Understanding the changes to the MiFID II suitability assessment

If 2021 was the year of Sustainable Finance Disclosure Regulation (SFDR), 2022 is the year of MiFID[1]. The next stage in the European Union’s sustainable finance package is the addition of “sustainability preferences” in the MiFID suitability assessment in August 2022.

According to MiFID, advisers must carry out a suitability assessment before they recommend a product. This involves understanding the client (for example, their investment knowledge, financial situation, investment objectives etc.). Then it involves knowing the investment products, their objectives, risks, returns, costs etc. So that based on a client’s profile and investment goals, an adviser can recommend a “suitable” product.

What is changing from August 2022, is that advisers must include an additional consideration on whether clients have sustainability preferences. According to the regulation, the client can express these in one or a combination of three ways:

1. The percentage of a product’s alignment to the EU Taxonomy
2. The percentage of a product’s allocation to sustainable investments as defined in the Sustainable Finance Disclosure Regulation (SFDR)
3. Consideration of principal adverse impacts (PAIs); these are indicators aiming to capture material negative effects that investments have on the environment and/or society.

If the client expresses preferences with these options in a way that does not match the available product set, then a product cannot be sold unless those preferences are adapted.

There will be practical issues along the way.

As we have written before, the order in which different pieces of EU regulation come into effect is such that, currently, the process will be marred by data gaps. Specifically, the option of Taxonomy alignment will be difficult for products to report and for advisers to use. There will also be some gaps in the reporting of PAIs as company reporting of such indicators will become mandatory in waves, starting from 2024 (with the Corporate Sustainability Reporting Directive).

A further complication is that the definition of ‘sustainable investment’ in SFDR is open to interpretation so the methodologies behind the reported numbers for the second option will be different.

So, what can advisers do?

Firstly, advisers will have to explain all this to their clients before the actual preferences conversation starts. It will be important to help retail clients understand the different concepts and what they are trying to capture, as they will probably not be familiar with those.

To prepare, advisers themselves might need to examine what products are available, what they are reporting for the three options, the data coverage, any differences in approach or the levels across different asset classes, geographies and sectors. They should also be aware that these three options, viewed in isolation, can give only an incomplete picture of a product and would fail to capture the product’s investment objective, process, the sustainability characteristics it promotes or sustainable objectives it pursues (if any).

The next big question is how clients will express their preferences, if this will be close to the regulatory definition, and whether preference for specific aspects of product design will emerge.

As always with sustainability regulation: to be continued.

[1] Markets in Financial Instruments Directive II.