There’s no ‘perfect form’ for KYC

Advisors need to worry less about the specific form used and focus more on building a relationship with their clients so that they truly know them on a personal level, according to speakers at the Advisor Group’s Fall Compliance Conference.

“The best way for us all to protect ourselves, and more so to make sure we’re doing the right thing for the client, is to turn the form into a process,” says John Kelleway, regional vice-president, GTA, & branch manager, Dundee Securities.

While a KYC form may provide a useful starting point in the discovery process, forms alone leave room for misinterpretation. What the client understands as “medium risk” is likely very different from the advisor’s definition.

“Many of the mutual funds that we see today are rated medium risk at most firms, and some of those are down 40% to 50%,” he says. “I think we all underestimated the risk ourselves.”

The KYC is a two-way street, but as the professional in the relationship, it is up to the advisor to ensure the client understands this. At the bare minimum, the client should keep the advisor apprised of any major life events, including marriage, the birth of a child, divorce and the death of a relative.

“It works in partnership. You’ll be calling them when things change from your end, but it’s important that they call you as well,” says Kelleway. “That is one of the things that I see not happening as well as it should.”

Dundee’s software tracks the date of the last modification to the client’s profile. If it has been two years since the last update, the company’s “two-year tickler” alerts the advisor that the client’s file may be getting stale, and prompts him or her to contact the client for an update.

Kelleway points out that advisors who hold themselves out as planners, rather than investment advisors, will be held to a higher standard by regulators. Obviously, creating a holistic financial plan requires far more detail than asset management alone.

Regulators are aware of the shortcomings of the standard KYC form. Advisors should collect supporting documentation for some of the key entries on the form, according to Prema Thiele, partner, Borden Ladner Gervais.

“If you’re selling exempt securities under an accredited investor exemption, you would think that your KYC form should include the kind of information that you need to be sure that you have the accredited investor exemption, i.e., that it has the income and net worth specification that clearly allows you to perfect that exemption,” she says. “Remember, what we’re trying to do is bullet-proof yourself with these forms.”

Another problem with just filling in the blanks is that the entry may be ambiguous. Thiele offers the example of a form in which the time horizon was listed as “none.”

“Does that mean that I have an extremely long time horizon, or does that mean I have a very short-term [horizon]?” Thiele asks. “Or does it mean that I don’t care? What does ‘none’ mean when we don’t have a time horizon?”

Information on a form may also be inconsistent. One client was listed as having a “speculative” investment style but also a “low” risk tolerance. The terms used on the KYC form often need to be defined by the advisor.

Kelleway recommends using demonstrations to which the client can relate. For example, a client may profess to be comfortable losing 20% of his or her assets inside a month. But would that client still be comfortable if his or her $100,000 portfolio turned into an $80,000 portfolio? Possibly not.

Complicating matters further are clients with multiple accounts, in which case Thiele suggests advisors conduct a KYC process on each account. The risk tolerance on an RRSP account for a 45-year-old may differ significantly from that on an open account.

Thiele says it is important that the advisor not substitute his or her assessment of a client’s ability to absorb a loss for the client’s own risk tolerance.

“It has been suggested that one’s risk tolerance should be the lower of the client’s willingness to accept risk, versus the client’s ability to withstand a decline in their portfolio,” says Thiele. “It’s not just the client’s comfort level or attitude towards risk but also the client’s ability to withstand financial loss.”

Just as important is that the advisor not base the risk profile on the client’s expected return. The client wants a 10% annualized return, but if he or she is unwilling or unable to sustain a significant market downturn, the advisor needs to manage expectations.

“Sometimes I think risk tolerance is determined by other things that you have on your forms,” says Thiele. “I think on the determination of risk tolerance, those factors ought not to dominate your assessment. Just looking at the fact that [the client] earns more than $2 million a year — that’s not enough.”

Follow-up questions are vital. A 30-year-old client may tell his advisor that he has a long-term investment horizon and wants a 100% equity allocation in his RRSP. That may sound reasonable, but if it is his only account, the advisor should probably ask if the client owns a house. If not, does he plan on funding a purchase from his RRSP? Suddenly the time horizon may have shortened to only one or two years.

“We just heard the other day that the S&P 500 was back to levels from 1997, so after 11 years some people who held the index made no money,” says Kelleway. “Eleven years was supposed to be one of those long-term [horizons] where you can take a lot of risk because you have the ability [to recover].”