There is no one size fits all solution when it comes to determining a client’s risk profile and capacity for loss.
Yet it is important to make sure that as a firm, your processes are robust enough to assess a client’s personal appetite for risk and capacity for financial loss, while satisfying regulatory requirements.
Here we take a look at best practice when assessing a client’s risk level.
What are the FCA's expectations?
First, it's worth taking a look at the relevant FCA rules from its Conduct of Business Sourcebook (COBS):
- COBS 9.2.1R requires a firm to take “reasonable steps” to ensure that a personal recommendation 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 to ensure they are able to financially bear any related investment risks consistent with their investment objectives
This mean's the client’s objectives, attitude to risk, capacity for loss and investment experience need to be central to all investment recommendations.
What's more, documenting this is central to demonstrating suitability.
As advisers, it's your responsibility during the advice process to make sure the client fully understands the risks involved with investing, and is comfortable with the agreed level of risk.
Establishing the risk a client is willing and able to take with their money is a key part of the suitability assessment.
There are three key elements to an individual’s risk profile:
- Their psychological willingness to take risk, or risk attitude
- Their financial ability to take risk, or risk capacity
- Their need to take risk, including the need to accept risk to meet an objective, avoid falling short of a goal or having wealth eroded by inflation
We recommend that the following six factors need to be addressed and included on an investment file in order to evidence the client’s attitude to risk and capacity for loss.
1) Clear investment objectives
The fact-find should include investment objectives such as:
- What the money is invested for (such as children’s education)
- If there is an income or growth requirement
- The length of time there is to meet the goal
- The importance of meeting the goal
- The effect of not meeting the goal
2) Risk profiling
A client's psychological willingness to take risk is about their attitude to risk rather than their financial circumstances.
Risk profiling tools can be a useful aid in client conversations as they help to provide structure for the discussion and promote a consistent process throughout a firm.
However, a risk profiling tool shouldn't be used in isolation but rather as the beginning of the process.
As well as using the outputs from the tool, advisers should also hold a meaningful discussion with the client regarding the level of risk they're comfortable with. This should then be recorded in the notes section of the fact-find.
For couples, we recommend separate questionnaires should be completed by both parties as attitude to risk and loss are individual.
Firms should also be satisfied that the risk profiling tool is providing outputs that are appropriate and fit for purpose.
Any limitations should be mitigated in the fact-finding process through client conversations and when assessing suitability of the recommendation.
It's worth carrying out the risk profiling process with every new investment, or at least every three years for new business or where a periodic suitability assessment is being made.
This is because the client may wish to take a different level of risk depending on their objectives.
Where risk profiling hasn't been used, the file should record the conversations held around risk and the client’s capacity for loss.
The definition of risk categories used to assess risk need to be clearly recorded in a way that's meaningful to the client. The file should also document if the client agrees with the assessment made.
The suitability report should record the outcome of the assessment and we recommend this is personalised to the client.
3) Capacity for loss
The FCA defines capacity for loss as a client’s ability to absorb falls in the value of their investment.
If any loss of capital would have a detrimental effect on their standard of living, this should be taken into account when assessing the risk the client is able to take.
Areas that can help demonstrate this include establishing a client’s known or likely future spending, the level of emergency funds held and how much this will reduce the chance of the client having to rely on invested assets in a crisis.
A client may be able to sustain greater capital losses and be willing, following discussion, to tolerate a higher level of risk to potentially generate the desired returns.
If this is the case, we recommend the firm should document that this is the risk the client is willing and able to take, along with the reasons for this.
However, if there's a situation where the client doesn't have the capacity to sustain the potential loss of an investment strategy, we recommend the adviser must explain the consequences and document this on the file.
It's a critical part of the advice process to engage the client at the outset around potential outcomes.
These conversations must enable clients to understand the impact of these outcomes on their objectives.
It's equally important to make sure these conversations are documented on file, with the outcome of these discussions clearly confirmed and personalised in the suitability report.
4) Investment experience
It's worth documenting the investment experience a client already has as this will need to be considered in order to make a suitable recommendation. We believe the FCA would expect to see information on file regarding:
- how long the client has invested
- the types of products and asset classes they've invested in
- whether they've chosen their investments
- whether they've experienced market losses/volatility.
5) Making sure the investment meets the agreed risk
Consider what due diligence and research is needed so that you're familiar with the nature and risks of the products and funds being recommended, as required by the product intervention and product governance (PROD) rules.
We believe the FCA expects the suitability report to confirm the risk level of the recommended investment strategy and why it is suitable.
The file should demonstrate the adviser has researched the investment choice and the provider/manager market adequately.
The outcome of the research should be explained in the suitability report, including why the investment strategy and a particular provider/manager has been recommended.
The relevant risks of the recommendation should also be confirmed to the client in the main body of the suitability report.
6) Sense check
Finally, a thorough review of the file is required to sense check the recommendation.
This serves to make sure the advice is suitable considering the client’s objectives, timescales and attitude to risk, as well as their capacity for loss, investment experience and the complexity of the recommendation.