Sustainability preferences in investment products: the suitability test becomes (even) more complicated

Just how difficult it is to determine a good model by which to inventory a client taking out an investment service, so that regulatory requirements are properly taken into account, was already evident from a study earlier this year [1]. This study looked at how MiFID investor protection provisions relating to suitability are complied with in practice by private banks. One of the conclusions was that the questions asked as part of the suitability test vary enormously, from 15 to 49 questions. The survey did not yet include the suitability questions regarding sustainability, because the survey was conducted before the new obligations were in place. You will understand, the list of questions is not getting shorter because of the new obligations.

What is changing in the suitability test?

The new delegated directive (EU 2021/1253) amends the old MiFID directive on a number of points, including the suitability test. This directive came into force on August 2 and means that for existing clients, during the regular update of the test, sustainability preferences must also be included, at least once a year. For new clients, of course, this must be done immediately upon becoming a client.  

In our experience, adapting the suitability test seems easy at first glance, but the difficulty lies mainly in the assessment model behind it. The inventory of elements should be done with an "open mind" and should not be steering towards the investment firm's products. Once the elements have been collected, only then should the translation to possible products of the investment firm take place. ESMA also indicates in its guidelines [2]:

…. the assessment of clients' sustainability preferences should precede the presentation of the financial products to which an investment firm has access, to avoid influencing the expression of clients' sustainability preferences. 

Let's start again at the beginning. The suitability test comprised 3 elements:

• Client knowledge & experience 
• Financial resources of the client, including the ability to bear losses
• Investment objectives including risk tolerance 

To the latter element, in accordance with the Delegated Directive, sustainability preferences are added. In concrete terms, this means that an investment firm must take stock of whether a client is interested in:

1. A sustainable product according to the EU Taxonomy; and if so, what minimum percentage of 'sustainable' activities according to the EU Taxonomy.
2. A sustainable product in accordance with the Sustainable Finance Disclosure Regulation (SFDR); and if so, what minimum percentage.
3. A product that accounts for Principle Adverse Impact indicators; and if so, which indicators.

Leaving aside the fact that this categorization is different again from the different products distinguished within the SFDR (gray - Art 6, light green - Art 8, and dark green - Art 9), the above questions can be added quite easily to an existing questionnaire used to determine suitability. But then it needs to be determined whether the client's preferences sufficiently match the investment firm's products. In developing this "new" test, we use at least the following steps:

A. Inventory of products [3]

First of all, provide an up-to-date product overview in which the sustainability factors for each product are clear. This is because the sustainability factors are important in determining whether the product matches the client's sustainability preferences. This also touches on the product governance rules that are changing. A product can only be offered to a client once the institution has determined whether the objectives of the product fit the target market. 

B. Modify questionnaire:

1. Take stock of the importance the client attaches to sustainability. That way, a client does not have to delve into the technical definitions right away. After all, a client may also have no sustainability preferences. 
2. Also identify which sustainability categories the client considers important, environmental, social or governance. If a client does not consider social sustainability factors important at all, then products that focus predominantly on those social factors are also less likely to be considered.
3. Inventory the client's sustainability goals in accordance with the aforementioned format:
   1. 1. EU Taxonomy sustainable,
      2. SFDR sustainable, or
      3. Principle Adverse Impact indicators

and consider also establishing a relationship with the categorization maintained by the SFDR (Art 6, 8, and 9 products).

C. Translation to the products

Based on the client's characteristics, determine which products qualify. Of course, not only the new sustainability preferences play a role here, but also the other three elements from the suitability test. 

D. Communication with the client

Transferring these new obligations including the somewhat confusing definitions of sustainability within the EU Taxonomy and the SFDR is also a major challenge. A clear protocol for the advisor/relationship manager in which the client is educated to understand the ESG factors and indicate his/her preferences therein is essential in this regard. After all, how do you explain to a client that he or she can have sustainable product according to the SFDR but that does not mean it is "truly" sustainable (according to Taxonomy legislation)? And how do you ask the client about preferring a certain percentage of investment aligned with the EU Taxonomy if you are actually not sure if that percentage is feasible with your current products? And then what does that mean for product development within the investment firm?

As already concluded in the study referred to above, there are several roads that lead to Rome but not everyone needs to go to Rome, and some consider Paris far enough. These new sustainability preferences will complicate the suitability test and especially the translation of the suitability test results into the company's products.
Those who want to go to Rome and properly bring the client into the new requirements, might also just become the most sustainable.

For more information on this topic, please contact Miranda Haak - miranda.haak@4esgconsulting.nl

[1] Implementation of MiFID II investor protection provisions by private banks within the European Union, March 2022

[2] ESMA Guidelines on certain aspects of the MiFID II suitability requirements, September 2022

[3] SFDR kwalificeert als product onder andere: pensioenregelingen, individuele beleggingsportefeuilles en beleggingsinstellingen.