A couple of critical components in the Canadian Securities Administrators’ client-focused reforms (CFRs), which are set to come into effect at year-end, stand the risk of becoming almost pointless, time-wasting checkbox exercises given the way many are mishandling their implementation.
Most of the industry is well aware by now that the CFRs include a sweeping set of updates to the know-your-client and know-your-product rules governing client suitability and product selection. Specifically, the reforms require advisors to measure and assess clients’ risk tolerance and risk capacity to demonstrate why they recommend a particular investment or portfolio to a client.
Unfortunately, the way many firms are planning to implement these risk assessment reforms means they’re likely to miss the mark and turn something that could’ve protected clients into a process based on hearsay rather than science.
While “risk tolerance” and “risk capacity” might sound like the same thing, their differences are well documented in academic circles. Risk tolerance is a personality trait and represents a client’s willingness to take on financial risks. In contrast, risk capacity measures a client’s ability to take on investment risks without endangering their financial goals.
Before the CFRs, advisors were supposed to consider clients’ risk tolerance and risk capacity broadly as two factors among many. Starting in 2022, advisors will need to implement a specific process for assessing both factors – and they’ll need to document their results.
Typically, risk tolerance is measured using psychometric questionnaires that ask clients about their attitudes, perceptions, and acceptable trade-offs. Many advisors are skeptical of these questionnaires – and they have a right to be.
Yet, there are more than a dozen scientifically validated and commercially available risk-assessment tools on the market. Most, if not all, of these tools have been developed by or with the help of experienced academics, and all of them validate the efficacy of their methods.
With this abundance of options, implementing the risk-tolerance assessment portion of the CFRs should be a snap. Nevertheless, it appears as though many firms are continuing to rely on their less effective in-house tools.
Hacked together by compliance, sales, and marketing departments, and supplied to advisors by investment and mutual dealers as well as investment fund companies, these ad hoc tools are almost useless. They often recommend investment allocations that fly in the face of client responses, and the results can be biased heavily toward products a firm is seeking to promote.
Worse yet, firms have no educated and informed peer-reviewed proof these “home-grown” questionnaires actually do what they’re supposed to and measure clients’ risk tolerance effectively.
Meanwhile, measuring risk capacity requires benchmarking a client’s investments to their financial goals as set out in a financial plan. Of course, this means that before risk capacity can be measured effectively, a client must have at least a rudimentary financial plan in place.
However, the reality is that most advisors aren’t preparing even the simplest goals-based financial plans for their clients. Moreover, while best practice for assessing risk capacity would require advisors to work with clients to identify goals, develop a plan to meet them, and then stress-test the plan – perhaps using Monte Carlo analysis and scenario tests modelling varying market conditions – there’s no requirement for this standard.
The result? Although the risk capacity reforms require advisors to validate that a client’s investments won’t disrupt their progress toward their goals, there’s currently no requirement to establish those goals in the first place.
So, where does that leave things? Word on the Street is that advisors will be given whatever CFRs tools their investment or mutual fund dealer determines necessary, but that “flexibility” in implementing the CFRs will be permitted.
This begs the question: Should advisors be permitted to even open an account for a new client without first assessing these two parameters of risk validly? The only possible answer for an industry that wants to be taken seriously as professionals, rather than salespeople, can only be no.
The requirements in the CFRs surrounding risk tolerance and risk capacity are needed, well intentioned, and have the potential to lead to better client outcomes. But the financial advice industry needs to respect the science behind these requirements and implement solutions that actually work for these reforms to meet their goals.
Jason Pereira is a partner and senior financial consultant at Woodgate Financial Inc., a financial planning firm under the IPC Securities Corp. umbrella in Toronto, and president of the Financial Planning Association of Canada.