Rethink risk tolerance questionnaires

There are still no standard practices for how advisors should determine a client’s risk tolerance. It means investors are receiving varying levels of service and advice, leaving advisors vulnerable to complaints.

It also means firms and advisors want more support from regulators. Following the dismal results of an OSC study (see “Current tolerance questionnaires are inadequate”), several firms reached out for risk tolerance assessment tips, says Shawn Brayman, CEO of PlanPlus in Lindsay, Ont., and the lead researcher for that study. In particular, many advisors struggle to come up with accurate risk scores when trying to assess a person’s objective financial details alongside their investment behaviour and attitude. Scores are often judgement-based because there are no clear guidelines.

As a result, “many firms are moving away from more subjective approaches,” says David Di Paolo, a partner at Borden Ladner Gervais in Toronto. While working with firms during enforcement investigations, he has seen more automated back office systems and processes that focus on clients’ vital statistics, and this objective data augments the more subjective information. “It’s a tool that assists the advisor,” says Di Paolo. These automated processes “provide the advisor additional information to allow them to set that score.”

Regulators say technology can’t replace face-to-face time with clients. Automated tools are useful for monitoring the suitability of all portfolio transactions and for catching exceptions, Di Paolo explains, but many firms are also developing robust, continual discovery processes that do involve advisors reviewing clients’ information more regularly.

Tolerance assessment tips

Before going through a risk questionnaire, show clients how and why risk scores are calculated, says Darren Coleman, senior vice-president and portfolio manager at Raymond James in Toronto. First, he says, “you need to have a common understanding of what risk means in the context of investing. People need to know there are trade-offs, or a balance between taking on risk and making money, and seeking safety.” And when you ask questions about clients’ primary and secondary goals, and about when they need money throughout their lives, explain that final risk scores typically take all these details into account—they’re based on more than how much money investors can currently stand to lose.

“Having this dialogue involves educating and coaching clients,” versus simply going through lists of questions, says Coleman.

Current tolerance questionnaires are inadequate

The problem: Current risk tolerance assessment forms aren’t thorough. As a 2015 OSC IAP study finds, only 16.7% of these questionnaires are considered “fit for purpose.”

Why?

• 27.8% contain poorly worded questions; and
• 75% have scoring models that arbitrarily weight questions.

Also, regulators haven’t offered much guidance to change this—even though investment suitability continues to be the most common issue.

The good news: An industry-wide risk tolerance roundtable happened in September 2016, and the OSC plans to release a public follow-up report on how to improve risk profiling. Also, due to CRM2, advisors must now reassess suitability more often. Instead of focusing on trading-related triggers, they must revisit portfolios when:

• securities are received into an account by way of deposit or transfer;
• there’s a change in the advisor or portfolio manager responsible for an account; and/or
• there’s a material change in a client’s life that impacts KYC.

Wendy Rudd, senior vice-president of Member Regulation and Strategic Initiatives at IIROC, says, “These changes […] encourage more of an ongoing, versus transactional, relationship between firms, advisors and clients.”

Also, avoid vague questions such as how a client would compare their risk tolerance to their friends’, Coleman says. Instead, go beyond what many assessment forms require by asking in-depth questions. Visuals during risk discussions are also helpful (see “Ask this, not that”).

Ensure assessments are thorough and accurately reflect risk tolerance. Show clients how and why risk scores are calculated.

It’s best to go beyond basic information such as current income and age, he adds. For example, “[I] also look at a client’s short- and long-term liquidity requirements, and even at [current] tax needs,” he says, to gain a full picture of a client’s needs when determining risk tolerance. “[The] assessment [becomes] part of the larger discovery conversation, instead of a small piece of the KYC process.”

Next, when presenting a client’s risk tolerance (whether it’s conservative, medium or high), Coleman explains the score. He discusses “the breakdown of how much risk [she] can have in [her] portfolio based on that score—a process that clients find helpful. I might say, ‘You can have risk of loss of between 5% and 10%, 20% and 40%, or 75% and 100%.’ ” He’ll also present example investments and strategies based on the client’s risk score, which means she’ll better understand what her portfolios will look like. Then, Coleman can measure her emotional response, and double-check whether her score is correct. If that client’s needs change going forward­—she may get married or may retire—Coleman will go through the entire risk assessment process again.

“The industry doesn’t say you have to review people’s risk tolerances [on a set basis], but I currently ask whether clients’ lives or plans have changed [during annual KYC reviews]. I also check if their emotional response to markets has changed,” to determine if a client’s risk tolerance has shifted.

This method takes more time, says Coleman, but it “aligns better with a process that involves in-depth planning, and is educational for advisors and clients. However, if you don’t do this type of complex planning, this process may be too long and may not work for you.”

Ask this, not that

When assessing risk tolerance, ask clear and insightful questions. Darren Coleman, senior vice-president and portfolio manager at Raymond James, suggests the following.

Don’t ask:

How does your risk tolerance compare to your friend’s risk tolerance?

Instead:

Would you say you’re more adventurous or conservative than the average person?

Don’t ask:

Would you say yes or no to this statement: “My investment decisions make me nervous.”

Instead:

Would you say yes or no to this statement: “Based on my investment experience, I’m comfortable with how I make portfolio decisions.” Please give past examples.

Best questions:

• Do you understand investment trade-offs and the role volatility plays in your portfolio? TIP! Use real-life examples to illustrate these concepts and tie in a client’s real return expectations.
• Let’s look at the typical investor lifecycle, which runs from the wealth accumulation to the decumulation stage—when portfolios typically decrease in value. Where are you on this scale today?