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Why your firm should revisit risk profiling tools

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2 days ago

September 17, 2024

Why your firm should revisit risk profiling tools

The Financial Conduct Authority’s thematic review of retirement income advice has put client risk-profiling tools back into focus.

Firms are revisiting their processes to ensure clients with an income objective have their risk profiles accurately assessed.

If your firm is among them, now might be a good time to consider the regulator’s broader views on these tools.

Expectations

Under COBS rules, firms must ensure all tools used when assessing suitability (including risk-profiling tools) are fit for purpose and any limitations are mitigated through the suitability assessment process.

Risk-profiling tools can vary considerably, ranging from a simple client questionnaire through to those capturing other know-your-client areas and providing cashflow forecasting and asset allocation. There’s no one-size-fits-all approach.

Advice firms must understand exactly what the risk-profiling tool is aiming to provide. They must be satisfied that the process, inputs and outputs are appropriate for their firm and their clients on an ongoing basis, and they must be able to plug any gaps in the suitability assessment process that aren’t delivered by the tool.

This might mean deciding to use one tool or a combination of tools. Either approach is fine, provided you can justify your rationale.

You also need to consider clients’ best interests, Consumer Duty (including consumer understanding), finalised guidance on assessing suitability (FG11/5) and more recent comments on retirement income advice.

Client understanding

You should think about how likely clients are to understand the risk assessment process, its purpose and its outputs.

Is the process easy for clients to follow, complete and return?
Is language and presentation fair, clear and not misleading?
Are different formats and supporting resources available for different client needs, including vulnerability characteristics?
Can the client revisit parts of the process or ask questions?
Is there evidence of consumer testing?

It might help to provide an explanation of the risk-profiling process up front to help clients understand and engage with it from the start (taking care to avoid leading client responses).

Advisers also play a key role in helping clients understand how their risk profile impacts their financial plan. For example, where a client’s investment objectives don’t align to their risk profile, further discussion of planning options and goal expectations may be needed.

Are all relevant areas captured?

Certain areas must be considered under the suitability rules and the FCA has made it clear in its guidance and review findings which other factors it expects to see addressed.

Check your risk-profiling process covers the following:

A prompt to consider debt repayment, short-term income needs and cash-only investors before defaulting to investment
The option of different risk profiles for joint investors and for different objectives (short-term savings, pension accumulation, immediate and future income)
Risk tolerance, capacity for loss and knowledge and experience considered separately but in context
Inflation, liquidity and income risks considered where appropriate (including the impact of investment returns on income levels and changing income levels on the client)
Considers mismatches between a client’s risk profile and investment objectives (can their investment goal be achieved with their risk profile) and inconsistencies in client responses (a mix of high and low risk)
Can an adviser initiate further discussion and exercise judgement where appropriate (to address discrepancies or borderline risk categories)?
Clear documentation of risk discussions, outcomes and client agreement, including the purpose and date of the assessment so it’s clear when to revisit

Due diligence

What evidence is there of due diligence carried out by your firm?

Areas to consider:

Relevant experience of the tool provider
Target market, purpose of the tool and its limitations
Spread of risk categories, how they’re described/illustrated and whether they’re reflective of your firm’s typical clients and the spectrum of investment risk
Evidence of testing (against some of your own client bank if appropriate) to ensure outputs are consistent and interpretation of client responses are an accurate reflection of the risk they’re willing and able to take
Inputs and assumptions, such as inflation, investment growth rates, annuity rates, life expectancy – are they appropriate and can they be set by your firm to align to its views?
Data and management information (MI) – how is client data protected and what reports are available? What back-office integrations are available?

Where relevant:

Asset class representation and diversification, selection and monitoring process
How asset class risks are measured and illustrated, such as volatility, downside risk, liquidity risk etc.

Common gap – risk mapping

The FCA has warned that, where a firm builds centralised risk-rated portfolios and uses an automated risk-profiling process, if the process has been set up incorrectly or if there’s insufficient flexibility or controls in place, there’s a risk of systemic misalignment where recommended portfolios don’t align with the risk descriptions and outputs from the risk-profiling process.

It’s essential risk profiling processes and investment propositions are not designed and reviewed in isolation and that the process allows for adviser challenge and client-specific flexibility.

Plugging the gaps

Risk profiling approaches may vary from firm to firm, but should be consistent and repeatable.

Your process should be clearly documented and shared with relevant staff, so they understand the steps involved, how to use third-party tools and what additional actions or judgements are needed to deliver good outcomes for individual clients.

Senior managers should take responsibility for consistency across the business, ensuring the process remains fit for purpose and that staff are following the process as intended.

Julie Hardie is policy consultant at Threesixty Services

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