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Risky business… The latest on risk, risk profiling

19 August 2021 Gareth Stokes

A client’s investment risk profile hinges on the interaction of three distinct risk elements, namely risk required, risk capacity and risk tolerance. This according to a Risk-profiling Workgroup (RPWG), that used the Financial Planning Institute of Southern Africa (FPI) Retirement and Investment seminar as a platform from which to launch the latest locally-produced whitepaper on risk profiling. The RPWG is a co-industry initiative between the FPI and the Financial Intermediaries Association of Southern Africa (FIA).

Wresting with risk profiling definitions 

In the distant past, the financial planning industry determined a client’s risk profile based on the client’s responses to a risk questionnaire, which varied widely from one advice practice and / or product supplier to the next. Sound financial advice then involved the adviser recommending products in line with the client’s risk profile ‘score’. “The risk questionnaire does not constitute an advice-led process because it involves little more than making a product recommendation based on a client’s perceptions, often tainted by how that client felt on a given day,” said Swanepoel. He added that a basic standard of advice-led investment advice had to be met, before commenting that the latest paper laid the foundation for how risk profiling should be applied in the future. 

Swanepoel was joined on the virtual stage by Solani Baloyi CFP ®, Rand Regional Manager at the FIA and David Kop CFP ®, Executive Director: Relevance at the FPI, both of whom served on the RPWG. The workgroup was thus made up of practising financial planners assisted by behavioural finance experts and members of the academia and advice-focused associations. “We considered risk profile from a client perspective and set about clarifying the concept from a broader industry perspective; financial planners are at risk for as long as uncertainty persists,” said Kop, before handing over to Baloyi to describe the four objectives that the workgroup set out to achieve. 

Objective 1: Define risk profiling from an investment planning perspective.

“The Financial Advisory and Intermediary Services (FAIS) Act regulates advice and the GCOC makes mention of ‘risk’ and ‘risk profile’ in its suitability requirements; but neither document offers a clear definition for these terms,” said Baloyi. The working group determined that risk needed to be defined from a client / investor, financial planner and product point of view, with the overarching consideration being for clear and sound definitions that could be applied correctly and consistently by all industry stakeholders. 

Objective 2: Articulate a risk profile framework and philosophy based on sound principles

The second goal was to create a consistent, practical and simple definition that was easy to apply and understand. “We had to address the confusion that arose from financial advisers, financial planners, clients / investors and other industry stakeholders referring to risk profile when they actually meant risk tolerance,” said Baloyi. This blurring of the lines between these unique constructs is at the heart of many misunderstandings between the advice community and the FAIS Ombud, with dire outcomes for clients. 

Objective 3: Formulate a risk profile framework

The working group set out to create a framework that both accommodated regulatory requirements as well as serving as an industry standard. “We expect that the FAIS Ombud’s office will take notice of the work that has been done here, and will not be surprised if future determinations reference some of the principles we have laid down,” said Swanepoel. “The FAIS Ombud will continue applying a strict interpretation of the amended GCOC”. 

Objective 4: Publish a risk profile paper

The 46-page paper was made available to FPI members immediately following the seminar. “We believe that this paper is going to lay the foundation of how the advice community will view risk profiling going forward,” said Swanepoel. Financial planning professionals were encouraged to read the paper and engage with the workgroup to further its development. 

The three elements of risk

The three elements that make up the risk profile definition are risk required; risk capacity; and risk tolerance. Risk required is the level of risk that would have to be taken to meet a pre-determined financial objective over a given period. Risk capacity refers to the investor’s ability to absorb or remain invested through market downturns, and advisers must make sure their clients have enough assets and cash not to be forced out of their investment during the minimum holding period. And finally, risk tolerance refers to the investor’s willingness to be exposed to the chance of a capital loss. 

Even so, the primary risks that the industry must consider are those highlighted in sections 7 and 8 of the GCOC. Risk profile is mentioned in section 8(1)(a) and again in section 8(1)(c), while risk profiling appears in the general terms. Insofar 8(1)(a) it is important that you must consider risk profile prior to giving advice. So, you must consider your client’s risk required, risk capacity and risk tolerance up-front. Another important consideration is that risk capacity has been specifically written into the legislation as ‘the clients ability to financially bear any costs, with the emphasis on risk’. “We cannot, therefore, give advice without considering the impact of negative market movements, where this volatility may force our clients to liquidate some or all of their portfolio at a loss,” said Swanepoel. 

A comprehensive risk framework must consider all role players, including the client / investor, financial adviser, and regulator. It must also reflect the financial planning process and acknowledge the risks inherent in the chosen investment product. The workgroup spent hours debating concepts such as appropriate benchmarks; capital losses versus paper losses; and nominal versus real return measurement, among others. “The interests of the client / investor took centre stage throughout our debate about risk, risk profile and risk profiling,” said Baloyi. “And in consideration for our clients / investors, we always assessed the financial planner against the investment goals that the client / investor set for themselves”. 

Losing money is a primary risk

The workgroup observed that a client’s or investor’s primary risk centred on losing money, whether in nominal or real terms, and irrespective whether this was a paper or realised loss. Financial planners, meanwhile, view inflation as a key risk element over a 10 to 20 year period. Combine these risks and you end up with the risk that the client / investor does not outperform inflation in the medium to long term. Finally, we are concerned with the client / investor not meeting their financial objectives. CEO of the FPI, Lelané Bezuidenhout CFP®, was on hand to grill the panellists. “The entire exercise took place in the context of asset management and investment planning … why is it important for us to understand this?” she asked. 

According to Kop, it comes down to risk management and eliminating the risk that resulted from conflicting understandings of common terminology. Context is important too… “The work group agreed that definitions for ‘risk’ and ‘risk profile’ should not be included in the legislation because these words mean different things in the investment, life insurance and short-term insurance contexts,” explained Swanepoel. South Africa boasts an advanced, principles-based financial services regulatory framework which allows scope for industry definition of critical issues. It seems sensible, therefore that the FIA and FPI drive the understanding of these terms from an advice perspective. 

Basic principles for financial planners to live by

The paper is not intended as an academic paper, but rather as a setting out of basic principles for every financial adviser and financial planner to follow. “To cement everything, do not forget the value of the record of advice and the importance of it reflecting the risk tolerance that the client / investor agreed to at the time of advice, because the client / investor may easily forget what he or she agreed to when faced with an aggressive market downturn,” concluded Swanepoel. 

Writer’s thoughts:
The consequences of mistakes during the financial advice or financial planning process are dire, with negative outcomes for both adviser and client. It is for this reason that legislative requirements around risk must be given careful attention. Are you surprised that the industry is still debating the definition of risk, risk profile and risk profiling more than 15-years after the FAIS Act was implemented? . Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts [email protected].






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