We all know about capacity for loss. To be precise, it is set out in the Financial Conduct Authority’s rulebook – Cobs 9A.2 – which looks at businesses' obligations when assessing suitability.
The rules specifically mention that a business must obtain the necessary information regarding a client’s financial situation, including the ability to bear losses.
Arguably, capacity for loss is potentially more important than attitude to risk. To put it another way, if a client does not have the money, it does not matter how they invest.
Capacity for loss is all about whether the client is at risk of a materially detrimental effect on their standard of living, or as I prefer to say: is the client still okay if their investments drop in value?
To understand this, advisers need to understand what their client’s standard of living is, what the downside is, and the impact of that downside on their investments. That is where capacity for loss becomes quite tricky to work through. So how do you calculate this?
We have come up with four main ways you could identify capacity for loss:
- Ask the client.
- The probability of a client meeting their standard of living over time.
- Expenses being met.
- How a client’s actual assets compare to what they need.
Let us take each of these in turn.
Ask the client
Clients get asked a common question: 'What’s the maximum fall in the value of your investments that you would be happy with?' Most people, understandably, would simply answer 'none'. But even if they did try to answer, there are too many elements to this, and a client is unlikely to give a meaningful answer.
Most of the time as advisers you should not need to ask this question, directly anyway, as the fact-find, and further investigation where needed, should give you the answers you are after. But there are soft factors you can ask or tease out.
For example, is this money providing daily living expenses? Obviously, the more important the money is, the more important it is that a client has the capacity for loss. Are there financial dependents? Are emergency expenses covered? Is there anything else the client can think of that they might need this money for? If the answer to any of those questions indicates there could be a problem, you will need to do a more detailed analysis.
Probability and standard of living
Here the focus is on the chance that a client’s standard of living will be covered, even if markets performed poorly. This is where cash flow modelling comes in; taking the client’s assets, debts, income and expenses and setting the target income you are trying to achieve.
There are a few things to highlight if you use a deterministic approach, which will give a cash flow outcome based on a single scenario. This can be useful, but this kind of forecast also tends to ignore the issue of sequencing risk, particularly for income in retirement. In addition, the timing of external events or bad market outcomes can make a big difference.
