Risk-assessment tools inadequate, study finds

The research found that many risk concepts do not have a standard definition and that there is a lack of understanding of the factors involved in assessing clients’ risk appetite.

“Almost all regulators surveyed are principles-based and provide little guidance on how a firm or advisor should arrive at the determination of a risk profile,” the report says. “They all recognize and rely on the professional judgment of the advisor and the ‘process’ created by the advisor or firm to determine a consumer’s risk profile. No regulator provides clear guidance on how to combine the multiple factors and form a client’s risk profile.”

Similarly, the review found little academic consensus on the most effective methodology for combining objective and subjective factors to create an appropriate risk profile.

While risk questionnaires are widely used in the mutual fund dealer channel, the report found, the vast majority (83.3%) of these questionnaires “are not fit for purpose.” The report found that these surveys have too few questions, use poorly worded or confusing questions and involve arbitrary or poorly conceived scoring methodologies. More than half (55%) of risk questionnaires have no mechanism to identify highly risk-averse clients who should be invested solely in cash.

The report identifies best practices in other jurisdictions and provides recommendations for regulators, the industry and the academic community.For example, it calls for a “clear regulatory framework that includes all aspects of risk in its definition.” It recommends that regulators define the components of risk that they expect advisors to review with their clients in order to establish a client’s risk profile.

The report says that risk questionnaires should not be made mandatory, but that regulators should provide more detailed guidance on their use:”We do not believe that there is sufficient academic evidence to mandate that any specific questionnaire process would, in and of itself, generate better recommendations than advisors. That said, we believe that properly vetted ‘fit for purpose’ questionnaires encourage transparency, consistency and accountability for all concerned.”

The report calls on regulators to “provide improved guidance in respect to proportionality of the [know-your-client] and risk-profiling requirements for firms.” It suggests that the academic community should undertake more research into factors such as riskcomposure, risk perception and risk capacity, and how the various factors should be combined into a final “risk profile.”

The report stresses that advisors should have flexibility in utilizing risk assessments. “Advisors should evaluate a client’s risk tolerance before giving a recommendation, but they should also be given the flexibility to incorporate the risk-tolerance assessment into building a strategy that gives a client the best opportunity to meet long-run financial goals,” the report notes.

“Risk-profile assessment is key to a successful know-your-client (KYC) suitability process,” said Ursula Menke, chair of the IAP. “The IAP hopes that regulators and industry participants will use the information in the report to build better, more robust client risk-profiling systems.”

Menke also noted that the IAP has asked the OSC’s new Investor Office to “coordinate with PlanPlus Inc. to offer briefings on the research findings to members of the Canadian regulatory community and to industry members and representatives to ensure that these findings are well known and understood.”