Irrespective of how well orchestrated a financial planning strategy is or how well selected products may be, there is generally an element of risk for the client.
Where problems seem to commonly arise for both financial planner and client alike is not so much from the fact that there are risks per se, but rather where the appropriate risks have not been adequately disclosed to the client.
The need to provide risk information to clients is not a new concept. Before the Financial Services Reform Act (FSRA), the conduct of business rules embodied in Policy Statement 122 (PS 122) perpetuated the ‘know your client’ and disclosure requirements.
Specifically the policy statement discusses the “common law obligation of adopting due care, diligence and competence in preparing advice or reports to ensure they are suitable for the purpose for which the investors to whom they are provided are reasonably likely to use them”.
The policy statement goes further to say that a failure to comply could be seen as a failure to act “efficiently, honestly and fairly”.
Thus, in order to comply with the obligations and exercise sufficient due care, a financial planner must ensure a client is placed in a fully informed position to make a decision — and that includes a thorough disclosure of all potential risks.
Similarly, Rule 111 of theFinancial Planning Association’s (FPA) rules of professional conduct state that “in preparing oral or written recommendations to clients a member shall provide an explanation of the nature of the investment risks in terms that the client is likely to understand”.
The requirements thus place the onus on the planner to:
1. Identify the risks of both the strategy and the product recommended. If the strategy recommended to the client has inherent risk associated, such as a gearing strategy, then the client must be advised that this is the case. They also need to be aware of the risks associated with the product or class of products recommended.
2. Ensure that the information on the risks is relevant and not too generic. It may not be appropriate to merely provide the client with a page of standard text that lists every risk factor from A to Z. In this instance, it would be difficult for a client to determine which of the risks applies to their situation and thus the information, in being too generic, has placed the client in no better position. The client needs to be able to understand the risks and the implications for their individual situation.
3. Ensure that the information is phrased in a way that the client can understand and can use it to assist them to make a decision on whether or not to accept the advice. The use of jargon and terms that are too technical will only ensure the client is confused. Knowing a client is not fully equipped with the appropriate information to make a decision does not display “due care and diligence” and is not acting “efficiently, honestly and fairly”.
Even given this onus on the planner and the importance of adequate disclosure of risks to clients, it appears this obligation may not necessarily be particularly well executed. TheAustralian Securities and Investments Commission(ASIC) and the Australian Consumers’ Association (ACA) survey on the quality of financial planning advice found that the explanation of investment risks was rated as a ‘fail’ or ‘poor’ in 34 per cent of plans surveyed and ‘good’ or ‘excellent’ in only 19 per cent of plans surveyed.
The survey revealed problems with respect to a lack of evidence that risk had been specifically addressed, too much generic material, and no discussion of risk profile to support recommended allocations in investments.
The survey said it was disappointing that risk had been so poorly addressed, given the market situation at the time the survey was conducted.
The last point made by the survey is particularly pertinent and illustrates one of the reasons why explaining risk to clients is so important. Movements in the market are felt by clients not only via their portfolios but also emotionally — when the movement is negative so too is the emotion.
For the client who has not been provided with adequate tools to understand the risk they were likely to encounter, actually encountering the risk can threaten the relationship and trust they had developed with their planner and see the planner facing a serious complaint.
For the client who has been provided with the appropriate information and in turn understands the risks they face, the movements in the market, while not pleasant, are part of the strategy they have undertaken to achieve their end goals.
The obligation to disclose applicable risks to clients remains in the financial planning world post-FSR. Risk will be disclosed to clients in both the Product Disclosure Statement (PDS) and the Statement of Advice (SoA).
Product issuers are required to outline the risk associated with their products in the PDS, however, this in no way diminishes the obligations for the financial planner to ensure they outline the risks of the product and also the strategy when advising on it.
The legislation does not specify risk disclosure in the list of prescribed detail that must be included in the SoA. What it does address, however, is the need for the client to be placed in a fully informed position in relation to the advice being provided, so they are able to make an educated decision.
Similarly, Policy Statement 175 (PS 175) advises that the SoA needs to set out why the advice provided is appropriate and in doing so, outline the advantages and disadvantages for the client when acting on the advice. Financial planners need to ensure clients are given the full picture, not just the glossy brochure.
Accompanying the FSR, there also remains the FPA’s rules of professional conduct and the duty of financial planners to act with due care and competence in providing advice to clients. The requirements together not only dictate the content of information that needs to be supplied to clients but can also provide financial planners with guidance on the effective methods of delivering the information to a diversified client base.
Discussing risk is not only about complying with a series of obligations and best practice standards, it is also about assisting clients to make informed decisions that will lead them to achieve their goals in a way that controls the risk they encounter.
Jennifer Smith is assistant manager, compliance, financial planning, atHSBC .
