To that end, there have been attempts to create pan-European pension products, and to get more retail investment into private markets (i.e. the ELTIF).

But, so far, the EU has not tackled the regulations that underpin retail investment activities – MiFID II – which predates the CMU initiative. However, the European Commission is now considering significant changes to its investor protection rules that could not only change the way that investment firms do business, but also fundamentally shape the way that ordinary people invest.

The end of suitability and appropriateness tests

Much attention has been paid to the EU’s consideration of whether to introduce a UK-like ban on retrocession payments. There has been less focus on proposals to replace the sometimes-maligned MiFID suitability and appropriateness assessments. Advisers and distributors must undertake these tests before selling or recommending an investment to a retail client, and their overhaul is arguably as significant as a retrocession ban (ESMA says that “both [assessments] have been at the centre of supervisory and policy work over past years.”)

Currently, the tests are applied based on the type of investment service offered to the client. Distributors offering discretionary portfolio management or investment advice must subject their clients to the more onerous suitability assessment. Certain types of investments deemed to be non-complex, such as UCITS funds, can be sold to retail investors on an execution-only basis but only if the investment is found to be appropriate for the investor in question. Both tests are applied on an investment-by-investment approach.

The tests have been criticised for their onerousness. The application of the assessment to each transaction made by or on behalf of a client has particularly drawn ire because it means that the process must be applied each time a client switches out of one investment and into another. This can be onerous for wealth managers, for example, that oversee their client’s portfolio under a mandate from the latter.

Since August 2022, intermediaries must also consider their client’s sustainability preferences as a second step in these assessments. This has caused problems for firms due to a mixture of delayed regulatory guidelines, a current lack of good quality ESG data, and imperfect alignment between the suitability reforms and other sustainable finance regulations. These challenges are surmountable, but it is also true that the assessments have become more complex and place greater burdens on advisers’ knowledge, record keeping and processes.

The European Commission has proposed to introduce a new unified assessment that would replace and seek to improve on the current suitability and appropriateness tests.

The unified assessment

The Commission has provided an outline of the new regime that it is considering.

Scope

• The assessment would be “retail investor-centric” instead of focused on the types of investment services being undertaken (i.e., an assessment would be applied when a retail investor is involved in an investment activity, rather than applying different tests depending on whether the client is delegating portfolio management, receiving investment advice, or engaging in an execution-only transaction).
• It would be focused on portfolio composition rather than on individual products (i.e., the assessment would apply to the investor’s entire portfolio, rather than applied to each individual investment that the client might make).
• All retail investors would be subject to the new regime and not only wealth management / high net worth retail investors. It is not clear whether intermediate categories, such as semi-professional investors, must be subject to the assessment but our assumption is that it will not be a requirement.
• The new assessment should be the same under the MiFID and the Insurance Distribution Directive (IDD) rules (i.e., the same tests would apply whether the retail client is considering investing directly into investment products or to do so via an insurance wrapper).

Component 1: the retail client assessment

• The first stage would consider the investor’s investment objectives, personal circumstances, risk tolerance, and perhaps other aspects relating to suitability. The Commission does not mention the investor’s knowledge and experience, which apply under both current tests and which ESMA recommends should apply under the new assessment.
• The assessment’s main goal would be to provide the investor with the best possible returns, rather than simply identifying which investments are permissible in their individual circumstances.

Component 2: the personalised asset allocation strategy

• The output would include a personalised asset allocation strategy, an individual investment plan that encompasses the considerations made in the retail client assessment and that suggests an optimum allocation across asset classes (perhaps defined in percentage terms).
• The retail investor is not bound to follow the guidance and can choose to invest outside of their personalised plan. It is not yet clear whether there might be outer limits to opting-out, such that a retail investor cannot opt to invest in a way that is unsuitable for them.

Outputs

• The two components of the assessment should be provided to the retail client in a structured and machine-readable format for future reference.
• The assessment should be portable, allowing other financial intermediaries such as brokers and platforms to access the assessment with the client’s permission. The Commission envisages an assessment that is transferable along the value chain and between competitors offering investment services.

The implications

The proposed reforms would be more than a practical change but comprise an entirely different approach to the treatment of retail clients. Although not quite as all-encompassing as the FCA’s upcoming Consumer Duty, the EU’s retail client assessment demands that firms consider their investors’ circumstances and interests in a more comprehensive way than at present. At a minimum, it suggests a move away from the more tick-box or routine aspects of the current suitability and appropriateness assessments to a less mechanised, but more considered, manner of engaging with retail investors.

Although the broad direction is clear, there are many details to resolve, and the Commission emphasises that it is considering its options. Some of these issues were raised by the Commission in its targeted consultation, which closed in March 2022, such as whether the retail client assessment should include consideration of factors such as liquidity, regulatory and tax factors. Some of these issues are practically material; for instance, the extent to which a personalised asset allocation strategy should bind subsequent intermediaries that the retail client chooses to engage (the answer should probably be ‘no’ because the asset allocation guidance is not binding on the investor themselves).

On 13 April 2022, ESMA published a letter in support of the Commission’s proposals. Noting that key elements need to be decided, ESMA identifies some challenges, such as:

• Whether a “one size fits all” regime can serve all retail investors and in all circumstances. An example – not specifically addressed by ESMA – is whether an investor, perhaps only wishing to execute an order, might decline the assessment and asset allocation guidance, or whether the regime will be a requirement for all retail investors undertaking any investment activity. Underlying this point is a more general question as to whether the process can be standardised across firms, all retail investors, and all eligible investments. If not, there might be a trade-off between equal protection and portability versus a more tailored and individual approach.
• The significant operational changes required of firms, including changes to IT systems, will require sufficient time to implement. Firms might welcome the attempt to remedy the problems with the current suitability and appropriateness assessments, but the changes could come with large initial compliance costs – and greater ongoing costs and regulatory risks as compared with the more straightforward current regulations that are already embedded in firms’ processes.
• The change to the retail investor assessment necessitates a review of related rules, such as costs and charges disclosures, portfolio depreciation reporting (which firms must report to retail clients when their portfolio declines by 10% in value), and cost-benefit analyses that currently apply when recommending a client switch an investment. Although not mentioned by ESMA, firms will also wish to consider how the new assessments interact with client classification rules, which differ in some jurisdictions and for certain products (e.g., Germany has a semi-professional investor class, as do some pan-EU products such as venture capital and social enterprise funds).

Next steps

We are in the early stages of the policy process and there are many issues for the Commission to resolve before making a formal legislative proposal. ESMA’s public support for the initiative suggests that the Commission will move forward, and we should see further feedback from the Commission soon. These reforms form part of the Commission’s broader Retail Investment Strategy, and the process to be coordinated with the wider reforms (and with other potential amendments to MiFID II and the IDD). Depending on the other reforms, we can expect perhaps two years or more before legislation is finalised.

Incidentally, the EU’s reforms would not be automatically copied into the UK’s on-shored MiFID II legislation. The Financial Services and Markets Bill will require the UK’s regulators to take decisions about all on-shored EU rules, whether to copy, amend or to scrap existing requirements. The UK is already undertaking a review of retail investment disclosures, and related regulations will be under consideration too.

In the meantime, given the significance of these changes, firms with retail clients should closely watch the development of the proposals and, if necessary, engage with the consultation process at an early stage.