All the major providers of financial products still require your financial adviser to complete an investment risk questionnaire before they will accept investment applications from their clients, despite the fact that these questionnaires are “fundamentally flawed”, the annual conference of the Financial Planning Institute (FPI) heard this week.
Anton Swanepoel, co-founder and director of Amity Wealth who has been in leadership roles in both the FPI and the Financial Intermediaries Association of Southern Africa (FIA), told the conference there is overwhelming evidence both locally and internationally that risk-profile questionnaires are problematic, yet advisers are unable to place investments with companies or investment platforms unless they have used them.
A risk-profile questionnaire is typically used to determine the extent to which you should be exposed to investment risk, on a spectrum from conservative (little to no risk) to aggressive (a high degree of risk).
You might receive inappropriate advice if the advice is based on a risk profile that was determined using a flawed questionnaire.
The general code of conduct that forms part of the Financial Advisory and Intermediary Services (FAIS) Act obliges financial advisers to advise you on products that are appropriate to your risk profile and your financial needs.
If you are given inappropriate investment advice, you can complain to the Ombud for Financial Services Providers. In many cases heard by the ombud, advisers have been held liable for the losses suffered as a result of advice that was inappropriate for the investor, and the ombud has ordered them to compensate their clients.
Swanepoel surveyed nearly 550 South African financial advisers who are members of the FPI and FIA, and 85 percent of them reported that, in their view, the risk-profile questionnaires they use are inadequate in assisting them to provide appropriate advice.
Swanepoel says the first major flaw with risk-profile questionnaires is that they do not take into account how much investment risk investors need to take in order to reach their financial goals. This is despite the fact that the FAIS code of conduct specifically requires an adviser to understand your investment needs and objectives.
FAIS ombud’s view
Swanepoel says Noluntu Bam, the Ombud for Financial Services Providers, said in her 2012 annual report that in many of the cases that came before her she found a disconnection between a complainant’s tolerance for risk, as assessed by his or her answers to a risk-profile questionnaire, and the complainant’s financial circumstances and ability to withstand losses (capacity for risk). Bam found the mismatch to be particularly prevalent in cases where advisers had recommended that pensioners invest in high-risk unlisted property syndication schemes, even though, because of their limited means, they could not afford any investment losses.
Bam said the answers to risk-profile questionnaires can be interpreted in several ways, and the questions are not always specific or relevant to the investment at hand. Risk must be disclosed in “clear, unambiguous language”, she said.
Swanepoel says investors should understand the range of returns they can expect from their investments and the losses their investments might incur.
In the same year that Bam’s report highlighted the shortcomings of risk-profile questionnaires, the regulator of financial services in the United Kingdom, the Financial Services Authority (FSA), released the findings of a survey that found that nine out of the 11 risk-profile questionnaires it scrutinised were fundamentally flawed.
Despite these findings, the financial services industry has done nothing about risk-profile questionnaires, Swanepoel says.
Since the FSA’s survey, research in Canada has found that 83.3 percent of risk-profile questionnaires are “not fit for purpose”.
The independent company that completed the research for the Canadian Investor Advisory Panel found that the questionnaires had too few questions, poorly worded or confusing questions, poor or arbitrary scoring models, or the scoring merged multiple factors, according to a paper written by Swanepoel.
His paper is being scrutinised by the FAIS supervisory department of the Financial Services Board (FSB), Swanepoel told the FPI conference.
He urged his peers in the FPI who hold the Certified Financial Planner accreditation – one of the highest qualifications an adviser can obtain – to do something about risk-profile questionnaires before the FSB introduces regulation on risk profiles.
What do the terms mean?
One of the problems with risk-profile questionnaires is that they seek to determine if you are a conservative, moderate or aggressive investor, in the absence of a standard definition of what these terms mean. Some questionnaires seek to obtain more information and attempt to determine if you fall within one of five different profiles, including moderately aggressive or moderately conservative. Different asset allocations are then deemed to be suitable for each risk profile. Typically, if your profile is conservative, your allocation to equities is reduced, while your allocation to cash and bonds is high, and vice versa if your profile is aggressive.
Swanepoel says a dictionary definition of conservative is an aversion to rapid change; moderate means avoiding extremes, while aggressive means angry. With terms that are open to such broad interpretations, you and your adviser may have different ideas of what conservative, moderate and aggressive mean, he says.
He says the definitions and the methodology used to determine what type of investor you are need to be standardised.
He says that when the FPI and FIA surveyed advisers, they asked them whether they regarded themselves as conservative, moderate or aggressive investors. They then asked the advisers what returns and what losses they expected their investment could make over any one-year period.
An adviser who identified himself as a conservative investor said he expected a return of 16 percent a year over five years, despite the fact that this is 10 percentage points higher than the inflation rate and totally unrealistic for someone who is invested conservatively.
Swanepoel says the same adviser was not willing to incur investment losses of even one percent of his investment over a 12-month period in order to achieve an average return of 16 percent a year over a five-year period.
An adviser who said he was a moderate investor stated that he expected a return of 25 percent a year, while an adviser who identified himself as an aggressive investor said he expected a minimum return of 12 percent a year.
Swanepoel says if advisers themselves do not understand the returns they can expect and the losses they could incur when exposed to different levels of investment risk, they cannot be expected to communicate this message to you.
Warnings about the inadequacies of risk-profile questionnaires have been sounded repeatedly over the past four years, but “nobody gave a damn and nothing has changed”. Risk-profile questionnaires are still “used slavishly”, Swanepoel says.
As financial advisers may be held accountable for advice they give and are compelled by the industry to use risk-profile questionnaires, the financial planning profession needs to do something about these flawed questionnaires, he says.
FPI members have been asked to comment on Swanepoel’s paper, which has also been sent to Bam.
WHAT IS YOUR RISK PROFILE?
Your investment risk profile should be made up of three parts:
1. Your need to take investment risk. This means how much risk should you take in order to reach your financial goals. This is determined using the amount you need to save and the time horizon you have, as well as the returns of various asset classes. Typically, an adviser will determine that, for example, you need to earn a return of inflation plus two percentage points and can invest fairly conservatively, or you need a return of inflation plus six percentage points and therefore need to invest more aggressively, with a high exposure to equities.
2. Your risk tolerance. This is a measure of how much investment risk you can tolerate without worrying about your investments. Your risk tolerance should take into account how well you can sleep when markets perform poorly and your investment shows a loss, even if that loss is not realised by you cashing in the investment.
3. Your investment capacity. This is a measure of how much investment loss you can afford to take and is directly related to your time horizon and ability to remain invested until markets recover. If you are drawing an income from an investment, you will have a lower capacity for risk than a person who is saving for retirement many years later.
TOP PLANNERS’ VIEWS ON RISK PROFILES
Top financial planners have the following to say about your risk profile:
* Peter Hewett, the managing director of Hewett Wealth and the 2014 Financial Planner of the Year, says you need:
– A clear understanding of what investment volatility is;
– A clear understanding of what the potential returns of your investment are; and
– Examples of what your investment losses could be over various time periods.
An investor’s risk profile should take into account that market performance can affect how he or she feels about investment risk.
During bear markets, investors who said they wanted to invest aggressively become “pussy cats”, but when markets are roaring ahead, investors blame advisers for not having invested more aggressively, Hewett says.
He says the financial services industry needs to define investment risk and develop a standardised methodology to quantify it.
Risk-profiling needs to comply with the principles of Treating Customers Fairly and the Financial Advisory and Intermediary Services Act.
* Natasja Norval Hart, a wealth manager at GCI Wealth and the 2010 Financial Planner of the Year, says it is important for you and your financial adviser to have a conversation about investment risk.
In cases where the Ombud for Financial Services Providers ruled against advisers for failing to provide appropriate advice, the ombud considered more than the risk profile itself, but also the process the adviser used to determine it, the conversations the adviser had with the investor and the supporting documents the investor was given, she says.
Norval Hart says the focus should not only be on your tolerance and capacity for risk, but also on your need to take risk. It is highly unlikely that these three factors will be aligned.
She says she discusses investments goals and objectives at her initial meeting with a client and leaves conversations about risk for later, because often there are too many things for you to absorb when you first meets an adviser.
She says once you and your adviser have a clear idea of your goals, you can have a fruitful discussion about the returns you need to target and the investment risk involved.
We often think we understand the impact of inflation on returns, but we underestimate the risk of investing too conservatively, and this is something you and your financial adviser should discuss, Norval Hart says.
She also recommends that you and your adviser discuss your returns and investment risk at each annual review, at which time your adviser should remind you why you are invested in a particular way and of the probability of negative returns.
* Wouter Fourie, a financial planner with Ascor Independent Wealth Managers and the 2015 Financial Planner of the Year, says he does not believe that people with the same amount of money to invest but totally different objectives should have the same investments, but this is what risk-profiling achieves.
His advice process involves 22 steps intended to ensure you make an informed decision, he says.
His process involves showing you a cash-flow plan for your investments and ensuring that you understand the investment you are making. You won’t trust the advice you have been given if you do not understand it, he says.