Confusing elements of risk profiling and capacity for loss, as well as overlooking client knowledge and experience, are three areas where advisers can avoid common suitability pitfalls, says Rory Percival.
Speaking at PortfolioMetrix's ‘The Mix Forum', the former Financial Conduct Authority (FCA) technical specialist-turned consultant said advisers were still making mistakes in those areas and the regulator was keeping an eye on them.
Percival (pictured) based his guidance on his experience working on the FCA's suitability review last year, which had examined 1,165 client files from about 700 firms.
Here is what tends to go wrong and how advisers can fix it, according to Percival:
1 Risk profiling
Percival warned of contradictory answers sometimes being given by the risk profiling tool or by the client themselves. To avoid any confusion, Percival urged advisers to revisit answers in such cases or have a discussion with the client and ensure the clarification is recorded on file.
He also warned of the danger of relying on tool-generated descriptions when categorising clients into different levels of risk. This was highlighted by former regulator the Financial Services Authority in its 2011 guidance paper, where it indicated nine out of 11 profiling tools were not working adequately, which included concerns about "vague" risk descriptions.
Instead, Percival suggested "quantifying" the risk by offering clients graphs or tables explaining what the returns or drawdown might look like in the future.
He said: "One way or another you need to ensure risk descriptions adequately quantify the risk associated with each category.
"The regulator wants the client to see what their investment journey might look like and whether they're ok with it."
2 Capacity for loss
Percival said managing clients' capacity for loss was "really quite poor" in most firms.
"I would go so far as to say I don't think most firms do capacity for loss adequately. Looking at files I've seen a lot of poor practice. Sometimes when talking to firms and their advisers they don't actually seem to understand it," said Percival.
He defined capacity for loss as the monetary value at which clients would feel a "material impact".
The problem was many advisers he spoke to approached this from an emotional stand point instead, he said. They were effectively mixing up capacity for loss and risk profiling, including a short number of questions in the capacity for loss section with answers that should be in the risk profiling section.
"This includes answers like 'I wouldn't be happy if…'," he explained. However, he conceded: "Getting that capacity for loss is actually quite difficult and asking the client that question directly won't get the right answer."
Instead Percival suggested advisers should break the client's income down by fixed outgoings, "discretionary" funds or those used for holidays and hobbies, and the excess income that can be saved.
From this advisers can gauge how much flexibility exists to manage potential losses and plan the investment accordingly. "I would say the only way of doing this is cash flowing planning," he said.
3 Knowledge and experience
Percival said ensuring adequate client knowledge and experience was "often the forgotten part of the risk picture".
He said: "This is more a matter of disclosure, where the adviser needs to explain the recommendation for an investment in a way that the client is likely to understand."
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