A longer read.
Capacity for loss
There has been some real nonsense talked about capacity for loss (CfL) recently.
In this article I aim to set the record about what CfL is, what it isn’t, why it’s important and why it is, first and foremost, a planning issue rather than a regulatory one. But first I need to clarify a commonly-held but fundamentally incorrect understanding of the FCA’s approach to regulating financial advice. Many believe the FCA has a view on how advisers should give advice in particular situations, what type of solutions advisers should be recommending, for example, that advisers should take a safety-first approach with retirement planning. A view that there is a secret checklist of what it expects in any given situation. It doesn’t. It sets out rules that require firms to go through appropriately robust processes with a view to ensuring suitable advice is provided. It doesn’t regulate what the advice should be, but instead requires you to do your job professionally. What good advice looks like is something that is determined by the advice sector, not the FCA. This is very important. Where firms try and guess what solutions or detailed approaches the FCA expect, they are usually wrong and involve clunky and ineffective processes.
What CfL is and is not
In the context of Cfl, this means that the FCA does not have a view about how you should assess and mitigate against CfL. Let’s look at what the FCA actually says:
COBS 9.2.2R: ‘A firm must obtain from the client such information as is necessary for the firm to understand the essential facts about him and have a reasonable basis for believing … that the specific transaction to be recommended … is such that he is able financially to bear any related investment risks consistent with his investment objectives’.
So, ‘able financially to bear’. No detail about how you should do this. As I say, the FCA requires you to look at this in your planning process but doesn’t say how you should do it. You must be professional but it’s not dictating what your advice should be. Finalised Guidance FG11/5 provides more information:
In a footnote on page 3 it states ‘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.’ It doesn’t say:
· you have to ask the client what their CfL is;
· you have to calculate a specific percentage fall that is the client’s CfL (or some other score);
· you have to avoid investment risk at all costs;
· you can’t recommend a risk investment if there’s only a slight chance that investment loss will have a material impact on the client’s lifestyle;
· it’s more important than other risk factors such as risk profile, inflation etc;
· you can’t take into account other issues such as capacity not to take risk;
· you have to secure a client’s full income needs before you can recommend a risk investment;
· volatility results in permanent loss;
· CfL is about permanent loss only; or
· a full assessment needs to be undertaken for every single client
That’s a lot of things it doesn’t say but have all be attributed to the FCA’s CfL requirements. None of these apply to CfL which is just as well as they are all wrong.
The definition does, however, use the expression ‘any loss’ which, I appreciate, can be read two ways. It can mean ‘any loss at all’ or it could mean ‘any particular level of loss’. The FCA mean the latter. I can assure you of this with 100% confidence as I wrote this explanation in FG11/5! The former would mean that CfL is only relevant to people with zero CfL which doesn’t make sense.
What the explanation in FG11/5 does say is the same as my initial point; it says quite explicitly and clearly that this is a planning issue for you to address in your advice process, it doesn’t dictate to you how to give advice.
And one other thing. I thought the sector would have understood this point by now but recent media exchanges have suggested otherwise. CfL is not about the client’s feelings. That’s risk profile, attitude to risk, risk tolerance, whatever you want to call it. CfL is a numbers thing (well, mostly, see below).
OK, one more thing. You don’t 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 5 – 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 take other actions like saving more. CfL is not a significant issue for younger clients.
Why CfL is important
CfL has been called a lot of things – ‘pointless’, ‘noise’, ‘nonsense’, ‘intellectually bankrupt’, ‘horrible phrase’ and more.
The ironic thing is that the people who made these comments in practice appear to take CfL into account. Maybe they don’t understand what CfL actually means – they appear to have ascribed some of the incorrect facets listed above so maybe they misunderstand the FCA’s position.
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 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 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’s also in breach of the client’s risk profile. True, but it’s 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 wasn’t aligned with their risk profile.
Example 2: temporary loss
The client has a need for a high level of income from his drawdown plan and the advice is to withdraw 7% pa. The markets suffer a significant (temporary) fall. The adviser, in the review meeting with the client, says that 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 can’t meet her standard of living at the significantly reduced rate. She asks how long this will be necessary and the adviser can only reply that he doesn’t know, it could be a week, a month, a year, maybe years. This has breached the client’s Cfl on a temporary and indeterminant basis.
Again, you might think that it’s 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 risk breaching the client’s CfL.
You might think these examples are poor advice and they are. But the FCA – and FOS and the Courts – need a rule to enable them to take advisers to task when they give unsuitable advice such as this. That’s why it is important to have a CfL rule. Just because it’s 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, doesn’t mean that CfL is not important.
How you should assess CfL
This is not done well enough by many firms in the sector. When I was involved with the Assessing Suitability Review at the FCA, I came away with a clear view that there were two significant failings in the advice sector and the way firms approach CfL was one of them. Since leaving the FCA I haven’t seen anything to change my view on this.
One of the main issues is that firms and advisers see assessing CfL as part of the adviser/client interaction. That you need to ask the client what their capacity for loss. Many of the risk profiling tools have a separate section – usually three questions – for CfL. They include the key question ‘how much can you afford to lose without having a material impact on your standard of living?’, usually with a series of drop-down answers (‘none or very little’ etc). To be fair to the risk profiling tool providers, several have said that they don’t consider this to be all you need to do to assess CfL.
However, I would say that these are no use at all and should not be used. In my opinion, you should not ask the client this question, or what their capacity for loss is, as you will always get the wrong answer. It will be wrong for two reasons. First, clients are unable to divorce their emotional response to losses (risk profile) from the numbers-based issue that you are asking about (CfL). I have reviewed dozens and dozens of fact-finds which have the question – ‘how much can you afford to lose without having a material impact on your standard of living?’ – but get the wrong answer. Invariably – and I mean genuinely without exception – the answer given by the client and recorded on the fact-find was along the lines of ‘I wouldn’t be happy if …’. The adviser has asked about CfL but has got risk-profile based answer. Second, 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 etc. The client is not able to work this out in their head and give you the right answer.
So, step one, do NOT ask the client about their CfL. Ask them:
· What income they need to maintain their standard of living. This is not just ‘heating and eating’, it includes discretionary expenditure as well as 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. I said before that CfL is a numbers thing. There is one element where the client’s feelings are relevant too. However, this is NOT about their feelings about investment losses, it is their feelings about a reduction in their income and hence standard of living. Their feelings about what is material. A client who enjoys having three overseas holidays a year might well say that if income had to be reduced temporarily and they could only afford two overseas holidays, or three UK holidays, that this was not a material impact, but that not being able to afford any holidays for a period would be material.
It’s 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.
I have made the assumption throughout that we are referring to a client’s income needs in retirement. CfL could also apply to a capital objective, eg having enough to fund the children or grandchildren through university. There may be more flexibility with this objective and, of course, money is money whatever the source and however it is used so losses in funds designed for this purpose could be made up with other assets but then it is a case of assessing the impact on the client’s overall financial position and, in practice, the impact on their overall retirement provision.
Step two, assess the client’s CfL. The important thing is that this is not asking the client, but it is part of the analysis and planning stage. 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 cash-flow 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 cash-flow 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. You know about sequence of returns risk so if you haven’t looked at this risk as part of your planning process then I would suggest you are being negligent and, in the event of a complaint, you would lose your case with the FOS or in Court. Deterministic tools usually allow you to model previous market crashes or you could create your own version.
If you use a stochastic cash-flow planning tool then stress-testing is inherent within the process to arrive at a probability-based result – an X% chance of meeting your objectives, ie not running out of money (and hence breaching the client’s CfL). Now, what is an acceptable percentage? It can’t always be 100%, there is always a risk whatever one does in life. As others have pointed out, if you don’t some risk then you are more likely to not meet your objectives in the long term. But what percentage is acceptable in planning terms? Well, you are planners, what do you think?
In my opinion, I think 95% or more is fine. Probably 90% too although whenever I re-word this as having a one in ten chance of running out of money, I am less convinced. I think lower figures – 85%, 80% and lower is 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. You should also be asking clients about their view on the compromises between flexibility (drawdown) and security (DB, 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 guaranteed secure income for life, I would strongly suggest you take the same approach with clients at retirement with DC pots too. Where clients feel they want to be at the more secure end of the spectrum, then a higher probability percentage would be appropriate.
CfL is a really important area for firms to get right and I think – and see – too many not doing so. Although important, it is only one issue and others are important too. 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 cash-flow plan that is stress-tested and hence CfL is not a single number 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.
This piece was contributed by Rory Percival, a regulatory expert, for which we are very grateful.
For more, visit his website: www.rorypercival.co.uk
 There is one main exception to this – defined benefit transfers where it states (COBS 19.1.6G) ‘… a firm should start by assuming that a transfer … will not be suitable … [unless it] can clearly demonstrate, on contemporary evidence, that the transfer … is in the retail client’s best interests.’
15 July 2019