Should 401k Plan Sponsors Ban Risk Tolerance Questionnaires?

August 13
00:10 2013

There’s something about a good old-fashioned market free fall that gets people to stop bad habits. Those people include both everyday investors as well as financial professionals. While in the throes of the recent market tumult, BusinessWeek 517386_68751012_scanning_test_stock_xchng_royalty_free_300presented this lead sentence in one of its stories: “Add risk tolerance questionnaires to the list of products that didn’t work as advertised during the financial crisis.” (“Reassessing Investors’ Risk Tolerance,” Ben Levisohn, BusinessWeek, July 30, 2009).

This may have been seen as an odd statement by some academics. Although, at the time, still widely regarded in the industry, researchers had long since questioned the rationale for using risk tolerance questionnaires. As early as a decade before Levisohn wrote his piece for BusinessWeek, a study concluded “…the emphasis in current financial planning practice on identifying an index or measurement of ‘risk tolerance’ for clients may be misplaced. Indeed, the present results suggest that assessing risk tolerance and representing it as a unidimensional index may only serve to exacerbate client communication difficulties… Focusing clients’ risk definition in terms suitable for mathematical optimization models may only serve to impede effective risk communication between client and advisor.” (MacGregor, Donald G., Slovic, Paul, Berry, Michael and Evensky, Harold, Perception of Financial Risk: A Survey Study of Advisors and Planners (September 1, 1999). Journal of Financial Planning, 1999. Available at SSRN:

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Despite such condemnation, industry veterans and organizations employment of risk tolerance questionnaires remains. Just how many continue to use this outdated tool? “There are too many to count,” says Adam D. Koos, President of Libertas Wealth Management Group, Inc. in Dublin, Ohio. “Pick up any 401k enrollment kit from virtually any company you choose. Nationwide, ING, Great West, John Hancock, etc. They all typically have an enrollment book that includes a risk tolerance questionnaire with points attributed to the answers that then correlate with a specified ‘model’ portfolio.” Koos believes “the reason companies still do this is because it’s a more ‘blanket’ method of getting a portfolio constructed – which means it’s less expensive than alternative methods that would be more efficient and useful to the plan participant.”

It’s not without some (albeit anachronistic) justification that one finds even industry regulating bodies continuing to work with risk questionnaires on an everyday basis. John Ledford, President of Ledford Wealth Management Group in Orlando, Florida says, “The overriding concept that advisors need to be aware of in advising and handling client funds is to know your client. These rules are covered in detail within FINRA rules 2090 and 2111. These combined rules address authority and suitability and put the onus on the advisor, not the client, to demonstrate the ‘reasonableness’ of all recommendations. In practice, a questionnaire consistent with Modern Portfolio Theory (MPT) is still being used by most practitioners and looked for by most SROs, Certification Organizations (including the CFP) and most broker/dealers. All professionals and entities, including employers, want at least a minimum level of client understanding and despite, some inherent short comings of MPT, these questionnaires give clients and advisors a baseline from which to get to know each other.”

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For 401k plan sponsors, who are held to a higher (fiduciary) standard, as opposed to brokers (who are held only to the “suitability” standard), the use of risk tolerance questionnaires becomes problematic in light of academic studies like the one referenced above. In other words, what works for a broker may not work for a 401k plan sponsor, especially if plan participants are left to their own devices after answering a risk tolerance questionnaire. “The real downside is that many investors will end up testing as either too aggressive or too conservative,” says Ledford. “Even if the plan is robust and offers quality and diversification, the client is rarely allocating properly based on the provided testing.” Many, like Ledford, however, advise clients once they use these surveys. “Rarely do we find a client whose initial allocation is on par with what we are doing for them. When we work directly with 401k participants, we use the test as a baseline and then customize based on an interview. We don’t consider them as invalid but just one piece of the puzzle. Clients need to understand there is no cookie cutter allocation as everyone is different, has diverse needs, goals, resources and expectations. Everything has to be taken into account and not just their age and experience which is where many tests fall short.”

Risk tolerance questionnaires can lead to many problems for fiduciaries like 401k plan sponsors (or the fiduciary advisers they hire). Koos points to a classic which he calls “The Big One.” It occurs when “a client who is close to retirement and needs to generate a 6% rate of return in order to retire when he/she desires, without running out of money while in retirement. If this client answers the questions in a risk tolerance questionnaire in a manner that steers them toward a portfolio that is too conservative, they could be signing their own pink slip without even knowing. To take things a step further, let’s imagine the ‘CD Investor’ who feels that the questions they’ve answered are too risky, even though the allocation recommended is only 20-30% invested in the equity markets. Let’s say this investor decides to use the guaranteed option (such as an FDIC insured money market) – they could end up ‘going broke safely’ if they don’t take any additional risk.”

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While a broker can justify using a risk tolerance questionnaire to gauge the “suitability” of a particular investment, a 401k plan sponsor could be held liable for allowing a plan participant to rely on that same questionnaire as it might inappropriately lead the investor to an investment that is not in that investor’s best interests (e.g., the “going broke slowly” example mentioned by Koos). This is why, if plan sponsors endorse the use of risk tolerance questionnaires – either by administering them directly or through third party vendors – they need to make sure a fiduciary adviser is also available for the participants. “Most investors,” says Koos, “don’t realize that, without a proper analysis of their current income, expenses, assets, and projected inflation/rate of return numbers, by investing in ‘guaranteed’ allocation options, they could end up ‘guaranteed’ to run out of money.”

What can government regulators, the industry, certification associations and firms do to avoid the problems associated with risk tolerance tests? Ledford says, “The only real answer is to encourage employers to demand that their participants spend more time with their plan advisor. Education and relationship are the big keys here and too few employers and advisors are doing an adequate job. The advisor also needs to have multiple avenues to educate participants including enrollment meetings and online resources such as account access and educational seminars. Unfortunately, all of this impacts cost and over the past decade regulators have spent too much time witch hunting expensive plans and over compensation to the detriment of the industry. Advisors have to be paid a reasonable wage for the service they provide to both the plan and participants. Under the current structure the advisor is really working for the plan for an institutional wage to the detriment of the participants because the margins are so thin.”

Readers might also be interested in: Risk and the 401k Investor: How Plan Sponsors Can Avoid Misleading Employees

In the end, no risk preference will change the math with regard to an employee’s investment needs when it comes to growing their retirement assets to meet their individual goals. This is a process far more complicated than a mere list of questions can yield. As Koos says, “I think that just having the option available for participants to have a simple financial plan constructed – and then advertising it heavily via statements, newsletters, and plan meetings – would be a huge step in the right direction… away from MPT and silly, pointless questionnaires.”

Readers might also be interested in: Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans.

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

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  1. Chuck Miller
    Chuck Miller August 13, 16:39

    The biggest problem with risk tolerance quizzes is they only assess one type of risk, and attempting to minimize one kind of risk may maximize another type. It’s like trying to hold water in your hand.

    Large investment funds like corporate DB plans or college endowments realize they have to balance all the various types of risk to reach their objectives.

  2. James Watkins
    James Watkins August 15, 17:08

    Risk tolerance questionnaires serve no purpose, as they are usually poorly constructed, both in terms of the questions and, in some cases, the weighting given to certain Q&As.

    From a liability perspective, under FINRA and supporting legal decisions, the answers to such questionnaires do nothing more than provide a false sense of security to any of the plan’s advisers and fiduciaries subject to FINRA, as FINRA has consistently stated that it is the rep’s duty to properly assess a customer’s risk tolerance, both in terms of the customer’s willingness and ability to bear investment risk. If a client is financially unable to bear market risk, then the customer’s answers to any questionnaire are irrelevant. We are also seeing the emergence of a third threshold question that a rep/adviser must address – the need for a customer e.g., HNW customer, to accept market/investment risk at all.

  3. Scott Kubie, Chief Strategist, CLS Investments, LLC
    Scott Kubie, Chief Strategist, CLS Investments, LLC August 19, 10:50

    My view is three basic attributes drive a client’s risk allocation. They are subjective risk tolerance, objective risk situation, and goals. Different people emphasize one of these over the others. I would put Finametrica, an Australian research firm, in the first camp. They emphasize the psychological aspects of risk. Most 401k questionnaires emphasize the objective risk tolerance and focus on time horizon and income needs. The writer of the article is firmly in the goals camp. I favor a questionnaire focused on the first two combined with financial counseling in the years leading up to retirement.

    The article is of mixed value. Some of the deficiencies of questionnaires, were based on the client not liking the results and ignoring them and choosing something more conservative. From my view, this was a powerful argument for questionnaires. They are a low-cost way to encourage people to take decent risk.

    The goals approach also incorrectly identifies the goals as fixed and every other item as flexible. In reality all three of the attributes are flexible. If faced with a disconnect between subjective risk tolerance and goals, clients will often tack on a little more risk, work a little longer (increasing the time horizon while lowering the income percentage), and reduce their goals. Many times it is easier to adjust their goals than to take risk beyond their comfort zone.
    [These opinions are mine personally and do not necessarily represent the views of my employer.]

  4. Fred Farkash
    Fred Farkash August 19, 12:34

    Chris, thanks for starting an interesting discussion but I’m not sure I agree with some of the article’s assertions. If an investment questionaire qualifies as “interactive investment materials” under the DOL education vs. advice regulations (see 2509.96-1(d)(4), it would qualify as education (not advice). There is also certainly no legal requirement for 401k plan sponsors to provide investment advice to plan participants just because you give them education. One of the key points of the DOL guidance mentioned above is that in lieu of taking their entire financial picture into account (e.g., getting information about all their outside accounts), you can just tell participants that they need to consider their outside assets in addition to those in the plan in determining their asset allocation.

    So how could providing a questionnaire that properly qualifies as education (not advice) result in liability for the plan fiduciary? Are you saying 2509.96(1)(d) is somehow inapplicable because most questionnaires don’t qualify as education in practice, or are you saying that somehow this DOL guidance would not hold up in court?

  5. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author August 19, 15:40

    Not sure we disagree. While you can’t change the math of the goals, you can (sometimes) change the goals. In the end, though, the math is still sacrosanct. Still, it makes sense to have a professional adviser working with the investor in any case.

  6. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author August 19, 15:42

    Fred, thanks for the comment. Like any “advice” given in an education setting, I would agree it’s protected. The trouble is, most of the time the questionnaires are used to comply with FINRA, which is explicitly part of the investment – not education – system.

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