Why You Need To Know About Capacity-for-Loss and Its Long Term Investment Reality

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A quandary lurks at the heart of retirement planning. It hangs in the air, even when the conversation about long-term financial outcomes gets into its stride. 

If the date for our demise is unknown, how do we manage our money when future money market performance is also unknown? 

Planning for our retirement would be a lot easier if we knew how long we were going to live and how financial markets would perform. 

Know your loss limits 

What a financial adviser should bring to the discussion table, says Sheetal Dhanuka of AdviceBridge, is a nuanced understanding of their client’s capacity-for-loss.

This examines what impact a loss – temporary or permanent – might have on a client’s life.

Your capacity-for-loss depends on your financial circumstances and future goals, says Dhanuka, while your attitude to risk depends on your emotional response to losses. 

Unfortunately, the financial planning industry is notoriously poor at anticipating long-term uncertainty.

It manages these limitations and unknowables by pushing the attitude-to-risk (ATR) profile questionnaire to the fore in the planning process. A good adviser will consider both says Dhanuka.

No client should be exposed to more risk than they are willing and able to take. However, many advisers focus on ATR only, paying little attention to a client’s capacity-for-loss. Which means they may be taking more risk than they should. 

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Factors that affect your capacity-for-loss: time, the standard of living, flexibility 

  • Your own capacity-for-loss is dependent on your time horizon i.e. when you are likely to need more or less money and the level of reserves you’ve saved already
  • Your capacity-for-loss could be defined as the risk level you are able to cope with without materially impacting your standard of living, should the financial climate worsen
  • Your situation depends on your level of discretionary spending vs non-discretionary spending. That’s because you can usually reduce discretionary spending more easily without impacting your standard of living 

Live better with uncertainty 

Many people’s capacity-for-loss is a trade-off between uncertainty and their financial goals. These are always in flux and, sometimes, beyond our control. 

A client may have low capacity-for-loss today but higher in five years’ time, Dhanuka says. This is particularly relevant as a client’s portfolio is most sensitive to risk around the period they retire.

But what is controllable – or at least measurable – is knowing how much you can’t afford to lose, which merits a serious discussion.

Part of this conversation could include a shortlist on what you might want to do with your savings. Then, consider how much of your capital could be lost in real terms, without compromising these plans. 

Is your adviser using the right planning tools? 

  • Even if your financial adviser looks hard at capacity-for-loss, too many planning tools make broad-brush assumptions on how markets may perform, as well as how long you will live
  • But markets and life expectancy are not known – so planning should absorb your ability to tolerate losses without hitting your standard of living
  • AdviceBridge does the hard maths by running thousands of scenarios to simulate a wide spread of outcomes to ensure a client will have enough money if a) they live longer than expected and b) markets perform poorly

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Dipping into the money maths

When evaluating a client’s capacity-for-loss, AdviceBridge’s Tom Nielsen says it’s important to simulate a spread of possible futures involving both the uncertainty in financial markets and a client’s life expectancy.

That means you have some scenarios with a long life and poor market performance. From a financial viewpoint, this is the worst-case scenario because your wealth has to last longer.

We would look at a long life with strong market performance, plus multiple other outcomes that help us arrive at an appropriate equity allocation strategy for the client.

This spread of outcomes is the building block for a recommendation that reflects a client’s attitude to risk and, just as importantly, their ‘real world’ capacity for managing future losses. 

Timing is all – why sequencing matters a lot 

  • In a nutshell, sequencing means withdrawing money when markets are falling can be far more expensive than when markets are strong
  • For example, a client – let’s call him Mr. Jones – has £100,000 and wishes to draw £10,000 a year. For the first nine years of Mr. Jones’ retirement, the market rises 5% a year but falls 90% in year 10
  • In a second scenario the market collapses 90% in the first year then rises 5% per year until year nine. In both cases, the market is at the same place after 10 years
  • Yet for Mr. Jones, recently retired and reliant on a predictable income, the two outcomes are profoundly different, dramatically affecting his long-term financial choices
  • Unlike a client’s attitude to risk which tends not to change too much, capacity for loss can vary over your lifetime. In particular, your capacity for loss can fall significantly at the point you retire

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The matching risk to investment choice 

A client’s capacity-for-loss should be based on carefully judged risk evaluation – and a diversified portfolio that protects their standard of living whatever happens.

However, some financial planners fail to illuminate the long-term investment risk for a client, thereby adding an extra current of uncertainty to their situation.

Conversely,  a client may be directed into cash or bonds prematurely, rather than equities, despite have a very high capacity-for-loss.

The point is that these options should be scrutinised as part of the process to help a client understand why one recommendation is more suitable than another. 

Health and investment return – two key uncertainties to live with 

  • Much financial planning typically swivels between cashflow planning and our health. This tends to assume, more or less, that we know when we’re going to die. It also assumes that we know what the return on our investments will be in the future
  • Yet neither of these ‘guesstimates’ is realistic. Yes, cash flow planning can help to an extent. But in order to really understand the risk, we have to understand uncertainty and how we can best manage it – whatever happens in the future 

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Make low fees a priority 

Some of the uncertainty can be handled by focusing on fees, suggests Tom Nielsen, which means passive investment vehicles to keep costs down. Nielsen firmly recommends a globally diversified, low-cost tracker.

But the risk proportion – how much in equities and how much in bonds and cash – remains critical if long-term income is to be maintained at an acceptable level. 

If your annual income, exceeds 5-6% of your portfolio then you may struggle. If your income needs are below 3% then you are probably going to be okay – explains Nielsen

Will you meet your long-term essential needs by being invested in cash, equities or both? 

Pension ‘freedom’ is a high risk 

  • The advice environment has become particularly sensitive since George Osborne announced in the House of Commons in his 2014 March Budget, a year before the 2015 election, that ‘Pension Freedom’ had now arrived
  • While Osborne’s decision bought more ‘freedom’ and choice for how pension pots are used, it invited more risk for those little used to taking personal responsibility about their long-term investment options. A monumental decision process
  • This issue of investment risk and capacity-for-loss is further supercharged with so many force-marched into defined contribution schemes. Millions, like it or not, are now amateur investors, facing a bunch of investment choices that will profoundly affect their retirement
  • Finally, at a time when interest rates are low and the proliferation of fund choices has never been bigger. Tax and pension rules are a big factor too in retirement planning. Just one simple mistake could mean paying more tax than necessary 

Will risk or loss evaluation change? 

The fund management industry has the potential to improve risk and loss scenario information. While hindsight is useful, foresight is altogether different. 

Few fund managers offer a forward-looking view on anticipated loss scenarios should markets turn sour. However the increasing sophistication of modeling tools could help – so watch this space.

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How much do I need to pay for essentials? 

This should list not just regular expenditures like utility and mobile ‘phone bills but also family gifts and meals out. What about holidays or weekends away?

Will you need to replace your car or are you able to rely on public transport? What, in other words, is my minimum acceptable standard of living? 

Conclusion 

This capacity-for-loss examination admittedly sounds somewhat abstract. But you can boil it down to this: How looking hard at the impact of future losses could affect your life?

Such scrutiny is different from predicting the future. Yet for many people, it is a conversation they should have. 

AdviceBridge deploys the latest ‘deep learning’ techniques to run thousands of simulations to find the best financial options for you. 

This leaves our advisers free to do what they do best: protecting your long-term financial priorities leaving you to get on and enjoy your life. 

Practical steps to take now 

There are practical steps that everyone can make. For example, getting a projection of your State pension (check the HMRC Gateway; the form is BR19 and is downloadable). 

Using this service you can check how much you might need to increase your State Pension contributions and when you will get it. The current rate (January 2020) is £168.60 a week.

General FAQs

What is capacity for loss?

Capacity for loss is the amount of loss that the client can actually afford to bear and is objective. To have a low capacity for loss means that the loss of capital would have a materially detrimental effect on a client’s standard of living.

How to assess attitude to risk?

It is commonly assessed through psychometric risk-profiling techniques which take account of a client's investment experience and reaction to potential losses.

How to measure capacity for loss?

Capacity for loss is a much more scientific measurement. It assesses facts - taking the real numbers around a client's financial situation and testing them against the client's ability to absorb falls in value and the impact this will have on their standard of living.

What does capacity for loss mean vs. attitude to risk?

When assessing a client’s suitability, both need to be taken into consideration to have the full picture of a client’s circumstances. Also, whilst an individual’s attitude to risk may not necessarily change through their life cycle, their capacity to bear loss may vary more as their personal circumstances change. Attitude to risk is subjective, and capacity for loss is a financial matter of fact.