Posted: 30th December 2013
Failure to appropriately assess customers’ risk profile as part of the sales process is not a new problem for financial planners. Our work with firms reveals four steps to good risk profiling, in line with the regulator’s continued messaging on the topic.
The persistence of this risk profiling failure led the then Financial Services Authority to publish its “Assessing Suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection” guidance paper in March 2011. The risk has featured in the regulator’s risk outlook papers since 2011 and is likely to be present again in 2014.
The same problem is cited in a number of recent high profile enforcement actions including Tenon, Sesame, Barclays, AXA Wealth to name but a few. It was also the subject of the recent thematic work: wealth management suitability and lump sum investment mystery shopping reviews.
Four step guide to good practice
Regulatory guidance is clear and sets out the steps firms should take to appropriately assess the level of risk the customer is willing, able and needs to take.
1) Assessing the customer’s attitude to risk (ATR)
It is fair to say that this is the area that has seen the most improvement in recent years with well-regarded risk assessment tools available in the market place. Many of these incorporate sophisticated academic input and play a valuable part of any risk profile assessment.
This is, however, only the first step to assessing a risk profile and is the starting point for discussions with your customer. It is also fundamental to evidencing suitability that these subsequent discussions and, any resulting changes, are appropriately recorded on your file and played back in the suitability report.
2) Risk description
Most firms we see use descriptions of risk aligned to those used by the corresponding risk assessment tool. However we have seen cases where firms have purchased a risk assessment tool which defines risk in one form – low, medium and high – yet reference is still made to another – cautious, moderate and adventurous, within the suitability report.
Articulating risk is an important part of evidencing that the customer is in an informed position regarding both the risk and the reward of the selected investment strategy. Firms may wish to provide some benchmark of actual volatility – potential gains and losses – for each of the risk categories within a common investment period.
3) Personal circumstances and objectives
This is the area where we commonly see documentary gaps and no obvious link between the initially assessed attitude to risk and the one selected in the final recommendation.
Following steps one and two above, it is important to consider, and document, the individual customer circumstances and their objectives. For example these may include the level of certainty required, the customer’s capacity for loss and the investment term.
A customer moving up or down from the initially assessed risk category is not unusual. In fact, it is completely acceptable as long as the reasons and rationale are clearly documented.
Firms should still monitor ATR outputs to ensure they are as expected and identify any potential issues with the initial assessment tool. Good practice is to set a reasonable tolerance based on pre-defined investor attributes such as age, experience, percentage of assets invested. The advisor can then focus existing controls, such as new business file checking or customer outcomes testing, on cases falling outside these tolerances.
4) Fund selection
An important part of selecting the right fund includes consideration of the underlying asset allocation and how this fits with steps one to three above. This is the most common area of failing that we encounter.
Many firms still fail to ensure that the funds they recommend are appropriately aligned to the corresponding risk descriptions provided to their customers. Firms also fail to implement controls to ensure that the recommended funds remain aligned to the stated description of risk.
Good practice is for the firm to undertake regular reviews of the funds they recommend to ensure the underlying asset allocation is as described to the customer, particularly important in times of market stresses.
Is technology the answer?
A final thought on technology. It is a common misconception that technology is necessary for meeting suitability of advice and risk profiling standards. In reality, technology can be a useful aid and a valuable control; but it does not negate the responsibility of the adviser, nor the firm, to comply with the above expectations. Technology has its limitations. There is no replacement for the judgement of a well-qualified, experienced financial adviser.
If you are following the above steps then you probably do not need to lose sleep over this crucial area of investment suitability. If you are not, then this provides you with an important 2014 new year’s resolution.
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