Is your risk profiling process in need of a regulation refresh?

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The FCA’s current suitability review has a clear focus on retirement advice and, while we don’t yet know what exact aspects the regulator will focus in on as part of its review, the use of risk profiling tools is likely to come up.

Risk profiling has become an integral part of the advice process for the majority of firms and many will use it with all clients, regardless of whether they’re in accumulation or drawing down income. However, risk profiling can become trickier in the context of retirement advice, as a client’s lifestyle factors, financial needs and risks can change significantly and become more complex when they hit retirement.

And with MiFID II having strengthened the responsibilities of advisers in this area, now feels like a particularly important time to recap the key issues you may need to think about.

A round-up of risk profiling regulation

Most advisers will use tools to help support their advice process, whether it’s risk profiling, wrapper selection or cashflow modelling. In almost all cases these tools support, instead of replace, the need for human advice, and as a result it’s important to understand the scope and limitations of the tools and be able to mitigate against any weaknesses within the wider advice process.

Some of the regulatory requirements in this respect have existed for a number of years already, having been issued originally by the FSA. But then MiFID II came along and placed responsibilities on advisers to take reasonable steps to ensure the information collected about their clients is reliable. This includes (but is not limited to):

“ensuring all tools, such as risk assessment profiling tools or tools to assess a client’s knowledge and experience, employed in the suitability assessment process are fit-for-purpose and are appropriately designed for use with their clients, with any limitations identified and actively mitigated through the suitability assessment process;” [1]

It's also worth looking further back at the final guidance published in 2011 by The FSA (as it was then) on the use of risk profiling tools, FG 11/05 Assessing Suitability because the guidance very much still stands. There are four main issues that advisers need to be aware of and act on if necessary:

• Risk profiling. This looks at the tools themselves. Advisers need to understand how the tools are designed to work, their scope and limitations. This doesn’t need to be a forensic deep dive - think more drivers guide as opposed to Haynes manual. As well as learning how the tools work, advisers should also make an assessment to ensure the questions are worded appropriately for their target client and, if it’s a risk tolerance tool, that this includes the ability to highlight clients who are unwilling to accept any loss at all.
   
• Risk descriptions. If the customer is going to understand the output from the risk profiling tool, it’s vital that the risk descriptions are clear, fair and not misleading. To make sure this is the case, advisers need to watch out for:

1. Vague language
2. Failure to quantify risk
3. Subjective descriptions that could be misinterpreted, for example “cautious”
4. Jargon

• Other factors. Most risk profiling tools will have a defined scope, for example assessing risk tolerance, so advisers need to be certain that their KYC process assesses all factors that can impact the risk the client is willing and able to tolerate. The FCA highlights the following as areas to focus on:

1. Term
2. Capacity for loss
3. Knowledge and experience
4. Risk required
5. Client objectives.

• Asset Allocation. Last but not least, close attention should be paid to the asset allocation recommended by the tools. It’s important that advisers have the ability to deviate from the model where the client circumstances require such a move, whether that means altering the asset allocation or adopting a different approach. When making the final recommendation, advisers need to consider all aspects of the clients’ profile to ensure a suitable recommendation is being made. Adopting a tick box approach with over-reliance on the tools output, without a sense check on client suitability, will almost certainly be viewed as poor practice.

As well as the individual issues above, advisers should also think about the end to end process. If you are using a risk profiling tool and asset allocation model developed by different third parties, how do the input and outputs match together? And how robust is the mapping process?

Good practice tips

If you want to make sure your risk profiling is up to scratch, you probably can’t go wrong with sticking to the following suggestions from the FCA on the areas for advisers to review when reassessing their risk profiling process:

• Understand the risk profiling tool and its limitations
• Use risk profiling tool - a basis for discussion
• Clarify contradictions
• Ensure your risk descriptions are clear and quantify the level of risk
• Ensure you adequately collect and assess other information – e.g. term, capacity for loss, and knowledge and experience
• Adapt solutions to clients’ individual needs and circumstances
• Assess the risk level of solutions

Some helpful further reading:

FG 11/05 Assessing Suitability

https://www.fca.org.uk/firms/assessing-suitability

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