In these exceptionally challenging times and an uncertain economic environment, a client’s capacity for loss has arguably never been more important.
The subject of capacity for loss has actually been high on the Financial Conduct Authority’s (FCA’s) radar since pension freedoms were introduced back in April 2015. Since then, with more clients moving into flexible retirement, there’s been a wholesale shift of focus by adviser firms on spending more time on capacity for loss. As there are no earnings to mitigate risk, clients in retirement are likely to have a lower capacity for loss than clients pre-retirement.
Before pension freedoms, the main focus for many clients, on matching to suitable investments, was on using attitude to investment risk. Capacity for loss was always another appropriate measure. However, it has increased in importance since the FCA published its review of defined benefit (DB) transfer advice. The FCA specifically stated the need for advisers to consider capacity for loss separately from attitude to investment risk.
From the regulator’s perspective, it wants to know advisers have raised capacity for loss with clients before they come out of a DB pension and take a risk with their ability to have a sustainable income for life. The FCA wants to be assured that clients have the capacity for loss to be able to do that. Importantly, however, this applies equally to all clients in retirement and using pension freedoms.
Capacity for loss versus attitude to risk
Both capacity for loss and attitude to investment risk contribute to an adviser’s understanding of the client. But two separate assessments are needed as they are two very different measures:
- Capacity for loss is an objective measure which looks at whether the client has enough income and assets to maintain a comfortable standard of living. It’s about whether they can afford to take risk; and what they can afford to lose if an investment performs poorly.
- Attitude to investment risk is a subjective measure and shows how much risk a client ’feels’ they can withstand. It’s a ‘behavioural’ measurement, essentially examining whether the client is comfortable taking risk.
Measuring capacity for loss is much more fact based than attitude to investment risk, as risk is an emotional driver. However, they can’t be assessed in isolation as an adviser needs to be aware of the client’s overall objectives and financial situation.
During these challenging times, how have things changed?
At the current, highly uncertain, time for many clients in retirement, their capacity for loss has probably not changed, although for a few individuals it may have done. However, with the market volatility and economic uncertainty the pandemic has brought, capacity for loss has almost certainly become more important.
With clients’ fears at an all-time high, using an objective measure like capacity for loss can really help demonstrate to clients how they can still afford to live comfortably.
Where capacity for loss looks like it may now be an issue for some clients, it might be worth reviewing. A client’s view on what a minimum comfortable level of income is may have changed given they have less ability to spend and require lower income. They may also be able to afford to take more risk.
If a decision is taken to update a client’s capacity for loss at this time, advisers should be careful to determine that the update is appropriate and reflects a real underlying change. Advisers should also determine whether any change is temporary, reflecting the current situation, or is a more permanent change, reflecting a better understanding of a client’s capacity for loss as this could affect advice.
How to go about assessing capacity for loss
Every adviser has their own way of assessing capacity for loss, but the gold standard is perhaps a cashflow modelling analysis. Cashflow modelling offers a baseline for assessing how changing personal circumstances could impact a client’s standard of living.
It doesn’t have to be complicated. An understanding of typical yearly income and how that may change over time could be sufficient. It can provide a picture of the client’s income stream and expenditure, as well as useful data about how a market downturn could affect their standard of living. But cashflow modelling can be time-consuming and not every client will want the expense that comes with carrying out a deep-dive into their full financial background.
Assess capacity for loss with our updated guide
Our updated Assessing capacity for loss guide (PDF, 871 KB) suggests a variety of ways to assess capacity for loss, which you can use alongside your own advice process and risk profiling tools. The guide:
- provides a structure to help assess capacity for loss
- helps navigate the process of assessing capacity for loss
- offers approaches to help identify conflict between risk tolerance and capacity for loss
- shares practical tools that can help in discussions with clients during the fact-find process
- gives examples of how advisers could document evidence that shows capacity for loss has been assessed alongside attitude to risk in determining suitability
- provides a template for recording client discussions which you can refer back to when making any future assessments
The benefit of pension freedoms
For clients approaching retirement, one certainty they will be looking for is a comfortable standard of living. Although it’s sometimes difficult for clients to articulate or visualise what their minimum income requirements are, these are likely to be an influencing factor in the capacity for loss and attitude to investment risk discussion.
It’s an area highlighted in our Assessing capacity for loss guide (PDF, 871 KB). For most clients, their basic needs will probably be covered by the state pension, particularly for a couple. It’s after this point where the benefit of pension freedoms comes into its own, as extra assets can be used as desired, rather than for meeting basic needs.
Capacity for loss is also topical because of the FCA’s renewed focus on pension freedoms and defined benefit (DB) transfer advice, as outlined in its recent ‘Dear CEO ’ letter sent out to adviser firms at the end of January.
In the letter, the FCA highlights its concern that clients in retirement aren’t getting good outcomes and how it wants to make sure adviser firms have robust processes in place.
The letter has only dialled up the focus on capacity for loss.
As adviser firms look to refine and enhance their processes, our updated Assessing capacity for loss guide (PDF, 871 KB) can help you put good procedures in place, a reassuring necessity in these acutely difficult times.
You can download our Assessing capacity for loss guide here (PDF, 871 KB). Speak to your usual Standard Life contact if you’d like further information.
The value of investments can go down as well as up, and could be worth less than originally invested.
The views expressed in this blog should not be regarded as financial advice.