Suitability test and sustainability preferences

On 2 August 2021, delegated regulations/directives for MiFID II, IDD/SOLV, AIMFD and UCITS following the SFDR were published in the Official Journal of the European Commission (EC). We would like to draw your attention to the suitability test component of Delegated Regulation (EU) 2021/1253.

This Delegated Regulation requires the suitability test to be extended to include customer sustainability preferences from 2 August 2022.

What are sustainability preferences?

The Delegated Regulation defines what is meant by sustainability preferences:

“Sustainability preferences” is the choice of a client or potential client as to whether, and if so to what extent, one or more of the following financial instruments should be integrated into her or his investment strategy:

1. a financial instrument for which the client or potential client determines that a minimum percentage should be invested in environmentally sustainable investments within the meaning of the Taxonomy Regulation;
2. a financial instrument for which the client or potential client determines that a minimum percentage should be invested in sustainable investments within the meaning of the SFDR;
3. a financial instrument that takes into account the main adverse effects on sustainability factors where the client or potential client determines the quantitative or qualitative elements that must show that these effects are taken into account (within the meaning of the SFDR).

Financial product versus financial instrument

Perhaps you noticed something when you read the definition? Wasn’t it that the SFDR is based on a financial product and that this is not the same as a financial instrument?

The Delegated Regulation specifies whether, and if so to what extent, the sustainability preferences of certain financial instruments should be integrated into the client’s investment strategy. And the financial instruments in question are linked to the Taxonomy Regulation (TR) and the SFDR, which therefore presuppose a financial product.

Implementation example

We will show you how this can work and what you can do to manage the implementation of this delegated regulation. Before you know it, no model portfolio will be suitable for clients.

Consider an investment firm with a number of grey, light green and dark green model portfolios. It is September 2022 and your client enters in the first box (sub a) of the new suitability form that at least 40% of the financial instruments must be invested in an environmentally sustainable investment in accordance with the TR.

The investment firm in question has neatly filled in the pre-contract templates for all the (model) portfolios that fall under Article 8 or 9 of the SFDR, so you can easily look up what the intended/planned asset allocation is based on the investment/selection policy.

You will quickly discover that only one of your Article 8 SFDR portfolios has any taxonomy-aligned activities at all. Only 30% of this model portfolio contains taxonomy-aligned activities.

You are looking at your Article 9 SFDR model portfolio. In line with the European Commission’s Q&A on the SFDR and the AFM’s report on the SFDR, this model portfolio consists almost entirely of sustainable investments. However, this model portfolio includes sustainable investments as defined by the SFDR (excluding environmentally sustainable investments as defined by the TR). As a result, this model portfolio does not meet (any of) the client’s completed preferences.

This example shows that when the client fills in the first box of the sustainability preferences, your investment firm’s model portfolios already fail to meet the client’s preferences. This is despite the fact that you offer a number of light green and dark green model portfolios in addition to your grey model portfolio.

In this example, the client entering a minimum percentage in the second box (sub b) would most likely not result in the Article 9 SFDR model portfolio(s) being “unsuitable”, but a similar problem as outlined above is not inconceivable in practice.

In short, once a client enters a minimum percentage under the sustainability preferences, a model portfolio that qualifies as an Article 8 and 9 SFDR may be “unsuitable” as a result.

Mismatch between supply and demand

What does this example show? With the arrival of the Delegated Regulation and the associated changes to the suitability test, there can easily be a mismatch between supply and demand.

The EC’s SFDR Q&A and the recently published AFM report on the SFDR give (some) parties reason to take another good look at the investment/selection policy for Article 8 SFDR and Article 9 SFDR products.

We recommend that you also assess in advance, using different scenarios, how the sustainability preferences in the suitability test will fit in with your investment/selection policy and the asset allocation of your model portfolios. Of course, you will need to provide some guidance on the number of scenarios you use.

Want to know more?

Would you like to learn more about the rules around sustainability preferences from MiFID II, and what the implications are for investment advice and asset management? Then follow our e-learning ‘MiFID II and sustainability preferences’.

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