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Capacity for loss and appetite for risk:
drawdown’s conundrum.
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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.
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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,
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03/2016