Investment Advice Process PDF

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Document classification: Confidential Topic 1: The investment advice process in practice FPC008 Investment Advice Contents Overview.......................................................................................................................... 1.1 Topic learning outcomes.......................................................................................................................1.2 1 Stages in portfolio development........................................................................... 1.2 1.1 Establishing the starting point..................................................................................................1.3 2 Cash flows, net worth and asset allocation........................................................... 1.4 2.1 Constructing the cash flow statement.....................................................................................1.4 2.2 Establishing net worth..............................................................................................................1.6 2.3 Summarising current asset allocation......................................................................................1.7 2.4 Funds available for investment................................................................................................1.8 2.5 Matching risk profiles.............................................................................................................1.10 2.6 Life stages...............................................................................................................................1.11 3 Understanding client goals.................................................................................. 1.12 3.1 Determining the client’s goals................................................................................................1.12 3.2 Incompatible and non-achievable goals.................................................................................1.13 3.3 Investor objectives.................................................................................................................1.13 3.4 Investor constraints................................................................................................................1.15 3.5 Identifying insurance and estate planning needs..................................................................1.19 4 Gap analysis and trade-offs................................................................................. 1.20 4.1 Process of gap analysis...........................................................................................................1.20 4.2 Constructing projections........................................................................................................1.21 4.3 Initial projections....................................................................................................................1.22 4.4 Negotiating trade-offs............................................................................................................1.23 4.5 Revising goals and strategies..................................................................................................1.24 4.6 Documenting trade-offs.........................................................................................................1.27 5 Tailoring asset allocations to client needs........................................................... 1.28 5.1 Asset allocation approach......................................................................................................1.28 5.2 Risk tolerance and asset allocation........................................................................................1.29 5.3 Adjustments to asset allocations...........................................................................................1.29 Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education Topic 1: The investment advice process in practice 6 Developing an investment strategy..................................................................... 1.33 6.1 Steps in investment strategy development...........................................................................1.33 7 Investment strategy case studies........................................................................ 1.39 8 Building the client investment portfolio.............................................................. 1.41 8.1 Steps in building the client investment portfolio...................................................................1.43 9 Portfolio case studies.......................................................................................... 1.47 10 Ongoing portfolio management.......................................................................... 1.50 10.1 Ongoing servicing...................................................................................................................1.50 10.2 Portfolio review versus investment strategy review..............................................................1.51 10.3 The review process.................................................................................................................1.52 10.4 Parameters of the review process..........................................................................................1.53 10.5 Conducting the review...........................................................................................................1.54 10.6 Analysing existing client data.................................................................................................1.54 10.7 Assessing suitability................................................................................................................1.56 10.8 Making recommendations to maintain or alter investments................................................1.57 10.9 Implementing review recommendations...............................................................................1.57 Suggested answers......................................................................................................... 1.58 References..................................................................................................................... 1.68 Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.1 Overview It is important for investment advice to be implemented in line with the financial planning process. This topic outlines the investment advice process and discusses the three steps in delivering effective investment advice: 1. Client needs and objectives Client needs and objectives drive the financial planning process. Identification and analysis of those needs and objectives is therefore at the core of developing appropriate strategies to include in the statement of advice (SOA). For an investment portfolio to be suitable and appropriate for a client, it needs to be tailored to their needs and objectives, as well as the timeline required to achieve those objectives. The client’s goals and objectives and how they relate to risk tolerance are also considered. A client’s risk tolerance is the key consideration in developing investment strategies to meet their needs. Relevant aspects of investment risk that must be explained to a client are examined, as well as methods of managing risk within a portfolio, particularly through diversification. 2. Investment strategy development and recommendations Preparation, research and analysis leads to the development of an appropriate strategy for the client. The topic explains how to build the client’s portfolio once the investment strategy has been developed. An investment portfolio should reflect the appropriate asset allocation, constraints and structures relevant to the client’s circumstances, and must be compatible with all other aspects of their broader financial plan, for example superannuation and insurance. The investment strategy forms part of the SOA, which may incorporate other strategies such as debt reduction, estate planning and personal risk management. 3. Ongoing portfolio management While managing a portfolio of investment assets is often considered a core component of ongoing financial advice, strategic review and management of client needs and objectives are just as important in building the relationship between adviser and client. This topic covers the steps involved in the ongoing review process as well as the legislative requirements (including documentation) associated with the ongoing management of a client portfolio. ‘Portfolio’ in this context refers to the strategic aspects of client advice as well as to product advice which has been implemented. This topic specifically addresses the following subject learning outcomes: 1. Evaluate the investment advice process in order to meet the client’s investment objectives and constraints. 4. Construct and evaluate effective investment advice. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.2 Topic learning outcomes On completing this topic, students should be able to: analyse client data and effectively determine the client’s current cash flow requirements and net worth, and their impact on achieving the client’s goals and objectives complete a gap analysis to identify any shortfalls between a client’s objectives, risk tolerance and their current financial situation develop and document an appropriate investment strategy build essential disclosure components of a statement of advice explain the legislative requirements for making recommendations and the adviser’s ongoing obligations conduct an annual review using the steps for reviewing a client’s financial strategies and recommended products analyse existing client data and effectively determine the ongoing suitability of a client’s portfolio demonstrate an understanding of the changing environment regarding portfolio management. 1 Stages in portfolio development Not every fund is appropriate for every client. Making investment recommendations is not as simple as selecting the best performing managed funds for your client’s portfolio. Very few fund managers can provide top performance consistently every year. Advisers should realise that such an approach is not a good basis for developing a long-term client relationship. Consequently, it is vital that advisers use more than just the outlook for fund manager performance in making recommendations about investment strategies. Key concept: Developing an investment strategy In formulating a strong investment strategy, the advisor needs to understand the client's starting point, their goals and timeline, and their tolerance for risk. An investment strategy, in this context, includes all the appropriate tax and investment structures, asset allocation and financial measures needed to achieve a client’s financial objectives. Client needs can only be established after a thorough data collection process, followed by an analysis of that data and discussion with the client to resolve any issues arising from conflicting expectations. Although collecting client information seems basic, much litigation and many client complaints stem from advisers collecting inadequate information, or none, or incorrect information from clients, and making inaccurate assumptions about them. Financial advice: What consumers really think, published by the Australian Securities and Investments Commission (ASIC) in 2019, summarises the results of a study that explored the use of financial advisers, motivators and barriers to seeking personal advice, and consumer attitudes towards the financial advice industry. More than one-third of respondents reported that they either actively did not trust financial advisers or were unsure and held only a little trust in financial advisers. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.3 Go to the following ‘Recommended resource’ in KapLearn (ASIC 2019) Report REP 627 ‘Financial advice: What consumers really think’. This report provides details regarding overall demand for advice, why Australians get advice, how Australians choose financial advisers and why Australians do not get advice. The research explored overall use of financial advisers, motivators and barriers to seeking personal advice, and consumer attitudes towards the financial advice industry. The article provides insights that will assist students in understanding some of the key requirements from consumers seeking advice from a financial planner. 1.1 Establishing the starting point To provide quality financial advice, a considerable amount of client data must be collected to establish the starting point for assessing the client’s current situation. This data enables an adviser to understand the client’s situation — to establish their goals and objectives clearly. When providing investment advice, advisers need to gather information which will enable them to tailor their recommendations to suit the client’s: short and long-term goals financial situation particular personal and financial needs investment objectives willingness and ability to undertake investment risk investment constraints. Complete and accurate data collection will allow the adviser to know their client in order to make appropriate recommendations on strategy and investments to assist in achieving their goals. Conflicts in data Any conflicting data must be identified and clarified. Often, a risk profiling tool or questionnaire will help to identify conflicts in a client’s understanding of, attitude towards and expectations from their investments. Examples relating to investment advice are: A client may state that capital security is of primary importance but also have expectations of annual returns of 10% or more. A 30-year-old client may state that their investment time frame is three to five years, so they want conservative investments; however, all of the funds are preserved in superannuation and not accessible for 30 years. The adviser will need to discuss such conflicts in expectations with the client and explain how they relate to risk and return. The client must agree to trade off one or the other before the adviser can proceed with the advice process. The financial adviser must ensure that all relevant issues have been discussed with the client before formulating the investment strategy and portfolio. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.4 2 Cash flows, net worth and asset allocation All the information and data collected should be organised to enable a comprehensive analysis to be performed. Using software, spreadsheets or paper, a client’s data can be organised into important reports such as a cash flow statement, net worth statement and asset allocation report. 2.1 Constructing the cash flow statement Cash flows are about the inflows and outflows that occur during any given time. For example, salary is an inflow (income) and a home loan repayment is an outflow (an expense). The client’s cash flow acts as a benchmark and an analytical tool. It should be an annualised account of the client’s income from all sources and should include deductions, tax liabilities and expenditures to arrive at the client’s potential net savings capacity. Besides highlighting to the client ‘where their money goes’, the net savings capacity identifies funds available for investment purposes each year. Cash flows are indicative only and are used to identify issues and opportunities. Go to the following ‘Recommended resource’ in KapLearn (Taylor & Juchau 2019) Cash flow and budgeting. This resource provides additional information about how a cash flow statement is constructed. If additional detail and explanation in relation to cash flows are required, you are encouraged to use this resource. Some practical examples are provided to demonstrate the key components in the process of cash flow analysis. In addition to establishing net savings capacity, the cash flow statement can be used to discuss: sources of income and the related taxation consequences the deductibility of certain investment items (e.g. borrowing to invest). Cash flows may be projected out until or throughout retirement, showing moneys being invested or allocated to specific expenses. For example, the client may expect increases in the cost of children’s education over a number of years or may want to undertake home renovations at some point in the future. Any assumptions (such as the return on investments) must be clearly stated and supported; and must always be realistic. Abnormal items Where clients may be in receipt of abnormal income, such as proceeds from the sale of an asset, an inheritance or a one-off bonus, these items may be included in the cash flow but must be highlighted as ‘one-offs’ because they are not expected in future. These amounts will often form part of the capital that the client has available for investment, or the client may have a predetermined short-term spending goal which should be recorded in the outflows. Bonuses may be included when they are paid regularly and are generally of the same amount. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.5 Change of circumstances Where the client expects that next year’s cash flow will be different from their current cash flow, this should be noted. For example, perhaps a client intends to travel for six months in the following year, during which time they will receive their annual salary or superannuation guarantee (SG) contributions. This should be accounted for in the following year’s cash flow. Parental leave or time out of the workforce to start a family is another example of a change in circumstances that will have a heavy impact on cash flow — not only the absence from work, but also the additional cost of childcare expenses if the parent returns to work. Case study: Amy and David Amy (aged 39) works as a senior operations manager. Her partner, David (aged 41) is an IT project manager. They have approached you to provide advice on their financial position, specifically in the creation of wealth over the long term. They have provided the following income and expense details: Amy’s salary: $120,000 (plus SG) David’s salary: $180,000 (plus SG) David’s bonus: an average of $50,000 p.a. over the last three years. David has an investment unit in an inner-city suburb, valued at $950,000 (market value) with rental income of 3% net of associated management expenses. The unit is in David’s name with an investment loan of $500,000 with interest-only repayments of 5% p.a. Their home in the suburbs is jointly owned and valued at $1,200,000. They repaid their mortgage last year and plan to spend $45,000 to renovate the kitchen and bathroom next year. David has an Australian share portfolio of $120,000. The dividend return is assumed to be 4% (50% franked). Amy and David have superannuation funds but do not wish to receive any advice on these. They estimate their living expenses to be approximately $80,000 p.a. Their combined annual cash flow would be constructed as follows: Year 1 Year 2 Income $ $ Combined salaries 300,000 300,000 Bonus 50,000 50,000 Gross rental income 28,500 28,500 Unfranked dividend 2,400 2,400 income Grossed-up franked 3,429 3,429 dividend Total taxable dividend 5,829 5,829 Total income 384,329 384,329 Expenses Living expenses 80,000 80,000 Tax* 106,803 106,803 Medicare* 7,187 7,187 Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.6 Medicare levy 5,390 5,390 surcharge** Loan repayments 25,000 25,000 Renovations 0 45,000 Total expenses 224,379 269,379 Net surplus 159,949 114,949 Note: This table assumes income return of 4% on Australian shares. * Using 2023/24 tax rates, and franking credits where relevant. ** Using 2023/24 Medicare levy surcharge rates. Apply your knowledge 1: Cash flow projections Based on the information provided in the case study above, Amy and David have surplus cash flow of $159,949 available in Year 1 for their capital expenditure items and further investment. What sort of questions would you need to ask Amy and David to allow you to project accurate cash flows in the following five years? 2.2 Establishing net worth Clients may already have investment assets. Before recommendations to invest in new assets can be made, the existing assets must be assessed for their appropriateness and performance. The first step is to establish a comprehensive picture of the client’s current assets and liabilities. This will show their net financial position, enabling the financial adviser to determine the amount of cash available for immediate investment. This also allows the adviser to identify investments that are inconsistent with achieving the client’s objectives, for example investments that are non-income generating, poor quality, performing poorly, providing irregular income or not in line with the client’s risk profile. The next step would be to determine which assets could be substituted for these underperforming investments. The cost of switching investments and any capital gains tax (CGT) implications must always be considered as part of this analysis, and sound justification to support these recommendations should be provided to the client. Key concept: Net worth A client’s net worth is a calculation presented in a balance sheet that shows the client’s total assets less their total liabilities. It is used to get a snapshot of their financial base at a point in time. It is an indicator of their wealth, providing a summary of past savings and investment results. The completed balance sheet will form a benchmark for the Statement of Advice (SoA) and will be revised at each annual review. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.7 Amy and David’s net worth (excluding their superannuation funds), based on the information in the case study above, can be established in the following balance sheet: Assets Asset Owner Value ($) Lifestyle assets Principal residence Joint 1,200,000 Total 1,200,000 Investment assets Australian shares David 120,000 Investment property David 950,000 Total 1,070,000 Liabilities Payment Interest rate Payment amount/ Tax Value Liability Owner % p.a. type frequency deductible ($) Investment loan David 5% Interest-only $2,083/month Yes 500,000 Total 500,000 Total net worth 1,770,000 2.3 Summarising current asset allocation The client’s net worth can also be used to develop their current asset allocation. This can be used as a basis for discussion about the client’s risk tolerance and asset allocation requirements. This information is often presented in a table or pie chart. In constructing the initial asset allocation report, the adviser needs to consider the following: Should all lifestyle assets be excluded or should any lifestyle assets be included? Should cash lump sums awaiting investment be included or excluded? How are annuities, defined benefit pensions and insurances accounted for? How is debt (mortgage, margin loans etc.) accounted for? Could advanced techniques, such as including the present value of future income, be appropriate? To answer these questions, an adviser must have a deep understanding of the client’s investment objectives and assets. Another critical consideration is the definition of asset classes utilised and how the client’s assets fit into these asset classes (this is discussed in detail later in this subject). The asset allocation report may highlight issues such as: asset allocation biases whether further diversification may be required if there are insufficient accumulated cash assets whether there is a misallocation of assets (i.e. not in line with the client’s preferred risk tolerance). Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.8 Using the above case study, Amy and David’s current asset allocation could be as set out in a pie chart, as in Figure 1 below. Figure 1 Asset allocation pie chart for Amy and David Asset allocation 16% 84% Australian shares Property Apply your knowledge 2: Net worth and asset allocation What does the asset allocation pie chart in the above case study highlight in relation to Amy and David’s current investment strategy and their net worth (excluding superannuation funds)? Relevant information about how assets have been accumulated should be recorded in client files to correct any assumptions about the level of risk the client may be prepared to accept. Investment recommendations should be prepared in accordance with the client’s established level of risk tolerance, rather than simply relying on their previous investment history in isolation. Key concept: Risk tolerance assumptions A client with a significant amount of money held in cash assets does not necessarily have a low risk tolerance. The funds could be proceeds from the sale of a property, for example, and the client may be waiting for advice on investment. Or the client may have accumulated cash and not had time to carry out research and invest it. On the other hand, a client may have a substantial portfolio of direct Australian shares as their only investment asset, but this does not necessarily mean that they have a high tolerance to risk. This portfolio may have been inherited and they may not be aware of the level of risk associated with the investment. 2.4 Funds available for investment Even though a client may provide an adviser with information on their entire net worth, it is common for the client to only seek advice on a portion of their assets. This is sometimes referred to as limited or scaled advice. For example, they may not want to receive advice on an investment property or an inherited share portfolio. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.9 The best interests duty outlined in both section 961B of the Corporations Act 2001 (Cth) and Standards 2 and 6 of the Financial Planners and Advisers Code of Ethics 2019 permits advisers to offer advice with restricted scope as per the client’s request. However, these provisions also mandate advisers to use their professional judgment to assess whether such limited scope advice could substantially compromise the obligation to deliver sound and comprehensive advice. For instance, Amy and David’s high property allocation may not compromise their overall position based on their future salary earnings and strong cashflow, if they asked for advice that excluded their investment property. But how would this change if they were on the brink of retirement, and wished to meet living expenses that exceeded the net yield of the property? Once cash flows and net worth have been established, the adviser can establish what funds are available to be invested. Funds available for investment can come from: lump sums (e.g. accumulated assets such as superannuation) net savings capacity (i.e. surplus cash flow) borrowed funds. Key concept: Net working capital For any business, there are, in general, three financial decision areas. These are: working capital decisions capital budgeting decisions financing decisions. These decision areas can be visualised by referring to the balance sheet, as shown in Figure 2 below. Figure 2 The balance sheet and the financial manager Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.10 Working capital As shown in Figure 2 above, decisions regarding working capital relate to current assets and liabilities. These two components of the balance sheet are focused on the daily running of the business, and in particular, the cash flows required. Good management of cash flow ensures that operations continue and that the company is able to meet liabilities as they become due. The difference between current assets and current liabilities is known as net working capital. Capital budgeting Capital budgeting decisions relate to non-current assets. These are the productive assets of the organisation. They are the resources that managers use to meet the company’s strategies and goal of profit generation. Investment into assets and the sale of existing assets are two of the most critical decisions that a financial manager must assess and make. Financing Also known as ‘funding’, this area looks at where the business gets money to invest in new assets and take advantage of business opportunities. As shown in Figure 2, the finance manager can look for funding from two key sources: non-current liabilities (lenders) or equity (shareholders). A firm could also utilise existing cash for capital expenditures instead of raising further funds from investors or lenders. This could be seen as a form of equity funding due to the potential for excess cash to be distributed to shareholders (i.e. dividends forgone). 2.5 Matching risk profiles An asset allocation will need to be devised using the risk profile identified in the client analysis questionnaire, as well as through further investigation of a client’s immediate and long-term objectives. Most licensees have their own standard risk tolerance profiles and these can vary slightly from one organisation to another. Alternatively, they may utilise models provided by research houses. A risk profile is an agreed benchmark for the level of investment risk that will be held in a client’s portfolio. Agreeing to a risk profile may involve a process of uncovering, discussing and reviewing: a client’s prior investing experience their tolerance for drawdowns in the portfolio the client’s time frame for investment the client's need for returns to achieve their objectives. Understanding and agreeing a client’s risk profile is important because it helps to match the client’s needs and objectives with their expectations. A well-run, diversified investment portfolio may still have a poor outcome for a client if the level of drawdown exceeds their expectations or capacity, and they switch the investment strategy at an inopportune time. Most asset allocations give a benchmark and range for each asset class against each investor risk profile. For example, the appropriate asset weightings for a balanced investor may have a benchmark of 35% for Australian shares with a range of 28–48%. This allows for short-term fluctuation within the asset allocation and caters for particular client situations. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.11 2.6 Life stages Investors will invariably have different investment needs depending on their stage of life. Age typically dictates how much risk an investor is willing to take on in their investments. The general rule is that the younger the person, the more risk they can tolerate. As they get older, typically the amount of risk in the portfolio will decline. An investor’s risk profile should be fluid and evolve over time as they progress through their career and adapt to significant personal events. But what does a typical risk profile look like for each age group? The investor will be at the beginning of their career. At this age, it is likely they will have a lower salary as well as a smaller emergency fund to fall back on. However, due to the length of time left until retirement, there is 20s still plenty of opportunity to recoup any losses caused by unforeseen events. Saving early also comes with the added benefit of compound interest, meaning that anything they put away will have a long period during which it can increase in value. The investor may have surplus cash flow due to a larger salary. They will still have quite a long time to recover any losses on money or investments they put away. So an investor should still be able to take on some risk. 30s However, this age bracket also typically comes with more financial responsibility, such as a mortgage or children, and this may reduce risk tolerance. 40- At this point, retirement is approaching, but an investor is likely to be earning their highest salary, so there is 50s potentially an opportunity to invest and save at a larger rate than previously. For those who have decided to retire, this is a time to reap the rewards of hard work. However, this does not mean that investments need to stop, as it is possible to use their investments to supplement their retirement 60+ income. There are two distinct ways to invest in retirement – draw down a portfolio and reinvest spare retirement income. Risk profiles at this age are usually relatively conservative with the intention to protect the retirement income. Due to increasing longevity, it could be argued that another phase can be added to cover aged care. In this phase, security of capital and income is of prime concern, as is retention of Centrelink benefits and minimisation of residential aged care fees (where applicable). A special feature of this phase is that often only one partner remains alive, and there may be a third party acting under a power of attorney or guardianship on behalf of the client. This is likely to be of increasing concern for financial advisers due to the ageing population. Apply your knowledge 3: Considering life stage risks Answer the following questions based on the above paragraphs: 1. In what ways might these age-based risk profiles impact future investment choices? 2. Have you experienced any shifts in your own investment risk tolerance as you have grown older? If so, what influenced these changes? 3. Considering your financial responsibilities and goals, how do you currently balance risk in your investment decisions? Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.12 3 Understanding client goals Once the data collection process is complete, and cash flow and net worth have been analysed, the client’s current position will be apparent. The next step is to review the available information to determine whether the client’s goals are achievable. 3.1 Determining the client’s goals Clients often have difficulty in expressing their goals. They may not have given much thought to what they want to achieve, or they may not know how to put their goals into words. Clients will often approach advisers with a general request to assist in building wealth. They know they should do something but are unsure of where to begin, or they want to know what they should do next. The financial adviser can assist clients to work out their financial goals and clearly articulate them. The importance of goal setting in the process of designing an investment strategy cannot be emphasised enough. These goals provide the direction for a client’s financial plans, and in turn guide the recommendations made by the adviser. One way to begin is to simply outline the client’s immediate or short-term needs (over the next two years), then progress to medium-term goals (the next two to seven years) and then discuss long-term goals. Short-term goals Short-term goals might be: pay off credit cards pay this year’s school fees buy a new car implement a savings and investment plan use new money wisely (e.g. salary increase, bonus) use a lump sum wisely (e.g. inheritance). Medium-term goals Medium-term goals might be: repay mortgage upgrade home purchase a holiday home travel more fund their children’s education improve standard of living. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.13 Long-term goals Long-term goals generally relate to retirement. Clients may choose to quantify a specific annual income needed to cover expenses in retirement, or may simply state that they wish to maintain their existing lifestyle. Clearly stating their goals in the short, medium and long term is important to the client as it helps them to understand how to define their goals and objectives, and to refine them if necessary. It is also important for the adviser to outline the client’s goals in writing and present this to the client in the SOA document. This helps to: ensure that the adviser understands the client’s needs clarify whether there have been any changes to the client’s circumstances determine whether the client’s goals are achievable. 3.2 Incompatible and non-achievable goals Some clients may wish to implement strategies that assist in creating wealth over the long term; however, they do not want such strategies to interfere with their current lifestyle. Assisting clients to realise that some of their goals are not achievable or are conflicting is a difficult part of the financial planning process. The financial adviser’s role becomes one of negotiator, helping the client to accept a trade-off. For example, the client may need to modify their goals, adjust their expectations or change their current financial behaviour. The concept of a ‘trade-off’ is explained in more detail later in this topic. Example: Potentially incompatible goals Some examples of conflicting goals are shown in the following table. Client wishes to: Client also wishes to: Retire early Retire with a high level of income Continue to spend available funds on Have high levels of retirement savings current lifestyle Be certain of investment outcomes Have high levels of return and take on risk Repay non-deductible debt Increase expenditure on lifestyle assets Have high level of retirement income Maintain a high level of estate assets 3.3 Investor objectives In general, an investor’s goal for owning assets is for them to provide for current and future liabilities (e.g. living expenses, mortgage repayments, gifts to children). These goals can be broken down into a return objective (how much the assets need to grow) and a risk objective (how certain are the returns from the assets). Ultimately, the return and risk objectives have to be consistent with reasonable capital market expectations (expected return, risk and correlation of equities, property etc.) as well as client constraints. If there are inconsistencies, they must be resolved by working with the client. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.14 The return objective Often the return can be divided into ‘required’ and ‘desired’ components. How it is divided depends on what is important to that client and the facts they present. Required return is what is necessary to meet that client’s high-priority or critical goals. They might include living expenses, children’s education or health care needs. Desired return will similarly depend on the client, but might include buying a second home or world travel. There is an argument for distinguishing between return from income and growth sources. This can, however, be considered inferior to a total return approach. Total return does not distinguish return from dividends, interest, or realised or unrealised price changes. As long as a sufficient return is earned in the long run, funds can be available to meet the return needs. The return objective will also specify whether it is nominal (including inflation) or real, and before tax or after tax. The risk objective This objective should address both the client’s ability and willingness to take risk. The client’s ability to take risk is determined objectively, while willingness to take risk is a far more subjective, emotional matter. Ability to take risk The ability to take risk refers to the ability of the portfolio to sustain losses without putting the client’s goals in jeopardy. It concerns how much volatility the portfolio can withstand and still meet the client’s required expenditure. Ability to take on risk is significantly affected by the investor’s time horizon and the size of the expenditure relative to the portfolio. Generally, if expenditure is small relative to the client’s portfolio, the client is more able to take on risk. The portfolio can experience significant losses and continue to meet the expenditure. Likewise, if the time horizon is long, conventional wisdom states that the portfolio has more time to recover from poor short-term performance. All else being equal, the longer the time horizon, the more the client’s ability to take on risk increases. If expenditure is large relative to the size of the portfolio, the amount of loss the portfolio can sustain while continuing to meet required expenditure is significantly reduced. Another consideration is the importance of goals. To determine the importance of a goal, consider the consequences of not meeting it. For example, goals related to maintaining the client’s current lifestyle, achieving a desired future lifestyle and providing for loved ones are usually classified as critical. Those related to acquiring luxury items, taking lavish vacations etc. might be important but are usually considered secondary. The importance of required expenditure and the ability to take risk are inversely related. All else being equal, as the importance of an expense increases, so does the importance of ensuring that it is met. It is therefore necessary to protect against portfolio losses that could place it in jeopardy. The ability to take risk is reduced, and the portfolio needs to be structured with low expected risk. If a spending goal or amount can be changed, the client has flexibility. For example, assume a lavish retirement lifestyle is built into the client’s planning. If the annual retirement spending can be safely reduced without causing much concern to the client, this flexibility means the client is more able to take risk. In determining flexibility, look for the ability to reduce spending and eliminate or change bequests or charitable donations. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.15 If the client is still working or has other assets, this will increase their ability to take risk, as asset value that is lost can potentially be replaced. Liquidity needs could also be a factor that reduces the ability to bear risk. If the client requires large amounts of the portfolio to be distributed, this will significantly reduce the available assets. Willingness to take risk The client’s willingness to take risk is subjective, and can be determined through an analysis of their psychological profile. There is no hard and fast rule for judging willingness to tolerate risk, so look for statements or evidence in the client’s actions. Clients sometimes indicate their willingness to take risk by what they say. These statements usually take the form of disallowing risky investments, or can be specific statements about their attitude to risk itself. Either type of statement could indicate that the client is focused on risk and is less willing to take it. 3.4 Investor constraints In general, there are five investment constraints that may apply to an investor: time horizon tax considerations liquidity legal and regulatory factors unique circumstances. An individual investor may have constraints in some or all of these categories. In understanding the client’s investment goals, it is important to understand these internal and external factors. Time horizon Time horizon is often important because it affects ability to bear risk. In the most basic terms, an individual’s time horizon is the expected remaining years of life. It is the total number of years the portfolio will be managed to meet the investor’s objectives and constraints. While there are no precise definitions, 15 years or more is typically considered long term; short term is usually three years or less. Also, many time horizons are multistage. A stage in the time horizon is indicated whenever the client experiences, or expects to experience, a change in circumstances or objectives significant enough to require evaluating the investment policy statement (IPS) and reallocating the portfolio. Consider the following time horizon statement for a 50-year-old individual planning to retire at age 60: The individual has a long-term time horizon with two stages: 10 years to retirement and retirement of 20–25 years. In this case, as in most, retirement means a significant change in circumstances for the individual. Before retirement, the person likely met most, if not all, living and other expenses with their salary, maybe even managing to save (add to the portfolio). At retirement with the subsequent loss of salary, the person will have to rely solely on the portfolio to meet any liquidity needs, including living expenses, travel and entertainment expenses, gifts to family or charity etc. Changes in the client’s circumstances are significant enough to warrant reallocating the portfolio according to a new set of objectives and constraints. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.16 Tax considerations The effect of taxes must be considered when determining the investment strategy for any taxable investor. Capital gains taxes, for example, affect the realised selling price of an asset regardless of when it is sold. Annual taxes reduce the value of the portfolio every year and thus affect the final multi-period value of the portfolio through a reduction in annual compounding. Understanding a client’s tax position is essential because returns from different investments may be taxed differently and may therefore impact significantly on the level of tax paid. The tax treatment of these investments will depend on the composition and source of the return. The following provides some general principles: Income is treated as assessable income and taxed at the client’s marginal tax rate. For the 2023/24 financial year the brackets are as follows: Taxable income Tax applicable in each band (not including Medicare levy of 2%) 0–$18,200 Nil $18,201–$45,000 19c for each $1 over $18,200 $45,001–$120,000 $ 5,092 plus 32.5c for each $1 over $45,000 $120,001–$180,000 $29,467 plus 37c for each $1 over $120,000 $180,001 and over $51,667 plus 45c for each $1 over $180,000 The Medicare levy surcharge also applies to certain thresholds and rates. This is dependent on income level, as below: Threshold Base tier Tier 1 Tier 2 Tier 3 Single threshold $93,000 or less $93,001–$108,000 $108,001–$144,000 $144,001 or more Family threshold $186,000 or less $186,001–$216,000 $216,001–$288,000 $288,001 or more Medicare levy 0% 1% 1.25% 1.5% surcharge Note: The family income threshold is increased by $1,500 for each MLS dependent child after the first child. Capital gains will be taxed when realised. If held for less than 12 months, then the total gain is assessable income; if held for more than 12 months, then only 50% of the gain is assessable on sale. The CGT discount is not available for any assets held in a company structure. The CGT discount is reduced to 33.3% for assets held in a superannuation fund, in the accumulation phase, again for 12 months or more, while superannuation assets in the retirement or pension phase are exempt from CGT. If there have been carried forward losses, these will allow a taxpayer to use the losses and offset the taxable income in future years. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.17 Imputation credits can be offset against any tax payable and if there is an unused balance, this will be refunded as a cash payment. Other specialist assets have specific tax treatments which need to be understood. Some of these investments are tax driven and take advantage of provisions in the taxation legislation to encourage investment. Income from foreign investments is treated in a similar fashion to local investments. However, there may be foreign tax credits that need to be considered. Foreign investments do not have imputation credits. Distributions from managed funds will be treated according to the composition of the distribution and may contain dividends, interest, distributions, capital gains, franking credits and other tax benefits. There may also be foreign earnings and foreign tax implications in the distributions. Superannuation contributions and superannuation funds are taxed differently to normal investments. There are benefits in investing in superannuation. However, it is also necessary to be aware of the future impact of these contributions, which may lead to additional tax being paid when the person accesses these funds. Since 1 July 2021: – the general concessional contribution cap is $27,500 for all individuals, regardless of age. Concessional contributions are contributions to a superannuation fund that are included in the fund’s assessable income. These contributions are taxed at a ‘concessional’ rate of 15%, which is often referred to as ‘contributions tax’ (ATO 2022b). – the non-concessional (after-tax) contribution cap is $110,000, or $330,000 over three years, when eligible to trigger the bring-forward provisions. The general transfer balance cap is $1.9 million in 2023/24. This limits the amount of superannuation that can be transferred into the retirement or pension phase, where there is no tax on investment earnings. The cap of $1.9 million will only apply to clients who have not held a retirement phase income stream between 1 July 2017 and 30 June 2023. If they have held a retirement phase income stream prior to this date, their personal transfer balance cap will be between $1.6 million and $1.9 million. When you start a retirement phase income stream for the first time, you will have a personal transfer balance cap equal to the general transfer balance cap at that time. From 1 July 2023, this is $1.9 million. If you had a retirement phase income stream before 1 July 2023, your personal transfer balance cap will be: if you exceeded your transfer balance cap at any time between 1 July 2017 and 30 June 2023, your transfer balance cap that applied at the date at which you first exceeded it. in all other cases, between $1.6 and $1.9 million, based on the highest ever balance of your transfer balance account. The general transfer balance cap, on which your personal transfer balance cap is based, is increased in line with the consumer price index in $100,000 increments. Company tax rates have fallen for small businesses (base rate entities). From 2021/22, if the business’s turnover is less than $50 million, the company tax rate is 25%. The tax rate for all other companies with turnover greater than $50 million (non-base rate entities) remains at 30% (ATO 2022a). Further detail on taxation is provided in ‘Topic 8: Tax issues in investment advice’. Accordingly, when developing a client’s portfolio, it is necessary to be fully aware of the implications the investments will have on their current and future tax position, to structure the portfolio to give the maximum tax advantage. In addition, if the client has current investments, the tax impact also needs to be considered before they are retained or sold. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.18 Go to the following ‘Recommended resource’ in KapLearn (ATO n.d.) General transfer balance cap. This resource has details the transfer balance cap, which is a limit on the total amount of superannuation that can be transferred into the retirement phase. Liquidity Liquidity can have an important effect on the ability to bear risk and in the details of the return calculation or strategic asset allocation (SAA). Depending on the situation, liquidity can have several meanings and interpretations. In a portfolio context, it means the ability to meet anticipated and unanticipated cash needs. The liquidity of assets and of a resulting portfolio is a function of the transaction costs to liquidate and the price volatility of the assets. High costs and a lengthy time to complete the sale make for lower liquidity. Higher price volatility makes for less liquidity, as it increases the probability the asset would be sold for a low value. Clients’ needs for liquidity include the following: ongoing, anticipated needs for distributions, such as living expenses emergency reserves for unanticipated distributions could be appropriate if client-specific and agreed to in advance. Otherwise, they create a ‘cash drag’ on the portfolio return by continually holding assets in lower return cash equivalents. Holding three months to one year of the annual distribution in cash reserves could be reasonable, if agreed to in advance one-time or infrequent liquidity events to meet irregular or unplanned distributions should be noted. It is necessary to be as specific as possible as to how much is needed and when positive liquidity inflows not due to portfolio assets should be noted liquidity to take up upcoming investment opportunities including those created following market downturns illiquid assets, such as those restricted from sale or those on which a large tax bill would be due on sale, should be noted the client’s ownership of a home is generally an illiquid asset and could be noted here. Legal and regulatory factors The legal and regulatory constraints that apply to individuals typically relate to tax relief and wealth transfer. There are several tax vehicles available to clients, including superannuation, family trusts and a company. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.19 Unique circumstances This is a catch-all category that can affect the management of the client’s assets, and includes factors which are not covered in the other constraints, such as: special investment concerns (e.g. socially responsible investing) special instructions (e.g. gradually liquidate over a period of time) restrictions on the sale of assets (e.g. a large holding of a single stock, not wanting to sell an investment property) asset classes the client specifically forbids or limits based on past experience (i.e. position limits on asset classes or totally disallowed assets) assets held outside the investable portfolio (e.g. a primary or secondary residence) desired bequests (e.g. the client intends to leave their home or a given amount of wealth to children, other individuals or charity) desired objectives not attainable due to time horizon or current wealth. 3.5 Identifying insurance and estate planning needs The goals a client initially identifies may not extend to the areas of insurance and estate planning. It is the role of the financial adviser to help the client understand the importance of being appropriately covered in these areas. Having appropriate insurance cover is not a goal in itself. Rather, it is the mechanism by which personal goals can be achieved in the face of death, disability or trauma. It may assist in protecting a client’s wealth should one of these unfortunate incidents occur. A skilfully developed and implemented investment strategy will be useless if the client suffers from a trauma, disability or untimely death. Estate planning encompasses the entire financial planning process, from wealth and asset acquisitions, and growth and protection of assets through to the tax-effective transfer of assets to the nominated beneficiaries. While clients may not have considered approaching a solicitor to draft a will or grant their partners an enduring power of attorney, both are critical if the clients want their wishes to be carried out. Both insurance and estate planning are therefore essential components of good advice. As a financial adviser, it is your responsibility to raise these issues and help the client realise their importance. Sensitive questioning can help clients to consider both needs and make appropriate decisions. Furthermore, it helps to extend the client–adviser relationship beyond investment advice alone. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.20 4 Gap analysis and trade-offs A gap analysis is an analytical process that uses financial projections to determine if the client has a reasonable probability of achieving their goals, assuming they do not change their lifestyle or investment habits. For many clients, achieving their goals will require significant changes, and unless a gap analysis is completed, neither the client nor the adviser will know what level of change is required. This will often involve the client making a trade-off. Figure 3 below outlines the gap analysis process. 4.1 Process of gap analysis The process of gap analysis involves: constructing projections based on current investments comparing projections to goals over the relevant time frame revising goals and existing strategies if necessary constructing revised projections that take account of any revised goals or investment strategies. These aspects of the gap analysis process are discussed below. Gathering sufficient information The financial adviser must have confidence in their assessment of the client and the client’s willingness to make certain trade-offs. This will be achieved through discussions and confirmation with the client. While it is ideal to work closely with clients over several meetings, the reality is that most initial financial plans are developed after the first meeting and presented in full at the second meeting. If the adviser has not obtained all the relevant information about the client, it is likely that there will be deficiencies in the initial advice and there is a good chance that the client will not accept the advice. Redeveloping an SOA to incorporate additional information once an investment strategy has been developed can be costly and time consuming. Therefore, it is important to gather comprehensive information in the first instance. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.21 Figure 3 Gap analysis process Constructing revised Consructing projections projections Begin by projecting the future value After revising your goals or of your current investments based strategies, create new projections on historical performance and that account for these changes. expected returns. These projections These revised projections reflect the provide an estimation of your adjusted investment approach and investment growth over a specific provide a clearer picture of potential timeframe. outcomes. Revising goals and strategies Comparing projections to goals If the projection–goal comparison Compare the projected value of reveals a significant gap, consider your investments to your revising your goals or investment established financial goals. This step strategies. This might involve highlights whether your investments adjusting target amounts, are on track to meet your objectives timeframes, risk tolerances or asset within the intended timeframe. allocations. 4.2 Constructing projections One of the key inputs to a gap analysis is the use of projections. It is ideal first to see what eventuates if no changes are made to the client’s existing investment strategy; that is, what happens if the client continues to do what they are currently doing? In order to do this, assumptions may need to be made. These assumptions need to be detailed in the SOA and repeated where the projections are made. Projections serve two purposes in giving advice: They are an analytical tool for advisers to compare scenarios and make informed decisions about their recommendations. Projections will help to demonstrate the appropriateness of the advice. They are an excellent tool for illustrating outcomes and benefits to clients. Some of the requirements for constructing projections are as follows: Use reasonable earning rates in all projections. Earning rates should be based on the expected rates as determined by an internal or external research source. Use reasonable indexing rates. For example, assume that a middle manager’s salary will increase in line with the increase in general wages (average weekly ordinary time earnings (AWOTE)). Make sure that all assumptions regarding the projections are included. Test the projections with different variables and analyse the results. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.22 4.3 Initial projections Projecting the current situation can indicate whether the client will be able to achieve their goals if they make no changes. In most instances, projections based on the current situation will highlight any gaps and show that a revised investment strategy is needed to achieve the client’s goals, as shown in the following case study. Case study: Melissa and Lee Melissa and Lee (both aged 50) each earn $50,000 p.a. and have no dependent children. They would like to retire in 10 years’ time on a combined income of $40,000 p.a. indexed to inflation. For a number of reasons, they have low superannuation balances and no personal investments apart from their home. They are both conservative investors. Melissa’s superannuation balance is $31,000 and Lee’s is $60,000. Their employers pay SG contributions of 10.5% p.a. (2022/23 FY) and mandated SG contributions are expected to increase progressively to 12% by 2025 (ATO 2023). They estimate they have $20,000 p.a. savings capacity, having recently repaid their mortgage. They now direct some surplus cash flow to superannuation as non-concessional contributions ($4,500 each). The first step is to look at their superannuation balances if they continue the way they are going (i.e. no-change scenario). Using a standard projection model, and assuming their superannuation is earning 3% after fees and taxes and that their income increases with AWOTE (assumed at 3% p.a.), Lee’s balance will be $199,261 and Melissa’s will be $160,129 ($359,390 combined) in 10 years’ time. Go to the following ‘Recommended resource’ in KapLearn (Kaplan Higher Education n.d.) Projections for Melissa and Lee. * AWOTE assumed at 3% p.a. Combined, their income stream falls short of their desired retirement income over the long term. It appears that their combined pensions will only be capable of generating about $10,000 p.a. until they reach age 90, not the $40,000 they were hoping for (refer to Figure 4 below), and if they did take $40,000 p.a., their superannuation would be depleted by age 68 (Figure 5 below). Figure 4 Projection — account-based pension income to age 90 Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.23 Figure 5 Projection — account balance if income of $40,000 is taken Note: Any Centrelink entitlements have been ignored for the purpose of this case study. Apply your knowledge 4: Gap analysis Using your understanding of the gap analysis process, answer the following questions: 1. Consider the goals you have set for your investments. Do you believe your current investments are adequately aligned with these goals? Are there any potential gaps you are concerned about? 2. How comfortable are you with constructing projections based on your current investments? Are you confident in your ability to estimate future investment performance? 3. Reflect on the idea of revising goals and strategies. How open are you to adjusting your investment approach if your projections do not align with your goals? What factors might influence your willingness to make changes? 4.4 Negotiating trade-offs The financial adviser must assess what level of change is required to achieve a client’s goals. This will require them to compare the client’s risk tolerance to their financial goals and investment time frame. If these elements do not match (i.e. it appears unlikely that the client will achieve their goals given the time frame and level of investment risk they are prepared to take), then the adviser will need to negotiate a trade-off that will allow the client to achieve their goals. The client may need to accept a greater degree of risk, or compromise, with respect to their financial goals. The following case study illustrates what the concept of a trade-off means in this context. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.24 Case study: Negotiating a trade-off Joanne (aged 50) intends to retire in 10 years’ time. At that time, she would like $30,000 p.a. to cover her living expenses. After completing the investor risk profile questionnaire, her financial adviser has determined Joanne to be a ‘moderately conservative’ investor. If Joanne currently has investments totalling $200,000, based on her current strategy her retirement capital in 10 years will be $431,800. The adviser calculates that Joanne will need approximately $460,000 in capital to fund her retirement. This assumes the following: income of 4% p.a. and growth of 4% p.a., net of fees inflation of 3% p.a. nil taxation (i.e. 100% of her capital will be held in retirement phase) her capital depletes over a term of 30 years. Her financial adviser will need to discuss with her the possibility that she may not meet her retirement goals ($30,000 p.a.). If she has limited savings capacity, which does not allow her to boost her retirement savings dramatically, one way to achieve her retirement goal is to consider if she would be comfortable investing a greater proportion of her assets in ‘riskier’ growth investments, such as Australian and international equities and alternative assets and, if so, to what extent. Such investments offer more potential for growth; however, there is also the potential for greater losses. The adviser will need to explain this carefully to Joanne and she will need to agree to this revised investment strategy. Alternatively, she will need to trade off her retirement income aim of $30,000 p.a. Joanne may feel more comfortable drawing a slightly lower amount of income in retirement rather than deviating from her risk profile. Of course, at some point in time in her retirement, the government age pension will assist in meeting Joanne’s retirement income needs. This will need to be factored in over time, when estimating income sources and capital drawdown rates. It is the role of the financial adviser to explain the implications of Joanne’s options in a way she will understand so that she can make an informed decision. 4.5 Revising goals and strategies Projections based on current investments will highlight any problems in meeting the client’s stated financial goals and the adviser will then look at what options are possible to address these issues. For example, at this point in the gap analysis for Melissa and Lee (see ‘Case study: Melissa and Lee’ above), the clients should be provided with a range of options to modify their goals, change their investment strategy, or both. For example, they can: spend less and save more work longer take a lower income in retirement increase their allocation to growth products. Usually, the goal that clients are most reluctant to change is the amount of money they require in retirement. This means that, to some extent, some or all other goals will need to be traded off. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.25 For example, Melissa and Lee might consider: retiring in 15 years instead of 10 (working five more years) taking a more aggressive approach to investing adopting a strategy to contribute to superannuation via salary sacrifice. Revised projections In some instances in the past, excessively high earnings rates were used in financial projections in order to sell products to clients. ASIC expressed concerns about the use of inflated assumptions and performance projections for products or asset classes, and issued Regulatory Guide 170 (RG 170) ‘Prospective financial information’ which gives guidance on financial forecasts and projections (ASIC 2011). While it is necessary to use projections to illustrate both a ‘change nothing’ investment strategy and the new ‘recommended strategy’, it is important, as shown previously, to state all assumptions used in such projections and to ensure that reasonable earnings forecasts are used. Go to the following ‘Recommended resource’ in KapLearn (ASIC 2011) Regulatory Guide RG 170 ‘Prospective financial information’. This resource provides guidance on ASIC’s approach to the use of prospective financial information (including financial forecasts and projections) in a disclosure document or product disclosure statement (PDS). While this Regulatory Guide was issued in 2011, it is still applicable today. The guide is intended to help issuers of financial products understand whether and how to include prospective financial information in a disclosure document or PDS. It outlines: when prospective financial information can or should be disclosed what are reasonable grounds for stating prospective financial information how prospective financial information should be disclosed. Looking again at the case study about Melissa and Lee, the first revision might be to increase the rate of savings through salary sacrifice, as they have significant savings capacity. Instead of contributing post-tax savings of $4,500 p.a. each to superannuation, Melissa and Lee begin to salary sacrifice $10,000 p.a. each to superannuation. They agree to adjust their portfolio to include more growth assets which are designed to provide an average return of 4% p.a. after fees and taxes. They also decide to put off retirement until age 65 (i.e. 15 instead of 10 years’ time). Figure 6 below presents the results based on $20,000 of salary sacrifice contributions to superannuation until retirement (split equally between Melissa and Lee). Based on these revised projections, Melissa’s and Lee’s superannuation balances increase to $355,351 and $408,140 respectively by age 65, giving them a combined balance of $763,491. (See the Appendix Projections for Melissa and Lee). Figure 7 below shows that they can now generate their desired income of $40,000 to around age 82. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.26 Figure 6 Account balance with $40,000 per year based on revised projection salary sacrifice to age 65 and increased risk/return Figure 7 Required pension income until life expectancy Melissa and Lee’s retirement income from the increased capital base has greatly improved as a result of the recommended strategies. They still face longevity risk, which the adviser will need to address through further modelling and discussions with the clients. Other variations that could be assessed to further refine the projections include: further increasing their current savings levels, cash flow permitting whether they may wish to work part-time after age 60 boosting savings through strategies such as gearing and transition to retirement, as applicable undertaking strategies to maximise Centrelink entitlements taking on more risk to potentially increase the rate of earnings (e.g. to 5%) by increasing allocation to growth products. By revisiting the projections, the adviser can work through the clients’ goals, current investments and savings behaviour and test their willingness to trade off their goals to achieve their primary objective. Other considerations must be factored in to create a holistic plan which works for the clients in the short term as well as long term. This includes maintaining a balance between savings or investments held inside and outside of superannuation (to meet any preretirement goals), the need for insurance cover, and liquidity and cash flow considerations. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.27 4.6 Documenting trade-offs Once this analysis has been completed and the client has agreed to the recommended modifications, the process is summarised and the agreements are included in the SOA. It is important that recommended asset allocations that deviate from the client’s investor risk profile are highlighted and explained in the SOA. Clients cannot make an informed decision about investment recommendations unless the adviser has clearly explained any differences between the risk of the recommended investment portfolio and their investment risk tolerance. Through this process, the recommended portfolio effectively becomes the agreed portfolio. Financial advisers have an obligation under the Corporations Act 2001 (Cth) to provide recommendations that are in line with a client’s willingness to sustain investment risk. There is also a requirement for financial advisers to explain what investment risks the client is likely to face if they implement the recommendations made in a plan. At the product recommendation stage, advisers must discuss the risks associated with the recommended products. Where the asset allocation required to achieve the client’s goals has a higher allocation to growth assets than their preferred asset allocation, the client must understand and accept the expected higher levels of volatility. The financial adviser can guide the client by educating them about the level of risk needed to achieve their goals. Such discussions must be noted in detail in client files. Alternatively, if the client is not willing to accept the level of risk, the adviser will need to discuss revisions to their goals and the client will need to revise their expectations. Such discussions must be noted in detail in client files. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.28 5 Tailoring asset allocations to client needs Given a client’s investment needs and their risk tolerance, an appropriate asset allocation across all investment products must be developed. However, it is important to clarify certain aspects of the asset allocation process at this stage of the planning process. 5.1 Asset allocation approach There are different approaches that can be taken when managing an asset allocation. Strategic asset allocation (SAA) Strategic asset allocation involves having a benchmark with narrow variation ranges, so the allocation of funds is expected to remain largely fixed, unless the client’s risk profile itself is changed. Tactical asset allocation (TAA) Tactical asset allocation involves more aggressive short-term variations from the benchmark allocations, in order to take advantage of a view that different sectors may be over or under-valued. This might involve variations between specific asset classes (e.g. holding a greater level of emerging market equities, relative to developed market equities), or across the growth and defensive asset divide. Dynamic asset allocation (DAA) Dynamic asset allocation represents similar variations from benchmark allocations, but with a longer period of time in mind. It can be based on long-term forecasts of economic or market outcomes that may take some time to eventuate. The aims of both tactical and dynamic variations may be to secure higher than market returns (i.e. alpha), or to secure a similar long-term return as a strategic asset-allocation approach, but with a smaller volatility in returns or with lower risk. These approaches are discussed further in ‘Topic 5: Portfolio construction techniques’. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.29 5.2 Risk tolerance and asset allocation Once the gap analysis has been completed and the client has agreed to any trade-offs required, the process is detailed and those agreements are confirmed in the SOA. Appropriate asset allocations can then be determined. Licensees will usually have their own asset allocation categories based on their risk analysis profiling. These serve as the general guideline for advisers to create suitable investment portfolios for their clients, by matching the client’s risk profile to the corresponding asset allocation category. It is unlikely that simply referencing the investment risks in the SOA or through a product disclosure statement (PDS) will improve your client’s understanding of how these investment risks affect their portfolio performance, even though it may meet ASIC requirements under RG 170. A better way of addressing this is to discuss investment risk with the client in person, using language they understand. Where recommendations are made in the SOA, the specific risks associated with those recommendations should be outlined. For example, if an adviser recommends a particular managed fund, such as an Australian equity trust, it is important that the adviser has a thorough understanding of the fund’s features and associated risks and explains them clearly to the client. The explanation can include (but need not be limited to) the fund manager’s approach to investment; whether they undertake gearing; the sectors in which the fund invests; the number of stocks included in the portfolio; the key people managing the fund; the investment process; the fund philosophy; major holdings; expected volatility and behaviour during market downturns; and risk of capital loss. It is also appropriate to include a summary near the end of the SOA that reviews the benefits and risks associated with implementing the recommendations. This provides an opportunity for the financial adviser to review the risks involved and settle any questions or misunderstandings that the client might have before the advice is implemented. 5.3 Adjustments to asset allocations As noted above, the risk tolerance assessment allows the financial adviser to determine the client’s preferred asset allocation. It also indicates the degree of volatility the client will accept. One of the outcomes of completing a gap analysis (as discussed in section 4) is that clients might have to accept an asset allocation with a higher percentage of money invested in growth assets in order to achieve their objectives. This is especially true where the client has a low savings balance and a relatively short time in which to save before retirement. However, the investment time frame for growth assets is greater than seven years, and this will affect short-term goals. If the adviser recommends asset allocations which are not in line with an investor’s risk profile, the adviser must negotiate with the client and explain the level of risk involved. The adviser should note such discussions and explanations in the client’s file. For example, it will not be appropriate to allocate 50% of a balanced investor’s portfolio to international equities unless there is a good reason for this (e.g. to achieve their stated objectives) and the client is aware of, and comfortable with, the additional risks. If a higher level of risk must be taken, a clear explanation of the reasons should be included in the SOA. This adjustment can be illustrated by providing two asset allocation tables — one that shows the client’s benchmark asset allocation based on their risk profile and another that shows the recommended allocation — and explaining why an adjustment is advisable. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.30 Case study: Adjusting Peter’s asset allocation Peter’s risk profile indicates he is a balanced investor. The asset allocation ranges for this level of risk would be as follows: Cash: 0–20% Fixed interest: 0–40% Australian shares: 28–48% International shares: 12–32% Property: 0–15% Within these ranges an appropriate benchmark asset allocation could be as set out in Figure 8 below. Figure 8 Benchmark asset allocation suitable for a balanced investor However, based on Peter’s goals and objectives, you believe that it would be more appropriate to recommend a higher allocation to growth assets. This can be done within the asset allocation range for a balanced investor, and therefore still align with Peter’s risk tolerance. By increasing the allocation to growth assets (i.e. equities and property) within the asset allocation range and reducing the allocation to defensive assets (i.e. cash and fixed interest), a revised asset allocation with stronger growth potential could be recommended, as indicated in Figure 9 below. Figure 9 Recommended asset allocation The allocation to cash and fixed interest has been reduced in the recommended portfolio. Peter may be willing to accept the recommended portfolio once the increased growth potential and level of risk are explained. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.31 The above case study demonstrates how adjustments can be made to asset allocations in accordance with a client’s risk profile. However, if it is necessary to move, for example, from a conservative to an aggressive growth portfolio to achieve a client’s goals, it will be unreasonable to expect the client to accept a substantial change immediately. In this case, the adviser can recommend a small initial increase in the allocation to growth assets and then look to increase that allocation progressively over time, once the client is comfortable with the level of risk. Note: Many licensees stipulate that advisers must adhere to the asset allocation determined by the client’s risk profile, allowing a variance of no more than +/–5% from the recommended asset allocations for each asset class. Where the recommended asset allocation is outside this range, the adviser may need to seek one-off approval from the licensee by providing appropriate reasoning. When an asset allocation is being changed, it may be implemented by: auto-rebalancing a portfolio using a platform feature re-weighting an existing portfolio adding additional funds to a portfolio. When deciding how to implement the change, an adviser may wish to consider the impact of transaction costs and taxation on the method selected. Depending on the investments used, fees and charges such as buy/sell spreads or brokerage may be charged on any transactions. The selling of existing investments may also trigger a liability for tax for the investor or a related entity such as their superannuation account. When available as an option, the same change to the overall asset allocation may be possible by allocating new portfolio funds to investments that balance with existing investments, reducing transaction costs. Depending on the size of the change, having new income distributions re-invested in a different manner may achieve the desired change with fewer transactions. Document classification: Confidential FPC008 Investment Advice | FPC008_T1_v12 © Kaplan Higher Education 1.32 Apply your knowledge 5: Asset allocation

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