The Securities Litigation Expert Blog

The DOL Fiduciary Rule - Risk Tolerance Questionnaires

Posted by Jack Duval

Aug 2, 2017 7:31:02 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

In my last blog post, I discussed how the traditional three-choice Investment Objective and Risk Tolerance options would no longer be sufficient under the DOL FR.  In this post, I will expand on topic of Investment Policy Statements (“IPS”) and an often-missed aspect of their drafting – determining both the client’s ability and willingness to take risk.

The Difference Between the Ability and Willingness to Take Risk

Most financial plans focus on the client’s ability to take risk.  This is usually accomplished mathematically, by predicting cash flows and evaluating those against known liabilities.  Generally, the thinking is if the client can sustain losses and still meet her needs, then she has the ability to take risk.  (For instance, if the client needs $20,000 per month to sustain her lifestyle, but her portfolio can generate $40,000 per month, after fees and taxes, then she has a high ability to take risk.) 

The client’s willingness to take risk is a softer metric that requires getting to know the client and their history, going through questionnaires, and scenario planning.  Many of the questionnaires and scenario plans revolve around a series of questions, hypothetical situations, and attempt to determine the client’s probable responses to market events.  For instance: what would you do it your portfolio declined by 10, 20, or 30 percent?

Problems with Risk Tolerance Questionnaires

In my experience, most risk tolerance questionnaires lead to inflated risk tolerances.  The reason is that unless the most conservative answer is given to every question, the client will be scored with a moderate or moderate-aggressive risk tolerance.  Furthermore, if even one question is answered with the most aggressive option, the client will typically end up with a moderate-aggressive or aggressive risk tolerance.

Another flaw in risk tolerance questionnaire design is that they are generic and rely on percentage gains and declines in their examples.  Percentage losses don’t live for clients, but dollar losses do.  For instance, many clients can be philosophical about a 30 percent decline in their portfolio, but most would not be as sanguine about a $3 million decline on a $10 million portfolio.

These flaws can have far-reaching implications.  The skewing towards aggressive Risk Tolerances can lead to misaligned asset allocations, unsuitable investments, and higher than expected volatility.  This frequently leads to clients changing their Risk Tolerance (to what it should have been originally) after a market decline.

Ironically, if litigation should ensue from misaligned asset allocations originating from skewed Risk Tolerances, the questionnaires underlying the improper allocations will be presented as proof of the client’s willingness to take risk, and used to justify aggressive and/or speculative investments.

The Prudent Expert and Risk Tolerance

For background on the Prudent Expert Standard required under the Best Interest Contract Exemption, see my previous posts here and here.

Simplistic, one-dimensional Risk Tolerance Questionnaires will not meet the Prudent Expert Standard.  Instead, the due diligence required to "know the client" is at least a two-dimensional approach to risk tolerance that encompasses both the ability and willingness to take risk.

If only one type of Risk Tolerance is identified, the advisor cannot make a Prudent Expert determination of the client’s true Risk Tolerance.  This will not meet the fiduciary standard, nor even the suitability standard.

One of the few financial writers to address the two dimensions of Risk Tolerance is Michael Kitces.  Some of his writings on risk tolerance can be found here, here, and here.  Kitces has created some very useful charts comparing Risk Tolerances that arise from the one- and two-dimensional Risk Tolerance methodologies.

Chart 1:  One- and Two-Dimensional Risk Tolerance Methodologies[1] 

Accelerant - Risk Tolerance - The Ability and Willingness to Take Risk.png

The central idea illustrated in these charts is that in the one-dimensional methodology (left pane), both the ability and willingness to take risk act as a floor to the resulting Risk Tolerance.  Conversely, in the two-dimensional Risk Tolerance methodology (right pane), both the ability and willingness to take risk act as a ceiling to the resulting Risk Tolerance. 

Unpacking One- and Two-Dimensional Risk Tolerance

In the one-dimensional Risk Tolerance methodology, both the ability and willingness to take risk increase Risk Tolerance.  Thus, if the client has either a high ability or high willingness to take risk, she will end up with an aggressive Risk Tolerance.  However, this is the perverse Risk Tolerance outcome discussed above.

Under the one-dimensional Risk Tolerance methodology, a low ability to take risk is overridden by a high willingness to take risk, at the same time a low willingness to take risk is overridden by a high ability to take risk. 

However, under the two-dimensional Risk Tolerance methodology, this cannot happen because both the ability and willingness to take risk decrease Risk Tolerance.  Thus, if the client has either a low ability or low willingness to take risk, she will end up with a conservative Risk Tolerance.

Under the two-dimensional Risk Tolerance methodology, a high ability to take risk is overridden by a low willingness to take risk, at the same time a high willingness to take risk is overridden by a low ability to take risk.

The two-dimensional Risk Tolerance methodology results in much more accurate Risk Tolerances and helps implement a financial advisor’s version of the Hippocratic Oath: help clients achieve their goals with the least amount of risk possible.

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Notes:

[1]       Michael Kitces; Nerd’s Eye View; Adopting a Two-Dimensional Risk Tolerance Assessment Process; January 25, 2017.  Available at: https://www.kitces.com/blog/tolerisk-aligning-risk-tolerance-and-risk-capacity-on-two-dimensions/; Accessed August 1, 2017.

 

Click to view useful links on our DOL Fiduciary Rule - Securities Litigation Resources page.

To learn more about fiduciary expert Jack Duval, click here.

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Topics: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard, Due Diligence, litigation, Investment Policy Statement, risk tolerance, suitability

UBS Poised to Unilaterally Change Customers Risk Tolerances

Posted by Jack Duval

Feb 2, 2013 2:31:41 AM

Fox News is reporting that UBS is set to unilaterally reclassify fixed income investors risk tolerances from conservative to aggressive.  (UBS)  The anticipated move reflects UBS beliefs that interest rates will rise, causing bonds to fall in value.

According to brokers inside UBS, new guidelines will reflect a growing belief among the firm's market strategists that the bull market in bonds has largely run its course, and that those investors who believed they had constructed a “conservative” portfolio by being heavily invested in bonds could be reclassified as “aggressive." Some also believe the move may be an attempt by the firm to lessen its liability in the event clients who are holding large positions in bonds decide to take legal action against UBS.

Mike Ryan, the chief investment strategist for UBS, said so-called “non consent” letters will be sent out to investors in the coming weeks alerting them of their changed classification – but he says it has little to do with a firm-wide bias against bonds. Rather, UBS is changing “its long-term view” reflecting what it views as a “volatile market…not just in fixed income.”


Such unilateral changes in client risk tolerances are contrary to industry practice.  Furthermore, the use of non-consent (or negative response) letters has been on the wane for many years and is not sufficient for a change of such magnitude in risk tolerance.  If the goal of these changes is to avoid litigation, it could backfire.

Indeed, Finra Rule 3012 speaks to this issue under 3012(a)(2)(B)(iii):

(a) General Requirements

(2) The establishment, maintenance, and enforcement of written supervisory control policies and procedures pursuant to paragraph (a) shall include:

(B) procedures that are reasonably designed to review and monitor the following activities:

(iii) customer changes of investment objectives and the validation of such changes of investment objectives. (Emphasis added.)



Notice that the rule reads "customer changes", not "member firm" changes.  While these customer changes in investment objectives (or risk tolerance) could come after conversations with their Registered Representatives, they cannot be unilaterally imposed on the client by the member firm.


Industry practice and the standard of care is to fit investments to risk tolerances, not risk tolerances to investments.  If UBS feels this strongly about the potential for rising rates, their Registered Representatives should be repositioning their clients into short-term fixed income instruments that do not have interest rate risk.


Changing risk tolerances instead of changing investments is a recipe for disaster, both from an investment and litigation standpoint.
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Topics: FINRA, risk tolerance, UBS, investments, supervision, fixed income, Compliance

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