Compliance Top Tips: Capacity for loss

31 July 2021

Capacity for loss is central to the suitability of the advice being given and so has to be understood by the client, says Christian Markwick, Apricity Compliance.

Capacity for loss is something that we find many advice firms still struggle with, particularly when it comes to making sure clients fully understand what their capacity for loss actually is. All too often we see firms telling clients that they have a ‘low/medium/high’ capacity for loss, but how often do clients understand what this means to them and their financial goals?

Labelling capacity for loss in this way is hard to quantify and probably meaningless to the client. This is also completely subjective; one client’s definition of low may be another client’s high capacity for loss.

Capacity for loss is central to the suitability of the advice you are giving. This should marry up with the client’s knowledge and experience and attitude to risk.

Advisers should be aware that assessing capacity for loss is a regulatory requirement, here’s what the FCA describe capacity for loss as…

‘A firm must obtain from the client such information as is necessary for the firm to understand the essential facts… (b) is such that he is able financially to bear any related investment risks consistent with his investment objectives; …’

It’s therefore not on the nice to have’s, this assessment is a must-have.

Capacity for loss should be forward-thinking and we recommend that adviser’s approach this from the angle of ‘how would a drop in capital impact the client’s ability to sustain their lifestyle/meet their long-term financial objectives?’. It’s important to understand that while capacity for loss is important in assessing the client’s ability to meet their desired expenditure, it should also take into account any planned capital expenditures (large holidays, new cars, weddings etc).

Our view is that clients who are in drawdown or are within five years of the switch between accumulation and decumulation, should have their capacity for loss assessed in £ and/or % figures.

For example:

Your cash savings (also your emergency fund) consist of circa £70,000.

You have £150,000 invested between your ISA and GIA.

Should your partner pass away, you would be in receipt of their Defined Benefit pension which would be £15,000 per annum. This would cover the majority of the household expenditure.

Your state pension will commence when you reach age 67, this guaranteed income will meet the majority of your household expenditure of £18,000 per annum.

Your investment timeframe is the rest of your life.

At present, you could afford to lose £678,000/67% of your investable assets and still maintain your lifestyle.

When it comes to accumulation clients and capacity for loss, this should be a combination of their need to take risk and their need for income from their investments. In essence, the calculation is how much money a client needs in order to have a sustainable income of £X in retirement. This projection is calculated using a combination of contributions and anticipated returns. These figures can then be used to confirm what capacity the client has for not achieving the levels of returns and the impact it could have on the client’s objectives/needs.

For example: 

You have a desire for £30,000 per annum in retirement, which will be derived from a mixture of state and personal pensions. We have calculated that to sustain this level of income you will require a fund value in excess of £600,000. Using an anticipated growth rate of 5% per annum and your current contribution level of £20,000, your projected fund value is £750,000. We have calculated that you require a minimum growth rate of 3% in order that you reach the target fund value, meaning that you have the capacity to withstand significant losses or periods of investment underperformance.

Cashflow modelling tools can be used to generate stress test examples which allow you to identify a % that the client can afford to lose, which can then be converted to £ terms for the client. This should also help them to understand the level of risk that they can afford to be invested in.

When stress testing, a consistent approach is required at firm level and the ‘crash’ scenario numbers should be directly linked to the client’s attitude to risk and mirror any likely volatility they could experience in the recommended funds.

Apricity’s Capacity for Loss Guide can be downloaded here.

Professional Paraplanner