Former Financial Conduct Authority technical specialist, Rory Percival, explains how you should assess capacity for loss
In my experience, assessing capacity for loss (CfL) is not done well enough by many firms in the sector. One of the main issues is that firms see assessing CfL as part of the adviser/client interaction – that you need to ask the client about their CfL (sometimes using the CfL section of the risk-profiling tool). These CfL sections are no good at all and should not be used.
In my opinion, you should not ask the client about their CfL as you will always get the wrong answer. It will be wrong for two reasons:
- Clients are unable to divorce their emotional response to losses (risk profile/attitude to risk) from the numbers-based issue that you are asking about (CfL).
- CfL is a complicated mathematical calculation based on income, outgoings, savings rate, future income and capital needs, flexibility in these income and capital needs, levels of pensions and investments, underlying asset classes, investment returns, etc. The client is not able to work this out in their head and give you the right answer.
In my opinion, you should not ask the client about their CfL as you will always get the wrong answer
Fact finding
So, do NOT ask the client about their CfL. Instead, ask them:
- What income do you need to maintain your standard of living? This is not just ‘heating and eating’, it includes discretionary expenditure as well. This is all the fun stuff – holidays, eating out, hobbies, etc – that make up such a significant part of their standard of living.
- How this will vary over time? Most people’s expenditure reduces gradually in retirement as they become less active (and for some, hikes up for care costs but let’s put that issue to one side for the moment).
- How much flexibility is there in this level of income before a reduction becomes material? A client who enjoys having three holidays a year might well say that if income had to be reduced temporarily and they could only afford two holidays, that this was not a material impact, but that not being able to afford any holidays for a period would be material. It is likely that many clients will not know these figures, but part of the role of an adviser is helping and educating clients about their finances, so you should be able to work through to some best estimates. These can be reassessed as part of the annual review service.
You should also be asking clients at retirement about their view on the trade-offs between flexibility (drawdown) and security (defined benefit annuity). See COBS 19.1.6(4)(b) G. This sets a series of questions around this for DB transfers cases but, given that an annuity is very similar to a DB scheme in providing a secure income for life, I would strongly suggest you take the same approach with clients at retirement with defined contribution pots too. This will help with planning your retirement income recommendations and there is another reason for this too – which I will now explain.
Assessment
The assessment of the client’s CfL then occurs at the analysis and planning stage, not by asking the client. You should stress test your recommended plan to assess whether, in adverse market conditions, there is a material impact on their standard of living. In practice, you are likely to be using cashflow planning to plot out the client’s retirement objectives. For some clients, this may not be necessary – they have so much money and, whatever happens to the markets, they will always have enough money to live on and meet their objectives. For most clients, however, you will need to stress test the plan.
If you use a deterministic cashflow planning tool, then you need to build in some stress tests. Deterministic tools use straight-line assumptions for investment returns, inflation, etc, and we know this is not how real life works. Deterministic tools usually include previous market crashes, or you could create your own version.
If you use a stochastic cashflow planning tool, then stress testing is inherent within the process to arrive at a probability-based result – an X% chance of meeting your objectives, such as not running out of money (and hence breaching the client’s CfL). But what is an acceptable percentage? It cannot always be 100% – there is always a risk whatever one does in life. Well, you are planners, what do you think?
In my opinion, 95% or more is probably fine. When you asked the client about their views on the trade-offs between security versus flexibility, if they want to be at the more secure end of the spectrum, then a higher probability percentage would be appropriate. I think lower figures – 85%, 80% and less – are running too big a risk of breaching the client’s CfL to be acceptable planning. In these scenarios, I think other planning ‘levers’ should be pulled – saving more, retiring later, working part-time for a while, scaling back objectives, etc – to make the plan work.
Summary
CfL is a really important area for firms to get right and I see too many not doing so. Make sure the assessment of CfL is at the analysis stage rather than being at the fact-finding stage. Mostly, the assessment will be by means of a cashflow plan that is stress tested and hence CfL is not a single number or score but an overall calculation.
In practice, you need to understand the client’s objectives and plan a suitable solution – and the mechanics of addressing CfL is simply the addition of stress testing the plan and hence not a major, time-consuming exercise.
Rory Percival of Rory Percival Training & Consultancy
