There has been a lot written in the media recently about the challenges facing those approaching retirement. More quantitative easing and falling annuity rates the latest to be discussed.
However these are by no means the only risks that people in, or nearing, retirement are currently exposed to. Good retirement planning will consider an individual’s attitude to risk and develop strategies to control risks in line with the stated aims of the individual.
A good strategy will sift through these risks and categorise them into those that can be managed to some extent and those that cannot. For example, political, legislative, longevity and mortality risks could be difficult to anticipate, but counterparty risk can perhaps be assessed by due diligence and minimised by investor protection schemes.
The risks that are, in theory, easier to address are investment and asset allocation risks. This is where the FSA’s pronouncements on investment suitability and risk profiling feature in the equation.
The FSA has said that adviser firms should have a process for understanding their clients’ attitude to risk. Clients should be asked to think about what their attitude to risk is, not necessarily in relation to their finances specifically, but conceptually. They should spend some time thinking about the concept of taking a risk, how it makes them feel and particularly weigh this up against the sorts of returns they require from investing. Attitude to risk should also be something that is reviewed regularly to take into account changes in circumstances.
Another key theme is that firms must also consider carefully the customer’s overall financial situation and whether they have the capacity to absorb losses that could arise from investing in accordance with their stated attitude to risk. If there is a discrepancy between the two, it is up to the firm to explore this with the customer and if necessary alter the customer’s risk assessment accordingly and this needs to be a more in-depth and holistic process for many firms.
The use of risk profiling tools warrants a more detailed look because such tools are increasingly used by firms and the FSA has some significant concerns in this area.
Something that makes the job of a financial planner interesting is that every client is different. It is these differences that make it impossible to establish the level of risk that every client is willing to accept for the rest of their lives based solely on the output from one set of questions.
Guide
Risk can never be an exact science and any risk profiling questionnaire or other system can only ever be viewed as a guide to bring a degree of consistency to the process. A questionnaire can act as a “proof point” for advisers to be used in future reviews in reaction to changing circumstances, but a detailed discussion of risk with the customer is needed to ensure clarity. It has been suggested that many firms assess attitude to risk and discuss this with their clients, but fail to discuss their conclusions in detail with them. These valuable conversations are in danger of disappearing as a result of the proliferation of risk-profiling tools.
The outcome of these discussions should be documented in the factfind and meeting notes, and subsequently combined with the risk questionnaire results to form the basis of investment advice. If there is a difference between the score produced by a questionnaire and any discussions, these can be discussed with the client and recorded appropriately.
You would not undertake a road trip around Europe after looking at the map just once before you set off on the journey, and the same can be said of financial planning. Advisers and their clients need to consider how long the results of a risk-profiling questionnaire remain valid and when a new questionnaire should be completed.
There is no right or wrong answer to these questions. Each firm needs to take a view.
A typical extract from a firm’s procedures on risk profiling might read: “Every client who receives a regular review should be asked to revisit the questionnaire as and when changes in their personal and/or financial circumstances dictate, but as a minimum every two years.”
It is important to have the systems in place to monitor all clients with such a service agreement to highlight those who have not completed a questionnaire in the past two years and ensure a fresh one is completed at the next review.
Different financial planning objectives with different investment time horizons would be expected to give rise to differing views on the acceptable level of risk, but how often do advisers ask clients to complete more than one risk questionnaire?
For example, a client who wants to save for his child’s school or university fees over the next five years may not be prepared to accept the same level of risk with this element of his financial planning as he would for funding his own retirement, which may be 30 or 40 years in the future. Which objective does he have in mind when he completes the initial risk-profiling questionnaire?
Advisers should be having a conversation with their clients about the relevance of their headline risk score to the specific financial planning objective and, if relevant, differentiating the subsequent investment recommendations accordingly.
A user-friendly and robust risk-profiling tool will help advisers take a snapshot of client’s experience and understanding of investment risk, the degree to which they are prepared to expose their capital to risk and how they would expect to be rewarded in return for taking that risk.
Only by using the risk-profiling questionnaire as a stimulus for discussion, both initially and in the future, can we hope to understand how our clients feel about their money and advise them accordingly.
The types of risks that advisers, clients and a retirement planning strategy will need to consider are:
• Market risk – the risk of poor market return in relation to any assumed returns.
• Asset allocation risk –the risk that investments are in the wrong assets at the time of encashment.
• Interest rate risk –the risk that interest rates move in the opposite direction to what was assumed.
• Political risk – the unintended (and perhaps unforeseeable) consequences of decisions made for political or macro-economic reasons, for example quantitative easing and falling gilt yields causing a squeeze on annuity rates and GAD rates for income drawdown.
• Employment risk – the risk that employment income does not reach expected levels and contributions cannot be made or that employment ends early due to redundancy.
• Inflation risk – the risk that inflation leads to an erosion of the real purchasing power of retirement income.
• Health/liquidity risk – the risk that poor health brings about a need to liquidate financial assets earlier than anticipated .
• Mortality risk – the risk of dying too early post-annuitisation, or the loss of any material human capital needed to supplement retirement incomes.
• Longevity risk – the risk that an individual lives longer than anticipated meaning that the period in retirement is increased.
• Behavioural risk – the risk of behavioural biases leading to inappropriate retirement planning decisions, including saving too little.
• Counterparty risk – the risk that a financial institution providing guaranteed benefits fails.
• Legislative risk – the risk of a change in legislation that reduces future income. This could be as simple as a reduction in GAD rates or as complex as the effect of Solvency II on annuity rates.
Andy Zanelli is head of retirement planning of Axa Wealth
