The FCA’s Thematic Review into Retirement Income Advice has triggered many conversations, and a renewed focus on ‘capacity for loss’. These conversations have exposed extensive confusion around what capacity for loss (and the related but importantly distinct ‘Risk Capacity’) really means, and the roles they each play in giving suitable advice.
There is little to no confusion that to be suitable, investment recommendations must meet the investment risk a customer is ‘willing and able to take’.
There is similarly scant confusion that a customer’s willingness refers to their risk tolerance.
(Though widespread errors in assessing risk tolerance and mistaking risk tolerance for the overall risk profile remain frustratingly common).
There is far too much confusion over what the ‘able’ bit means.
Most know it’s got something to do with ‘capacity’. The terms ‘Risk Capacity’ and ‘capacity for loss’ are both frequently heard, and often used seemingly interchangeably.
This is a major problem.
For it has contributed to:
- a lack of sufficiently robust means of measuring investors’ financial ability to take investment risk;
- the ignorance of investors’ emotional ability to take risk (their behavioural capacity); and, given (1) and (2),
- an excessive reliance on Risk Tolerance relative to Risk Capacity in the assessment of suitability, despite Risk Capacity usually playing the more important role.
To clear up the confusion, we need to consider both: a) what the regulations say (and why they say it the way they do); and b) what it is we are actually trying to do when accounting for a ‘financial ability to take investment risk’.
The most important point to note is that the two terms aren’t at odds with each other. Capacity for loss is fully contained within the broader notion of Risk Capacity. If you measure Risk Capacity, you are, by definition and by default measuring capacity for loss as a side-effect. The reverse is, however, not true.
What do the regulations say?
The FCA’s May 2011 guidance states:
"The Conduct of Business sourcebook (COBS) 9.2.1R requires a firm to take reasonable steps to ensure that a personal recommendation, or decision to trade, is suitable for its customer. COBS 9.2.2R requires firms, among other things, to take account of a customer’s preferences regarding risk taking, their risk profile and ensure they are able financially to bear any related investment risks consistent with their investment objectives. We use the expression ‘the risk a customer is willing and able to take’ in this report as a shorthand description of these elements of COBS 9.2.2.R"
The same guidance later states that:
"By ‘capacity for loss’ we refer to 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."
Note that this ‘capacity for loss’ should be ‘taken into account in assessing the risk that someone is able to take’. It is not a full measurement of the risk someone is financially able to take, but a component part of it, i.e., of the broader notion of Risk Capacity.
The FCA is also very clear that how firms take account of these various elements of suitability is up to them. As the guidance states:
"We do not prescribe how firms establish the risk a customer is willing and able to take"
This is important to remember, especially in the context of Risk Capacity / capacity for loss. Given their commitment to non-prescriptive rule-setting, the FCA must leave a fair amount open to interpretation. However, because ‘open to interpretation’ too often leads to ‘tick off everything the regulations mention, as cursorily as possible’ there’s a clear direction of travel of subsequent guidance being increasingly direct, especially when highlighting what is not acceptable.
For example: the MiFID II guidance that explicitly states the need to not merely disclose risks but to make an effort to ensure a customer understands them; and spells out that a checklist of previously owned product types is not a valid way to test knowledge and experience. It would not be at all surprising if future guidance does something similar for the ability to take risk. We look at these examples (and others) in more detail in our blog ‘MiFID II: Putting the investor first’.
This makes it necessary to look not only at what the regulations tell you to consider, but the role doing so plays in giving suitable advice.
What role does 'ability to take investment risk' play in a suitability assessment?
Taken at face value, the definition of ‘capacity for loss’ given above is clearly far too narrow a view to hold for suitable advice.
To see why, consider someone whose income covers their expenditure. They could arguably lose all their investible assets without any ‘materially detrimental effect on their standard of living’. The definition as it stands, therefore, can only really apply to investors near to, at, or post, retirement.
In response, you could naturally argue that ‘standard of living’ has to look over a longer timeframe, and that while no, losing all one’s investible assets wouldn’t affect their standard of living right now, it could affect it further down the line. So what we need to do is account for someone’s wider financial circumstances.
After all, if information about wider financial circumstances isn’t known and incorporated into recommendations, for example, the degree of insurance held, the size and likelihood of future capital injections or extractions, or the extent of emotional attachments to (usually non-investible) assets, can you give truly suitable advice?
Measuring those aspects in a robust, reliable, and repeatable, way, that clearly accounts for how they each affect an investor’s overall suitable risk level, is what a good Risk Capacity assessment does.
Moreover, the extent to which a fall in investible assets affects your standard of living in the future is dependent upon your Risk Tolerance – the less willing you are to take risk, the more a fall now means you’re less likely to catch up later. A good Risk Capacity measurement, while it needs to be designed to combine with Risk Tolerance should be calculated independently of it, something the FCA’s Retirement Thematic Review explicitly notes:
"Our published final guidance indicates that assessing [attitude to risk] and [capacity for loss] separately avoids the risk of conflating these outputs (FG11/05)."
Indeed, that final guidance states:
"We have seen instances where information such as the customer’s attitude to risk and their capacity for loss is gathered together along with information related to the term of the investment or the age of the customer and conflated into a single output. By bundling information on different factors together, the value of each distinct piece of information is potentially lost because arbitrary weightings are applied to different factors which may negate a preference or need. This can result in output that does not accurately reflect the trade-off decisions that a customer is willing or able to take. If such an approach is used, the tool, or wider suitability assessment process, needs to be capable of accounting adequately for each of the different pieces of information […] We have seen approaches to assessing the risk that the customer is willing and able to take (including where tools are used) that concentrate separately on the customer’s attitude to risk or capacity for loss and therefore avoid this conflation risk"
In addition to telling us how falls in the value of investible assets could affect someone’s current and future standard of living, the wider notion of Risk Capacity tells us the right level of risk to take with investible assets, so as to align the risks of an investor’s overall wealth with their Risk Tolerance. It provides a mathematical methodology for combining an investor’s risk tolerance and their financial circumstances in assessing the suitable risk level for that investor.
This is – one hopes obviously! – absolutely fundamental to delivering suitable advice.
The difference between Risk Capacity and Capacity for Loss
It’s worth repeating that capacity for loss is fully contained within the broader notion of Risk Capacity. If you measure Risk Capacity, you are, by definition and by default measuring capacity for loss as a side-effect. The reverse is, however, not true.
Risk Capacity functions as a more sophisticated measure of capacity for loss for both decumulating and accumulating investors.
For decumulating investors, a) the higher withdrawals are as a percentage of investible assets, b) the sooner you need them, and c) the more you really do need them, the lower your capacity to lose the capital that’s providing them. Our Risk Capacity measure takes account of every anticipated cash injection or withdrawal, accounting for their timeframes and relative priorities.
For accumulating investors (or those whose future spending is likely to be fully funded by income), their capacity for loss is technically infinite, because if you don’t need the capital to fund your lifestyle forever more, you technically have the ‘capacity’ to lose all of it.
When future spending and income are exactly in balance (accounting for size, timing, and priority of all cash flows in aggregate) then an investor’s current capacity for loss is infinite… but they could be not far away from tipping into decumulation. This is quite different from an investor with 30 years’ worth of high savings potential ahead of them, who’s much further away from tipping into decumulation. Capacity for loss is blind to this difference, but it absolutely needs to be reflected in a capacity calculation.
The further someone is from this tipping point, the higher their Risk Capacity, and the more risk they are able to take, because of their strong anticipated net savings.
Risk Capacity in detail
An intuitive way of looking at Risk Capacity is as a measure of how much you rely on your investible assets (relative to everything else you own, or will own) to fund your lifestyle. The more you rely on them, the less risk you are able to take with them.
If Risk Tolerance identifies your willingness to take risk in the long-term, Risk Capacity shows how this is influenced by where you are right now.
Though there is a lot of detail unpinning it, Risk Capacity is essentially encapsulated in a single ratio: of their overall wealth position (including future human capital and goals) to current investible assets. Your risk tolerance identifies how much risk you can take over your total wealth position. But your total wealth is different from your current investible assets. So Risk Capacity is essentially identifying how much to adjust for your current situation.
It is affected by all aspects of your financial circumstances, including your current balance sheet, and all your anticipated future cash flows (in and out). The question you need to know the answer to is: how much risk should I take with my investible assets? This is all the money you currently have available to invest, including current investments, investible pension assets, and cash savings less the amount of cash you need to keep aside for your safety buffer (usually around 3-6 months of your monthly expenditure).
The lower this ratio, the lower the capacity, since when a smaller portion of your total wealth is invested, you can take more risk with this amount. For example, big future spending needs (future liabilities) lead to a lower capacity – more goals to fund means less headroom to risk losses in the investments being used to fund them.
Any assets you have that are not part of your investible assets also increase your ability to take risk with the money you can invest. This is because, relative to investors who don’t have these assets, they provide you with some wealth buffer beyond the assets you're taking investment risk with. In case things turn south you have some ballast relative to those who don’t have any other assets to fall back on.
The key example here is those who own their own home (net of any mortgage of course). Relative to the same investor who does not have any home equity, a homeowner has an asset beyond their investments which can be drawn on if absolutely necessary. They might not want to sell their home but in the event of financial stress it provides them options (renting out, downsizing, extending mortgage, or selling). This gives them some capacity to safely take a bit more risk with their investments.
However, for most investors the main non-investible asset to consider is their human capital – the wealth that is bound up in their education, knowledge, and future earnings power.
In particular, for investors that are young, educated, and have a steady income, but haven’t yet managed to save and invest much, the overwhelming bulk of their wealth is in their future earnings power, not in their current investible assets.
Such individuals have a very high capacity to take risk with their investible assets. Their expenditure is funded from their income, and even if their investments tank, these are hardly relevant in the context of their lifetime earnings power. They should get their savings into the markets, be prepared to take high (but diversified!) risks, and wait. Over time the power of compounded returns will far outweigh any downside of the risk on their current wealth.
Risk capacity, then, can be seen as a measure of how much of your overall wealth is currently investible. If you have home equity, or human capital, or indeed any assets outside of your investible wealth, then your risk capacity goes up, giving you the financial ability to take some more risk with your investments.
Quantifying the broader notion of Risk Capacity (relative to stopping at the narrower notion of capacity for loss) not only enables a more accurate, and therefore more robustly suitable, assessment of the right level of risk for an investor to take, but also accounts for three crucial aspects of a suitability process that are often overlooked.
- Holistic risk assessment – The right level of risk to take for a set of investible assets is a subset of the right level of risk to take for an investor as a whole, accounting for all aspects of their financial situation. Risk Capacity does this by quantifying the Financial Situation and providing a methodology for combining it with an investor’s Financial Personality.
- Dynamic – Risk Capacity automatically deals with the transition from accumulation to decumulation and accounts for shifting time horizons, priorities, and sequencing risk. Unlike Risk Tolerance, which is unlikely to change much (except perhaps with major events like marriage, births and deaths), Risk Capacity is in a constant state of flux, changing with shifting goals, earnings expectations, asset valuations, and even taking out insurance; its measurement should reflect this.
- Simple, but not too simple – Risk Capacity dispenses with the unnecessary complexity of certain cash-flow approaches. It’s easy to update, or to test ‘what ifs’ and is designed to work with Risk Tolerance, not as a workaround. The elements of the calculation are likely to be updated either automatically or routinely anyway, so no, or very little, additional work should be required beyond asking investors to validate or update information captured previously.
In summary, therefore:
Focusing on Risk Capacity rather than capacity for loss doesn’t downplay the importance of capacity for loss as defined by the FCA. Far from it! It ensures that it is fully incorporated within the appropriate wider context, relevant to those at every stage of their investment journey – seamlessly covering both accumulation and decumulation, and the vital transition between them.
For more information on accurately measuring client investment suitability, please click here to read our guide online now.
Thumbnail image by John Schnobrich on Unsplash
