There has been some real nonsense talked about capacity for loss recently. Rory Percival aims to set the record straight and explain why it is, first and foremost, a planning issue rather than a regulatory one
Let’s look at what the Financial Conduct Authority (FCA) says capacity for loss (CFL) actually is. In Finalised Guidance 11/5, it stated: “By ‘capacity for loss’ we refer to the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take.”
This definition says quite explicitly and clearly that this is a planning issue for you to address in your advice process; importantly, it does not dictate to you how to give advice. So, CFL is not about the client’s feelings. That is risk profile, attitude to risk, risk tolerance, whatever you want to call it. CFL is a numbers thing; it is about affordability.
You do not need to undertake a full CFL assessment for every client. It is (mainly) about maintaining the client’s income level in retirement. Hence, in practice it only becomes an issue for clients in retirement or in the run-up to retirement, say in the last five to 10 years. Investment losses for a 40-year-old are irrelevant in the context of their retirement plans, as there is so much time for markets to recover and/or to take other actions like saving more. CFL is not a significant issue for younger clients.
Why is CFL important?
I can best describe why CFL is important by a couple of examples where the client’s CFL is breached.
Example 1: permanent loss
The client has £500,000 in a self-invested personal pension (SIPP) and reaches retirement. It is his only pension other than the state pension. He has no other significant savings or assets to live off in retirement; the pension pot is his main source of income in retirement. The advice is to put the full £500,000 in an unregulated investment. This investment subsequently goes pop and he loses all of his money and only has the state pension to live off. This has had a material impact on his standard of living. Permanently.
You do not need to undertake a full CFL assessment for every client. It is (mainly) about maintaining the client’s income level in retirement. Hence, in practice it only becomes an issue for clients in retirement or in the run-up to retirement
You may think this is terrible advice and you would be right. But it happens. I was in court last year and am doing three further legal cases this year where this is the type of thing that happened. And you will have seen plenty of cases in the press too. You might think there should be a law against it. There is – CFL. You might say it is also in breach of the client’s risk profile. True, but it is the fact that the client has been left destitute – ie it has breached their CFL – that makes us upset when we see these cases, not that the investment was not aligned with their risk profile.
Example 2: temporary loss
The client has a need for a high level of income from her drawdown plan and the advice is to withdraw 7% a year. The markets suffer a significant (temporary) fall. The adviser, in the review meeting with the client, says the client needs to reduce the income significantly, or completely, for a period until the markets recover as the high level of income coming out of a reduced drawdown pot may result in long-term irrecoverable loss. But this drawdown is the client’s main source of income and she cannot meet her standard of living at the significantly reduced rate. She asks how long this will be necessary for and the adviser can only reply that he does not know – it could be a week, a month, a year, maybe years. This has breached the client’s CFL on a temporary and indeterminate basis.
Again, you might think that it is unsustainable to recommend a 7% withdrawal rate in the first place and you would be right. There is plenty of good research about to show what sustainable withdrawal rates are, so exceeding these normally risks breaching the client’s CFL.
Taken to task
You might think these examples are poor advice and they are. But the FCA – and the Financial Ombudsman Service and the courts – need a rule to enable them to take advisers to task when they give unsuitable advice such as this. That is why it is important to have a CFL rule. Just because it is not an issue when you give good advice – having assessed CFL – and that there are other important factors to take into account such as inflation risk, does not mean that CFL is not important.
Rory Percival of Rory Percival Training & Consultancy