Suitability and risk - Aifa

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Suitability and risk - Aifa

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Introduction

One of the Financial Service Authority’s (FSA) key areas of significant concern noted earlier this year, is the ability of

financial advisers to establish the level of risk that retail customers are willing to accept and bear in their investment

decisions.

A possible outcome of this increased regulatory pressure on investment advice in the run up to the RDR is an

increasing number of firms outsourcing to discretionary fund managers and increasing their use of technology, but

this does not reduce the adviser’s accountability. As it is the adviser’s responsibility to assess the suitability and risk

considerations of any investment recommendation, they should not assume that any support tool provided via a

platform or a discretionary fund manager is fully appropriate for their client base or a substitute for ‘know your client’

disciplines.

This AIFA document aims to support the good practice provided by many Independent Financial Advisers who deliver

investment advice and help advisers ensure they remain compliant.

The advice process and determining

investment risk profiles

Understanding the risk profile of any client is a crucial step in any financial advice process, reinforced by ever increasing

regulatory scrutiny and the tough action taken where poor practice is identified. The definition of risk can be explained

to clients as being the extent to which a consumer is willing to risk experiencing a less favourable financial outcome in

the pursuit of a more favourable financial outcome.

In determining this, there is a need to assess the consumer’s appetite and capacity for loss, as well as their desire

for gain. There are a range of factors to be considered, amongst which it is always important to put any answers in

the context of the age of the consumer and their capacity to repair losses. One further factor is to assess both the

consumers need for capital security, set against their need for a return on the investment, particularly where

income or later access to capital may be required.

Whilst some firms use a single risk profile per client, others use

differing profiles for distinct “pots” of money or for different

goals. Both have a place, but need to be explained in the overall

context of the investment approach.

In designing and applying any approach to assessing risk

and then making an investment recommendation, due

consideration will have to be given to the various risks that

may apply:

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- Capital

- Inflation

- Diversification

- Volatility

- Return

- Liquidity

- Counterparty

- Longevity


In order to assess one or more of these, risk profiling questionnaires and tools provide assistance to advisers. They also

allow effective information flow between the front and back end of a financial adviser’s office. Data mining, analytics, client

management and reporting capabilities are now the expected norm from risk profiling tools alongside asset allocation

planning tools, with full integration with platforms and portals.

The majority of advisers use risk profile questionnaires (RPQs) when making

recommendations to clients, with two in three stating they always use RPQs

Risk profiling tools should be able to clearly outline future financial scenarios for clients using either stochastic or

deterministic models. Clients should be able to outline their life goals and provide input on expected future cash flows.

Risk profiling tools do not simply calculate risk but can go some way to evidence suitability and help to demonstrate that

the firm is treating the customer fairly.

The majority of advisers use either an off the shelf RPQ , an ‘in-house’

tool designed specifically for their firm or a combination of the two

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An assessment of the many risk profiling questionnaires and tools available to financial advisers indicates that they

have benefits that include:

- Assessment of a client’s overall risk category in numerical terms

- A starting point for further investment research

- Highlighting the funds that should be recommended to the client

- Stochastic modelling systems

- A summary of the client’s risk profile

- The production of suitability reports

- Additional validation of the client’s statement of risk

Depending upon the nature of the advisory business and client types, it may be appropriate for more than one risk

profile questionnaire to be used.

Where a firm is covering issues such as taking retirement benefits, it is usual for a distinct set of RPQs to be used, or

where investments are being made with significantly different time horizons.

Asset class recommendations

FSA has stated “where firms rely on tools they need to ensure they are actively mitigating any limitations through the

suitability assessment and ‘know your customer’ process.” With the recent difficult economic background, FSA has

also stated that some advisers might have recommended that clients invest outside of their normal risk profile and

asset class preference to seek more attractive returns. Advisers know that it is not enough to have procedures in place

to assess clients’ attitude to risk, but there must be more thought about the substantive outcome and an evidenced

‘sense check’ on investment recommendations in order to remain compliant.

Over three quarters of advisers will either always or usually stick to

the asset class breakdown prescribed by the RPQ they are using

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The regulatory requirements when advising

on investments

The FSA’s Assessing Suitability guidance published in March 2011 reinforces that advisers need to take appropriate

account of a client’s capacity for loss. The significant falls in the markets in 2002 and 2008, and the general confusion

of how to describe the risk of some funds and sectors has led the industry as a whole to review how they should

monitor and describe risk.

The Conduct of Business Sourcebook (COBS) 9.2.1R requires a firm to take reasonable steps to ensure that a

personal recommendation, or decision to trade, is suitable for its customer. COBS 9.2.2R requires firms, among other

things, to take account of a customer’s preferences regarding risk taking, their risk profile and ensure they are able

financially to bear any related investment risks consistent with their investment objectives.

Investment advice considerations

> The client’s investment objectives have been established and documented?

> The client is able to financially bear any related investment risks consistent with their investment objectives?

This has been explained in a fair, clear and non-misleading way?

> A client that does not want any risk to capital is advised to consider cash deposits?

> Has the client the necessary experience and knowledge in order to understand the risks involved in the

transaction or in the management of their investments?

> Has the client’s capacity for loss been explained and agreed?

> Clients’ questions and answers have been fully explored such as ‘I neither agree nor disagree’ has not been

attributed to a middle risk profile as this indicates a lack of client understanding.

> Are all client details input into a Risk Profiling Questionnaire or Fact Find? If not limitations are mitigated?

> Having researched the investment options has advice been provided based on a suitability assessment

process in the best interests of the client?

> Is there documented evidence that the advice provided matches the client’s risk profile and the client has

agreed to and understood his or her risk profile and the risk associated with any investments recommended?

> Does the client file and correspondence include the length of time for which the client intends to invest and

the purpose of the investment?

> Has the client been treated fairly and ethically?

> Has it been agreed how often the investments are to be reviewed?

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Reassessing client’s changing risk profiles

There is no specific guidance on how often an adviser should review a client’s investments against his or her risk

profile, as it depends upon the type of client and the nature of the financial planning needs. Where there is an ongoing

service agreement, it is important to regularly revisit the client to check that any investments recommended remain

suitable against the client’s possibly changing risk profile.

Approximately three quarters of advisers using RPQs re-assess their clients annually

against recorded risk profiles; just under one in five tend to review as and when required

Fund selection considerations

When adviser’s clients are asked what their views are on returns versus risk, the majority (69%) are attracted to

acceptable consistent returns with only 15% attracted to stellar returns. 42% want a mix of both and 7% don’t know 1 .

In order for IFAs to provide clients with investment funds that offer the possibility of acceptable consistent returns, the

popularity of investment in absolute and balanced funds has increased.

Research commissioned by RBS 2 reveals that IFAs put c44% of their clients’ money into balanced and cautious funds

between June and December 2010. Despite this level of popularity amongst IFAs, many IFAs are unable to recommend

around one third of balanced managed funds to clients because they feel they are too risky, and the corresponding

figure for cautious managed funds is 28%. Overall, 29% of IFAs said that they are concerned about the fact that many

investors don’t understand the risk profile of their cautious and balanced funds.

As an example of investors’ lack of understanding about the risks associated with cautious managed funds and

balanced managed funds, when asked what they believe is a maximum amount that is an acceptable worst case

loss in any three year period, c49% don’t know. A quarter believing a decline of less than 10% of the money originally

invested is acceptable with the remaining investors questioned stated higher loss figures than 10% 1 .

In addition, whilst some measure potential downsides against a three or five year time horizon for likely outcomes, an

issue is more likely to arise with short term volatility. If a 10% loss over a three month period would cause customers to

disinvest, it may not have been appropriately risk assessed.

1 | ICM interviewed a random sample of 2013 adults aged 18+ via online between 7th to 9th January 2011. Surveys were conducted across the

country and the results have been weighed (grossed up) to the profile of all adults (over 18s). ICM is a member of the British Polling Council and

abides by its rules. Further information at www.icmresearch.co.uk

2 | IFA interviews were conducted by George Street Research on behalf of RBS in December 2010. A total of 206 interviews were completed

among a cross-section of advisers throughout Great Britain with a weighting towards those whose business is primarily with investment clients.

Quotas were imposed on the total sample in respect of size of IFA firms, region and areas of specialisation.

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Market volatility

In 2011, with the introduction of UCITS IV, we see the launch of the new Key Investor Information Document (KIID)

that aims, amongst other things, to standardise the documentation of all UCITS funds across Europe. UCITS IV also

defines a new methodology for describing risk, known as the Synthetic Risk and Reward Indicator (SRRI). This new

methodology, that provides a rating between 1 and 7, is based on the volatility of a fund.

The volatility of an asset is certainly the most widely used risk indicator in the financial world. It is the measure of how

much the periodic performance of an asset typically deviates from the longer term average periodic performance and,

mathematically, volatility is the measure of the Standard Deviation from the mean. Volatility can be defined for any

period of time, but, as investors tend to look at annual expected performance, volatility is often expressed as annual

volatility.

Practically, it can tell us, for example, whether a 1% yearly return of an asset is comprised of a series of +6% and -5%

monthly performances, or of - 0.95% and +1.05% monthly performances. In short, the greater the volatility of a fund,

the wider the universe of possible future performance and the less certain future performance will be.

In the eyes of many investors, risk can mean the probability of losses. Volatility is more an indicator of uncertainty than

it is an indication of future losses, but there is a clear correlation between times of high volatility and falling markets.

Volatility can give a really useful indication of the uncertainty of an asset performance and its potential for losses,

especially when looking at volatility measured over a long period. The inability to change asset allocations to counter

changing volatility can have a significant impact regarding meeting a client’s expectation for capacity for loss.

Client’s tolerance for loss

Discussing with the client their tolerance for a loss in value of any

investments is an important part of financial planning and assessing a

client’s risk profile. This was highlighted by the FSA in Guidance: Accessing

suitability document, ref 1.8 1: ‘although most advisers and investment

managers consider a customer’s attitude to risk when assessing suitability,

many fail to take appropriate account of their capacity for loss’.

There are various methods which can be used to calculate loss within an

investment portfolio:

- An in-house developed risk profiling software tool

- Off the shelf risk profiling software tool

- Product provider or platform provider risk profiling tool

- Self-styled manual scoring system

- Discussion based around the completion of a RPQ

It is important to keep in mind that no perfect risk indicator exists and past

performance is no indication of future performance.

Conclusion

In assessing the risk a consumer is willing and able to take requires the

assessment of a number of often competing priorities and limitations. What

is important is that advisers know the characteristics of the recommended

investment so that it matches the consumer needs. Finally what is crucial

is to stand back and ensure that rather than slavishly following the

“model”, that the solution makes sense when thinking about the customer.

Finally, having robust documented processes and clear sets of consumer

communications will reduce the opportunity for mismatches between

expectations and outcomes.

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Research carried out by NMG Consulting.

NMG Consulting is a consulting and research business operating exclusively within the financial services industry

across UK, Europe, Asia Pacific and Canada. NMG’s UK business offers strategic level advice to financial institutions,

particularly those in the retail life, pensions and investment sector.

AIFA is the voice of the IFA profession. We are here to present the interests of our membership to the regulator and

those policy makers who have an impact on the IFA market place and the business operation of IFAs. There is a clear

need for IFAs to speak with one strong voice. Our role is to bring about this united front.

We influence the opinions of decision makers to direct policy towards an approach more conducive to the growth of

advisory firms, and are sought out to provide our knowledge and expertise to better understand and define practical

policy. We are funded by our members and industry supporters, and are a not-for-profit organisation.

Association of Independent Financial Advisers

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Registered office: 100 Fetter Lane, London, EC4A 1BN

July 2010

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