Supporting Clients with Risk Profiling: Highlights from the January Investment Forum Part 1

The January Investment Forum focused on advances in risk profiling tools and featured expert panellists Ed Carey from Timeline, Paul Resnik from The Suitable Advice Institute, and Zahid Bilgrami from Defaqto. This article includes Ed and Paul’s thoughts on current events, building a sustainable portfolio, and the future of risk profiling.

Paul Resnik:

I don’t think there’s any surprises in the last year other than if you’ve listened to the news, the markets have behaved recently consistently with past behavior. There’s a lot of noise. The market goes up and down, or in this case down and up. What did we learn over the last 50 years’? Diversification pays!

Those of us who’ve been following the broad diversified market in terms of our investments (over the last year) will have discovered that if we invested in the broad indexes net effect is negligible. Certain stocks have gone up and certain stocks have come down. The valuation of stocks has not changed. It is a function of number of buyers and sellers in the marketplace.

So nothing has changed in risk profiling that I can think of that hasn’t emerged over the last 20 years. Fundamentally, there are four rules: rule one, make sure you know your client’s psychological preference for risks and you’ve measured that in an effective way. Second, make sure that the portfolio construction that your clients have is designed to meet their needs. Thirdly, make sure that the portfolio has been constructed in such a way that in a down-market, they don’t have liabilities to meet which causes them to sell at an inopportune time – so they don’t get caught in what we politely call sequence risk. And the fourth one is manage sequence risk by understanding your client’s liabilities. There’s nothing in that that’s different from the message that good advisers have been applying since I’ve been in the industry, which goes back to the mid eighties and has been emphasised consistently over the last 15 years.

Zahid Bilgrami:

Thanks, Paul. And as always, the eloquence of your answer is absolutely spot-on, but I’d like to pick up on one of the points that you made around sequencing risk. Perhaps it’s not so much about what can we learn in the last year– because you’re quite right, these sorts of events have happened in the past.

The last year is most notable because it’s the most recent past, but I think what makes things different now is that we have more scientific ways in which advisers can measure sequencing risk. And when they do that risk profiling of their clients, they can identify the level of sequencing risk that clients may be comfortable with, taking into account durations and the level of income that they may require if they’re in retirement and select suitable portfolios in order for them to do so.

So I think the technology and the maths and the thinking has moved along to make these institutional class decisions something that could be far more local between an adviser and a client.

Ed Carey:

I think the biggest learning in the last 12 months is that equities recover. We’ve seen this before. We’ve seen different shapes and we’ve seen different styles of market decline. But what we saw in Q1 last year, if we ran the clock back exactly 12 months, to think that markets were to fall so sharply to the middle of March was scary for people. It was a concern for people, but the recovery of the markets were so quick as Paul said, it bounces up and down, it goes left and right. Equities recover.

And I think if people took that message and remembered that message, that would have been super helpful. We’ve looked at and modeled previous bear markets, the 1920s, the Second World War, Black Monday, the financial crisis in 2008 whatever it may be… Equities recover. So you can give clients and advisers comfort that yes, it’s difficult. Yes, people will be concerned. Yes, there’ll be issues around sequencing risk and those sorts of things. But if you are patient, time will be your friend and the portfolios will recover.

Zahid Bilgrami:

I think the key is that to have discussions with your client before such an event as what happened last year, so that they’re well-prepared to deal with such catastrophic dips. So when you’re in that dip, they thought about it before going into that. And I say this in the context of stress testing portfolios because tools that are around today allow us to help explain to our clients the impact of such a catastrophic fall and what that means. And I’m now talking specifically about clients that are in that concept of taking an income.

So those that are in an accumulation phase of their life, where you have dips, but the impact of sequencing risk in the long-term goes away if you continue to be invested, you don’t have the pound cost ravaging, and all is fine. But where it does have an impact is if you’ve got clients who are taking an income, and it’s really critical to then stress test the portfolios that they’re invested in, and specifically to agree with them that if there is such a catastrophic fall in the value of that portfolio, will they indeed take a fall in the income and can they take a full income and by how much can they take a fall in the income that they take from that portfolio, whether they’re able to take a break in the income for a number of months or a number of years in order to make sure that there is time to recover, or whether they’re willing to have the comfort to reduce the duration.

Clearly, if people are taking an income for that old age, they can’t vary when they’re going to die. But with other goals that may be possible. And really stress testing portfolios and making sure that they can cater for clients in one of these three ways based on the sequencing risk, when you do have such a catastrophic series of events as was the case in the last year. Luckily we’ve had a bit of a “V” so far.

So it hasn’t been that pronounced, but there have been periods in time in the past, and maybe this is just the beginning of a longer traction of time where you have a more prolonged recovery, and that really does have a massive impact for those people. Taking income from their profiles is critical to stress test what they’ve invested in– or to stress, to agree with them, the level of what they’re willing to take in the event of such a catastrophic fall. So that whatever portfolio they invest in, that has been properly stress tested against this mandate.

Ed Carey:

I think it’s really important through lots of lenses. I think the client in terms of that savings journey, you’re saving money or investing regularly, you may accumulate or inherit some money or whatever it may be. And ultimately you’re going to hang up your boots and go, “I’m going to finish work on whatever I’ve accumulated at that needs to be sustainable.” And some questions that clients will have are: have I got enough money saved? Will I be okay? What are my objectives in retirement, what am I trying to do?

With an aging population, being able to prove to a client, that how they are invested today they will be okay, is hugely valuable and comforting both to the end-client and giving a nice competitive, boost for the adviser too, because they can demonstrate that it is sustainable. So I absolutely agree.

One of the things that the founder of Timeline, Abraham, has recently issued a paper on this is the pattern of retirement spending, which is another really interesting dynamic. And there’s a ton of academic research, which shows that actually your retirement spending will fall. As you get older, you retire, you’re fit and active, you’ll required income of X. And as you get less fit and active, you will spend a little bit less. And then as you get older, it will fall further. So actually the ability to prove that and model that in a portfolio is hugely valuable, and hugely comforting for clients to think “I am going to be okay.”

Zahid Bilgrami:

I’ll echo what you’ve said. So going thorough due-diligence in what’s being invested in from a practice standpoint, clearly we do fund reviews of funds that in order to make them transparent for advisers and their clients, but also looking at ratings and, perhaps not pay to play type ratings, but ratings that cover the whole universe.

Again, from a Defaqto standpoint, Woodford didn’t get anything more than two diamonds out of five. And was therefore never something that we would have considered as being top of the curve or anything that we would put in front of clients. The other point, and I think Paul you reflected on this before, is to be appropriately diversified. So if you do have bad eggs in the basket, if you like, that you don’t have too much exposure to them. And therefore it’s not going to catastrophically impact your client.

Zahid Bilgrami:

Adapting to a more digital environment is something that certainly we thought long and hard about even just at the beginning of the pandemic. I think that, and we’re not exclusive in this, clearly others have followed this route of investing in technology that makes it easier for a client or for advisers to interact with their clients. For example, we’ve built in video conferencing into our financial planning tool.

And again, one point I’d like to know too, is with us being on Zoom so much more and sharing screens and that sort of thing, the risk to advisers of sharing a screen, which may contain not only that client’s information, but somebody else’s information, is not something to be ignored, that there is a risk around that. And so therefore in order to have proper processes in place in your workflow on your desktop, we built in video conferencing to our financial planning software. So it’s easier for advisers to share screens with their clients.

We built in specific screens that allow advisers to have discussions with their clients in an engaging way, whether it’s online or sitting next to them, hopefully in time. And so for example, doing a remote review, or indeed getting clients to do things offline before meeting, and we’re not of course exclusive in this way.

But one positive, is that I think this different way of working that we’ve experienced in the last year is going to have a really positive impact in the longer term, because I think that there are ways in which we’ve learned that the advisers can engage with that clients in perhaps a far more positive and different method to what they’ve done in the past. Maybe making client face-to-face time more accessible, certainly from a geographical standpoint, or getting time in their calendars and having a regular review becomes perhaps maybe easier if you don’t have to travel or have to be face to face in order to do so.

Paul Resnik:

Last year, the blow-up of Woodford, was perhaps the single most significant event in the UK marketplace. I think Woodford has been an outrage, an absolute outrage, and an embarrassment to everybody in the industry. To call a fund an income fund, to put illiquid assets in it, to have the FCA sit on their fat arses and do nothing and to have no punishment administered to people like Hargreaves Lansdown who put Woodford on their best-buy list, but did not put it on the best sell-list or a hold-list when they had all of the data (to give that advice) is just a disgrace beyond all momentum.

I think one of the pieces that (comes to mind) is that we simply cannot rely on anybody else to manage the diversification of our portfolios. Open-ended funds containing illiquid assets are a catastrophe waiting to happen. And when you look at the Woodford fund, it had professional investors and the public in there – the professionals took their money out early leaving the poor buggers, the people we’re supposed to look after, with the rubbish at the bottom of the shit pile. It’s particularly important that we avoid such embarrassments in the future. We have something that George Bush would have described as an axis of evil, the FCA, Hargraves Lansdown and Woodford – a disgrace.

Ed Carey:

It’s a good challenge. I think it must be down on the due diligence, which advisers use to scrutinize the investment choices that they’ve got. I remember when I started in the industry things were done in a slightly different way. Advisers often would pick research their own funds panels and it would be seen as a way of adding value. Now that trend has moved so advisers are focused on planning issues and in most cases outsource their investment selection.

So I think in order to narrow it down and they don’t repeat the horrors of Woodford, is to make sure their due diligence process to select that outsource partner is robust. Make sure that their DD processes are rigorous and put the onus on that DFM or Investment Manager to prove to you the product is suitable.  There’s lots of research houses and tools out there, but I’d encourage significant investment into that part to make sure that they are getting a robust answer.

Ed Carey:

I think it’s made us all a lot more productive with less travel, less airplanes, trains and more time to focus on work, even if this is remote. I think this way of working can be significantly more productive. We’ll miss meeting up, obviously we will get back to that position, but I think what we’ve gone through here is game changing.

And I think we will see more of this type of interaction, both as an industry and I guess with clients too. I think in terms of the end-client side of things, I take your point about security because I think that’s a really, really important one. People need to be confident in the way they’re sharing data in any format. But I think the ability to interactively show people on a Zoom call the impact of buying an investment or making a planning decision is quick, it’s very impactful, and I think it’s here to stay.

So we’re perhaps coming from a different place than Ed. We’ve always provided tools that help advisers with clients that are accumulating portfolios. But a couple of years ago, we launched a tool that helped advisers with helping clients if they were taking an income with natural income. And we are in the process of launching now a tool that helps clients take a full down income, buying cash in units, and a portfolio that they may have built up. And in doing so we think that there are three things that are absolutely critical.

The level of sequencing risk in that portfolio, the duration of that portfolio, and you can use all sorts of means to work out what that duration is, and the level of income that they’re looking to take. And whether that’s a maximum sustainable amount of income, either a nominal or real terms, or whether that’s a lesser amount, if they want to have a pause at the end, as a legacy. So our module allows advisers, as part of engaging our financial planning software, allows advisers to extract their client’s mandates around duration, level of income, and sequencing risk, and to find suitable portfolios based upon those three attributes.

Paul Resnik:

So for those of you not aware, FinaMetrica started in 1998. We brought our product to the market as a web business, paid for on the web. So we never existed in any other form. And, for a chunk of time I thought we were offering a risk tolerance test. I was very proud of the test, and it was only after talking with around 30 advisers in a row who basically said, “we love your science, but it’s irrelevant. What we really love is the conversations that it creates with our clients.” And what I discovered over the following years, that there was a world of two sorts of advisers– ones that wanted to talk with clients and another group that was scared to talk with their clients. And so in my world, the way it worked its way through is the advisers who took up our product early were brave.

To go back to the adoption model, they were early adopters and they were quite creative, they were prepared to make themselves vulnerable. But as you go along the adoption cycle, the capacity to be vulnerable diminishes. What I discovered was advisers would say “twenty-five questions? I can’t convince the client to do that. Can you give us one question?” We saw a major schism and we had people say I couldn’t ask my clients to spend 15 minutes answering questions, it’s too long. There was a complete split. We were in two worlds – the world that didn’t want complexity, wasn’t prepared to put itself at risk, just saw compliance as tick a box, a necessary evil and even wanted to get around it if it could. Now the way that played itself out, and forgive me for those of you not aware, we had a major review of fee-for-service in Australia three years ago. It found that there was a sophisticated capacity to collect ongoing fees, but little capacity to deliver ongoing service. Of course this wasn’t the way in the U.K. The FCA made changes along the way. In the U.K. crisis discovery was regular.

What happened was the majority of planning businesses, part of vertical integrations owned by the banks, were sold. Now all the banks have removed the reputational risk from their life insurance, their platforms, their financial advisory businesses by selling them, or closed them down in the last two years, because they were unable to deal with the loss of confidence in their brand and their integrity. Vertically integrated banks were making losses on their financial businesses which were obviously going to damage their brand. So the piece that comes back to Ian’s question if I can, is if you’re charging fee-for-service make sure you provide a relevant service. I can already see the FCA is reviewing current behaviours and saying that there’s cross subsidies between retirees and pre-retirees because of the way the fees are charged ad valorum.

The easiest way to illustrate value is to show customers that there are always conflicts in their lives caused by heuristics and shortcuts. That if we go back to the three major variables, the sleep at night portfolio, the portfolio that will likely reach their goals and the portfolio that deals with meltdowns. As we saw last year and with the like of Woodford, it’s those conversations and the rebalancing and working with clients collaboratively to make decisions about what’s the most important to them. That’s the critical issue going forward.