In this blog, we examine the different methods that can be used to identify your clients' capacity for loss in drawdown, pointing out some of the pluses and minuses of each approach when applied individually. It’s a good time to reassess this aspect of financial planning as part of responding to the accelerating regulatory drive for client suitability.
Capacity for loss is central to suitable financial advice. But what does the term mean specifically?
The FCA defines capacity for loss in COBS 9A.2 as a “client's ability to bear losses”. It specified in its April 2017 Guidance Consultation on the Financial Advice Market Review: “If any loss of capital would have a materially detrimental effect on [the client’s] standard of living, this should be taken into account in assessing the risk that they are able to take”. In plain English, this means that the adviser needs to evaluate how reliant the client is on their investments for income or capital growth and whether they would still be able to live comfortably if their investments significantly fall in value. It is a key consideration when deciding the amount of investment risk the client can take.
To assess this properly, you need to take several factors into consideration – the client’s desired standard of living, whether their investments are central to delivering that standard of living and the possible downside risk to the investments.
Correctly calculating capacity for loss can be a challenge, but it’s not insurmountable if you go about it in the right way. To help this process, we’ve identified a series of questions to ask to properly assess and fully evidence the client’s capacity for loss.
A good place to start is with the client. I don’t mean simply asking them directly ‘What’s the maximum fall in the value of your investments you’d be happy with?’ Put that way, most will probably answer: ‘I’d rather there was no fall’. There are also so many factors to take into consideration, that a client attempting to put a number on it is unlikely to be particularly helpful anyway.
A different approach is to use the fact-find as the basis for a wider conversation; asking the client about different aspects of their lifestyle to help garner the necessary information. For instance, do you need this money for daily living expenses? Do you have a cash buffer to cover unexpected expenses? Do you have dependents that rely on you for money? Are your income requirements likely to change in the future? Do you have any large expenses planned? The more closely the money is linked to the client’s day-to-day life, the more crucial it is to ensure that they can cope with falls in their investments.
If the responses to any of these questions sound an alarm, you’ll want to delve deeper, with suitability foremost in mind. In this case, a good question to ask is:
An important part of assessing capacity for loss is making sure that the client will continue to enjoy a good standard of living even if markets don’t perform well.
Cash flow modelling is useful here, allowing you to take into account the client’s assets, income, debts and expenses to establish the target income they need to meet their overall expenditure. You can add in additional spending for goals and aspirations, or change the parameters for different retirement dates, for instance, bringing the financial plan to life and giving the client a clearer picture of the options for their future finances.
However, you need to be alert to the limitations of some cash flow tools.
One important factor that not all cash flow models consider is ‘dynamic correlation’. This is the risk that despite diversification, in some scenarios, all assets shift in the same direction. Dynamic correlation often occurs in crisis times, when even usually uncorrelated asset types experience falls and the benefits of diversification fly out the window.
Traditionally, bonds and equities are negatively correlated and usually seen as forming the basis of a diversified portfolio, but the current high inflation environment has seen a more frequent positive correlation of these asset classes.
There’s also the difference between deterministic and stochastic models. The former provides a cash flow outcome based on just a single scenario. While this can be useful, this type of forecast also generally overlooks sequencing risk. This is a particular issue for clients requiring income in retirement as they are likely to make more frequent withdrawals and will be more affected by falling markets reducing the value of their portfolio.
EVPro, our end-to-end financial planning tool, takes a stochastic approach to cash flow modelling, introducing some inherent randomness or uncertainty into the mix to fully test the strength of your financial plan. It helps you access the probability of meeting the client’s required expenditure every year across over 1,000 different independent market scenarios. It includes the worst-case scenario drop in essential income to show whether the base standard of living is maintained no matter what happens. For better result probability, it considers, tax charges on pensions, and whether any tax-free cash was withdrawn from each pension product. And it uses realistic annuity pricing, using results based on a yield model so the forecast of future annuity prices is accurate and consistent with other assets, unlike deterministic assumptions which tend to be based on current yields.
EVPro is the only solution that shows the probability of the plan working, taking into account the risk and reward of each asset, fund, portfolio and product as the standard output. If the probability comes out at lower than 5%, this shows that the client has no capacity for loss. On the other side of the spectrum, if the end result is 95%, then the likelihood is that expenses will be sorted. As you’d expect, the result will more often be somewhere in between these low and high points, and so a decision needs to be made on whether the level of risk is acceptable to the client.
These results, combined with the answers gleaned from the client and the data from the fact-find, provide a capacity for loss figures. However, this doesn’t show how much spare capacity there is, or how major the potential issue is.
You now know whether or not the client could sustain their standard of living, but does that mean they can pay all their expenses or none of them or somewhere in between?
Let’s take three investors who are all 60 years old, with a £500,000 pot and a target income of £16,000.
Arthur is cautious by nature and chooses to buy an annuity with his whole pot. He doesn’t have enough in any year to cover all expenses but can always meet 80% of them, even if markets fall significantly.
Now consider Dillon. He is blending an annuity with drawdown. He has a 5% chance of getting less than the target income, but even when the drawdown amount runs out he still has a residual income from the annuity and 40% of essential spending is still being met.
Ronald on the other hand wants to take the money via income drawdown. He has a 50% chance of covering 75% of his essential spending. However, with no secure income to fall back on once the drawdown amount runs out, he’ll have nothing left to cover any of his expenses going forward.
When you look at the worst-case scenario, falling markets will have more of a ‘materially detrimental effect’ on Ronald than they will on Dillon, with Arthur least impacted. By evaluating whether the client will meet their expenses, you can calculate what the worst drop is and put a number on how it will affect the client.
However, we still don’t know whether the client will have just enough money, or if there’s likely to be a bigger surplus to sort out larger issues that may crop up. This is where the final question comes into play:
Asset adequacy is the proportion of assets that a client has, compared with the assets they actually need to ensure that their expenses are settled with a sufficient probability.
To properly assess how likely your financial plan is to deliver adequate assets for the client’s needs, EVPro applies a stochastic forecast and works backwards (‘backsolving’) to specify the value you require in each product to give you sufficient probability of meeting your client's expenses.
Let’s look at two more investors, again both 60 years old with a target income of £16,000.
Marian has built up a £750,000 pot, she can cover her expenses with a more than 95% probability. Even in the worst year, 100% of her expenses would still be met. In fact, we calculate that she has 107% of the assets required to meet the target income. But what if the market falls more than 7% in a year? Although the current outlook is positive for Marian’s finances, it’s important to ensure you manage her expectations by explaining the worst-case scenario or adjusting the plan to increase her asset adequacy figure.
Jeffrey has a £1m pot and has 143% of the assets he needs to meet his income target. Even if the worst happens, he will be able to cover his expenses, which may allow him to reconsider some of his future plans.
Regularly assessing asset adequacy not only helps you to set client expectations around their future finances but also helps you keep track of whether a client’s assets remain in step with their income requirements.
Capacity for loss sits at the heart of suitability, but it’s not a one size fits all calculation. There’s no silver bullet that works across all scenarios, but by using the series of questions outlined here, you can gather the required detail to deliver an evidence-based capacity for loss answer to ensure your financial plan is suitable for the client’s needs and will deliver the best outcome for their personal circumstances.