Understanding client’s risk tolerance

Some customers handle risk differently from others. Mike Morrison explains the virtues of understanding their varying risk tolerances

Many years ago (1998, to be precise), I gave a talk for an organisation, and several days later received a book called Against the Gods: The Remarkable Story of Risk. It considers civilisation's ­effort to understand and control risk.

Despite it being a while since it was printed, it is still relevant today - a consideration of risk in all its manifestations must be at the heart of much of the ­retirement planning world.

Early this year, the FSA refocused on risk with the ­guidance paper ­Assessing Suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection and the Dear CEO letter of June. It pointed, among other things, to a risk of unsuitability due to:

• inconsistencies between portfolios and the client's attitude to risk, and
• inconsistencies between ­portfolios and the client's investment ­objective, investment horizon or agreed mandate.

Understanding risk

Obviously, consideration of a client's attitudes to risk is at the heart of financial planning, but it is not an easy task. Risk means different things to different people. The key is to express it in a way that is ­easily understood.

The FSA guidance goes into a lot of detail into what it sees as ­examples of both good and poor practice. There a number of ­issues worth noting.

Firstly, the capacity for loss is an important concept for both the adviser and the client. An ­individual earning £150,000 p/a with similar outgoing financial ­commitments will have less ­capacity for loss than someone earning £50,000 p/a with minimal commitments.

Secondly, a client may have different risk profiles attached to different pots of their savings.

A pension scheme might be seen as a longer-term investment due to its inheritance tax efficiency, or a particular investment might be ­earmarked for a child's education.

It is also important to consider the change from the accumulation phase to the decumulation phase.

As an individual is working and building up assets, there could well be the possibility of a greater acceptance of risk on the basis that a period of poor performance could be remedied by perhaps taking a bit more risk or even working longer.

Such a blip during the ­decumulation phase could well be much more difficult to withstand if assets are now finite and there are no further earnings to be added to the pot.

Retirement is now a process and financial planning allows an ­optimisation of income, tax and the ability to leave a legacy.

At the very least, this will require a clear understanding of each client's attitude to risk, as well as evidence that appropriate questions have been asked and the answers discussed with the client. This should include a consideration of the client's capacity for loss.

It will also require a robust and repeatable investment process that can be applied consistently across all clients.

In addition, it should have a clear range of investment solutions that can be used to meet each client's different investment requirements, and a review process to consider the effects of changes in personal circumstances or better/worse investment performance than projected.

Tools

The FSA also focused on risk ­profiling tools, which can be a ­valuable assistance in such a ­planning process.

But it made the point that these must be clear, unambiguous and that in reality the financial adviser must understand the assumptions underlying the planning tool.

Often the gateway to the whole process is a risk questionnaire. This is where some of the science comes in - or at least some of the behavioural psychology. Gone are the days of a one-to-ten scale where everyone comes out a five.

Increased longevity means that retirement could be a 30-year ­period. In most cases, it will be ­important for the client's assets to last that long.

But more subtly, income ­drawdown is an ­investment product and performance is a fundamental differentiator from an annuity.

Risk profiling will be a fundamental part of the retirement process in the future, alongside cashflow planning and regular review.

In the post-RDR world, this could well form part of a specialist ­retirement planning proposition.

Mike Morrison is head of pensions development at AXA Wealth