether additional contributions can be made. The client may be able to make extra contributions
to the pension scheme in order to make additional provision for retirement, and these may also benefit
from generous tax treatment.

If it is not possible to make additional contributions into the pension scheme, the adviser should
investigate whether the company pension scheme may also have arrangements where further
contributions can be made into a separate pensions vehicle. These are sometimes known as additional
voluntary contributions (AVCs) where they are part of the scheme itself; arrangements made with
another product provider may be known as freestanding AVCs and give the individual a greater degree
of choice of both provider and how they are invested.

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1.5 Presenting Recommendations
Learning Objective

8.1.4 Know the elements to be included in a recommendation report to clients

The recommendations made should be presented to the client in a written report so that they have the
time to consider the detail of what is being suggested and so that there is a documented plan that can
be referred back to at a later date, when progress is being reviewed.

The report will need to summarise the details obtained from the client and their current position. It
should then detail the objectives and priorities that have been agreed, and go on to explain how the
recommendations that are being made have been arrived at.

The report will therefore need to set out the results of the analysis that have been undertaken.

Needs and Goals

What the need identified was and any goals.

Existing Arrangements
Anything in place at the moment and how it fits or does not fit in with the clients’ needs and goals.

Restrictions
Any client restrictions or preferences agreed with the clients.

Income
• The level of income needed in retirement, adjusted for inflation.
• The proportion of income to be met from existing pension arrangements.
• Whether additional pension contributions can or should be made.
• Whether the existing pension arrangements are suitable or should be switched to an alternative
provider.
• The amount of additional income that will need to be generated in retirement over and above that
received from state, company and personal pensions.

Capital
• The amount of capital needed at retirement to provide an investment fund to generate the
additional income needed in retirement.
• The amount of capital needed to meet other plans of the client at retirement and to provide a cash
reserve into retirement.
• The value of any existing assets and the extent to which they can be utilised and invested to meet
these needs.
• The extent of any funds that are expected to be received from other sources, such as insurance
policies or inheritances.
• The growth rate that needs to be achieved to generate the lump sum needed.

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Protection
• The extent of any existing protection policies that are in place to address areas such as mortgage
protection, medical insurance and life cover that are relevant to the advice being provided.
• Essential gaps in protection cover that need to be dealt with.

It will then set out the recommendations that are being made, how they relate to priorities and
objectives, and an explanation of the choice of provider.

The report will be accompanied by any supporting product brochures, illustrations and key investor
information documents (KIIDs). It will also note the action needed to implement the requirements.

The purpose of the report is to provide the client with sufficient detail that they can understand
the recommendations that are being made and so make an informed decision. The adviser will,
however, need to meet with the client to discuss the recommendations and make sure, by appropriate
questioning, that the client fully understands what is being proposed.

The Recommendation
What is being recommended and why: that would include, for example, clients’ levels of risk and
conclude with why the advice and recommendation are suitable for clients. Advisers should also make
sure that any fees and charges are listed.

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Also what is important is anything that has been discounted and what was not covered, as this may still
need to be reviewed.

2. Protection Planning
In this section, we will consider some of the key features of a wide range of life and protection products.
Such products are designed to provide financial protection in case certain risks occur, but it needs to be
remembered that life is all about risk, and a judgment needs to be made as to which areas are in need
of protection. Just as it is not possible to eliminate risk entirely, it is not financially feasible for clients to
insure against all events.

As part of the meeting with the client, the adviser will collect all of the factual information needed about
the client. The core information that will be needed to assess the need for protection planning includes:

• Personal information – this will include age, marital status and employment information.
• Dependants – details of children and any other dependants whose needs will require taking care of.
• Health – information about the client’s health, their job and whether they engage in any potentially
dangerous or hazardous activities.
• Assets – the extent of their assets and whether they are sufficient to cover the impact of loss of job,
or illness.
• Liabilities – what debts have to be serviced and how these would continue to be met or repaid in
the event of illness or death.
• Income – details of the client’s income so that their income after tax can be established.
• Expenditure – the regular expenditure of the client so that the extent of their disposable income
and their ability to meet the cost of any protection cover is known.

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This is very similar to the information list in section 1.4.1, but you will see that the focus of the
questioning is slightly different, depending on what type of planning is being considered. The next
stage is to identify which needs should be addressed.

2.1 Main Areas in Need of Protection

Learning Objective

8.2.1 Know the main areas in need of protection: family and personal protection; mortgage; long-
term care; business protection

Life assurance and protection policies are designed and sold by the insurance industry to provide
individuals with some financial protection in case certain events occur.

Although product details may vary from country to country, the general principles of what the adviser
should be looking for in certain products, and their main features should be constant. The big insurance
companies are global operations, so the range of products they offer have common features and are
similar whether offered in North America, Europe or the Asia/Pacific regions.

The table below gives some indication of the range of needs and protection products available.

Areas in need Lifestyle and Home and

Life and family Business
of protection income contents

• Life cover • Income • Household • Key person

• Critical illness protection cover protection
cover • Accident and • Mortgage • Shareholder
• Life or earlier sickness cover income protection
Protection protection
critical illness • Unemployment • Partnership
products
cover cover protection
• Medical cover
• Long-term
care

It is important, therefore, to appreciate what the main areas in need of protection are and why that
is the case. With an understanding of this, the adviser will be able to consider the client’s personal
circumstances and make an assessment of whether taking out protection should be considered.

• Family and personal – the main wage-earner or another family member might suffer a serious
illness. In some cases the illness may be critical. Without protection, the family could lose its main
source of income and may have insufficient funds to live on. Additionally, there may be medical bills
and care costs arising. Similarly, the main wage-earner could lose his or her job. The family will lose
its main source of income and may have insufficient funds to live on.
• Mortgage – job loss or illness suffered by the main wage-earner could result in difficulty in meeting
mortgage payments. Furthermore, the main wage-earner might die before the mortgage is repaid,

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saddling the family with ongoing mortgage repayments. Protection policies could be used to
address these issues.
• Long-term care – if an individual suffers mental and/or physical incapacity, the cost of care could
drain and perhaps exhaust the individual’s savings.
• Business protection – a key person within a business might die or suffer a serious illness. The
business will no longer be able to generate sufficient profits without the key person’s contribution.
Alternatively, a substantial shareholder or partner within the business may die, and their shareholding
or partnership stake may need to be bought out by the remaining shareholders/partners.

2.2 Assessing Protection Priorities

Learning Objective

8.2.2 Know the need for assessing priorities in life and health protection – individual and family
priorities

To assess what type of protection is required involves the adviser exploring with the client what might
happen and what the consequences might be. Although none of us can predict the future, it does not
prevent us considering future events and then assessing whether we are prepared for that possibility.

8
This can be achieved by looking at each of the main areas in need of protection and asking what could
happen and what would be the effect if it did. The exploration of these points will reveal the extent of
the areas in which a client should consider taking action.

Area of need What could happen Potential impact

Your family lose your income and have

You suffer a fatal heart attack
insufficient funds to live on
You are diagnosed with a critical You face major medical bills and care
Life and illness costs
family You or someone in your family You may want immediate access to a
needs surgery private hospital
You are unable to look after The cost of care exhausts all of your
yourself and need full-time care savings
You lose your main source of Your savings are insufficient to maintain
income your lifestyle
Lifestyle
You suffer an accident or sickness Benefits from the state or your employer
and
that prevents you from working are insufficient
income
It takes a long time to find a new job
You lose your job
and you exhaust your savings

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 Area of need What could happen Potential impact

Major expenditure to repair the damage

Your home is flooded
and buy new contents
Home and You are unable to meet your mortgage
You lose your job
contents repayments
You die before your mortgage is Your family are saddled with ongoing
repaid mortgage repayments
The business can no longer generate its
A key person in your business dies
products or sales
Their shareholding needs to be bought
Business A shareholder dies
out
Their share of the partnership needs to
A partner is no longer able to work
be bought out

Having determined that protection needs to be considered, however, the adviser needs to move on to
find out whether doing so is sufficiently important that the client needs to prioritise it appropriately.

2.2.1 The Prioritisation Process

Learning Objective

8.2.3 Understand the requirement for prioritising protection needs

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, and
• establishing a plan which will allow some of the needs to be addressed.

Prioritising such decisions is not an easy process, especially as the client, having recognised the need,
may want to deal with all of them.

The adviser, therefore, has a key role in explaining the process to the client. They need to manage the
natural concerns that this will generate and explain that, although a risk has been identified and needs
to be addressed, the client needs to take into account the likelihood of it occurring.

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The age of the client may also give some indication as to what to prioritise:

• If the client is in their 20s or 30s and is married with children, if anything were to go wrong (eg,
serious illness, redundancy), it would have very serious financial consequences. Life, sickness and
redundancy cover should be considered a high priority.
• If the client is in their 40s, then their life and financial position will have started to change. Life
and mortgage cover may become less important, depending upon whether they have paid off
the mortgage and the children have left home. Sickness cover remains important, however, as
increasing age brings more risk of illness.
• In their 50s, their priorities will change. Life and redundancy cover may not be as important, as the
children will have left home and the mortgage possibly paid off. Sickness cover remains important
and consideration of long-term care starts to appear on the planning horizon.
• When the client is in their 60s or older, the need for redundancy cover is usually no longer applicable.
Life cover is even less relevant and, instead, clients will be thinking about preserving their wealth
and how to reduce any inheritance tax liabilities. Health and sickness cover should be a particular
concern as well as long-term care. Further considerations will apply for inheritance tax planning,
which is considered in section 3.

The adviser also needs to explain the long-term nature of this process, namely that the prioritisation
exercise can only identify the immediate priorities that should and can be addressed. The remainder still
needs to be addressed at some stage when the client’s circumstances allow, ie, they have been deferred
and not abandoned.

8
The process of prioritisation will enable a plan to be established of what needs doing and what will be
considered later. This leads naturally to the realisation that financial planning is an ongoing exercise and
that the client and adviser will need to regularly review progress and reassess the plan in the light of
changes to needs, circumstances and priorities.

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2.3 Quantifying Protection Needs
Learning Objective

8.2.4 Understand how to quantify protection needs

So far, the adviser has collected information about the client, assessed which areas are in need of
protection and agreed an order of priority of what will be addressed.

Before moving on any further, the adviser needs to quantify the type and level of protection needed
for each of those areas. Quantification is simply about comparing the future position of the client with
their current position and then assessing the shortfall. This can begin with producing an income and
expenditure plan that documents the client’s current position.

Outgoings Income

Rent or mortgage payments Salary after tax

Other loan repayments Other income – net

Credit card repayments

Local taxes

Food

Clothing

Gas, electricity and water

Schooling costs
Telephone and internet
connections
Car costs including petrol, servicing
and insurance
Socialising

Holidays and breaks

Other

Total Total

The client can then be asked how this position might change in the event that they were no longer able
to work, and the revised result will show what is at stake.

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This exercise can then be continued on by considering what would happen if something happened to
the client or their partner, seeking an understanding of what the impact would be on the family of the
following:

• If the client or partner were to die.

• If the client or partner became unable to work.

Who would look after the home or the children if the client or partner were unable to?

This may then indicate that it is necessary not just to replace lost income, but also to generate additional
income or a capital sum.

As a result, there are a number of other factors that should be considered, including:

• The adviser should determine whether the client will need capital or income, and whether this is
best met by a lump sum payment or the generation of income, or a combination of both. Generally,
a lump sum will be the best option, as it gives the client the flexibility to use the capital and either
invest it for income or draw on it as necessary.
• The amount of income that can be generated from a capital sum will depend on the level of interest
rates at the time the funds are invested and will vary. This will introduce a level of uncertainty if the
client will need a given level of income. As a result, any assumptions made need to be conservative.
• The effect that inflation will have on the income flow should be established. The importance of this

8
will depend on the length of time the income might be needed for.

These factors will direct the adviser towards the consideration of a type of policy that is appropriate to
the client’s need. This will also involve choosing between different types of policy that may be capable
of addressing the needs of the client. If a regular income is required, for example, this need could be
met by an income protection policy, but also by a term assurance policy that would pay a lump sum that
could be invested.

This process can then be repeated in a similar fashion for all of the other areas that may be in need of
protection.

2.3.1 Existing Protection Arrangements

The next stage in the process is to review in detail the existing protection products that the client has,
to determine if there are any gaps and make sure that all protection needs have been filled. In addition,
review the existing arrangements to make sure that they are suitable, meeting the client’s needs and
checking that the charges are appropriate.

As has been made clear earlier, the amount of information needed from the client is extensive and
obtaining it is essential, otherwise the planning process will be flawed. This also applies to the detail of
the existing arrangements the client has made, and the adviser will need to ensure they have sufficient
information to assess their suitability.

Any life assurance products the client holds may be intended to provide protection or to be used for
investment purposes, and the adviser needs to obtain details of the type of policy, its purpose, the
premium, the term and the potential benefits that may arise on death or maturity.

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They should also find out from the client why they were purchased, as this will provide further useful
information. It may indicate their future requirements or show that it is now superfluous, for example,
where a life assurance policy was taken out to protect a mortgage which has since been repaid.

Once the adviser has all of the information necessary, they will then need to measure the suitability of
these against the client’s current circumstances. There are many factors to consider, and these will be
driven by the type of product or arrangement. Items to consider include:

• their relevance to the prioritised needs of the client

• the extent of the cover provided and whether this is adequate given the client’s current needs
• whether there is an option for the cover to be extended
• whether they are affordable options or whether the client’s circumstances have changed so that
they can afford to increase what is paid
• whether the original timescale is still valid
• the degree of risk associated with the product considered against the client’s risk tolerance
• the extent of any diversification or lack of it
• the level of charges compared to comparable products, and
• any encashment penalties.

This analysis will then provide the basis for continuing the financial planning process. The results of the
analysis will show the following:

• which protection products should be retained

• where the amount of cover should be increased or decreased
• products that should be disposed of as they no longer meet the client’s objectives, and
• protection gaps that need to be filled.

The next steps are to identify suitable life assurance and protection products that can meet the client’s
requirements, and to evaluate their features.

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2.4 Life Assurance

Learning Objective

8.2.5 Know the basic principles of life assurance: types; proposers; lives assured; single and joint life
policies

There are two types of life cover we need to consider, namely life assurance and term assurance.

2.4.1 Basic Principles of Life Assurance

Before we look at types of life assurance, we need to consider some key terms.

The person who proposes to enter into a contract of insurance with a life
Proposer insurance company to insure themselves or another person on whose life they
have insurable interest.
The person on whose life the contract depends is called the ‘life assured’.
Although the person who owns the policy and the life assured are frequently the
Life
same person, this is not necessarily the case. A policy on the life of one person, but
Assured

8
effected and owned by someone else, is called a ‘life of another’ policy. A policy
effected by the life assured is called an ‘own life policy’.
Single A single life policy pays out on your death or if some other insurable event occurs,
Life such as if you are diagnosed with terminal illness and have critical illness cover.
Where cover is required for two people, this can typically be arranged in one of
two ways: through a joint life policy or two single life policies.

A joint life policy can be arranged so that the benefits would be paid out following
the death of either the first, or, if required for a specific reason, the second life
assured. The majority of policies are arranged ultimately to protect financial
dependants, with the sum assured or benefits being paid on the first death.

Joint Life
With two separate single life policies, each person is covered separately. If both
lives assured were to die at the same time, as the result of a car accident for
example, the full benefits would be payable on each of the policies. If one of
the lives assured died, benefits would be paid for that policy, with the surviving
partner having continuing cover on their life. Because the levels of cover are
effectively doubled when compared to one joint life policy, the costs of two single
life ones will generally be a little higher, but are unlikely to be twice as high. Using
two single life policies to provide cover usually, therefore, represents good value
for money.
If you want to buy a life insurance policy on someone else’s life, you must have an
Insurable
interest in that person remaining alive, or expect financial loss from that person’s
Interest
death. This is called an insurable interest.

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A whole-of-life policy provides permanent cover, meaning that the sum assured will be paid whenever
death occurs, as opposed to if death occurs within the term of a term assurance policy.

Technically, the term ‘life assurance’ should be used to refer to a whole-of-life policy that will pay out
on death, while ‘life insurance’ should be used in the context of term policies that pay out only if death
occurs within a particular period. However, these terms are not always used accurately.

2.4.2 Whole-of-Life Assurance

There are three types of whole-of-life policy:

• Non-profit, that is for a guaranteed sum only, where the insured sum is chosen at the outset and is fixed.
-

• With-profits which pay a guaranteed amount plus any profits made during the period between the
- -
-

policy being taken out and death. With-profits policies are typically used to build up a sum of money to
-
buy an annuity or pension on retirement, to pay off the capital of a mortgage, or in the case of whole-
of-life assurance to insure against an event such as death. One advantage of with-profits schemes is
that profits are locked in each year. If an investor bought shares or bonds directly, or within a unit trust
or investment trust, the value of the investments could fall just as they are needed because of general
declines in the stock market. With-profits schemes avoid this risk by ‘smoothing’ the returns.
• Unit-linked policies where the return will be directly related to the investment performance of
the units in the insurance company’s fund. Each month, premiums are used to purchase units in an
investment fund.

The reason for such policies being taken out is not normally just for the insured sum itself. Often they
are bought as part of a protection planning exercise to provide a lump sum in the event of death, which
might be used to pay off the principal in a mortgage or to provide funds to assist with the payment of
inheritance tax (IHT). They can serve two purposes, therefore: both protection and investment.

There is a wide range of variations on the basic life policy that are driven by mortality risk, investment,
expenses and premium options – all of which impact on the structure of the policy itself. Mortality risk
deals with the expected life of the person insured, whether any additional charges might be imposed,
and the level of risk borne by the life company, which can affect the cost of the cover provided.

Purchasing a life assurance policy is the same as entering into any other contract. When a person
completes a proposal form and submits it to an insurance company, that constitutes a part of the formal
process of entering into a contract.

The principle of utmost good faith applies to insurance contracts. This places an obligation on the
person seeking insurance to disclose any material facts that may affect how the insurance company
may judge the risk of the contract they are entering into. Failure to disclose a material fact gives the
insurance company the right to avoid paying out in the event of a claim.

Once the proposal has been accepted and the first premium paid, the insurance company will then issue
a letter of acceptance and the policy document. It will be accompanied by notification of cancellation
rights which allow the policyholder to cancel the policy. The policyholder will then have a stated period
of, say, 14 days during which they can cancel the insurance and receive a refund for any premiums paid.
After this period, they can still cancel, but will not receive a refund for premiums paid.

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The policy may also be assigned to a bank as security for borrowing, in which case the insurance
company will require the agreement of the bank before making any amendments to the policy, such as
an extension or renewal.

2.4.3 Term Assurance

Term assurance is a type of policy that pays out a lump sum in the event of death occurring within a
specified period.

It has a variety of uses, such as ensuring there are funds available to repay a mortgage in case someone
dies or providing a lump sum that can be used to generate income for a surviving partner or to provide
funds to pay the inheritance tax when a person dies.

When taking out life cover, the individual selects the amount that they wish to be paid out if the event
happens and the period that they want the cover to run for. If, during the period when the cover is in
place, they die, then a lump sum will be paid out that equals the amount of life cover selected. With
some policies, if an individual is diagnosed as suffering from a terminal illness which is expected to
cause death within 12 months of the diagnosis, then the lump sum is payable at that point.

When selecting the amount of cover, an individual is able to choose three types of cover, namely level,
increasing or decreasing cover.

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• Level cover, as the name suggests, means that the amount to be paid out if the event happens
-

remains the same throughout the period in which the policy is in force. As a result, the premiums are
-

fixed at the outset and do not change during the period of the policy.
• With increasing cover, the amount of cover and the premium increase on each anniversary of the
taking out of the policy. The amount by which the cover will increase will be determined at the
outset and can be an amount that is the same as the change in the Consumer Price Index (CPI),
so that the cover maintains its real value after allowing for inflation. The premium paid will also
increase, and the rate of increase will be determined at the start of the policy.
• As you would expect, with decreasing cover, the amount that is originally chosen as the sum to be
paid out decreases each year. The amount by which it decreases is agreed at the outset; for example,
if it is intended to be used to repay a mortgage, it will be based on the expected reduction in the
outstanding mortgage that would occur if the client had a repayment mortgage. Although the
amount of cover will diminish year by year, the premiums payable will remain the same throughout
the policy.

The other variable that is selected when the policy is taken out is the period for which the cover will
last. An individual is normally able to select a period up to 40 years, with a limit that the cover must end
before their 70th birthday.

It is very important to note, however, that policies are normally issued with cover that lasts for five years.
At each five-year anniversary, the individual has the option to renew without any further underwriting
and the insurance company can, equally, recalculate the premiums based on the individual’s age and
market conditions at the time. The client, therefore, needs to be aware that the premiums that are
payable can change.

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It is also important to recognise that this type of policy is not guaranteeing to repay a mortgage or loan,
but instead to pay a known sum.

Where it is used to provide protection for payment of an outstanding mortgage in the event of death, it
will only do so if:

• the initial amount of cover was not less than the outstanding loan
• mortgage payments are kept up to date
• the term of the mortgage has not been extended
• the period when the cover is in place is at least the same as the mortgage period
• any further mortgages are separately covered, and
• the mortgage interest rate does not exceed the one that the insurance company originally
quoted for.

The latter point is particularly relevant and requires regular checks to be made to ensure that the mortgage
interest rate does not go above the quoted rate, otherwise the client may have insufficient cover.

It should also be noted that life cover can be written in trust and so can be a valuable way for a client to
ensure that their beneficiaries will receive a lump sum to pay, for example, the IHT that arises on their
death. The policy is written in trust and if it becomes payable, then the lump sum is paid to the trustees
of the policy and may not form part of their estate for IHT or estate taxes.

2.5 Protection Policies

Learning Objective

8.2.6 Know the main product features of: critical illness insurance; accident and sickness protection;
medical insurance; long-term care protection

2.5.1 Critical Illness Insurance

Critical illness cover is designed to pay a lump sum in the event that a person suffers from any one of a
-

wide range of critical illnesses.

Some of the key features of such policies include:

• The critical illnesses that will be covered will be closely defined.

• Some significant illnesses may be excluded.
• Illness resulting from certain activities, such as war or civil unrest, will not be covered.

Looking at how many people suffer from a major illness before they reach 65, its use and value can be
readily seen. Illness may force an individual to give up work and so could cause financial hardship, to
say nothing of how they will pay for specialist medical treatment or afford the additional costs that
permanent disability may bring about.

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Critical illness cover is normally available only up to a certain age, for example, to those aged between
18 and 64 years of age and which must end before an individual’s 70th birthday. It will pay out a lump
sum if an individual is diagnosed with a critical illness and will normally be tax free. The cover will then
cease, and it is important to note that this can be the case even where more than one person is covered
under the policy.

There will be conditions attached to the cover that determine whether any payment will be made. A
standard condition applying to all illnesses covered is that the insured person must survive for 28 days
after the diagnosis of a critical illness to claim the benefit, and the illness must be expected to cause
death within 12 months.

There will be other conditions that have to be satisfied and, as a result, it is important to understand
what illnesses are covered and the circumstances in which a claim can be made. This requires a detailed
examination of the terms of a policy especially as the amount of cover needed will be significant and the
premiums can be expensive.

Critical illness cover can usually be taken out on a level, decreasing or increasing cover basis (see section
2.4.3) and can often be combined with other cover such as life cover so that the individual is then
covered, whatever happens first, the diagnosis of a critical illness or their death.

This type of cover can also be extended to provide for total and permanent disability to give a greater

8
level of protection, as it will normally cover conditions and circumstances that are not included as part
of the standard critical illness cover.

2.5.2 Accident and Sickness Protection

Personal accident policies are generally taken out for annual periods and can provide for income or
lump sum payments in the event of an accident.

Although relatively inexpensive, care needs to be taken to look in detail at the exclusions and limits that
apply. These may include:

• The amount of cover may be the lower of a set amount or a maximum percentage of the individual’s
gross monthly salary.
• The waiting period between when an individual becomes unable to work and when benefits start
may be 30 or 60 days.

The insurance company will assess eligibility at the time of the claim and may refuse a claim as a result
of pre-existing medical conditions even if they have been disclosed.

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2.5.3 Medical Insurance
Private medical insurance is obviously intended to cover the cost of medical and hospital expenses.
It may be taken out by individuals, or provided as part of an individual’s employment.

Some of the key features of such policies include:

• The costs that will be covered are usually closely defined.

• There will be limits on what will be paid out per claim, or even over a period such as a year.
• Standard care that can be dealt with by a person’s local doctor may not be included.
• Again, there will be exclusions, such as for pre-existing conditions.

2.5.4 Long-Term Care Protection ->ted

The purpose of long-term care insurance is to provide the funds that will be needed in later life to meet
the cost of care. Simply considering the cost of nursing home care explains the need for such a policy,
but its value to an individual will depend on the amount of state funding for care costs that will be
available. Premiums will be expensive, reflecting the cost of care, and the benefit will normally be paid
as an income that can be used to cover the expenditure.

2.5.5 Business Insurance Protection

Learning Objective

8.2.7 Know the main product features of business insurance protection: key person; shareholder;
partnership

Business insurance protection can take many forms. Some examples of its use are to:

• provide indemnity cover for claims against the business for faulty work or goods
• protect loans that have been taken out and secured against an individual’s assets
• provide an income if the owner is unable to work and the business ceases
• provide payments in the event of a key member of a business dying to cover any impact on its profits, or
• provide money in the event of death of a major shareholder or partner so that the remaining
shareholders can buy out their share and their estate can distribute the funds to his family.

In the following sections, we consider the key features of three of the main types of business protection
policies encountered.

Key Person Protection

Key person protection involves a company insuring itself against the financial loss that it may suffer
from the death or serious illness of an employee who is essential to its fortunes.

They are the individuals whose skill, knowledge, experience or leadership contribute to the company’s
continued financial success and whose death or serious illness could lead to a financial loss for the
company. They may be the founder of a company, a salesman, or a specialist who is essential to the
success of a company.

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The problems associated with the loss of such an individual may be either loss of profits or a loss of loan
facilities.

If a company were to lose a key individual due to death or serious illness, it could suffer financially for
one of a number of reasons, including:

• financial penalties due to a delay in completion of existing contracts

• banks and existing or new suppliers reviewing their credit lines
• lost sales and loss of competitive edge afforded by innovative or design expertise, or
• people issues including increased pressure on the remaining workforce to meet deadlines, impact
on staff morale and recruitment costs.

Some of the above will affect the company’s profitability in the short term, while others may last into the
medium and longer term.

Life cover and possibly critical illness cover may need to be taken out. This will require an insurable
interest to be established and, for financial underwriting purposes, the business must be able to justify
the amount of cover required and demonstrate how the figure has been arrived at.

The amount of cover needed can be determined in a number of ways: it can be based on a
loss-of-profit calculation, a salary multiple of the key individual, the length of time it may take the
company to recover, or the business loans secured on those individuals.

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Shareholder Protection
With a private company, the death or serious illness of a major shareholder can have a big impact both
on the future of a business itself and on their family.

Shareholder protection cover can protect both the company and the family by making sure that the
capital is available to buy out their shares without leaving the company crippled financially.

If a major shareholder dies, then their beneficiaries acquire the shares and this could lead to tensions in
the running of the company, as they may not have the necessary skills and experience to take on such a
role or may not share the objectives that the surviving shareholders have for the business.

Alternatively, they may want to receive the value of the shares in cash. The Articles of Association will
usually require that these are offered firstly to the surviving main shareholders, but these shareholders
may not have sufficient capital to purchase the shares. Without the necessary capital, the shares may
have to be sold to an outside third party, potential hostile bidder, or even a direct competitor.

Shareholder protection can provide cover to ensure sufficient funds are available to enable the purchase
to take place. This is achieved by establishing a policy on each of the shareholding directors’ lives for an
amount that reflects the value of their individual holdings. The policy is written under a special form of
business trust so that any proceeds payable will be due to the surviving shareholders.

This approach requires the shareholders to agree a policy at the outset that the shares will be purchased
at a price that will be calculated in accordance with an agreed formula. This is then included in a double
option agreement which gives each party an option to buy or to sell their holdings on death. If either
party chooses to exercise their option, the other must comply.

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Partnership Protection
As with a private company, the death or serious illness of a partner can have a big impact on the
future of the business itself, and on the partner’s family. To enable the continuity of the partnership,
a partnership protection plan can be put in place that enables the surviving partners to purchase the
share of the business from the deceased partner and provide the deceased partner’s dependants with a
willing buyer and cash instead of an interest in the business.

Other alternatives include:

• binding arrangements to buy and sell their share between the partners
• taking out a ‘life of another’ arrangement, although this can present issues when partners join or leave
• establishing an absolute trust – which has the disadvantage that it can be inflexible as partners
change, and
• joint life first death policies.

2.6 Selecting Protection Products

Learning Objective

8.2.8 Understand the factors to be considered when identifying suitable protection product
solutions and when selecting product providers

The next steps are to identify suitable protection products that can meet the client’s requirements and
evaluate their features. For life assurance and protection products, the process essentially involves
identifying the range of potentially suitable products, assessing the key product features against the
client’s needs and selecting the most suitable options.

The following factors should be considered when selecting a product:

• The product features will clearly need to be examined to ensure that they meet the client’s
objectives, but they should also be checked for any additional features that may be included which
may address one or more of the client’s other needs. They should also be checked to see if there is
an option to add additional cover at preferential rates. It is also important to consider if the cover
keeps up with inflation and whether the premiums will also rise with inflation.
• Price, or the premium that the client will pay, is clearly a most important consideration, as are the
charges. These can range from annual management charges, to a charge for buying units in a unit-
linked policy, to initial charges for set-up costs of the policy and a policy fee. If they are built into
the premium, they will be of less importance, as the product chosen may be the one with the lowest
premium.
• Any charges payable on the product should be clearly detailed in the key features document,
product illustration or product brochures. These should be carefully examined and compared
against comparable product offerings.
• In deciding which policy to recommend, the adviser must take into account the client’s tax position.
The tax treatment of the product and any payments made under it should be established, as this
could have a material impact on the financial position of the client should they need to claim under
the policy. The features of each product should be examined to see if the benefits payable under some
policies can be made tax free and whether there is any advantage or drawback to its treatment.

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• The commission paid to the adviser is usually based on the premium paid, and the adviser must ensure
that they recommend the most appropriate product and not the one paying the highest commission.

2.7 Selecting Product Providers

Learning Objective

8.2.8 Understand the factors to be considered when identifying suitable protection product
solutions and when selecting product providers

When the adviser has decided on the right product type to recommend, the next task is to decide on an
appropriate product provider.

The features of a product may vary from provider to provider and may therefore be a determining factor,
but if there are a number of providers of equally suitable products, the following should be considered:

• financial strength
• quality of service, and
• any regulatory comments or bad press (if a policy needs to be paid out, clients should not have
problems with this).

8
2.7.1 Financial Strength
Protection is an area of insurance where the capital strength of the provider is important, and it is a vital
factor to take into consideration when setting up protection cover.

Although the cost of the premiums may seem to be an immediate indication of the suitability of the
policy for a client, it is important for advisers to also factor in the financial strength of the provider they
are recommending. Protection policies can run for many years, so an adviser needs to be sure that the
company will still be around when the customer needs to make a claim in ten or 20 years’ time. A lower
premium is no help if the provider is not around.

Protection is a very capital-intensive business to write. It is estimated that for every £1 million of business
written, an insurance company needs around £2.5 million to fund it. As the economic environment
becomes more difficult, it is also an area that insurance companies will pull out of if they are struggling
financially. The recent past has seen protection insurers being bought up and some providers pulling
out of the protection market altogether in some countries.

An adviser needs to be aware of what might happen if a provider were to leave the market. If the provider
were to go bust or stop writing business, then it is possible the policies would be transferred to a closed
book specialist. This change of ownership could come with an adverse change in the company’s
approach to managing claims, as their motivation for being in the protection market will clearly be
very different from those providers writing new business. It can also be less straightforward and more
expensive to add to or amend cover once your client’s policy has been transferred in such a way.

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Worse still could be if the provider moves out of the market altogether and the client is left with no
cover and needs to start a new policy with another provider. For example, for medical or critical illness
cover, the client’s medical position by then could be such that they will have to pay higher premiums
and/or have some cover excluded for any pre-existing conditions.

There are also regulators that can help and so it is important to make sure any company is regulated. A
regulator should be able to assist with any financial issues. Also, an adviser should make sure there is no
negative press about a company having problems financially, especially in connection with paying out
policies.

2.7.2 Quality of Service

Assessing the quality of service of a product provider is also important, and the adviser needs to look
at both the servicing and claims record of the provider and their long-term commitment to the market.
This can be as important as financial strength, especially with regard to life assurance. If the policyholder
was to die and his wife exercised the policy, the policyholder would want to know that the company
has a good record of making sure that the policy would pay out with minimum problems or difficulties.

A reputable service provider should:

• produce documentation that is clear and understandable

• provide a hassle-free service
• have prices and rates that are clear and transparent, and
• progress medical examinations in a timely manner.

These and other indicators, including practical experience of dealing with the firm, will give an indication
of the servicing quality of the firm.

The other essential feature of the service level received by a provider is how they deal with claims. The
adviser will want to examine the firm’s claims experience and determine whether they pay claims fairly
and efficiently or put hurdles in the way of the client claiming under the policy. Establishing this can be
difficult and subjective. It would be up to the adviser to determine, based on their own experiences or
those of other advisory firms with which they network.

Protection insurance is a long-term product and an adviser needs to be sure that the provider has a
sound track record of handling claims fairly and that they will be in the market for the long term.

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2.8 Presenting Recommendations

Learning Objective

8.2.9 Know the elements to be included in a recommendation report to clients

We are now close to the end stages of the planning process. So far in this process:

• The adviser has collected information about the client, assessed which areas need protection and
agreed an order of priority of what will be addressed.
• They have then quantified the extent of cover required and assessed the suitability of the existing
products that the client has.
• Having reviewed those existing products and determined which remain appropriate to the client’s
needs, the adviser has determined where any cover needs to be increased and has identified the
gaps in the protection arrangements that the client has not yet met.
• The adviser has then considered what products are available and suitable to address those gaps and
identified a suitable provider.

The adviser then needs to bring the component parts together into a financial plan that can be
presented to the client. In preparing the plan, there are various criteria that the solutions identified will
have to meet, including:

8
• The solution chosen must clearly be adequate to meet the client’s needs. Sometimes, however, it
may not be possible to meet the requirements fully and it will have to be accepted that there is a
gap, or it may be that a combination of products may be needed, which is fine, so long as this is
clearly explained to the client in the report.
• The solutions put forward should be consistent with the client’s attitude to risk.
• Whatever is recommended should be as tax efficient as possible.
• The solutions must be affordable to the client and realistic, given their level of disposable income.

In this final section, we can now look at how these recommendations should be presented to the
client. Presenting the information in a clear and understandable manner is essential if the client is to
understand the advice being given and is an important part of the process of giving financial advice.
This is normally achieved by preparation of a formal written report, which can put the products
recommended into the context of the client’s circumstances and objectives.

There is no single correct way to construct a report, but its likely contents are:

• date of report
• an introduction that explains the content of the report
• the current position of the client limited to the most important aspects and a summary of their
current protection arrangements
• the objectives and priorities that have been agreed with the client
• the recommendations that are being made, how they relate to priorities and objectives and an
explanation of the choice of provider
• considerations that have been deferred until later
• any tax implications of the recommendations on the client’s position, and
• the action needed to implement the requirements.

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It will also be accompanied by appropriate product quotations, illustrations and brochures.

The report may, of course, be part of a holistic view of the client’s position and may, therefore, include
investment and retirement recommendations as well as protection.

Providing a written report is clearly an important way of recording what has been recommended and the
key information on which it has been based and should thus avoid the potential for misunderstandings
and act as a safeguard for the adviser.

Key Features Documents (KFDs)

It is a key feature of regulatory rules that the advice given to clients is suitable and that clients should
have the information made available to them to make an informed decision.

One way in which this can be achieved is by the provision of key features documents (KFDs), which
describe the product in a way that a client can understand.

A KFD will be provided to the client as part of the product illustrations and should contain the following
information:

• a clear description of the aims of the product

• the commitment the client will be making
• the risks involved in the product with a description of the factors which may have an adverse effect
on performance or are otherwise material to the client’s decision, and
• a question and answer section on the main terms of the product. This should provide the principal
terms of the product and any other information necessary to enable a customer to make an
informed decision. It will include the charges to be made.

A well-drafted KFD will aid the client in understanding the recommendations that have been made and
the commitments they are entering into, and will generally help in the overall planning process. The
adviser needs to recognise, however, that not all KFDs are written in a style that is succinct, clear and
understandable, and, where that is the case, they should assist the client with their understanding so
that they can make an informed decision.

Cancellation Rights
An important feature of many financial services products is the right of the client to change their mind
and cancel, or withdraw from, the arrangement without meeting charges. It is important that the adviser
fully explains these rights and any associated documentation to the client.

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3. Estate Planning, Trusts and Foundations

3.1 Estate Planning

Learning Objective

8.3.1 Understand the key concepts in estate planning: assessment of the estate; power of attorney;
execution of a will; inheritance tax; life assurance

Estate planning is concerned with ensuring that a client takes appropriate steps to ensure that their
accumulated wealth passes to their intended beneficiaries, and in a tax-efficient way.

Estate planning can be a complex subject but essentially involves determining who is to inherit the
assets of the client and which steps can be taken to reduce any estate taxes that will arise on death.

The steps that can be taken vary significantly from country to country. Some jurisdictions allow
complete freedom over to whom an individual can leave their estate, while in others, certain people will
have a right to a specific share of the estate.

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3.1.1 Assessing a Client’s Estate
A key first step in estate planning is to assess the extent of a client’s assets and liabilities.

These include their property, their savings and any investments, but it is also necessary to identify
any other funds that would become payable if the client were to die, such as the proceeds of any life
assurance policies or payment of death benefits if the client is still working. The assessment of a client’s
liabilities should also take account of any protection policies that may be in place to meet that liability,
such as a mortgage protection policy.

Once identified, these can then usefully be summarised into a balance sheet. This balance sheet can
then be used to direct the client to consider three key areas:

• Whether they need to execute a power of attorney to protect their interests when they are incapable
of managing their affairs.
• Whom they wish to inherit their estate and whether there are any specific gifts they wish to make.
• The extent of any liability to IHT or estate duties that may arise, and whether action should be taken
to mitigate this.

3.1.2 Powers of Attorney (POA)

A power of attorney is a legal document that a client executes to authorise someone else to undertake a
specific transaction or in order for someone to manage their affairs.

A power of attorney can be used for a variety of purposes such as property transactions, company
transactions and managing the financial affairs of an individual. A power of attorney may be described
as a general power of attorney where an individual appoints someone to manage all of their legal and

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financial affairs, or a specific power of attorney where the authority is limited to a specific transaction or
activity. The person appointed acts as agent for the client and may be known by various names such as
an attorney, the attorney-in-fact, an agent or a notary. While the person granting the power is referred
to as the grantor or principal. The power of attorney may remain in force until it is revoked or last for a
specific period only.

An individual can execute a power of attorney during their life while they are of sound mind and
appoint someone to carry out certain activities. Once they are no longer of sound mind, their authority
to continue to act ceases and that person will need to apply to the courts to be appointed to act. The
exception to this is if the law in a country permits the creation of a power of attorney that can continue
once the client becomes incapable of managing their own affairs; these may be known as a lasting,
enduring or durable power of attorney.

A client may hold a range of investments in their own name or may have appointed a firm to manage
their investment portfolio, and consideration needs to be given to what would happen if they became
incapable of managing their own affairs.

It is essential to appreciate that the authority given to the adviser or investment firm to act on behalf
of the client can continue only so long as the client can change their mind and cancel any contract or
agreement. Once a client becomes incapable of managing their own affairs, the authority to act ceases
and alternative arrangements need to be made. This principle extends beyond investment management
services to everyday financial products, such as bank accounts.

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Once an individual becomes incapable of managing their own affairs, someone else needs to be
appointed to act on their behalf. This may be either a member of the family, a lawyer, or even the
investment firm itself. How they are appointed will depend upon whether the individual makes
arrangements in advance or not, but either way, there is a series of rules and legal procedures that
have to be followed. An individual may become incapable of managing their affairs and have made
no arrangements for what is to happen in that event. If that occurs, someone else will need to apply to
the courts to have authority to act. That person may be known by various names such as a guardian,
receiver or an attorney.

3.1.3 Execution of a Will

A will is a legal document that tells the world what is to happen to an individual’s assets. Where possible,
the client should make a will in order to ensure that the assets of their estate pass in accordance with
their wishes, and should take specialist advice so that relevant laws are taken account of.

A will is generally regarded as essential for everyone, but particularly so in the case of a family with
young children and in cases of second marriage. A family with young children needs to consider
what would happen to the children if their parents were unfortunate enough to be involved in a fatal
accident. Who would look after the children, who would invest any money until they came of age and
what would happen if the child needed some essential expenditure such as the payment of school
fees? A properly drafted will should ensure that all of these points are provided for. In cases of second

8
marriage, the partners may wish their assets to be split in precise ways on the death of the survivor, and
again a carefully drafted will can achieve this.

If overseas assets are held, especially property, separate wills should be made in each country, and
generally this should be drafted by a specialist in the jurisdiction in question.

If no will is made, the legal system will determine who inherits. When a person dies without leaving a
will, they are described as having died intestate and a set of intestacy rules will determine who is to
inherit. These may well provide for the estate to pass in a way that the client would not have intended.

In some jurisdictions, it is not possible to make a will, and, where that is the case, consideration may be
given to an offshore trust (see section 3.2.4).

3.1.4 Estate Taxes

Having prepared a balance sheet detailing the client’s assets and liabilities, an adviser should be in a
position to estimate how much estate tax might be payable. In many countries, tax is imposed on the
assets that someone owns and the tax due may arise during their lifetime or on death. These types of
taxes go by various names such as death duties, estate taxes, gifts tax, IHT or wealth tax. These maybe
separate taxes or combined into one charge.

In most countries, there are exemptions and allowances that can be taken advantage of to mitigate the
eventual inheritance taxes that might 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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The liability to some form of estate taxes usually depends upon the domicile of the individual and
the location of the assets they own. It is important that wealth managers who are dealing with clients
from another country have an understanding as to how these taxes operate as this may impact the
arrangements they put in place for their client and as an inappropriate arrangement can lead to an
unintended tax liability.
insurance
Life
3.1.5 The Role of Life Assurance in Estate Planning
It may be possible to reduce estate taxes by a well drafted will and by decreasing the size of an estate
by making gifts during lifetime but, inevitably, it is usually not possible to avoid this altogether and life
assurance may then have a role to play.

It is possible to take out protection products, sometimes known as IHT policies, that are specifically
designed to help the client achieve their aim and which, typically, involve the client paying premiums on
a policy that is set up in such a way that the policies are payable directly to the beneficiaries and do not
form part of the estate. While the estate taxes are still payable, the client has ensured that the intended
beneficiaries receive a lump sum payment that can compensate for the amount paid out.

It is also possible, depending upon local laws, for a client to take out, say, a life assurance policy or
investment bond and invest significant amounts and then similarly write it in such a way that it passes
directly to the beneficiaries and avoids any estate taxes. This usually involves the use of a trust.

These arrangements or gifts usually have to be a made a number of years before the client dies to be
able to achieve the benefit. The value of any protection plan proceeds not written in trust must be added
to the life assured’s estate and may be subject to estate taxes.

3.2 Family Investment Vehicles >

- testabl
-
e.

Learning Objective

8.3.2 Know the uses of family investment vehicles: trusts and the types of trust available; offshore
trusts; offshore foundations; investment companies

There are a number of arrangements that can be conveniently grouped under the term family investment
vehicles, such as trusts and foundations, each of which can be used to manage family wealth.

Trust - Tenstee >

-

Beneficiaries
3.2.1 Trusts
.

Trusts are based on an English law concept and developed from the early Middle Ages onwards as a
way of preserving wealth and passing on assets on death in a controlled way. More recently, their use
has expanded internationally and they tend to be a feature of countries that have common law systems.
They are not exclusively found, however, in common law jurisdictions. Their inherent flexibility has
encouraged countries in the Middle East to introduce trusts into their legal systems. In China, charitable
and family trusts are now permitted, but are still in the early stage of development and instead as seen
more often as vehicles for investment products.

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 Lifetime Financial Provision

A trust is the legal means by which one person gives property to another person to look after on behalf
of yet another individual or a set of individuals. The following diagram illustrates the parties and key
features of a trust.

imp

Starting with the individuals involved, the person who creates the trust is known as the settlor. The
person they give the property to, to look after on behalf of others is called the trustee and the individuals

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for whom it is intended are known as the beneficiaries. A trust protector may also be appointed.

• The settlor is the person who creates the trust and who passes
Settlor
ownership of their assets to the trustees.
• A trust is created by a legal document which will contain
provisions detailing its terms, the duties and powers of the
Trust Deed trustees and the beneficiaries who will benefit under the trust.
The legal document may be either a separate trust deed or it
may be contained in someone’s will.
• The trustees are usually appointed in the trust document itself
and it will usually contain the power to appoint further trustees
as and when required.
• The trustees hold the assets that are transferred to them and
Trustees manage these assets in accordance with the terms of the trust
and on behalf of the beneficiaries. The trustees have legal
ownership of the assets, but must act in the best interests of the
beneficiaries.
• Their powers to act are set out in legislation and the trust deed.
• A trust protector may be appointed to protect the interests of
the beneficiaries.
• The types of powers typically given to the protector would
Trust Protector include requiring their consent before certain transactions can
be carried out or to enable them to direct the trustees in certain
matters, including the power to dismiss the trustees and appoint
new ones.

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 • The trust deed will identify who the initial beneficiaries are
or specify a class from which the beneficiaries may be drawn.
Beneficiaries Beneficiaries may include the settlor, the spouse, children,
grandchildren, any future children not yet born, or any other
parties the settlor may propose.

A trust is essentially a legal vehicle into which assets are transferred and which is then managed by the
trustees, who have a responsibility to hold and apply the assets for the benefit of the named beneficiaries.

3.2.2 Uses of Trusts

Trusts are widely used in estate and tax planning for high net worth individuals and are seen throughout
the wealth management and private banking industry.

They have a variety of uses. Some of the main reasons they are deployed are as follows:

• Estate planning – as an alternative to passing assets by a will; a trust can give greater flexibility as to
the timing and terms under which assets are distributed.
• Asset preservation – as a way of preserving the family fortune.
• Business preservation – as a way to ensure the continuation of family businesses.
• Asset protection – to protect assets against the claims of others.
• Family protection – to safeguard the interests of young or disabled children, including the provision
of education, ensuring their interests are protected and that they receive funds at the appropriate
time.
• Tax planning – to reduce future IHT liabilities by transferring assets into a trust, and so out of the
settlor’s ownership.
• Charitable giving – as a way of ensuring certain charitable objectives are met.

· 3.2.3 Types of Trusts

One of the advantages of a trust is its flexibility and it is possible to create a wide range of trusts with
different characteristics. Trusts come in a variety of forms, but some of the main ones that will be
encountered are:

• Bare or absolute trusts – where a trustee holds assets for another person absolutely.
-
• Interest in possession trusts – where a beneficiary has a right to the income of the trust during
-
their life but the capital passes to another (remainderman) on their death.
• Accumulation and maintenance trusts – where the trustees have discretion but only for a certain
~
period, after which a beneficiary will become entitled to either the income or capital at a certain date
in the future.
-Discretionary trusts – where the trustees have discretion over to whom the capital and income is
•
paid, within certain criteria.
wCharitable trusts – where a trust is set up for a cause or purpose that will benefit a large group of
•
people or society in general rather than specific individuals.

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 Lifetime Financial Provision

An interest in possession trust, which is more usually known as a life interest trust, can provide a person
with a right to enjoyment of assets during their lifetime with no absolute right to the capital or the assets.
Instead, the trust can provide that this capital passes on to someone else after that person’s death.

Example
Mr A owns a house and creates a trust transferring the house to Mr B and Ms C as trustees. The terms
of the trust are that A’s daughter D has the right to live in the house and, on her death, absolute title
to the house is to be transferred to her daughter, E (the remainderman – who receives the principal
remaining in a trust account after all other required payments have been made). The trust does not
produce income, but D has the right to enjoy the trust property and is known as the life tenant.

A discretionary trust allows clients to select a list of discretionary beneficiaries when establishing a trust.
Beneficiaries can change over the lifetime of the trust. The discretionary beneficiaries have no immediate
interest in the trust. They receive proceeds of the trust at the discretion of the trustees.

A client may want to retain flexibility as to who will benefit under a trust, so that future children or
grandchildren who have not yet been born can be included, or for many other reasons. A discretionary
trust can provide for the distribution of the capital or income among a wide class of persons, with the
settlor giving the trustees discretion as to both the timing of any distributions and who is to benefit.

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Accumulation and maintenance trusts are often used for the education and general benefit of children
or grandchildren.

3.2.4 Offshore Trusts

The use of an offshore trust for tax planning and asset protection purposes is a popular method used by
wealthy individuals as part of their overall tax planning strategy.

Discretionary offshore trusts, otherwise known as offshore asset protection trusts, are the main type of
trust structure used, as they can provide privacy, security and flexibility. They are complex structures
that require specialist advice both for their creation and their ongoing management. They are usually
established in a tax haven or in a low-tax jurisdiction, such as the Bahamas, Gibraltar, Liechtenstein,
the Isle of Man and Jersey and Guernsey. These traditional centres are now being followed by centres
such as Bahrain and Dubai, which are aiming to become the most important, influential and successful
offshore and international financial centres in the Middle East.

The trustee of an offshore trust is generally a trust company.

Whilst the reason for an offshore trust being established will vary from case to case, there are a number
of common reasons why they are used:

• Privacy – offshore trusts may not be publicly registered and depending on the jurisdiction where
the trust is established, the settlor may be able to give assets to a trust anonymously. This can
enable someone to dissociate themselves from assets for the purposes of tax reduction or to remain
anonymous for personal or business protection purposes.

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• Protection – offshore trusts can protect assets and wealth from the threat of taxation or against the
risk of litigation.
• Inheritance – in certain countries, the law dictates to whom a person may leave their assets on
death, and so offshore trusts can be used to ensure that wealth is transferred in accordance with the
settlor’s wishes and not in accordance with the laws of the country where they live or are domiciled.
• Flexibility – offshore trusts can be designed to meet specific personal or family requirements such as
protecting the future of certain family members who may be less capable of managing their own affairs.
• Efficiency – offshore trusts can be used to centralise the management of assets owned throughout
the world in one location.
• Legal certainty – offshore trusts are recognised in all common law jurisdictions and receive
increasing recognition in important civil law jurisdictions as well.
• Tax planning – offshore trusts are an important tool when it comes to international income, capital
gains and inheritance tax planning and, as long as certain conditions are met, will not be liable to any
local taxes.
• Financial security – an offshore trust can help safeguard assets and wealth against political and
economic uncertainty in the settlor’s home country.

Offshore financial centres have traditionally been associated with low or minimal tax rates and with
attempts by individuals and companies to minimise their tax liabilities by exploiting tax laws. In recent
times, the public and political mood on the acceptability of this has changed and governments are
increasingly tackling all forms of tax evasion and tax avoidance.

3.2.5 Offshore Foundations

Foundations are similar to trusts and originated in civil law jurisdictions, but are also now available in
some common law jurisdictions as an alternative to a trust.

A foundation is an incorporated entity with separate legal personality but, unlike a company, it does not
have shareholders. Instead, it holds assets in its own name on behalf of beneficiaries or for particular
purposes and it operates in accordance with a constitution comprising of a charter and a set of rules.

Once incorporated, a foundation will act through its council which will govern the foundation in
accordance with the terms of the foundation’s constitution. The council members perform much the
same role as trustees.

As with trusts, foundations can have multiple uses for private, charitable and corporate purposes and
can be incorporated into a variety of potential structures tailored to best suit a particular client’s needs.

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Uses of Foundations

• Foundations may be particularly attractive as a simple alternative to trusts for

clients, especially from civil law jurisdictions, for whom the concept of a trust
may be unfamiliar.
• They can be used to achieve much the same ends as a private trust and are highly
flexible in respect of how long it lasts, how the founder may remain involved in
the administration and how much information the beneficiaries are entitled to.
Private
• As with trusts, provided they are appropriately drafted, the foundation may also
be a suitable vehicle for asset protection as it divorces the ownership of the
assets from the founder.
• It can also be used as part of a larger wealth management structure holding
various companies or assets or can hold more high-risk, less income-producing
assets which may not be appropriate to be held by all trusts.
• The term ‘foundation’ has positive connotations for philanthropic clients.
Charitable • Its purposes do not have to be exclusively charitable and so can be more flexible
-

than the traditional charitable trust.

3.2.5 Investment Vehicles

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Private trust companies can be created and used by wealthy clients as a way of managing large family
businesses that professional trustees might find difficult. A private trust foundation can also be used to
achieve the same purpose.

In this arrangement, instead of the family business being owned by a trust, additional layers are created
in the structure.

• A trust will hold the family business as its asset.

• A private trust company is created to act as trustee of the family trust.
• The private trust company is a limited company and the board of the company can be selected
to ensure that there are suitably qualified advisers appointed who understand the nature of the
business along with the settlor.
• Whilst the settlor could own the shares in the private trust company directly, it would probably be
undesirable to have any direct link with its ownership, whether for tax, disclosure or for a variety of
other reasons. Instead, a non-charitable purpose trust is created which holds the shares in a private
trust company as its sole asset.

Private trust companies and private trust foundations are used for owning and administering the assets
of wealthy families and are favoured because it enables the board of directors to be suitably qualified
and addresses the concerns of the trustees over their potential liability.

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