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For financial intermediaries only. Not approved for use with customers. Capacity for loss and appetite for risk: drawdown’s conundrum. e v i h c r A There’s been considerable debate about a client’s capacity for loss and their appetite for risk. In reality they are two distinct concepts which both need to be considered fully before a recommendation is made for a client to enter into drawdown. Capacity for loss isn’t the same as appetite for risk, but the two are closely related. Capacity for loss should be investigated before appetite for risk, for the simple reason that someone with no capacity for loss shouldn’t even consider taking on any investment risk. What is capacity for loss? Capacity for loss featured heavily in a March 2011 publication “Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection”, which was issued by the FCA’s predecessor, the FSA. The FCA describes capacity for loss as “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.” In other words: if you invest in something and it drops in value, can you withstand the fall? And if so, for how long? Measuring capacity for loss can be tricky, but it may help to consider it through the prism of retirement income. Where a client needs a consistent level of income to meet their personal minimum income requirement (MIR) in retirement, they can approach it in two ways. The first is by drawing on their invested assets, and the second is by purchasing a secure income that’s guaranteed for life – a pension annuity. Where it can be demonstrated that a client’s assets are significant and that their assets could significantly fall in value without affecting the client’s ability to draw the level of income they need, they would appear to have some capacity for loss. For example, if a client has a large drawdown fund, takes a relatively small income and has a number of other assets that could also be used to generate income if needed. However, where their assets are less substantial and there’s a risk that if, for example, a fall in the value of these assets could mean that the client could run out of money if they are reliant on drawing income directly from them, then they do not have any capacity for loss. A pension annuity will ensure that a client’s income needs are satisfied where there is no capacity for loss. In addition, it can also be used to help to deliver a secure income for those clients with greater assets, in effect helping to establish their capacity for loss. For example, if they need £12,000 annually to meet their personal minimum income requirement (PMIR), then buying an annuity to deliver this level of income could give them some capacity for loss in their other assets. It means that they could potentially tolerate a level of risk with any additional assets that they may have, knowing that their base minimum income requirement was secure. Put simply, they may not want their assets to fall in value, but they could tolerate such a fall if it happened. Call 0345 302 2287 or visit www.justadviser.com Capacity for loss and appetite for risk: drawdown’s conundrum Using a “bottom up” rather than “top down” approach to structuring retirement income may help retirees wading through multiple options. The essential outgoings that we all have today and that will continue through into retirement require a level of income that is known, stable and certain. Using a guaranteed income as a foundation offers the retiree flexibility to allocate any remainder of their pension fund as they wish, giving them an invested element with the potential for growth once they’ve carried out a detailed reassessment of their capacity for loss and attitude to risk. This middle-ground of need has been around for as long as people have been retiring. Perhaps in providing unlimited choice, the pension reforms have now made “blended” a more viable option and, in doing so, offers a solution that many retirees have been looking for without realising it. Some peoples’ appetite for risk will evaporate when the potential consequences are explained to them. We believe that this could be a contributing factor to why many people have historically chosen annuities over drawdown when it comes to taking their retirement income*, so it’s hard to see why this would change in the future. Even post pension reforms, an adviser isn’t going to recommend drawdown to someone with no appetite for risk. One without the other? So what happens when the client has a capacity for loss, but no appetite for risk? Technically they could go into drawdown because they could withstand any market volatility, but with no appetite for risk they’re unlikely to welcome the experience of watching their retirement fund fall and rise and fall and rise in value – something we’ll refer to as “retirement reflux”. The possibility of a better outcome could be outweighed by the risk of their assets falling in value – it’s a long way from the comfortable and stress-free retirement of their dreams. An annuity could offer a risk free solution for just such investors. e v i h c r A Appetite for risk Also referred to as “attitude to risk”, establishing a client’s appetite for risk is about asking how much risk they can tolerate. When asked how much risk they want to take with their pension funds, many people might say “none at all” or “as little as possible”. However, the truth of the matter might be different: once they’ve agreed their financial objectives – for example, keeping hold of their assets to pass on to their family whilst taking a sustainable income for life that keeps pace with inflation – then it might become apparent that an element of risk is not just a factor, but is in fact inevitable. It’s also proportional: the greater the need for income and capital control, the greater the level of risk that will need to be taken on. For example, someone who wants a 3% income that keeps pace with inflation clearly won’t need to assume as much risk as someone who wants a 6% income that keeps pace with inflation. If it’s established that a client does have some capacity for loss, the next step is to assess the level of risk they’re prepared to accept in order to achieve their income objectives. They need to understand that if things go well they’ll achieve their objective, but also that if things do not go well, not only will they not achieve their objective, but that they could be worse off – and in some cases, considerably so. Alternatively, a client may have an appetite for risk, but no capacity for loss – for example, if they have a pot of £60,000 and need more income than the 5-6% pa they can secure from an annuity. They could generate the income they need but it’s likely to require a higher level of investment risk, some may be prepared to accept this compromise. However, without the capacity for loss that comes from other assets, or sufficient income from other sources to meet their PMIR, the effect on their retirement could be catastrophic. The message here is very clear. If a client intends to use drawdown to deliver some or all of their income, it’s essential that capacity for loss and the appropriate appetite for risk are both present. Tony Clark Product Marketing Manager * ABI Quarterly Long-Term Business Report, 2013 Just Retirement Limited. Registered Office: Vale House, Roebuck Close, Bancroft Road, Reigate, Surrey RH2 7RU. Tel: 01737 233296. Registered in England Number 05017193. Calls may be monitored and recorded, and call charges may apply. Please contact us if you would like this document in an alternative format. Lines are open 8.30am to 5.30pm, Monday to Friday. 1311026.3 03/2016