Matching risk: Are you doing enough?
This information sheet is intended to help advisers check whether they are doing enough to assess and record suitability when recommending and matching a financial product to a private customers needs. Where reference is made to a customer this should be taken to be a private customer.
- Are you doing enough to identify, communicate and record a customer's attitude to risk?
- Do you have systems and controls in place to review a customer's changing appetite over time?
Advisers are encouraged to read examples of good and bad practice in these areas, consider how their own practices can be improved and to make any necessary improvements. By working together in this way, we will raise standards across the industry and help create a fairer deal for consumers.
Identifying risk
Ascertaining a private customer's true attitude to risk is critical for any adviser in assessing suitability and making an investment recommendation.
Risk should be explained in terms that a particular customer can understand. It may be necessary to explain risk in greater detail to certain types of customer, for example those customers with less experience or knowledge of investments will need a detailed and clear explanation of inherent risk with recommendations being made.
Individual customers may have different appetites for risk at different times in their life, dependent on the circumstances and their investment objectives. Firms may have ongoing relationships with customers where they will review a customer's portfolio of investments on a periodic basis and will need to be mindful of the fact that the customer's risk appetite may change over time. In explaining why a recommendation is suitable, for example in a suitability letter, the adviser will normally make reference to why a recommendation is consistent with the customer's attitude to risk and the customer's understanding of risk.
Ensuring such understanding will enable firms to make appropriate recommendations, improving the quality of advice and reduce the risk of future complaints. This information will act as a reminder of some of the key points and responsibilities that an adviser will need to consider when recommending investments.
Do you use a risk profile on your standard fact find with a scale, for example 1 to 10?
Scales on their own like this will often have little meaning to your customers whether used in a fact find or separately.
You will need to hold in depth discussions with each of your customers to explain what this means and how these numbers relate to risks that are real to them, perhaps covering aspects like, but not limited to:
- capital security;
- shortfall risk;
- interest rate risk;
- inflation risk;
- regular income withdrawals;
- charges;
- penalty fees;
- age;
- family commitments;
- the need for income and or growth;
- whether there is an investment target; and,
- the investment time horizon.
In making recommendations firms should look at the customer's risk profile and take into account his or her existing portfolio i.e. if a customer's risk profile suggests that say 10% of their portfolio should be in higher risk assets, the firm must take account of what assets are already held in making a recommendation.
You should reflect your discussions with the customer and their stated attitude to risk in the suitability letter. Of course, the customer may be prepared to take different risks for different objectives and over different savings periods – this should be reflected in the overall description.
Personalising the suitability letter and relating the risk discussion to individual objectives will enable a better understanding and be of more relevance to the individual customer. Clearly expressing the basis for the advice you are giving and relating it to the customer's personal attitudes and objectives may reduce the risk of future complaints.
Do you use defined categories of risk appetite, for example, low, medium and high or cautious, balanced and adventurous on your standard fact find with examples of the types of investments which fall into each category?
Remember, it is the adviser's responsibility to ensure that a customer fully understands the nature of all the risks associated with any product being recommended.
As markets and products rapidly change, firms should also review and, if necessary, change their defined categories and corresponding investment examples.
If your firm uses out of date examples you could be giving an incorrect description to a customer which may mislead that person into buying an inappropriate investment.
Do you use a risk profiling/asset allocation tool supplied by a third party provider?
We do not approve or endorse such tools but some firms do find them useful, if used correctly. Some of these tools aim to assist advisers in helping the customer visualise the level of investment risk they are prepared to accept for each of their investment objectives.
The conduct of business rules require firms to ensure customers understand risk - some firms find the use of such tools helpful in meeting that requirement. Where firms are using these tools, they should ensure this is adequately recorded on the customer file. However, even where such tools are used, firms should be mindful of the fact that it remains their responsibility to ensure their customers achieve the appropriate level of understanding.
There is a concern that some firms constructing portfolios for customers based on risk assessment and asset allocation planning tools are then getting the final risk profile wrong based on the use of managed funds. For example, a portfolio planning tool indicated a customer should invest across the following asset groups to match their stated risk profile:
• 10% Cash
• 10% Property
• 10% Corporate Bonds
• 50% UK Equity
• 10% European Equities
• 5% Japan
• 5% America
A firm may start by investing across the smaller asset classes, for example selecting funds to make up the 5% in American funds. The UK equities sector may contain a number of managed fund options. An adviser may then select the funds based on their own experience of these funds. In this example, a managed fund was selected to make up the whole of the 50% UK Equity sector. The problem comes where the underlying assets within this managed fund are constructed in the following way:
• 5% Cash
• 5% Property
• 10 Corporate Bonds
• 60% UK Equities
• 20% US Equities
In this example the overall exposure to American Equities would actually be 15% (i.e. the original 5% together with this further 10%) and not the 5% dictated by the asset allocation tool.
This demonstrates the need for advisers using these tools to fully understand the basis upon which funds are selected and to make their customers aware of any mis-matches in the portfolio agreed at the outset and the final selection. These tools should not dictate asset allocation. In selecting an asset split firms should be mindful of the investment strategies within managed funds.
Do you review a customer's portfolio and establish and update his or her attitude to risk and record this on the customer file?
Your firm should review a customer's portfolio as agreed between a firm and the customer through any terms of business or initial disclosure documents. Recording updated information relating to a customer on the original fact find is acceptable as long as there is a clear audit trail of when the changes are made and why.
You should decide the best way of maintaining this information. Record keeping usually presents the biggest problem with firms and as a result can expose them to risks of not being able to support the advice that has been provided should the need subsequently arise. Attitude to risk may change over time as customers' financial priorities change.
Does your firm use diagrams to visually explain what risk means?
If you are using diagrams to help a customer understand certain points then you should keep these on the customer’s file as they reflect on any discussions you would have had and may support any recommendations made.
Some customers do not wish to disclose all of their financial facts. This can make it difficult to gauge whether the risks inherent with any recommendation are appropriate to a customer’s overall portfolio.
Whilst it is expected that advisers gather as much information as possible, some people will not be willing to disclose everything. In this instance, you will need to make it very clear that any advice you provide will be based on the information they are willing to provide.
You will need to inform these customers that your recommendation will not take account of any information not disclosed e.g. other investments the customer has, and as a result the customer may be over / under exposed to the appropriate overall risk profile of the customer. This should be reflected in your firm's fact find (know your customer information) and suitability letter.
Blanket reference to non disclosure across all customers is not acceptable and FSA does not expect this to be normal practice. Advisers are reminded that they must have regard to facts about the customer of which they are or should reasonably be aware, i.e. the fact that the customer has not disclosed something will not exonerate the adviser should the firm have been reasonably aware of the circumstance in any event.
Does your firm recommend customers to have a flexible attitude to risk where they will have a low attitude to risk in times where the equity markets are producing low returns and then to switch to higher risk funds in times where the equity markets produce higher returns, or vice versa?
A customer's attitude to risk will be driven by factors such as his investment objective, time horizon etc. rather than the state of the stock market at any time. Advisers should not be recommending an attitude to risk; they should be explaining what is meant by various risks and their impact, and then seeking to establish the customer's opinion and understanding.
You will be expected to ensure you ascertain the customer's attitude to risk at any one time and ensure they understand fully any risks inherent with the advice provided. A customer's attitude to risk may change over time. However, they must understand how this will impact on any investment advice provided and the adviser will be expected to be able to demonstrate that the customer was made aware of the implications of any change in attitude to risk and associated advice at all times and in different market conditions.
A customer can have different attitudes to risk towards different objectives e.g. pension planning, savings, investments. If this is the case then the adviser will be expected to demonstrate this on the customer file.
Wouldn't it be simpler if the FSA produced a fact find document for small IFAs to use?
The FSA does not prescribe the method of obtaining sufficient personal and financial information about a customer. It is for a firm to decide how the information should be requested from the customer and recorded. This approach allows firms flexibility to develop a sales process consistent with their own type of business and the customers they deal with. A fact find document is merely one way in which a firm may decide to do this.
Why doesn't FSA specify the terminology to be used when explaining risk to a customer, e.g. low, medium, high or cautious, balanced, adventurous?
The FSA could not mandate terminology that would be useful in all circumstances. Flexibility is required for firms to adapt their processes to reflect their particular businesses and customer base.
It is for firms to be satisfied that a customer fully understands the nature of all the risks inherent with a recommendation. Care should be taken to ensure that the customer understands the risks involved with a particular investment, how that risk fits with the customer’s understanding of risk and the potential for investment growth or loss.
Notes
This information must be read in conjunction with FSAs Handbook Conduct of Business sections (COB) 2.3, 5.2 and 5.3.
Other useful information is contained in FSAs Handbook COB 5.4 in relation to risk warnings and the section on FSAs website relating to suitability letter.
This communication is not formal guidance and does not have the status of guidance in the FSAs Handbook. You cannot use this communication to counter a charge of breaking the FSA rules. In the event of any conflict between this communication and the Handbook, the Handbook takes precedence.