Last month’s FSA sector report on IFA advice painted a frightening picture.Thirty-six out of 50 mystery-shopped firms needed improvement and 21 needed “to eradicate non-TCF elements from their advice process”. In 46 per cent of mystery shops, the IFA advised before doing any in-depth fact-finding. Twenty-six per cent came up with an ambiguous attitude to risk and 8 per cent failed to provide any assessment in this area. Fifty-four per cent had an inadequate sales process and 10 per cent made an insufficient assessment of the client’s needs or attitude to risk. The FSA is rightly worried about a failure to document, ascertain and then advise consistently with the customer’s attitude to risk. Many of the financial services scandals since 1988 have started from this point. Mortgage endowment problems primarily involved the risk the customer took of not having his loan repaid at the end of the term. Zeros issued by splits often involved the question of whether the customer could tolerate the apparently remote risk of total loss. Precipice bonds raised the question of whether the customer was prepared to take the chance of a two- for-one loss once the relevant index fell below a certain point. Income drawdown involves the assessment both of investment and annuity risk, with mortality drag thrown in. The FSA’s own risk assessment framework describes risk as “something with potential to cause harm to one or more of” its objectives. Bad things happen to a variety of products in a falling market. Yet complaints do not come in evenly. Mortgage endowments caused much more concern than equity Isas. Yet both encountered the same market falls in the late 1990s. This relates to the extreme sensitivity of different types of risk. It is not good enough to classify customers on a one to 10 scale and make recommendations in line with that. Customers have different attitudes to chance depending on how central they consider the area to be to their financial well-being. People commonly have no mortgage, a final-salary pension with added years and a share portfolio. Home and pensions may be regarded as essential while investments involve making use of surplus money. Their success or failure is not so crucial. Fact-finding must involve a separate assessment of risk for each aspect of the customer’s finances. The problem with splits and zeros exposed the fact that advisers need to check whether the customer can cope with a highly unlikely but catastrophic event. Some customers were prepared to accept some risk with these types of investments but not the possibility that they could lose all their money. The adviser should have documented this warning to ensure at least that he had a defence when customers complained. A risk assessment may relate to the overall holdings of an individual. Some customers accept an overall view of their risk assessment and expect a portfolio with more or less risky investments averaging out at the right level. Others may regard their risk profile as representing the maximum level of risk acceptable. Advisers must find out which applies to each case. The biggest problems recently have come from linking risks, mortgage endowments being the classic example. Here, an investment risk (the possibility that the product will perform less well than cash) combines with its mortgage equivalent (the doubt as to whether any sum produced will repay the loan). The product does not succeed unless it meets both targets. Other linked risks exist. Advisers often recommended zeros to pay school fees. The customer needed to be comfortable with the risk that the product will not necessarily achieve its objective. If the client has other sources of cash, this will not be a problem but the adviser must document this. Any objective which involves the production of a particular sum at a specific time involves multiplying the risk involved further. The customer wants the investment to do well generally but it must achieve a particular growth and then at a particular time to meet its objective. If the market is down at the point when the customer needs the money, the overall quality of the fund will not prevent the investment failing. August’s Ombudsman News mentions a further element – leverage. If the customer borrows to invest, then loan interest has to be added to the transaction costs. The customer also needs a return which is sufficient to repay the loan. Having assessed the customer’s risk profile, the adviser has to make two further calculations. First, he must himself understand the risks inherent in any product recommended. He then has to match them to the client’s needs and feelings. On the first, an understanding of precipice bonds shows how difficult it must have been to find a suitable customer for such products. The investor must have wanted a guarantee but accept happily the possibility that when it was most needed, the guarantee would fail and losses double. A drawdown customer must be comfortable with a combination of fund and annuity risks, mortality drag and the effects of charges. The FSA mystery-shopping exercise encountered a number of advisers unilaterally increasing the risk profile of the investor or pushing the customer into agreeing a higher level of risk. In a number of cases, the suitability letter contained a higher profile to the fact-find meeting. Where a customer with historically cautious investments is interested in a change, an adviser should do it slowly. Wait until the customer is comfortable or used to a higher level of risk before putting significant sums in a more hazardous category. Finally, the advice must be suitable both objectively and subjectively. A reasonable person must find it reasonable and it must match the feelings, fears, objectives and aspirations of the client. If it fails one, it is not non-compliant. An adviser complained recently of a FOS case where the customer asked for a short-term equity investment while he was searching for a property. The adjudicator concluded that the equity fund was unsuitable because of the short-term goal of buying a property. The adviser passed the subjective test but failed the objective suitability test – at a cost of 16,000.