A retiree's concentrated income plan
Mrs Iqbal is 67 and widowed. She has a £620,000 portfolio: £300,000 in cash ISAs, £200,000 in a global equity fund and £120,000 in a UK gilt fund. Her only other income is a state pension of £14,000 a year; she spends about £32,000 a year. She wants to invest £420,000-about 68% of her portfolio-in the Meridian Emerging Markets Local Currency Bond Fund, which currently yields 7.8% and has returned 11% over the past year. She says: 'I need income and I cannot take risk; the yield is much better than cash.' The fund's factsheet shows 42% in three countries and 65% in sub-investment-grade sovereigns, plus currency risk. The adviser's risk questionnaire scores her as 'balanced' because she answered 'some risk' to one question, but she has no emergency fund and would need to sell investments to fund care costs if her health deteriorates. The adviser is paid a 1.2% annual charge and the fund pays the firm a 0.4% trail.
1. Identify the suitability issues and explain how the adviser should assess capacity for loss.
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The proposal is not suitable on the facts. A 68% allocation to a single emerging-market local-currency bond fund is a concentrated credit, currency and liquidity risk, with 42% in three countries and 65% in sub-investment-grade sovereigns. The 7.8% yield is not 'safe income'; it compensates for default, currency and volatility risk, and the past 11% return is not a guide. The client's spending need is about £18,000 a year above her state pension, and she has no emergency fund. Capacity for loss is not the same as risk tolerance: it requires an assessment of her ability to absorb falls without damaging her standard of living, her liquid reserves, care costs and time horizon. A single 'some risk' answer does not justify a 'balanced' score when her circumstances point to a lower capacity. The adviser should also consider vulnerability, the 1.2% advice charge and the 0.4% trail, and whether the fund's target market matches her needs. The file should record the reasons for rejecting the fund.
2. What recommendation should the adviser make, and how should it be documented?
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The adviser should recommend a diversified portfolio sized to her actual income need, not to the highest yield. A cash buffer of, say, 12-24 months of spending would reduce the need to sell assets at the wrong time. The remaining portfolio could combine investment-grade bonds, global dividend equities and a smaller satellite allocation to higher-yielding assets, with the EM debt fund limited to a small percentage only if she understands the risk. On a £620,000 portfolio, a 3.5% yield produces about £21,700, which covers the £18,000 shortfall, so she does not need 7.8%. The recommendation should set out the client's objectives, risk tolerance, capacity for loss, liquidity needs, charges and the reasons for rejecting the concentrated fund. It should record the client's comments, including her wish for income and dislike of risk, and any alternative considered. If she rejects the advice and insists, the firm should decide whether to accept an execution-only instruction, with a clear warning that it is not advice.
3. How should the firm treat the 0.4% trail paid by the fund?
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The trail is an inducement. Under COBS 2.3A, a firm must not pay or accept a fee or commission from a third party unless it is designed to enhance the quality of the service to the client and is disclosed clearly before the service is provided, or is paid to the client. The 0.4% trail creates a conflict because it may bias the adviser towards the fund. The firm should disclose it in cash terms, explain whether it is retained or offset against the advice charge, and assess whether it enhances the service. If the firm holds itself out as independent, it must not retain the trail. The 1.2% annual charge must also be disclosed. If the trail was not disclosed before the recommendation, the firm should correct the position, consider remediation, and review its conflicts policy. The file should show that the recommendation was not driven by the payment.