One of the common misconceptions our paraplanners see is that attitude to risk trumps capacity for loss, when it’s more likely to be the other way around. While a client may have the appetite for risk, they may not have the financial ability to absorb any losses that result from a higher-risk investment.
As part of the recent thematic review of retirement income advice, the FCA wrote-
“ATR is a subjective measurement of an individual’s willingness to accept risk while CFL relates to their ability to absorb losses. ATR and CFL are both key elements of risk profiling. When moving from accumulation to decumulation it is likely that the ATR and CFL for many customers will change so needs to be reassessed”
The FCA has reported that some firms are not assessing CFL for customers. Neglecting Capacity for Loss (CFL) in the decumulation phase can result in firms inaccurately pinpointing suitable income or investment-based solutions for their clients. This oversight may prompt customers to undertake excessive risk, potentially subjecting them to income reductions that exceed their ability to endure.
That’s why We Complement feels assessing capacity for loss is a vital part of many suitability reports and a concept that all paraplanners are familiar with. Read on to discover five important points you need to consider when assessing a client’s capacity for loss.
1. The Financial Conduct Authority (FCA) requires the capacity of loss to be considered
In March 2021, the FCA published its Finalised Guidance on Assessing Suitability. In it, the authority defined capacity for loss as the following:
”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.”
The statement follows the FCA’s 2017 Guidance Consultation document, which requires Advisers to consider a client’s attitude to risk as part of assessing suitability. It goes on to add that:
“The client’s capacity for loss (the client’s ability to absorb falls in the value of their investment) should also be taken into account.”
2. Several factors influence your client’s capacity for loss
When considering your client’s capacity for loss, there are many aspects of their financial situation that need to be considered carefully. These include:
- Income needs
- Present and future income sources
- Other assets
- Expected inheritances
- Time horizon before the investment will be drawn upon.
Once considered it’s vital to ensure that you make detailed notes in the fact-find.
3. There are two types of losses
Broadly speaking there are two types of loss advisers need to consider: permanent and temporary. The prospect of a client suffering a loss that they have no chance of recovering is different to a loss that they can expect to recover over time.
It’s important to assess this and understand whether the client could withstand one of these types of loss but not the other, both, or neither.
4. Understand the difference between the client’s willingness to accept risk (attitude to risk) and their ability to withstand it (capacity for loss).
While capacity for loss and attitude to risk are distinct from one another and should be assessed separately, it’s important to also consider them together. This will provide a balanced view of your client’s situation.
For example, if a client has a low capacity for loss but says they’re willing to take a high degree of risk, it’s likely that their capacity for loss will be the limiter on the solutions you recommend.
5. Cashflow modelling is a good way to determine capacity for loss
There is no single correct way to assess capacity for loss, and different advisers prefer different methods. Cashflow modelling is typically the most precise way of assessing capacity for loss, as you can calculate a loss in percentage terms and see how this interacts with your client’s cash flow forecast.
Capacity for loss questionnaires are also popular, or you could look at the client’s income requirements and how this could be affected by any loss made.
Get in touch
If you would like to discuss capacity for loss in more detail, or how we can ensure that your suitability reports stand up to scrutiny, please contact us online or call 01472 728 030.