How financial planners can determine investment risk

Before giving advice, financial advisers have a positive duty to actively assess and research the risks arising in relation to an investment. Paul Resnik outlines a set of precautionary measures to help planners properly assess risk, and avoid unfavourable outcomes.

The issues raised in the recent New Zealand case, Armitage v Church, are typical of the challenges faced by advisors around the world. A client with specific cashflow needs seeking high interest is caught in the 2008 market turmoil. He is burned in the ensuing product failures and successfully sues his adviser.

The judgment may provide a number of useful lessons to advisers, advisory groups and others seeking to understand the value of advisory businesses.

1. It is more appropriate for the advisor to undertake a cashflow analysis to identify the client’s liquidity needs rather than to rely on the investor’s analysis.
2. Disclaimers must be relevant and meaningful.
3. It is not sensible to give advice to friends or family if the local interpretation of the law may result in a judgment that might pierce the corporate veil. In this case the adviser was found personally liable.
4. The selection of simpler, less opaque and consequently more predictable investment options should be considered.
5. A diversified portfolio will avoid concentration risk.

6. An advisor cannot outsource his or her professional obligations to either an investment research house or a risk profiling provider.

The judgment was critical of the risk profiling undertaken. Over recent months the UK’s Financial Services Authority and the Australian Financial Ombudsman Service (FOS) have issued guidance on the use of risk profiling in the planning process. The FOS commentary is particularly pithy and worthy of reflection. Some might argue that it is retrospective law.

FOS’s observations of risk profiling practices and procedures

Financial services providers (FSPs) are unlikely to adequately meet their obligation to have regard to a client’s objectives, financial situation and needs by only relying on a risk profile tool. The reasons for this include:

Most risk profiling tools have inherent limitations that can only be overcome by FSPs putting in place techniques that address the limitations (this may be as simple as testing the client’s responses to a questionnaire and their understanding of questions).

Risk profiling tools offer an opportunity for FSPs to educate clients on the relationship between risk and reward in terms the client is likely to understand. FSPs who do not take this opportunity to educate clients are at risk of not obtaining the client’s informed acceptance of the risk profile and its possible investment implications.

Risk profiling tools should be used by FSPs to identify gaps between a client’s financial resources, their appetite for risk and the timeframe to achieve their objectives. Where gaps do exist, the FSP must undertake a transparent trade-off process where the FSP can either ask the client to consider:

• Investing more funds;
• Taking on board more risk to achieve a higher possible return; or
• Modifying future goals so that they are more in line with the client’s financial resources and the timeframe to achieve the client’s objectives.

The above process is also highly relevant to the client’s informed acceptance of the risk profile and its possible investment implications.

Are the FSPs’ risk profiling practices and procedures adequate?

FSPs seeking to establish their client’s tolerance to risk should not view the risk profiling process as only a means to establish the suitability of investments they recommend, but also as an important part of securing the client’s informed consent to make the recommended investments and/or employ the recommended investment strategy.

If the FSP can demonstrate the client’s informed acceptance of the risk profile and the possible investment implications that may arise from the outcome of the risk profiling process, it is less likely that FOS will find the FSP had breached its obligations in this regard.

FOS’s view is the usefulness of any risk profiling methods used lays in the opportunities those methods give FSPs to open meaningful discussions with clients that could identify gaps between their objectives, the timeframe to achieve the objectives and their appetite for risk and, if gaps exist, undertake a transparent trade-off process.

It is more likely that FOS will consider an FSP’s risk profiling practices and processes to be adequate if they are likely to result in securing a client’s informed consent about the level of risk they will need to take to achieve their objectives. 

(Source: Financial Ombudsman Service, Circular 6, Winter 2011, Risk Profiling in Financial Advice Disputes).

What is clear from the guidance is that the client’s informed consent to the risk in their plan is of critical importance. Over the years we have worked with advisers in many jurisdictions and have developed an overview of the planning process that seems to sit logically above local regulatory obligations. At its core is a process to help clients make an informed decision.

The Route to Informed Consent

Good advisory businesses serve their clients while protecting themselves by rigorously seeking to apply five proofs to their client advice process:

• They can prove know-their-client: current situation (assets and liabilities), present and future cashflows, aspirations, risk tolerance and risk capacity.
• They can prove that they have explored the range of alternative plans and strategies with the client. Strategies may include converting lifestyle assets to investment assets, a need to work longer, spend differently or change jobs.
• They can prove know-the-product for the products that they have selected. They may use external research to make those decisions, but the advisor is responsible for the final recommendation.
• They can prove that they have explained the risks in the strategy and in the products, particularly to establish performance and downside expectations. The advisor can then determine with the client the level of financial risk that the client is prepared to accept in pursuit of goals.
• They can prove that they received the client’s informed consent to accept those risks in pursuit of their goals, as well as illustrating the more probable outcomes they need to explore the worst case scenarios. They must be able to illustrate extreme events and explore the client’s risk capacities. They must be able to show the consistency of the financial plan with the client’s risk tolerance. They must have established processes for setting performance expectations and for ongoing management.

Obtaining the client’s informed consent is an ongoing activity. Ongoing informed consent is about ensuring that the advisor continues to understand not just the client’s risk tolerance (which is relatively stable), but risk perception (which can change in a heartbeat), risk required (which can change in time) and risk capacity (which also varies over time). There is relevancy in this case to all involved in valuing financial planning businesses.

Paul Resnik is co-founder of FinaMetrica.