With a variety of investment products and solutions available to meet a client’s investment objectives, attitude to investment risk becomes a central plank in the advice process to help ensure that the recommended solution meets the client’s tolerance for risk.
In the early days some fact finds offered the choice of three options: low risk, medium risk and high risk. The obvious omission here is ‘no risk’ which caused problems for firms offering an incomplete menu of investment risk tolerances. It follows that for a ‘no risk’ customer it is unlikely that an asset backed recommendation should be made. There would also be a discussion regarding risk with or without a commentary on the risk characteristics of each risk band but it was a fair bet that the medium risk box would have been ticked in most cases almost as a default choice.
This was followed in time by a risk profiler with generally around a dozen questions on investment risk but also questions on knowledge and experience. Again this process had its flaws as too many “don’t know” answers could result in a medium risk outcome by default. Another design flaw was that answers to the knowledge and experience questions sometimes fed into the investment risk score thus inflating the risk score purely by virtue of knowledge and experience. For example, where a husband and wife might have similar risk tolerances a potentially different investment risk score may emerge if one had greater knowledge and experience than the other. Ultimately, the effect of including knowledge and experience in the investment risk scoring computation meant that some customers were being ‘up risked’ potentially exposing them to greater risks than they were naturally prepared to accept. For customers with a good degree of knowledge and experience the investment risk score would be significantly higher and unrepresentative of their true attitude to investment risk. If unchecked, this could lead to an incorrect fund recommendation.
Nowadays there is greater sophistication in risk profiling tools although this still does not guarantee a ‘correct’ answer. Advisers must understand how their risk profiling tool works whether in-house or outsourced to ensure that a suitable fund is recommended to meet the client’s objectives and needs. Advisers should also discuss the results of the risk profiling tool with the client to challenge any inconsistent answers. Most clients will not be industry people and may not fully understand the questions asked or may misinterpret the question if they do not have a great deal of knowledge and experience. For the profilers to work effectively they should use common language that both customer and adviser would understand.
Some of the risk profiling tools may recommend an asset allocation to match the risk outcome but care is needed here as different profilers may recommend different asset allocations for the ‘average’ client (i.e. those with a straight middle score rating). Indeed a recent report has shown that for this ‘average’ client the proportion recommended for asset backed investments can vary between 43% and 65% which is quite a significant variation. Ultimately the adviser must take responsibility for the fund recommendation using the tools available at their disposal and therefore must sense check and justify their recommendation.
Another consideration regarding attitude to investment risk is that the one size fits all approach may not always be appropriate for the whole of the portfolio. For example, where the client is at retirement; consideration of segmentation may be appropriate to split funds to meet essential needs, lifestyle needs and legacy needs over different investment terms. For essential needs monies will be required to meet general day to day expenditure and therefore funds should be invested on a short term basis typically in less volatile asset classes, whereas lifestyle needs may be medium term goals which may permit more growth related investments to be used and legacy needs may allow a more aggressive investment approach given that volatility would expected to be evened out over the longer term.
Firms should also consider other transactional related risks e.g. transfers from defined benefit pension schemes into money purchase schemes. Not only is there is a significant change in the risk of the underlying investments as the safeguarded benefits will be at the mercy of the volatility of the investment funds selected but firms should also ascertain the client’s attitude to accepting this significant change and their ability to manage (or contract out) the initial investment approach and review of the investment approach to allow for changes in personal circumstances or objectives. The FCA has recently published the Consultation Paper CP18/7 entitled “Improving the quality of pension transfer advice” in which they have invited comments on the above proposed transactional risk approach for defined benefit pension transfers.
Attitude to investment risk rating is not the “be all and end all” behind a fund recommendation as the adviser must also consider and document the proposed investment term. As mentioned earlier asset backed investments are better suited for medium to long term investment periods. The adviser must also consider capacity for loss as while a customer may think they are prepared to accept a certain degree of risk the adviser is responsible for his personal recommendation regarding the investment fund to be proposed taking all the client’s personal circumstances into account. The adviser must therefore consider the client’s needs as well as their objectives and where they do not match further discussions are needed. Gone are the days where advisers can act as ‘order takers’ unless the client is adamant and wants to proceed on an insistent client basis. This in itself creates a challenge and would need to be documented and confirmed to the client that they are going against the adviser’s recommendation.
Overall, given the complexity of this area and its importance of attitude to risk as a cornerstone for the investment recommendation firms should review their attitude to risk profiling. Ownet (www.ownet.co.uk) can assist you with this process by sampling cases, offering feedback and make recommendations for any process improvements that might be needed.