Assessing a client's attitude to risk is all important when it comes to helping them plan for their retirement, says Lorna Blyth.
Establishing how much loss an investor could comfortably accept can be achieved by calculating their risk profile. This is split into two parts, risk capacity and risk attitude, and the two do not always go hand in hand. For example, an investor with a large pot of assets might have a low risk attitude but have a high risk capacity, as their wealth means they can afford to take on more risk than an investor with the same risk attitude but a smaller pot of assets.
Likewise some investors might feel ‘better safe than sorry’ and prefer the security of cash, while at the same time understanding that, over the longer term, this is likely to be a risky strategy.
While capturing an investor’s risk profile can be complex there are a number of risk profiling tools in the market place to assist with this. Most are question based, and apply scores to individual answers, then calculate an overall risk score. This translates to a risk profile, for example cautious, balanced, adventurous etc.
Of course risk profiling is just the beginning. Armed with this knowledge, the next stage is to decide on an appropriate asset allocation and create an efficient portfolio which maximises the investment return for the appropriate level of risk. In other words, the recommended investment must be suitable for the investor’s needs and objectives. Suitability of advice is one of the six Treating Customers Fairly (TCF) outcomes and advice that does not match an investor’s attitude to risk is one of the FSA’s main concerns in their pension switching thematic review. So it is important that an adviser gets it right. The FSA is happy for advisers to rely on third party expertise for asset allocations and fund selection, but the process must be clear.
One of the results of the FSA’s focus on suitability has been that many life companies now offer portfolios which match risk attitudes to asset allocations. Some also come with automatic regular rebalancing so that the original asset allocation is maintained and portfolio drift is avoided. This can ensure ongoing suitability and is an ideal solution to help advisers comply with the FSA requirements, as highlighted in the pension switching review.
However, an adviser’s work does not stop there. While a regularly rebalanced portfolio helps to retain the original asset allocation it cannot check that the asset allocation remains suitable for a particular risk profile during all market conditions. For example, during 2009 equity volatility increased significantly above historic levels and caused some commentators to revise upwards their assumptions for equity volatility levels in the future. For some investors this could have increased the risk profile of their portfolio and meant that the original asset allocation was no longer suitable. This can be avoided by offering an ongoing review which checks asset allocations against an economic and financial outlook. If there have been any changes in an asset’s long-term fundamentals the impact can be identified and, if necessary, the asset allocation can be altered to make sure it remains suitably matched to the original risk profile.
Of course many investors’ risk profiles will change as they get closer to retirement. A lifestyle arrangement will reduce risk over a number of years by automatically switching the portfolio into less risky assets. While these are common in the market, the different approaches to lifestyling mean there is no common glidepath. Some start reducing risk when the investor is five years from retirement; others start from ten years; and some from fifteen. Understanding the detail of the switching process within a lifestyle strategy will help an adviser understand how an investor’s risk profile is managed and whether this provides the most efficient risk/return model over the lifetime of the plan.
Defining a customer proposition
It is clear that understanding investment risk and ensuring ongoing suitability involves a lot of resource. Current regulatory pressures mean the standards of advice and processes advisers are expected to follow will cause additional burdens. For some advisers, this can represent an ideal opportunity to redefine their business model and customer proposition.
By recommending an investment that comes with regular rebalancing, lifestyling and built in ongoing reviews, advisers can deliver a strong customer experience; manage clients in a more cost effective manner; and help meet regulatory responsibilities.
Technically speaking there could be many different possible outcomes. But from the adviser’s perspective, the challenge is to make sure that the outcome for their clients, and for themselves, is not an undesirable one.
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