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The Inside Storey: Capacity for loss based on standard of living

Written by Andrew Storey | Oct 18, 2022 8:15:00 AM

In his latest blog, Andrew Storey, Propositions Director at EV, discusses the challenge of robustly measuring your clients' capacity for loss and how this can have a huge impact on their assets as part of cash flow planning if not calculated adequately.

There has been much talk about capacity for loss over the years, but not a lot has been created to help advisers robustly measure it.

I believe it can only be done objectively through a cash flow to check that the standard of living agreed with the client can be met with a high degree of probability.

Here's a step-by-step process of how I created a metric which can be used to solve exactly this capacity for loss problem.

 

Basic Capacity for loss

To understand if a standard of living is to be met, first, you must understand the level of expenses needed to meet that standard. Anything that the client considers to be key to their standard of living should be included.

You'll need to assume a period for planning since the end date isn't known for decumulation. Average life expectancy is not a good position to plan because half your clients will have run out of money and still be clients! Therefore I would tend towards a higher mortality age for this planning end age.

Capacity for loss can then be worked out by looking at the amount by which the value of the fund could drop immediately and the expenses still be met.

 

A simple example

For example, Arthur has £20k expenses a year, which don't increase, and has agreed to plan for 30 years from age 60 to 90. In a cash account without any interest or charges, he'd need £600k to maintain the standard of living.

Arthur has £1m in the bank, so he has the capacity for a reduction in the capital of £400k or 40%.

Put another way. He has £1m / £600k = 167% of the assets he needs. We call this figure asset adequacy, and it's useful to help clients understand their overall position. It needs to be over 100% to be in a good position.

We use this rather than the drop of 40% because using the drop figure makes less sense when you don't have enough money - a reduction of -20% is

 

Income tax

When money is held in a pension, you need to withdraw more as it will usually be taxed. In Arthur's case, his £20k a year would be reduced to around £18.6k a year by income tax, so he'd need to take out around £21.8k to maintain his standard of living and give him a net £20k a year income. This increases the amount needed to £652k instead of the £600k from an investment or cash. This means he only has £1m / £652k = 153% of the assets he needs.

 

Other income

The amount available will also be affected by other income, e.g., the inclusion of a state pension uses most of the personal allowance, so even more money is needed to be withdrawn each year.

Barbara is in the same position as Arthur but has £30k of expenses and a £10k state pension - so the fund still needs to provide £20k a year for 30 years like Arthur. We're ignoring inflation and increases for simplicity here.

For Barbara, because the state pension uses most of her personal allowance, she needs to take out £24k a year to meet the expenses. This means the asset adequacy is £1m / (£24k x 30) = 139% - a reduction just because of tax even though the pot of money still provides the same income level as Arthur.

 

Returns on investment

Where a client is invested and receiving returns, the value of a lump sum needed at the start can be lower as the remaining money will increase before it's used. This improves asset adequacy since the amount required at the beginning will be lower.

For example, Charlie has the same situation as Barbara but is invested with a return of 2% a year. This increase means he only needs 22.4 times the income rather than the full 30 years, so the value is £24k x 22.4 = £538k (based on a rough annuity calculation with no spouse's pension and payable in arrears). That leads to an asset adequacy of 186% - much better than Barbara’s.

 

Stochastic forecast required

The problem with understanding the current capacity for loss is that we don't know what the rates of returns will be in the future.

However, history tells us that the more risk we take, the more likely we are to have higher returns.

So if Deborah is invested, just like Charlie, but in a higher-risk fund that is expected to return 4% a year, she has improved asset adequacy to 241% because she only needs £415k to cover the expenses.

However, this takes no account of the likelihood of lower returns, too, particularly in the earlier years, so it could mean that more is required for the same expenses depending on the timing of expenses and the correlation of assets.

We need to have confidence that the expenses will be met - and for essential expenses, a level of 95% is a good target. This means looking at a wide range of returns and ensuring that in 95% of the outcomes, all expenses are met. High-risk funds can mean running out of money more quickly which is taken into account in this.

At this point in the calculations, it becomes too complex for a simple spreadsheet to deal with, so I need to reach for EVPro Goal to calculate the answer. With level expenses, a state pension increasing with RPI but starting at age 60 (to be consistent) and £1m in a pension in a mid-risk fund with no charges, the asset adequacy is 180% in this situation. This uses 1,000 market scenarios covering inflation and investment returns based on a mid-risk multi-asset fund.

 

More complex situations

There's more that also needs to be considered. If you're planning for income, an individual's income and fund values must be considered, including how they are taxed individually. Tax threshold increases are frozen until April 2026, so the net income available also depends on the level of inflation, even when the income increases with inflation.

It's very common for multiple products to be owned, all of which contain different funds, charges and potential tax treatment. Therefore, the asset level required must also consider all this.

Other sources of income don't start at the same age - the state pension in the examples above wouldn't be paid for another 7 years. In a joint life case, state pensions will also start at different ages.

Expenses aren't usually level over time - they would be expected to increase with inflation which also needs different scenarios on inflation to be considered. There can also be one-off or other time-limited expenses, such as extra holidays or a new car, that need to be considered.

Other one-off factors may be included in the plan, such as equity release or buying an annuity, which will impact the money needed.

 

Let the computer do the work

A powerful computer program must do the heavy lifting to properly identify the capacity for loss or the level of assets held compared to those needed. Using a simple calculation to work this out becomes unviable because even the simplest client situation is pretty complicated when probabilities and taxes are included.

We've spent the last 20 years creating and improving our stochastic calculation engine that can solve for the proportion that, when applied to each asset held, ensures you have a 95% probability of meeting essential expenses fully every year. This asset adequacy in the real world works for all cases, no matter how detailed or how many assets are held.

Creating a single metric with this purpose allows you to keep an eye on trends for clients over time to ensure they stay on track for their standard of living. It also provides the core robustness check for digital advice, ensuring that in the algorithm used that the plan remains able to meet the basic standard of living with a 95% chance.

 

Summary

With the current market uncertainties, capacity for loss is more important than ever. Using EVPro, we hope you can give your clients comfort that their plans will remain robust, and they will know they will be able to maintain their living standards.