As the FCA’s Thematic Review makes clear, since pension freedoms legislation was introduced, retirement-income advice needs have become more complex, the importance of getting that advice right has rocketed, and the suitability of the advice given has… frequently been found lacking.
What’s been lacking most is a sufficiently robust methodology for both calculating Risk Capacity and integrating it into the overall suitability process.
A good Risk Capacity assessment should be at the heart of every suitability process. For in most instances, it is Risk Capacity that is the chief determinant of the suitable level of risk for an investor to take.
This is especially true for managing the transition from accumulation to decumulation.
A robust Risk Capacity methodology manages this transition automatically. It makes it clear how an investor’s Suitable Risk Level should respond to their financial circumstances – both pre- and post-retirement. And it does so seamlessly, with no need for clunky workarounds or separate processes either side of a dividing line between working and not – a line that for many is increasingly blurry, if not entirely arbitrary.
Evidence and consistency
In financial advice, it's often not the answer that counts, so much as the reliability of the process that got you there. An outcome can only ever be as suitable as the process that produced it.
The FCA do not, of course, prescribe any particular methodology. But they do very much prescribe that you have one; and that it’s more than a bodging together of disjointed systems with subjective fudges creeping into the gaps. The backbone message of the Thematic Review was the need for evidence that suitability assessment methodologies gave consistent outputs for the same inputs, and were consistently applied.
In Risk Capacity, this need for evidence and consistency applies to two main areas: how Risk Capacity is measured; and how it’s combined with Risk Tolerance.
(For more on the widely underappreciated risk of inconsistent outcomes between different advisers of a firm, or even within the same adviser in different moods see our work on ‘Noise Audits’.)
How to Assess Risk Capacity either side of retirement
A good Risk Capacity assessment accounts for all relevant elements of an investor’s financial situation, so it automatically accounts for where somebody is in relation to ‘retirement’, whether that’s a hard stop or a decades-long withdrawal strategy.
Typical approaches are, however, not good; they are:
- Not quantified – Too often, Risk Capacity measurements are either subjective guesses, or workarounds such as cash-flow modelling. While these may touch on important factors such as age and non-investible assets, they generally do not do so in a consistent manner. When they are consistently quantified, they do not afford consistent integration with Risk Tolerance measures.
- Not dynamic – Suitability should be as dynamic as the investor circumstances it’s designed to deal with. Most suitability profiling is over-reliant on an initial assessment, and typically unresponsive to dynamically changing circumstances – either in a client’s life, or in the markets (for the latter, see how suitable risk levels should update in response to shifts in portfolio value).
- Not holistic – Typical approaches fall into the trap of overlooking the whole human investor in favour of ‘pots’ of money, each with their own arbitrary goal, and assessment of what is suitable for meeting that goal. Little effort is paid to how an investor’s goals interact with each other, or whether each one remains a suitable target as the investor’s journey unfolds. This leads to failing to recognise the valuably flexible nature of a human’s system of goals, as well as failing to take holistic financial circumstances into account with inevitably interdependent financial decisions. (See also ‘A Behavioural Perspective on Goals-Based Investing’.)
In addition to these mistakes of omission, there are mistakes of commission, for example, adding separate measures of ‘risk required’, or ‘time horizon’.
(For how risk required is unnecessary and likely unsuitably distorting, and how time horizons are automatically accounted for in a good Risk Capacity assessment, see ‘Risk required is not required’ and ‘Navigating tempestuous time horizons’.)
In the Review, the FCA note, as an example of good practice:
"The firm also completed quarterly checks to ensure [capacity for loss] limits were not breached"
This points to something important: that Risk Capacity (and therefore the ongoing suitability of advice) should reflect circumstances which are subject to changes, sometimes of the sudden and significant variety. But why stop at quarterly checks? A good AI-enabled Risk Capacity tool can monitor this constantly, automatically.
It also points to another common failing: confusing Risk Capacity with ‘capacity for loss’. Risk Capacity (when measured appropriately) wholly covers the far narrower concept of ‘capacity for loss’ and plays a far more fundamental role in assessing suitability.
The FCA’s 2011 guidance states:
"By ‘capacity for loss’ we refer to the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take."
‘Capacity for loss’, by this definition, can only really apply to investors near to, at, or post retirement. If your income covers all your expenditure whilst you’re accumulating early in life then you could lose all your investible assets without any ‘materially detrimental effect’ on your standard of living (as the narrow definition of ‘capacity for loss’ asks you to calculate). This is clearly far too narrow a view to hold for suitable advice, which should be accounting for changing financial circumstances both in accumulation and decumulation. It’s questionable if you can give truly suitable advice by merely relying on the most basic measure of affordability, and ignoring wider financial circumstances, such as the degree of insurance held, the size and likelihood of future capital injections or extractions, or the extent of emotional attachments to (usually non-investible) assets.
‘Capacity for loss’ is fully contained within the broader notion of Risk Capacity. If you measure Risk Capacity, you are, by definition and by default measuring capacity for loss as a side-effect. The reverse is, however, not true. Understanding the distinction is crucial to giving suitable advice. We’ve written about it in more detail here.
How to combine Risk Capacity and Risk Tolerance at retirement
In the regulations, a consumer’s willingness and ability to take investment risk go hand-in-hand. In the world those regulations govern, however, there is a concerning failure to see the two as interrelated components of the same suitability system.
In the Review, the FCA note that:
"Our published final guidance indicates that assessing [attitude to risk] and [capacity for loss] separately avoids the risk of conflating these outputs (FG11/05)."
This is of course true. But it opens the door to incorrect interpretation.
Just as important as the methodology for assessing each element of a Risk Profile is the methodology for combining those elements in arriving at an investor’s Suitable Risk Level. Without a robust means of doing so (such as the one we’ve developed and refined over the last decade at Oxford Risk) poor client outcomes are much, much, more likely… regardless of how well each individual component is assessed.
The Review also gives the following example of poor practice:
"One firm had a 3-step process for risk profiling, Risk Tolerance, Risk Capacity and Knowledge and Experience. Each stage was based around a discussion with the adviser and there were no standard questions to guide the discussion. There is a risk that this approach could lead to inconsistent outcomes between different advisers of the firm."
This points to the same failing. It is never enough to simply tick every box and believe that because you’ve assessed, say, Risk Tolerance, Risk Capacity, Behavioural Capacity, and Knowledge and Experience in some way, that you will be giving suitable advice. The way that you assess them, and the way the outputs of those assessments are combined, is crucial if the advice is going to be accurate, consistent, and documented.
At the very least, Risk Capacity must be assessed in a way designed to speak a language that Risk Tolerance assessments understand. If not, however good your intentions are in doing so, all you’re introducing to your suitability assessment is noise. The failure to understand this is a large reason why the importance of Risk Capacity is so commonly underplayed, despite the potentially catastrophic consequences of doing so.
The over-reliance on Risk Tolerance renders suitability much less dynamic – and the Suitable Risk Level much less responsive – than it should be. Doing it right rests on a reliable and responsive means of assessing Risk Capacity that’s neither based on subjective assumptions nor overfitted to initial circumstances.
You could argue here that it is the nature of the supplementary discussions that’s key. Supplementary discussions around risk profiling are clearly important, especially in terms of how well a client understands why such assessments matter, which can contribute to their engagement with and overall experience of their investing journey.
However, outputs of assessments should be inputs into a discussion, not the other way around. As our work on adviser ‘noise’ has demonstrated, humans simply aren’t well suited to making robust and reliable ad-hoc adjustments. Advisers should be able to adjust suitability tool outputs to account for nuances of clients’ situations, but if the tools are well-designed these adjustments should only ever be limited, infrequent, and well-documented. If they need to be more than this, then what’s really needed is a better tool.
Relying on subjective discussions to cover up the shortcomings of a suitability assessment, rather than to work with it also doesn’t fit well with another of the major themes of the Review – the need for robust profiling processes that (ideally automatically) provide evidence for how each client is being assessed in the same reliable manner.
The role of tech in better evidence, better consistency, and better outcomes
The use of tech is widespread in financial advice. However, the thoughtful and strategic use of tech is less common. Tech is often bolted on, rather than built in, and employed not because of its number-crunching and background monitoring skills, but because it’s shiny and new.
Tech should get involved with the parts that can – and should – be made more efficient, and then get out of the way. For example, consider the effect on annual reviews – especially for clients taking regular retirement-income withdrawals if relevant data could be automatically updated and analysed in the background. Any resulting portfolio or communication recommendations could be delivered to the adviser for their judgment, and interpretation, thereby allowing advisers to fully prioritise the human side of their client interactions over the more machine-like technical calculations.
As we wrote when answering ‘How Should Risk Tolerance Assessments Differ Between Accumulation and Decumulation?’:
"Oxford Risk’s Risk Capacity Assessment was designed to function on both sides of the accumulation/decumulation dividing line – to account for all relevant financial circumstances, and consequently assess how reliant an investor is on their investible assets to fund their future expenditure. It seamlessly accounts for the transition between accumulation and decumulation by fully accounting for changing circumstances."
Where the job requires consistent application of (and automatic evidencing of) a process that needs to analyse a ton of data points that move and interact constantly, it requires tech specifically designed for the task.
For more information on accurately and robustly measuring client investment suitability, please click here to read our guide online now.
Thumbnail image by Scott Graham on Unsplash
