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How to assess the client’s knowledge and experience?

18 October 2020

ATEB Consulting’s Steve Bailey considers this question and the practicalities of assessing and suitably recommending a course of action, particularly in the light of FCA case feedback.

It has long been a requirement to assess a client’s ‘risk profile’. In practice, the rules break this down into three elements.

  • Risk tolerance… the degree of volatility a client is willing to accept;
  • Ability to bear losses… more commonly referred to as capacity for loss, this is the degree of the client’s reliance on an investment in relation to income or capital objectives;
  • Knowledge and experience… knowledge and experience in relation to investments.

And, of course, when advising on pension transfers, there is also ‘transfer risk’. That is a different concept entirely and does not figure in this article.

How is the client’s risk profile assessed?
Most firms use some sort of tool to assess the client’s risk tolerance. We have written before about risk profiling tools and how many of them have fundamental flaws, especially in relation to capacity for loss, or can be used inappropriately.

What about knowledge and experience?
So how do you assess a client’s knowledge and experience (K&E)? Well, you cannot always rely on a third party risk profiling tool. Some do not incorporate this element at all and others that do often do so inadequately against the standards required by the FCA.

The first statement in the rules around K&E is:

“Knowledge and experience in the investment field relevant to the specific type of financial instrument, insurance-based investment product or service.”

Note that the assessment is supposed to be in relation to the investment under consideration. A client could well be knowledgeable about ISAs but know little or nothing about pensions.

The rules (COBS 9.2.2R(1)(c) ) then go on to state that firms should gather sufficient information about the client …

” … such that he has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of his portfolio”

Yet we often see clients being assessed as knowledgeable and experienced in investments because they once had, for example a very small holding of shares, or an ISA or perhaps because the client has a workplace pension. This is clearly not a robust conclusion. Merely having an investment does not automatically make the client an expert. And having wealth does not automatically confer experience. Sad to say, the converse is also true – having experience does not confer wealth!

The FCA’s third and final word on assessing K&E goes into a bit more practical detail on what is required and how to assess it. From COBS 9 …

“The information regarding a client’s knowledge and experience in the investment field includes, to the extent appropriate to the nature of the client, the nature and extent of the service to be provided and the type of product or transaction envisaged, including their complexity and the risks involved, information on: 

(1) the types of service, transaction and designated investment with which the client is familiar;

(2) the nature, volume, frequency of the client’s transactions in designated investments and the period over which they have been carried out;

(3) the level of education, profession or relevant former profession of the client.”

So a couple of quick self-assessment questions along the lines of ‘How knowledgeable would you say you are in relation to investments? a) Low, b) Medium c) High’ are not good enough. You must ask some more searching questions about specific investment related matters, e.g. ‘What do you understand of the relationship between risk and return?’ or ‘How aware are you of the difference between active and passive investments?’

These should be complemented by a specific identification of the client’s experience of different investment vehicles, and whether they invested directly or with advice.

And the assessment should also take account of any relevant education or career experience that might reasonably contribute to the assessment. This is the aspect that is most often not addressed by advisers, usually because it does not appear in the ‘questionnaire’.

The importance of knowledge and experience
Why does this matter? Well the rules clearly require firms to assess K&E. The COBS 9.2.2 rule stated above suggests that failure to properly assess K&E is an automatic rule breach.

Worse, it appears from recent FCA feedback on pension transfer cases they have reviewed that K&E could now be a reason to question the suitability of the advice. Consider these extracts from recent FCA feedback.

  • “The client is a first-time investor and the extent of his financial experience is limited to the DB scheme and taking a mortgage. There is no evidence of any savings or investments. The firm provided the client with some information on the difference between a DB scheme and a DC scheme, however, due to the client’s lack of knowledge and experience, the client should have been assessed as an unsuitable candidate for transfer. Therefore, we consider the firm has not complied with COBS 9.2.2R(1)(c) which requires a firm to obtain from the client such information as is necessary for the firm to have a reasonable basis for believing that the transaction recommended is such that the client has the necessary knowledge and experience to understand the risks involved.”
  • “The client has very limited knowledge and experience as evidenced by the apparent absence of any savings or investments. We do not consider the advice complies with the requirements in COBS 9.2.2R(1)(c) which requires …”
  • “The client was a first-time investor and the evidence on file suggests that the client has very limited knowledge and experience in relation to investments. Their client’s only experience of investments appears to be limited to being a member of DC pension arrangements … given the client’s knowledge and experience, we would have expected the firm to assess the client as an unsuitable candidate for transfer”

Our View

To suggest that any client with a low K&E is unsuitable for a transfer does not appear to be an easily sustainable argument. At first sight, it seems to be entirely in line with essence of COBS 9.2.2 but the flaw in the conclusion is that there is no defined standard scale of K&E. And if there were, at what score out of ten does the option of a transfer start to be worthy of consideration?

That the FCA application of the rule in the extracts quoted may be flawed is also shown up by looking at what would generally be considered strong reasons to transfer. You could well have a client with zero K&E but who is single with no dependants where hurdle rate considerations could play strongly to a transfer. Or even more strongly, the client could be in serious ill-health with dependants and a virtual no brainer for a transfer because of death benefit considerations. In such circumstances, the client’s level of K&E is absolutely irrelevant – to the recommendation, but not to its presentation.

ATEB’s view is that the point of assessing K&E is to identify the level at which explanations and suitability reports should be pitched. You might not know much about pensions, but that is exactly why you have engaged a financial adviser who does. The adviser’s responsibility is to ensure that all factors are taken into account and a genuinely suitable recommendation made – and explained at a level that the client CAN understand. Surely that is the essence of COBS 9.2.2.

So we arrive full circle at the issue of poor assessment of K&E. That clearly needs to be addressed, not least because the FCA seem to have K&E in its list of suitability issues.

Finally, writing this article reminded us of a FOS case from some years ago. It involved a high risk VCT and the adviser classified the complainant, who was an experienced investor and very wealthy as ‘Sophisticated’. The FOS was unimpressed, responding: “If the client was that sophisticated then he would not have come to you for the advice.” The IFA lost!!!

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