retirement planning

Profiling risk in a volatile market

It's time to talk about capacity for loss.

Recent market uncertainty has brought into sharp focus the impact of volatility on those taking retirement income and assessing individual client’s capacity for loss.

Here’s a reminder of why embedding capacity for loss into your client advice process, can play a valuable role in delivering better outcomes for your retirement income clients.

Capacity for loss has long been a focus for the regulator, with the FCA first raising the importance of assessing this in 2011 and then emphasising the importance of a having a process in place to do so six years later.

"When considering a customer's attitude to risk as part of assessing suitability, 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."

– FCA Guidance Consultation, April 2017. (GC17-04)

When devising a client investment strategy advisers are accustomed to undertaking a detailed risk-profiling process to match needs to suitable investments. Often Centralised Investment Propositions (CIPs) are utilised to create a structured process that aims to be consistent, repeatable and to deliver suitable outcomes for client segments.

Whilst this works in accumulation, retirement income needs are often more complex. This means it’s important to have a conversation about capacity for loss with clients who are approaching or already in retirement, where investment decisions will impact on the sustainability of their long-term income. This can form an important part of a Centralised Retirement Proposition (CRP) if adopted.

Capacity for loss focuses on what the impact would be if a client’s income reduces, or worse still, runs out prematurely during retirement. The implications are clearly very serious for clients, and any assessment should consider the severity of this impact which can help influence the level of risk a client feels they can take, and how secure their overall income needs to be.

Assessing whether your client’s lifestyle could withstand an income drop should take priority when providing retirement income advice. While attitude-to-risk still plays an important part in the advice process, its focus is more on a client's feelings and beliefs about investing and may not reflect their current financial situation; and is therefore more subjective. This contrasts with capacity for loss, which attempts to assess financial facts and is more objective, with a detailed analysis of a client’s expenditure (and likely expenditure) in retirement.

The starting point for assessing capacity for loss is an in-depth, comprehensive fact find, to thoroughly understand a client’s expenditure now, and their future plans.

Sterling pound symbol with magnifying glass

To objectively measure a client’s capacity for loss, detailed information about income sources and expenditure plans are required. By collecting comprehensive fact-find details, many advisers are establishing basic cash-flow models that demonstrate a breakdown of the household budget and how it will change over time. Cash-flow modelling software packages can help here by bringing the concept of capacity for loss to life for clients by demonstrating different scenarios that show the impact of events and actions on finances at different points in retirement.

One way of approaching capacity for loss is the safety first approach, which makes sure that the essentials a person needs are covered by their retirement income. This can be achieved by comparing how much secure lifetime income a client has (generally coming from three sources: occupational pension scheme, lifetime annuity or State Pension) versus how much income they need to cover the day to day essentials (items such as household bills or food).


If a client’s secure income doesn’t fully cover their essential expenditure, adopting a ‘safety first’ planning method, means consideration is given to using some of a client’s available pension fund to buy additional secure income (such as an annuity). If the client’s secure income fully covers their essential expenditure, consideration can turn to more flexible solutions, which involve more investment risk.

Important in this planning process is the annual client review, which provides an ongoing opportunity to comprehensively reassess a client’s circumstances, income and expenditure and manage any potential shortfalls in their discretionary income.

In summary, capacity for loss (and the concept of CRPs) appear to be much less embedded in our industry, but can play a valuable role in retirement income planning.  Capacity for loss should not be assessed in isolation, doing so alongside attitude to risk can help provide a more balanced view of clients’ retirement-income needs. An advice process involving both measures, as well as one that takes into account a client’s knowledge and experience of financial matters, gives context to a client's financial situation and overall objectives. 

This will help advisers recommend a package of appropriate product and investment solutions for each individual’s retirement needs.

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