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FCA: Industry does not understand capacity for loss

Many advisers do not understand what capacity for loss means and should rely on their own calculations rather than clients’ “emotional” responses, says the FCA.

Speaking at an Open University Business School conference in London yesterday, FCA technical specialist Rory Percival said some advisers still confuse capacity for loss with risk profiling.

He said: “One concern we have is that I personally have some conversations with people in the industry and I get the impression they don’t quite get what capacity for loss is. They start to talk about clients’ emotional reactions to losses and sound more like they are referring to the client’s risk profile rather than capacity for loss.”

Percival said in many respects capacity for loss is something the adviser can work out, rather than the client coming to their own conclusion.

He said: “One of the concerns we have about capacity for loss is that the way some firms approach this is to ask the client: how much can you afford to lose before it has a material impact on your standard of living?

“Our concern would be that that might be the right question, but are you getting the right answer? I suspect in the majority of cases there is the risk the client might give an emotional answer, rather than the hard-nosed numbers point that capacity for loss is really getting at.”

Percival said advisers can assess capacity for loss through a number of methods, including lifetime cash flow analysis, although he acknowledged this is “expensive” and not suitable for all clients.

He said: “For other clients it is about really having an understanding of what their income and outgoings are both now and in the future.”

Percival said while advisers have improved their approach to capacity for loss since the regulator first warned about risk profiling tools in January 2011, it is still an area where the industry “is developing what good practice looks like”.

He added that the FCA continues to find problems on a regular basis around risk descriptions.

He said: “Some of the descriptions include jargon, and quite often vague language. They rarely provide any quantification or differentiation of risk.

“So there are references like ‘you are prepared to take some risk’ – that is not really putting the client in the position where they can understand the risk of the solution that is recommended to them.”

Percival said some advisers are still focusing solely on the client’s risk profile and simply mapping their risk rating to a fund without taking into account factors such as capacity for loss and term.

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There are 33 comments at the moment, we would love to hear your opinion too.

  1. E L Wisty (an only twin) 20th November 2014 at 10:15 am

    There is much validity in what Mr Percival states. Capacity for loss is a helpful concept in truly understanding a client’s attitude to risk, and ability to commit to investment. Where used effectively, it also provides a defence against any retrospective complaint that the adviser made inappropriate recommendations. In any event, it’s not going away.

    Therefore, I would like to see more prescriptive examples from the regulator as to what good looks like. As otherwise I fear that this could be yet another example of us being led down a certain path, only to be subsequently criticised for our actions.

  2. Spot on Rory. Ask a client how much they can afford to lose may get an answer of 20%. Then ask if they know how much growth they need to get back to par – no Mr Client it’s 25%. And how long do you think it could take to make 25%? At 2% growth per annum, over 11 years. Now how do you feel? And those liabilities due in 10 years that you told me are critical to mitigate would be at risk in those circumstances.

    Putting challenging scenarios to clients in respect of the likelihood of achieving their goals, calculating the risk of ruin, and ascertaining the impact of a goal being missed are all part of a lengthy risk discussion that should come after any profile, and should be the core of the advice process.

    Product providers and platforms could do worse than to provide their adviser base with cash-flow management and perhaps “risk discussion” apps to better engage with clients, and to bring these issues to life.

  3. 50 shades of FCA!

    The FCA appear to me to look to create areas of doubt that can then justify their existence. How is it that we can concentrate on Capacity for Loss in an investment sense, but the regulator can allow registration and operation of the Pay Day Loan companies?

    Capacity for Loss is an emotive subject… I have clients who in discussion think they are High Risk, but when discussing loss and relative amounts and how they would feel, they all say they wouldn’t feel good about it, but then who does? So I recommend they reduce risk, explain why and still some appear happy to ‘gamble’. Am I not as an IFA required to advise, but also give my clients what they want without the Regulator creating a way for clients who suffer losses to complain…

  4. So now we’re supposed not only to ensure we ask the right questions but to ensure also that we steer the client towards giving the right answers? Or provide the “right” answers ourselves?

    Lifetime cash flow analyses are all very well but the future surely holds so many unknown variables that a cash flow analysis, really, can be no more than painting a completely speculative picture of what it [the future] MAY hold. A dozen unexpected events are likely to crop up that will completely derail and invalidate any such forecast so, if cash flow forecast is to be used at all, it really needs to be renewed every year, at great expense. Typical unknown future variables are health, employment, marital circumstances and the myriad variety of other risks that we’ve all read in various text books. Relying on a cash flow forecast is like trying to herd cats.

    Simple example:-

    Adviser: like your retirement income to represent not less than 50% of your final earnings, Mr Client? Based on predictions X, Y & Z, this is the amount you need to aside to get there.

    Client: There’s no way I can possibly afford that. And how reliable are these predictions X, Y & Z anyway?

    Now what?

    The FCA’s principal raison d’etre appears to be to dream up endless new requirements for financial planning, most of them completely divorced from the realities of actually doing the job, and then to find fault with the adviser community’s attempt to implement just about all of them. It’s bonkers, isn’t it?

  5. I’m afraid to say that I’m with Mr Percival on this one. I have seen more than my share of firms whose whole approach to capacity for loss is to take an ATR score and match it to funds with no account of the overall investment suitability factors.

    Risk profiling does not establish capacity for loss; it does not establish liquidity needs, nore investment horizons or any other factors required for investment suitability.

  6. Mr P infers that in any situation there is an answer that can be held to be objectively correct. If he believes that, he is just as dangerous as all the other regulators who have cleaved to this belief.

    As a previous correspondent has pointed out, we all face multiple uncertainties. How much loss can I absorb? It all depends. My adviser can help me make a judgement, which is what his job should be about. But in the end it has to be my call, and I have to take responsibility.

    An adviser using some daft computer programme to calculate my capacity for loss has to make so many assumptions that the number he or she produces might just as well have been drawn out of a hat.

    But these regulators are pretty cute. They can just go on and on dreaming up new ways to look backwards in order to use the benefit of hindsight to justify their continued existence.

    The’right answer’ delusion is central to the regulatory juggernaut. The more we explain that it is just that, a delusion, the more likely it is that the wheels will fall off and something sensible might emerge from the wreckage.

  7. Julian, totally agree, and with Victor M’s comment about pay day lenders. We are so over regulated that the entire industry is being completely stifled and we can’t help smaller clients because we can’t afford to. But what about the new pensions regime and the unregulated companies that will spring up to relieve ignorant (and greedy) people of their life savings by putting their money in all manner of schemes with no redress when it all goes horribly wrong? Rather more important than nit picking about capacity for loss I feel. No one at the FCA or government seems to be considering what will happen then. Or will we end up paying anyway? Or will they just impose another fine on a bank? Seriously time to retire.

  8. @Victor M
    Your comments are an example of what Rory is saying. The 2011 guidance clearly lays out the three aspects of risk that need to be addressed so it’s not new. In no particular order:

    1. Risk tolerance – this is the subjective atitude to risk (emotive bit if you like) that is specific to the individual. It needs to be assessed on this basis and measured on a relative scale to have meaning in an investrment context.
    2. Capacity for loss – a factual assessment of how much the client can lose now and in the future before it has a material impact on their standard of living. It can be calculated from hard facts.
    3. Objective risk – how much risk needs to be taken by the client in order to achive their objectives. Again, fact based.

    You are likely to get a different answer to each of these which means you need to discuss with the client which one is going to be the key driver for them, it will vary from client to client. You could have a client who loves taking risks but can’t afford to lose a pound of capital and needs to achieve a real growth rate of 4% per annum over the next 15 years. The combinations are endless. The imprtant thing to to make the assessment of each, discuss the implications with the client and agree the way forward in an open and transparent way – fully documented of course.

  9. I think the only way in which this can be evidenced is by way of cash flow forecasting. A crystal ball would be handy but we’re fresh out of these.

    Using scenario planning would help quantify the impact of falls in value which seems to be the nub of this issue. It would also help in terms of identifying the required level of risk needed to achieve a desired outcome.

    So to some extent, capacity for loss needs to be considered in the context of capacity for lack of long term risk. Where is the no risk option? Cash doesn’t provide this!

  10. But neither does the FCA.

    Is a client’s loss of opportunity from inaction or the ‘wrong action’ the biggest risk he faces? Or having all their money in residential property (and highly geared in many instances) low risk? Or not having any capital in assets which could offset inflation, or all the money on the bank account so that when interest rates decline from the comfortable 10% they were to 0.5% the poor investor realises that he has to eat his savings to bolster his income needs? Or all in safe government bonds which lose 33% of their capital as they’ve been bought over par and will decline more as interest rates rise as well as the investor finding the fixed income is poor compared to then contemporary rates?

    Then of course we have life expectancy perhaps – and possible survivorship and passing-on of market assets – or even the scope for inheritances in the future…. or taking pensions and buying awful annuities over the last few years, fixed incomes which in ten years may look atrocious compared to investment-related ones?

    Maybe the best investment anyone can make is in education to understand ‘risk’ and that managing it once understood is the only solution and not trying to ‘avoid it’ using superstition and recency only to find big (and not really wholly unpredictable) economic events have a horrible way of destroying people’s comfort…. A low risk person with little ‘capacity for loss’ should still have some capital within market investments (and be educated to explain why)… now should I be shot?

    As for advisers, perhaps in ten years the FOS will be upholding complaints from people who were not advising people to put some money into these other types of high risk assets away from the ‘other list’ above… and of course for the lost comparative return not the ‘nominal loss’.

  11. Dear Rory (if you can be arsed to reply)

    Why is the sharing of good practice, shrouded in secrecy by the FCA ? you tell us we are bad, and we don’t understand, & we are still getting it wrong in most cases !! (ATR, capacity for loss, suitability reports etc etc etc )
    Come on man up and be a good parent tell us how to do it right !!! us kids have to learn it one day ?

    More like you are scared you might get it wrong, as of course like God, you have to be seen as infallible

  12. Very simplistically (with emphasis on very!) – telling a compulsive gambler that the 4.30 at Cheltenham is a good bet, may not be the most appropriate suggestion if his family desperately needs the paycheck.

    Having lit the blue touchpaper perhaps I can backtrack a little, in that each clients CFL may well differ, issues become shades of grey / much is subjective etc and yes it probably is quite impractical to do full cash flow for every client each year. But that said there should be some questionning of the client who’s prepared to risk all when really, they should reflect more on the potential downside.

    The devil in the detail, is how to capture that, in a reasonably workable and cost efficent format.

  13. We’re stuck between a rock and a hard place. For rock read FCA, for hard place read FOS.

    In theory i agree with Mr Percival’s comments. Capacity for loss is an important consideration when making investments for clients. The reality is that we’re completely unsure as to what should be the driver for risk within an investment – ATR, CFR or Investment Objective. As an example what if ATR is significantly different to the CFR which is in itself different to the investment objective. Should the client decide to complain in the future which one will the FOS deem to be the most important?

  14. Whilst I do agree with Mr Percival, the problem being is there is no actual agreed way to document this requirement.

    I don’t like being pushed in a corner, but increasingly this is what is happening, this is how I feel. The regulator always makes sure they have statements covering both sides of the fence to protect them. They sit on the fence, making sure they can swing what ever way they wish.

    We get statements such as clients are being to cautious, they don’t understand risk, capacity for loss yet are not provided with suggested solutions by the regulator to document these facts. We don’t even have any examples of what they believe is good or bad. We have guidance coming out of our ears, but no actual examples.

    How do I document what is required to insure any future compliant is handled fairly. The truth is I cannot. There is no magic solution, why, because within an hour of leaving my office any clients circumstances can change, their feelings, capacity and then they have selected memory loss. Even if they have signed a statements that states all the risks, they can say they did not understand, even if its in BIG RED letters.

    I do not mind any reasonable request to improve our industry, I welcome them. However I am frustrated at being told I need to do better without being given even a hint of what would actually be acceptable.

    It’s like being told to defuse a bomb without instructions. Keep trying and hope you do not blow yourself up.

  15. Capacity for loss is a consideration but it is not the only one.

    Earlier this week I travelled by rail through Maidenhead Ladbroke Grove, Kings Cross and Moorgate. All places where, sadly, people suffered 100% irretrievable losses. All, I hope, are now safer but it could have happened to me.

    Or I could have come out of the station and been run over by a bus.

    But the likelihood of being killed was very small – so it was a risk I decided I could accept despite the potential magnitude of the loss being unaffordable.

  16. It only took them 10 years to wake up after I pointed it out. must be a record?

  17. Trevor Harrington 20th November 2014 at 7:56 pm

    Capacity for loss ?
    Risk assessment ?

    Read one and the same … LOOK – YOU MUST know your client !

    This is not about an individual investment that you happen to think is correct for that client.

    This IS about an individual investment … but ONLY in the context of the clients fully known circumstances.
    Pension forecast – capital – inheritance potential – asset values (ALL!) – incomes – health – tax status – liabilities – relationships ….

    You will not get the regulator to make a statement (I think they call it guidance), which enables you to abdicate your responsibility to KNOW YOUR CLIENT !

    Come on chaps – this is basic stuff !

  18. I get the sense that most of the contributors here actually know their business and given this professional understanding, diligent practice and adequate documentation, Mr Percival and the regular will, I suspect, not be directing the message at primarily at you guys. But there are an awful lot of advisers and firms who are less diligent, don’t understand COBs 9 and completely misunderstand the issue of capacity for loss. This group is probably not even reading this.

    Suitability = capacity for loss, volatility tolerance, investment horizons, liquidity needs, return expectations as well as some ‘softer’, let’s say, more emotional matters.

    Trevor Harrington, a previous contributor is absolutely right: Know Your Client. There is one thing that I would add to this: have a system (SYSC 3) in place for recording this information and reporting on it. Computer systems are certainly not mandated by the regulator but they can make life easier.

  19. I agree with Rory on this one – and many contributors who have responded. There is a difference between risk profile and capacity for loss. Clients don’t always know what is best for them and as an adviser one should advise them accordingly, even if that means putting them right or steering them in the right direction. What they think is their capacity for loss and what they actual capacity for loss is, can be two different things and any good adviser will be able to communicate this sensitively to the client. I also generally agree with his comments with regard to quantifying when it comes to attitude to risk. We incorporate the percentage likely to be invested into equities within our risk descriptions. It’s not perfect as there is of course inflationary risk, political risk, and so on, however, it goes some way to making it clearer for the client.

  20. Capacity for loss is a professional judgment, not a fact – it does not magically emerge from cash flow forecasts. Like any professional judgment it is based on applying ‘rules’ gained not just from theory but experience. That and the fact that the judgment can be affected by so many different client circumstances mean it is very very hard to quantify. But at the very least you ought to aim to assess the client’s capacity for loss as low, moderate or high and most importantly explain to the client what that means in terms of the maximum possible loss from any proposed set of investments. None of this is that hard nor is it that hard to design a process that requires all the advisers in a firm to follow a common process open to review by managers.

  21. I suppose again, sadly, the interpretation of all these things is nothing to do with the FCA;’s rules but the FOS’s judgement int he face of a complaint.

    Then, no technical defence is any good if the FOS rules that there is an unacceptable loss and it has to be compensated. Sadly that is where the regulator goes wrong in failing to understand the FOS interprets things to suit its specific cause at the time and no amount of ‘evidence’ appears able to counterbalance an inequitable judgement against an adviser who did the ‘right thing’ in accordance with his professional judgement. And by the way, the rules vary in accordance with custom and practice and hindsight… in that it is easy afterwards saying something was totally and obviously clearly wrong because it went wrong (and I am not taking Keydata or whatever either).

  22. What is ‘capacity for loss’?

    Loss of capital
    Loss of income
    Loss of investment growth

    The man in the street might actually have a higher capacity for loss as losing his life savings of £10k, having been invested to achieve capital growth that will make a difference to his life, might actually have lower impact than someone with £500,000 losing £100,000.

    Unfortunately the FCA wants everyone to fit into little boxes; which as we’re all individuals we don’t so this can become a very subjective matter.

  23. Here’s a thought ~ if “the industry” has trouble getting its head round CFL, then what hope for clients?

    Let us not overlook the facts that:-

    1. “the industry” i.e. advisers actually doing the job out here in the field, comprises mostly experienced, hands-on practitioners with solid, steady and mature businesses and

    2. if we’re ALL now properly qualified (though there are probably a good few people within the FCA who themselves have no relevant qualifications AT ALL, consider that we still aren’t),

    then why do people like Rory Pain-in-the-Arse-ival consider it their mission in life to tell us constantly that we ought to be doing better by taking on the FCA’s latest wet dream?

  24. @ Julian

    “why do people like Rory Percival consider it their mission in life to tell us constantly that we ought to be doing better by taking on the FCA’s latest dream?”

    Because it keeps the pressure on ! this is all well and good, but its gone too far and has now become counter productive.

    This is akin to “sales targets” you get pushed more and more every year or quarter, till you either circumvent the rules, leave, or go bust which in its self is the worst possible outcome.

    From the FCA’s point of view it gives them the appearance of being proactive, but in reality its gone way beyond good general housekeeping.

    Then I give you “team innovate” a prime example of the FCA knowing and in part acknowledging the fact the rule book and being able to offer a cleaner more cost effective delivery of service is, in the main, impossible ?

  25. DH, totally agree.

  26. Julian, there is plenty of evidence that a lot of advisers are not formally assessing or recording capacity for loss prior to making investment recommendations. It’s entirely legitimate for Mr Percival to point this out and tell those advisers they need to up their game.

  27. Yes, constantly dreaming up new criteria and concepts and processes by which to measure the quality of advice and the degree to which the outcome of that advice is likely to be utterly perfect is, of course, an ongoing programme of job justification. One can imagine RP from time to time being called in by whoever is his boss at Canary Wharf for his half yearly performance review:-

    Boss ~ What’s going on Rory? You don’t seem to have come up lately with any new challenging hoops or hurdles for the adviser community to wrestle with. That’s what you’re here for.

    RP ~ Er, I thought you’d said you’re trying to devise a simpler framework for advice because it’s all become so complicated, so time-consuming and so expensive that more and more people are finding themselves priced out and, even if they can afford it, they’re completely overwhelmed by the complexity of it all.

    Boss ~ Yeah, well never mind that, that’s just what we say to the press. Your job is to keep prodding the adviser community in the backside (and progressively ratcheting up the voltage) so that, however impossible it may be in practice, they’ll continue striving to reach the pot of gold at the end of the rainbow. That way we can claim to be striving ceaselessly towards ever higher standards of advice and better outcomes for consumers.

    RP ~ Ah, right, I see. So you want to see MORE not less complexity for advisers? Is that it?

    Boss ~ You got it. It all helps justify our raison d’etre and gives us ever more minutiae with which to find fault after the event. Now off you go and see what you and your team can come up with.

    RP ~ We may receive some representations from APFA about this unending complication of the advice process.

    Boss ~ WTF is APFA?

  28. Aside from obviously wrong recommendations to cautious and/or inexperienced investors to allocate money to high risk funds that are quite at odds with their ATR, tolerance for volatility (which, I suggest, is far more pertinent in the real world), investment time horizon and all those sorts of parameters, does any substantive body of evidence exist proving beyond reasonable doubt or dispute that, before the FCA dreamed up this CFL idea (another of its Friday afternoon wet dreams), people commonly received unsuitable or inappropriate investment advice without it?

    And is there any reasonable body of evidence on which to base any expectation that by adding CFL (which many advisers are having considerable difficulty getting their heads round) to the advice process, all these supposed problems that the FCA seems to think have arisen as a result of not quantifying CFL will disappear almost overnight?

    Because there’s no body to yank the reins and say Now just hold on, this is getting bloody stupid, the FCA can and seems intent upon dreaming up and imposing on advisers additional criteria ad infintum.

    My little business is approaching its 20th birthday. Most of my clients have been with me for between 10 and 20 years. In the early days, all that was required was very basic risk profiling, but I put together diversified portfolios as carefully as I knew how, I review them all at least twice a year (except for the very piddly ones), virtually all those portfolios have done what they were designed to do (especially the income ones) and the great majority of the clients I’ve taken on over the years are still with me, still happy, they still trust me and I still enjoy good business relationships with them most of my clients. I’ve lost a few, as do we all, but not very many, which is why I’m still here and my income is steady.

    So, is CFL really so necessary or even vaguely likely to achieve quantifiably better customer outcomes going forward? I really wonder. By all means suggest or even recommend using CFL assesment as possibly good practice for advisers keen to beef up their procedures, but I genuinely don’t see any justification for the FCA to ram it down everybody’s throats just because they ~ who don’t actually do the job and mostly never have ~ think it’s a good idea and aren’t prepared to listen to what anyone else might have to think or say on the subject.

    We’re not school children, only a tiny proportion of us are sharks or fools, we do care about looking after our clients and we do want to keep them long term. It seems that all the FCA ever fixates on is the minority bad stuff and, as a result, deems it necessary to regulate all of us according to the lowest common denominator. Is it any wonder that so many long serving advisers are leaving the industry or looking to the day they can afford to do so?

  29. Is there a ruler or scale for measuring capacity for loss?

  30. I was talking to another network earlier this year and they operate a range of model portfolios, each rated according to the extent to which each might fall in value over a given period. Each one even was even labelled with a percentage. Given the myriad range of completely unpredictable factors that can affect the value of various asset classes and funds, I asked But what if things don’t turn out that way in practice (as they almost certainly won’t)? He didn’t have an answer. (With the sincerest of intentions), they’d just done it in a valiant attempt to appease the regulator.

    There are some things that, IMHO, just cannot be nailed down on every conceivable parameter. Yet that is exactly what the regulator seems to be intent on forcing advisers to try to do. Perfect strategies/ portfolios/ solutions just do not and cannot exist. The “best” way to address any given set of circumstances and objectives is and to a large extent, always will be subjective. It’s the same old pot of gold at the end of the rainbow way of thinking.

  31. If the majority of advisers were asking ‘What level of loss or shortfall would result in the client’s life changing for the worse, and what set of investments can limit the possibility of losses/shortfalls exceeding that level?’ then the FCA wouldn’t need to bang the drum about capacity for loss. But even if advisers do ask such questions, they often have no way of demonstrating they have used consistent methods to move from their client assessments to their recommended investment solutions.
    Now ask yourself whether that sort of inconsistency would be acceptable with accountants or solicitors. I think it simply isn’t acceptable in a professional context – that indeed one of the implications of professionalism is having a set of methods and procedures that are applied consistently. Of course there is space within this for ‘rules of thumb’, but only as mental shortcuts to a shared methodology.

  32. @ Chris Gilchrist: ANY level of loss or shortfall would result in the client being worse off (even if only by a few pounds per month). Advisers struggle to quantify and record this amount because the clients themselves can’t/don’t know how much their future life may be impacted by something that may happen long into the future – there are too many variables and too many permutations for most people to be able to compute. And can someone please define the FCA’s meaning of “material lose”….in a quantifiable manner, not some airy-fairy ramble, that a typical client would understand.

    To compare the financial adviser’s responsibilities to either an accountant or solicitor is a little unfair since solicitor’s and accountant’s work is predominantly based upon backward looking actions.

    Whereas financial advisers are being asked to cater for long-term future events that may or may not happen. Last time I checked, my ‘kit bag’ didn’t include a crystal ball.

    Even cashflow modelling cannot help because it too is based upon too many assumptions/predictions of long-term life events, trends, inflation, expenditure & income; that’s why it should be an exercise that is revisited annually.

    However, providing investment advice is invariably with one eye on a target date of many years into the future. A future that, in most cases, clients haven’t really given any consideration to since life has too many unknown unknowns for 95% of the population. At best most clients will have a 5 year plan. It’s just beyond many’s comprehension to think longer term partly due to the ‘Live for today’ mentality (which to a degree I can understand).

  33. I suspect that the FCA entirely understands the ‘crystal ball’ nature of investment advise. Over a five to ten year period many things can and probably will impact on a client’s ‘life plan’: personal, spouse, family sickness, redundancy as well as the volatile impact of economies and markets upon investments. As Mark Coomber says, even cash-modelling based on assumptions and predictions is imperfect.

    At risk of appearing naive in my thinking, I believe that the regulator understands the challenges that advisers face and is simply trying to ensure that professional and diligent advice prevails. Without any evidence that a client’s investment suitability has been established reasonably, that it is recorded consistently and is reviewed regularly, then firms and advisers simply leave themselves exposed.

    Let’s not forget that we live in a litigious world and professional indemnity insurers understand this. Having sensible but consistent processes can only be a positive help to firms.

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