The concept of ‘capacity for loss’ has been a key part of financial planning for years now so why does it still periodically stir up strong passions?
Recent online debates seem to be split between vocal critics and staunch defenders.
Love it or loathe it, capacity for loss is integral to today’s regulatory framework which means incorporating and evidencing it as part of the advice process.
As part of our wider compliance support for advisers we have looked closely at the rules and think it worth putting it into context.
Capacity for loss is the client’s ability to absorb falls in the value of their investment without it materially affecting their standard of living.
It is particularly – but not exclusively – relevant during retirement when a client is depending on accumulated capital to generate income, raising the possibility that sustained losses could leave them short of cash.
Pension ‘freedom’ reforms have ushered in a new era of mass market drawdown.
FCA figures show that about two thirds of pension funds entering drawdown are advised but in many cases these are modest to medium-sized, with 57 per cent of pots that are providing regular income worth less than £100,000 in 2017-18.
These ‘Middle Britain’ customers are likely to face some tough choices because they often lack the size of pension they need to meet all their needs and aspirations – an income to cover essential and discretionary expenditure, with inflation protection, and flexibility to access lump sums, and the possibility of investment growth, and some left over to pass on too.
In these cases, priorities will need to be agreed.
Those with a modest level of assets lack the capacity of wealthier individuals to bear losses and still maintain their living standards.
Capacity for loss is therefore a ‘red line’ that advisers should be able to calculate following the fact find process and then recalculate during ongoing reviews.
One method of evidencing that capacity for loss has been assessed is by separating essential spending from discretionary spending (bearing in mind that what one client feels is discretionary such as a holiday, others may see as essential).
This should be revealed while getting to know the client’s individual circumstances during the fact find.
While advisers have broad scope to choose how to structure a financial plan that will meet the client’s mix of needs, it is likely that essential spending will need to be covered by investments that have a very high probability of success with more leeway to take risks around meeting other needs.
Exactly how this is achieved will depend on each client’s circumstances and their wider asset pool, such as the wealth tied up in a home.
Essential spending may already be met by State pension and pension income from defined benefit schemes.
