In our new series of 'Let's Talk Retirement 2.0', we're tackling some of the most thought-provoking aspects in the challenging area of retirement income advice.
In our third episode, Christian Markwick, Head of Adviser Support at Verve Group UK, shared his insights into both the straightforward reasons, and the regulatory requirements, that make assessing capacity for loss absolutely central when planning a client's retirement income. He also shared his views on how to go about making the assessment.
Watch the webinar here if you missed the live stream.
Three legs to the stool
Deciding to retire means stepping away from the security of a regular income to face a fairly broad set of new risks. These include the risks from variable investment returns, inflation, uncertain longevity and, potentially, significant later life spending needs.
When getting to know a client who's planning to retire, three distinct aspects of their situation are fundamental and need thoughtful research before deciding how well they might cope, and therefore their best course of action: .
1. Knowledge and experience – how well they understand the risks they face
2. Attitude to risk – how psychologically capable are they to accept these risks
3. Capacity for loss – how much of a wealth buffer they have to defend them from risk impacts
To be clear
It can't be stressed enough that capacity for loss is a topic distinct from attitude to risk. It's a financial factor, not a psychological one.
Christian pointed out how common it is to see clients answering questionnaires about their capacity for loss as if it were a subjective, personal quality, similar to preferences for investment risk or investment caution. But a capacity for loss assessment is something that requires careful calculation.
How to assess capacity for loss?
The most widely adopted approach is to produce a cash flow model. This considers how a client’s retirement spending (net of their secure income) will burn through their savings – or not. When working through a retirement income model, you quantify the extent of the client’s ability to absorb risk impacts – based on your assumptions, for spending, for returns, charges, life expectancy and inflation. Of course, these assumptions need to be reasonable and thoughtfully researched.
More advanced modelling, including indicators such as stochastics, brings into play ranges of possible investment and longevity outcomes. These have the added benefit of allowing a calculated probability of good outcomes that can be explained to the client or kept on file to support the final advice and recommendations.
The new investment and regulatory landscape
With interest rates reverting towards historic levels, and with Consumer Duty requiring advisers to achieve good outcomes for clients, debate has turned to the interaction of drawdown with secure income. That's because annuity produces guaranteed income and offsets risk impacts from poor investment returns and from extreme longevity. Although much more relevant now than at the height of quantitative easing, it’s likely that drawdown remains central to retirement for clients with the wealth to demonstrate capacity for loss. It’s just that annuity now needs to be very carefully discounted first.
Further help
Christian Markwick has authored a clear and comprehensive introduction to the topic of capacity for loss which he has shared with our webinar audience. You can download it here.
What's next?
Join us for the fourth in our Let's Talk Retirement series on 1st February at 11am when I'll be discussing what’s next for Life Time Allowance (LTA) with special guest Shaun Tucker – our SIPP technical expert.
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity.
Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.