Experts discuss risk – Part two

Reader Alert: This the second in our two part coverage of a roundtable risk discussion with Canada’s foremost CFAs. Click here for the ‘AE Risk Roundtable Photo Gallery’ and click here for Part One.

Clients witnessed risk in action in 2008, but have these lessons lingered?

Risk is a layered concept.

Individual investors—even high net worth clients—acknowledge their balance sheets. Do they truly recognize the forces behind them or even their own risk thresholds at all?

Advisor’s Edge hosted leading Canadian CFAs and business experts to examine just how deep that understanding goes.

They also discussed how advisors can best present risk concepts to create truly informed investors.

Participating in the roundtable were:

• Margaret Franklin, chair of the Board of Governors of the CFA Institute.
• Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University.
• Stephen Copeland, senior vice president investments and private client services at Foyston, Gordon and Payne Inc.
• Tom Trainor, managing director of the Hanover Private Client Corporation.

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Advisors’ Edge: The list of designations is growing. How do you get people to understand that you’re a professional, you’re here to help measure and temper their risk? Is that an education gap?

Milevsky: Branding. You need a campaign so anybody with any wealth understands that unless their advisor has a CFA designation, he or she is lacking some critical financial knowledge. Going into the bank or stumbling across someone on a golf course doesn’t mean anything. That’s one of the takeaways from the financial crisis.

Franklin: We haven’t articulated the fact that the client now truly owns their financial well-being, so it behooves them to educate themselves.

Milevsky: Do the higher net worth individuals need to be told that?

Franklin: You don’t need to tell the higher net worth clients. We use the concept of irreplaceable capital: What’s the probability you would be able to replace this capital you’ve either spent a lifetime saving up or you had the liquidity event. They say, “Not very likely.” And that changes the nature of the discussion.

Trainor: I don’t know if they know the questions to ask. They’ve asked for referrals from friends, but they don’t know how to package it all together. Especially if you’ve got lawyers looking after your estate trust planning, a portfolio manager looking after your portfolio and your CA helping you with your small business.

Copeland: A financial planner is supposed to do all that, but in Canada, it’s not that well defined. And people don’t like to pay for advice. That’s why the mutual fund industry exists, because there are a lot of hidden fees. Years ago, when the big corporations had people retiring, they sent them to financial planners. But that’s been cut out over the years. It’s also difficult to have one-stop shopping because many clients have long-term, trusted relationships with their lawyers, accountants and other professionals, and they don’t all work under one roof.

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Advisors’ Edge: The next question is about shifting more towards advice to your peers. How should advisors be assessing risk levels and what tools can help them do that?

Franklin: The CFA Institute created a private wealth body of knowledge. That’s one of the greatest tools. And there’s a list you can check off to say, “I do know about that or I’m not an expert in that field. I’ve now identified the mortgage, the insurance components and I do need to draw on other people’s expertise.”

Milevsky: Since we’ve continued to bring up the CFA, do you see the curriculum changing in the direction of things a CLU would learn?

Trainor: As a professional body, the CFA recognizes that if we have 30% of our members participating in private wealth, they have to know something that’s quite a bit different from the guys who are trading bonds or equities or are strictly institutional. If you are going to manage a portfolio, you have to do an investment policy statement. An integral part of constructing that is a person’s human capital—analyzing it and understanding the two principal risks: morbidity and mortality. So you’d better have an understanding of insurance.

Milevsky: One of the other designations that hasn’t come up here is the actuarial designation. They’re also trying to get into the space. Some started out working for large insurance companies but are now doing a lot of what you folks are doing.

Franklin: Actuarial science requires a lot of large numbers. The ironic part about actuaries going into wealth management is the institutional model doesn’t fit, because private individual clients are absolutely not predicated on the law of large numbers. Actuaries deal with very long time horizons and results are averaged over a large number of lives. That’s exactly what doesn’t happen in an individual family. A lot of times, the reason institutional strategies fail the individual investor is not that they’re bad; it’s the lack of recognition of that individual nature.

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Advisors’ Edge: Is risk simply a collection of uncovered needs or is it more? How do you look at it and how do you get the client to look at it? How are those views different?

Trainor: It’s up to the advisor to sit down and work with the client and figure out what the true issues are. It may be they have a child with a disability, who’s going to have to be protected for 70 years. It’s up to the advisor to ask the appropriate questions.

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Advisors’ Edge: That’s the thing—you talk about designations, you talk about questionnaires, you talk about all the stock stuff. Is part of your training on the job, and you learn by having these conversations?

Franklin: Our business is filled with analytical people. I think there’s a large component that can be trained around the empathetic tools that allow you to get out of a client what you need. Much of the work going on right now is architectural work: How do we take in all this information and put it in a framework of a portfolio that deals with all these components—whether it’s mortgage, insurance, human capital, the actual investments—and build something that really meets the clients’ needs?

Milevsky: We have financial risk aversion, and there’s also longevity risk aversion. The fact that a client may live to the age of 100 doesn’t faze them. They don’t want to plan for it. They’re longevity risk tolerant. Other people are longevity risk averse. They say, “What, there’s a chance I may make it to 100? That really worries me. I want to make sure I have enough if I get to 100.” How does that impact retirement planning?

Franklin: And it has huge investment, insurance and wealth implications. We need to be crystal clear on morbidity and mortality. We need to be crystal clear on longevity risk. Those kinds of conversations drive an investment and portfolio conversation.

Trainor: A study done out of the U.S. found that 50% of people aren’t going to work as long as they want to because of health reasons and a lack of employment opportunities. You may have somebody who is 60 and planning to work at a reduced capacity for another 10 years and all of a sudden they find out they’re going to have to start drawing on their portfolio today, not 10 years from now.

Franklin: BGI did a study on the preparedness of Americans in the 8th and 9th wealthiest decile for retirement. And guess what? Individuals in those deciles on average assumed their biggest asset, which is generally their real estate asset, is going to contribute to their portfolio. They say, “I have a $2 million house, I have $1 million in savings and I have a DC plan, so my retirement savings programs add up to another half million.” They haven’t done the accounting that says, “When I replace my $2 million house, it’s not actually a functioning asset because I still need a place to live.”

Milevsky: Would you be willing to fire a client?

Franklin: Sometimes you have to. And you have to be very honest about how the two of you are not a good fit because they’re looking for something that is inconsistent with what you believe is in their best interests.

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Advisors’ Edge: In terms of the clients you keep, do all of them come to you after being through the school of hard knocks?

Franklin: By the time it gets to us, the wealth becomes really relevant, because they’re approaching retirement and this is all their savings, so there’s a catalyst for them to be very focused.

Milevsky: So what are you telling the masses with only $30,000 in their RRSP?

Franklin: If you’re young, set up a savings program, and spend time on your risk profile. The magic of compounding interest can work for you, so you don’t need to take huge risks. If you’re 55, get used to working—you have to think very long and hard about your total portfolio and your expenses.

Milevsky: Anybody between the age of 40 and 60 sitting on a relatively small sum in their RRSP—unfortunately, there’s a very large group of them out there and they need help.

Franklin: Work longer, reduce your standard of living and by the way, you may have to sell the house.

Trainor: The numbers never work unless they reduce their cost of living. And often, they may have dependent children who are in their late 20s, early 30s, and the parents have never had the tough conversations with their kids.

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Advisors’ Edge: How can advisors show clients how to look at risk holistically?

Franklin: I think it requires being well educated, imaginative and brave to have the right conversation with clients.

Milevsky: Start using the language of finance more broadly, and start using common language with regard to the risks they face: Your house may burn down, you may live a long time and you may be unemployed. We all use different metrics and languages to discuss it. If we could somehow use the same language for all risks, maybe we could start thinking more holistically.