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Risk Profiling in Financial Advice Disputes


Purpose

This article explains the approach FOS takes when determining whether the risk profiling practices and procedures of a financial services provider (FSP) are adequate.

The aim of risk profiling includes the FSP obtaining a client’s informed acceptance of their risk profile and the possible investment implications that may arise from the outcome of the risk profiling process.


What is risk profiling?

FSPs that provide personal financial advice to retail clients are obliged to ensure the financial products they recommend are suitable having regard to each client’s objectives, financial situation and needs.1 An important part of an FSP’s assessment of a client’s objectives, financial situation and needs is the knowledge of the client’s tolerance to risk.2

Most FSPs who provide personal financial advice to retail clients have developed practices and procedures, known as “risk profiling”, which are designed to identify their clients’ understanding and tolerance to risks.

There is no mandated method of risk profiling and a number of methods have been developed by FSPs, including:

  • risk profile questionnaires;3
  • the risk tolerance line method;4
  • the life-cycle approach;5 and
  • the sensitivity analysis approach.6

 

It is important to remember that whatever method is used it is only a tool for FSPs to use as part of the process of determining clients’ tolerance to risk.

FOS also recognises that skilled advisers can secure their clients’ informed consent without using risk profiling tools.

Regardless of whether risk profiling tools are used or not, FSPs must keep detailed records that show they secured their client’s informed consent about the level of risk required to achieve their objectives.  Without these records, FSPs have greater difficulty defending claims involving the adequacy of their risk profiling practices and procedures.

 

The consequence of inadequate or poor risk profiling practices and procedures

The probable consequence of inadequate or poor risk profiling is a client making investments that are not suitable for their objectives, financial situation and needs7 and the FSP breaching its duty to have a reasonable basis for its advice.


FOS’s approach to investigating the adequacy of risk profiling practices and procedures

FOS will look at the FSP’s practices and procedures as a whole when investigating and making decisions about the adequacy of a FSP’s risk profiling practices.

This is likely to include a consideration of whether the FSP has:

  • addressed the inherent and specific limitations in the risk profiling tool used;
  • risk profiling practices and procedures that address both the client’s attitude to risk and capacity for loss;
  • determined the risk profile for each spouse or partner;
  • determined the risk profile of the client in each of the capacities the client acts (e.g. as an individual, in the client’s capacity as a trustee of a SMSF or company director etc);
  • conducted a transparent risk / reward trade off where clients do not have sufficient financial resources to meet their stated objectives in the timeframe they have identified and having regard to their stated appetite for risk;
  • sought to actively understand their clients’ concerns and objectives; and,
  • sought to educate their clients about risk and reward.


Has the FSP addressed limitations in the risk profiling tool used?

FOS expects FSPs to be aware that all risk profiling methods have some limitations and have in place adequate measures to address them.  FOS notes the following general limitations in the risk profiling methods used in the industry.

The Risk Tolerance Line tool is notoriously inaccurate as clients tend to understate how low any low risk tolerance is and how high any high risk tolerance is.  This tends to result in most clients indicating a moderate risk tolerance.

The Life Cycle Approach would have all clients in the same age group holding the same financial products and does not account for personal circumstances which could alter the asset allocation.

While the Sensitivity Analysis Method addresses clients’ financial capacity to absorb capital loss and volatility, it ignores clients’ subjective tolerance to capital loss.

The effectiveness of Risk Profile Questionnaires –the tool most commonly used by advisers – will often depend on the quality of the questions asked and the appropriateness of the grading and weighting of the client’s responses. 

A questionnaire may not be effective if, for example, it:

  • asks questions that contain complex concepts which assume a high level of financial literacy on the part of the client; or
  • uses vague or ambiguous language.

 

FOS expects FSPs using these risk profiling methods to be aware of these limitations and have in place adequate measures to address them.

FOS asks FSPs to be aware of limitations in tools they use and use measures to mitigate those limitations.  FOS may also analyse risk profiling tools, identify limitations relevant to the Dispute and ask the FSP to make submissions on the relevance of the limitations together with submissions and evidence on mitigation strategies employed by the FSP.


FOS’s observations of risk profiling practices and procedures

FSPs are unlikely to adequately meet their obligation to have regard to a client’s objectives, financial situation and needs by only relying on a risk profile tool.

The reasons for this include:

  1. Most risk profiling tools have inherent limitations that can only be overcome by FSPs putting in place techniques that address the limitations (this may be as simple as testing the client’s responses to a questionnaire and their understanding of questions).
     
  2. Risk profiling tools offer an opportunity for FSPs to educate clients on the relationship between risk and reward in terms the client is likely to understand.  FSPs who do not take this opportunity to educate clients are at risk of not obtaining the client’s informed acceptance of the risk profile and its possible investment implications.
     
  3. Risk profiling tools should be used by FSPs to identify gaps between a client’s financial resources, their appetite for risk and the timeframe to achieve their objectives.  Where gaps do exist, the FSP must undertake a transparent trade-off process where the FSP can either ask the client to consider:
    • investing more funds;
    • taking on board more risk to achieve a higher possible return; or
    • modifying future goals so that they are more in line with the client’s financial resources and the timeframe to achieve the client’s objectives.

The above process is also highly relevant to the client’s informed acceptance of the risk profileand its possible investment implications.


Are the FSP’s risk profiling practices and procedures adequate?

FSPs seeking to establish their client’s tolerance to risk should not view the risk profiling process as only a means to establish the suitability of investments they recommend but also as an important part of securing the client’s informed consent to make the recommended investments and/or employ the recommended investment strategy.

If the FSP can demonstrate the client’s informed acceptance of the risk profile and the possible investment implications that may arise from the outcome of the risk profiling process, it is less likely that FOS will find the FSP had breached its obligations in this regard.

FOS’s view is the usefulness of any risk profiling methods used lays in the opportunities those methods give FSPs to open meaningful discussions with clients that could identify gaps between their objectives, the timeframe to achieve the objectives and their appetite for risk and, if gaps exist, undertake a transparent trade-off process.

It is more likely that FOS will consider an FSP’s risk profiling practices and processes to be adequate if they are likely to result in securing a client’s informed consent about the level of risk they will need to take to achieve their objectives.


Footnotes

  1. Subsection 945A(1) of the Corporations Act
  2. ASIC’s Regulatory Guide 175 (issued May 2009) at RG175.118
  3. This tool uses a series of questions designed to examine the client’s reaction to different financial outcomes.  Each response is graded in some manner and the total score is assessed against a series of risk profile categories, usually ranging from conservative to aggressive profiles.
  4. This tool asks the client to indicate a preferred place on a scale (usually a five or ten point scale) starting from a low-risk tolerance ending at a high-risk tolerance.
  5. This approach is based on the life stage of the client and assumes a younger client’s focus is on wealth accumulation and older clients’ are more concerned with income.  A younger client would usually be considered to have a more aggressive risk profile than older clients.
  6. This tool tests how different outcomes would affect the financial capacity of the client by essentially asking: “How would the financial capacity of the client be affected if they suffered capital loss or expected benefits were not delivered?”
  7. Paige v FPI Limited [2001] NSWSC 627 at paragraphs 18 and 190